The Reserve Bank of Australia yesterday put out a Research Discussion Paper containing some discussion of the nature, and estimates of the size, of the social costs of counterfeiting of Australian banknotes.

It is good to see a central bank producing research in this area, and opening it to public scrutiny.  But I question the starting point.  I wonder how confident the Reserve Bank of Australia (and perhaps more importantly, the Australian Treasury as advisers to the Treasurer) can be that the statutory monopoly on physical currency  – which is what the anti-counterfeit measures are protecting –  is itself socially beneficial?

Without that statutory monopoly (on notes in section 44 of the RBA Act, and on notes and coins in section 25 of the Reserve Bank of New Zealand Act) banks would have been likely to have gone on issuing their own notes (and perhaps coins).  New Zealand banks issued their own notes until 1934, when the first Reserve Bank of New Zealand Act prohibited them from offering that payments medium, as part of (but not a necessary part of) the establishment of a central bank in New Zealand.

If the monopoly were removed today, it is likely that private issuance would resume, and central bank notes would revert to being issued/used primarily in quite extreme crises, when there was a generalised loss of confidence in liabilities of the banks.    There is no obvious reason why, in normal times, people would be any more reluctant to hold, say, ANZ banknotes delivered from an ANZ ATM than they would be to hold an ANZ demand deposit (as they were doing just prior to withdrawing the notes through the ATM).  People happily hold notes from the (legally limited) private issuance in Scotland and Northern Ireland.

Actual and potential dishonesty poses major and pervasive costs to society.  A society in which all people were angels would be unrecognisable to us mere flawed mortals. So private note issuers would, of course, have to spend money to protect the integrity of their notes, in just the same sort of way they need to spend to ensure the integrity of both physical (eg cheques) and electronic payments media (credit and debit cards, for example).  Banks must make judgements about how much to spend, and what balance to strike between imposing liability on customers, and assuming responsibility themselves.  It isn’t obvious ex ante what balance should be struck, but they face market tests in making those choices (unlike central bank issuers).  And in a competitive market for physical currency issue we would normally expect a much greater degree of product innovation, including perhaps around security features.

The market for physical currency is highly distorted.  The RBA paper focuses on the extent to which counterfeiting discourages use of physical currency, but currency is probably already under-held and underused even if there were no counterfeiting at all.   At least two factors drive that.  First, using legislation to prohibit use of any notes other than Reserve Bank ones imposes considerable private holding and transportation costs on banks, and customers  (some portion of which probably amounts to deadweight social costs).  By contrast, own-bank notes have no material holding costs to banks.  And second, central banks choose (legislation does not force them) to offer no return on their monopoly note issue[1].

Sometimes it is argued – usually by central bankers – that the zero interest nature of monopoly central bank currency issuance represents an efficient tax (since demand appears to be fairly interest- inelastic).  But, whatever the merits of the argument might be on certain textbook assumptions, it isn’t an approach countries take in the practical design of modern tax system.  Using state-granted monopolies as a source of revenue has been somewhat frowned on in advanced economies for several centuries.

Nothing about monetary control would be jeopardised if the note monopolies were repealed.  So perhaps the RBA could be asked to have its researchers go back to their desks and start a new study on the social costs and benefits of a state currency monopoly.   It might be a small regulatory issue in its own right, but regulatory restrictions should remain on the statute books only when there is a clear continuing case for them. I doubt there is such a case for the physical currency monopolies.  Perhaps repeal of these monopoly provisions could be added to the list for the Australia government’s next “Repeal Day”?

[1] Various authors noted years ago that lotteries based on serial numbers offered one way of providing a positive expected return.

UPDATE:  Just to be clear that what is proposed here is not what is described as “free banking”.  Free banking would involve the abolition of the central bank and a shift to a model in which banks’ issuance of credit etc was constrained only by market forces.  Simply abolishing the bank note monopoly does not change how current monetary policy works, operating on the marginal cost of/return to central bank electronic liabilities  (settlement account balances).  I might come back and explore some of the free banking ideas at some stage.