I have received a lot of push back against my blog post about cash being less important than credit. I would also freely admit that the evidence on the ground during this week does not suggest a smoothly functioning credit economy. But the reason for this unfortunate situation is not that cash is essential for a functioning economy. The true reason for the difficulties that we are seeing now is something more alarming – a partial disruption of credit expansion.
Cash substitutes are not emerging because there is a legitimate fear that the creation of such substitutes could be misconstrued as facilitating money laundering. For example, based on local and global historical experience, I am quite confident that if my Institute were to issue 500 rupee tokens or IOUs, it would circulate freely as money not only among the couple of thousand people on campus but also outside the campus (within a radius of a kilometre or so). A decade or two ago, during a period of shortage of small coins, many shops and institutions did issue coupons to substitute for the coins and these circulated quite freely. Today, however, probably no institution would want to tread that path for lack of clarity on how the government would react to such a move. Employers who have not been able to pay salaries in cash are not issuing IOUs which could ameliorate the cash shortage.
I firmly believe that the government should immediately step in with a public announcement that it would not frown upon the creation of temporary cash substitutes. In times like this, cash substitutes are essential because shortages lead to hoarding and much of the cash being paid out from the banks is not entering circulation, but is being locked away for future contingencies (cash could be even scarcer tomorrow than it is today). Almost everybody that I have talked to is today targeting a cash balance that is at least twice what they were holding two weeks ago. This has been the case historically as well as described very well in, for example, Andrew, A. Piatt. “Hoarding in the Panic of 1907.” The Quarterly Journal of Economics (1908): 290-299 (sorry that is behind a paywall).
As regards the feasibility of cash substitutes, I would once again link to the Irish experience that I linked to in my previous blog post. I would in addition describe the US experience of 1907. My source for this is unfortunately behind a paywall and I can only quote some material from there. The paper that I am referring to was published in the Quarterly Journal of Economics in 1908 shortly after the crisis of 1907 (Andrew, A. Piatt. “Substitutes for Cash in the Panic of 1907.” The Quarterly Journal of Economics 22.4 (1908): 497-516) and was based on extensive primary and secondary data collection. The author states that he wrote letters “addressed to banks in all cities of 25,000 or more inhabitants” and reports having got responses from 145 out of 147 such cities (response rates to mail surveys were much higher in those days than they are now!).
... we may safely place an estimate of the total issue of substitutes for cash above 500 millions. For two months or more these devices furnished the principal means of payment for the greater part of the country, passing almost as freely as greenbacks or bank-notes from hand to hand and from one locality to another. The San Francisco certificates, for instance, circulated, not only in California, but in Nevada and in south-eastern Oregon, some reaching as far east as Philadelphia, some as far west as the Hawaiian Islands. The banks of Pittsburg, on the other hand, reported remittances of certificates and checks, in denominations ranging from $1 up, from as scattered localities as Cleveland, Cincinnati, St. Louis, Chicago, Milwaukee, Duluth, Philadelphia, Danville, Va., and Spokane.
To put that $500 million number in perspective, the total coin and paper currency in circulation in the US was only about $2,800 million and the total gold coins was only $560 million (this data is from the Federal Reserve of St. Louis). In other words, cash substitutes were almost equal to the total gold coins in circulation and almost 20% of the entire gold and paper currency.
Andrew describes many different cash substitutes, but I would quote only one: bearer cheques “payable only through the clearing house,” (this clause meant they could not be redeemed for cash but could only be converted into other cash substitutes).
Last of all among the emergency devices were the pay checks payable to bearer drawn by bank customers upon their banks in currency denominations and used in all parts of the country in payment of wages and in settlement of other commercial obligations. These checks were generally “payable only through the clearing house,” ... they were not a liability of the clearing- house association or of the bank on which they were drawn, but of the firm or corporation for whose benefit they were issued.
The pay-check system reached its largest development in Pittsburg, where during the panic some $47,000,000 were issued, much of which was in denominations of $1 and $2.
Pay checks were also issued by railroads, mining companies, manufacturers, and store-keepers in a large number of other cities. Shops and stores and places of amusement in the neighborhood of their issue generally accepted them, and it is, indeed, surprising, considering their variety, their liability to counterfeit, and their general lack of security, how little real difficulty was experienced in getting them to circulate in lieu of cash
The last paragraph in the paper about cash substitutes in general is worth quoting in full:
Most of this currency was illegal, but no one thought of prosecuting or interfering with its issuers. Much of it was subject to a 10 per cent. tax, but no one thought of collecting the tax. As practically all of it bore the words “payable only through the clearing house,” its holders could not demand payment for it in cash. In plain language it was an inconvertible paper money issued without the sanction of law, an anachronism in our time, yet necessitated by conditions for which our banking laws did not provide. During the period of apprehension, when banks were being run upon and legal money had disappeared in hoards, in default of any legal means of relief, it worked effectively and doubtless prevented multitudes of bankruptcies which otherwise would have occurred.
Markets will find solutions to most problems if the government steps out of the way. In 1907, governments in the US were willing to do precisely that. Andrew quotes several official announcements during the panic of 1907 that allowed the creation of cash substitutes. For example, the following was a letter from the Government of Indiana of October 28, 1907:
To THE INDIANA BANKS AND TRUST COMPANIES:
Gentlemen,-Your bank being solvent, should it adopt the same rule that has been adopted by the banks of Indianapolis and refuse to pay to any depositor or holder of a check only a limited amount of money in cash and settle the balance due by issuing certified checks, or drafts on correspondents, such act, in this emergency, will not be considered an act of insolvency by this department.
The same rule will apply to trust companies.
P.S.-The question of your solvency is to be determined by yourselves upon an examination of your present condition.
The question today is whether the Indian government is willing to be bold and imaginative, and allow the market to find solutions to the current problems that are beyond the power of governments to solve.