Monday, July 11, 2016

What Going Cashless Could Mean

A few months ago, news broke that the Korean government plans to eliminate coins from its money supply by 2020. However, eliminating coins is not the end goal in and of itself. The ultimate goal is to eventually also phase out paper money. However, there is no set date for that yet.

At first glance, this makes sense. More and more people are using debit cards, credit cards, various smartphone apps such as Samsung Pay and Kakao Pay, as well as virtual cryptocurrencies such as Bitcoin (though Bitcoin does not seem to have become mainstream in Korea just yet) to make financial transactions. Considering the overall social trend that we are seeing in Korea unfold before our very eyes, it is understandable when the Korean government says that eliminating coins from the overall money supply would be able to help it reduce minting costs, which is about ₩60 billion (US$52.1 million) per year.

Although it is likely that the Korean government still has a positive seigniorage rate -- the profit made by a government by issuing currency, especially the difference between the face value of coins and their production costs -- in the long term, eliminating coins would be more profitable because of inflationary pressures that devalue money.

So going cashless certainly has benefits. An added bonus that comes with the elimination of cash is that it would severely inconvenience those engaged in criminal activity. As more and more people use cards, physical or virtual, to make and/or receive payments, it would become much harder for activities like tax evasion, gambling, money laundering, terrorism financing, human trafficking, and the drugs trade to go unnoticed by the government. And in Korea's case, it would help the government to better monitor the clandestine flow of money into North Korea, which is no small matter!

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However, there is another reason, a rather big reason, that the government prefers a cashless society; and it is one that is seldom talked about by those outside of groups that focus on cryptocurrencies or economics in general. The reason is that a cashless society would make it much easier for the central bank, in Korea's case that being the Bank of Korea, in tandem with the government, to potentially impose negative interest rates.

What are Negative Interest Rates?

Central banks all over the world are tasked with maintaining a certain level of stability in each country's financial system. Among the tools that central banks possess, nothing is as powerful as their ability to increase or decrease the discount rate, which is the interest rate charged to commercial banks and other depository institutions for loans received from the central bank.

So, for example, if a central bank decreases the discount rate, which is what is typically being done around the world these days, it would make it cheaper for commercial banks to borrow money from the central bank. In turn, the commercial banks would be able to pass on those savings to their customers -- you and me -- in the form of lower interest rates charged on things like auto loans or mortgage loans.

This would compel individuals to borrow and spend more money. That way, a stagnant economy would get the boost that it needs and it might be able to stave off or perhaps even recover from a recession.

Similarly, if an economy is overheating -- witnessing dangerously high inflation rates -- the central bank will increase the discount rate, which would then have a domino effect of making it more costly for people to borrow money, which would then help to cool the economy.

At least that's the theory anyway. But what happens if the theory doesn't match reality?

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What happens if an economy doesn't experience growth despite the fact that interest rates are kept close to zero? For example, interest rates in Japan have been kept at nearly zero for more than 20 years, but it has not helped Japan to escape from its deflationary trap. When we consider the fact that much of Korea's economy was modeled after Japan's economy (see here and here for more wonkish comparison) and also take into account that, like Japan, Korea has an aging population, the possibility of falling into a decades-long deflationary trap is not an unfounded fear.

As a result, more and more governments are now flirting with an idea that was once panned as being ridiculous -- negative interest rates. Basically, it's taking the idea of imposing lower interest rates to stimulate economic growth and injecting it with steroids.

The idea is that the central bank will go all in and impose a discount rate below zero percent for commercial banks. The idea is that if a central bank imposes a discount rate of, say, -0.5%, commercial banks would be less willing to park their money in the central bank where they would be charged money for doing so. So, instead, commercial banks may prefer to lend money to each other. The theory is that when more and more money circulates among commercial banks, then banks would more willingly lend money to their customers, which would in turn help to stimulate economic growth.

Does this mean that the Average Joe/Jane will have to pay to keep money in a bank?

That is a popular argument that many have made in regards to the negative interest rate. However, I think it is unlikely that commercial banks would actually do that. People who make that argument often neglect to look deeper into the very different relationship between central banks and commercial banks and the relationship between commercial banks and their customers.

Whereas the relationship between KB Kookmin Bank and me is one that can be characterized as a business/customer relationship, the same cannot be said of the relationship between Kookmin (or insert other banks here) and the the Bank of Korea. That is because central banks act much like regulators over their respective financial industries. In other words, consent is practically non-existent in the relationship between central and commercial banks. For good or for ill, central banks make the rules and regulations and in order to stay in business, commercial banks have to obey those rules.

It goes without saying that banks hold a lot of leverage over their customers, but no matter how powerful commercial and investment banks may be, there is one power they do not possess over their customers. They have no control over their customers' choices. For example, if Bank A charges their depositors an annual fee to keep their money in their bank, those depositors will more than likely look for other banks to save their money in where they won't have to pay such a fee. And Banks B and C and D and others will only be too happy to oblige.

That is why it is unlikely that commercial banks will somehow end up cannibalizing their customer base. Especially during periods of economic slowdown, market expansion might be a more practical strategy for long-term survival than profit maximization.

However, it does not change the fact that commercial banks would still be losing money because of the negative interest rates. So, they may partially push those costs to their customers by other means such as higher overdraft fees or eliminating free account transfers. So there is a chance that regular bank depositors might end up having to pay additional hidden fees, but being directly charged for saving money in a bank account sounds like a tinfoil hat conspiracy theory.

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What does this have to do with a cashless society?

The theory behind negative interest rates is almost sound. Incentives are important and when there is no incentive to save -- in fact, if there is every incentive to spend -- people will spend more money, which would help to stimulate economic growth. However, there is a problem with the theory. It depends entirely on the assumption that human beings think and act like Homo Economicus. The problem is that Homo Economicus does not exist.

Homo Economicus is all about maximizing one's economic utility and is aware of all publicly known information and responds accordingly. So for example, if the government taxes kale at 100% but taxes candy bars at only 10%, and assuming that they are the only two things that anyone can buy and depending on the utils that Homo Economicus derives from kale and candy bars, respectively, there is a very good chance that Homo Economicus would buy only candy bars. None of that describes a typical human being.

Human beings do not possess all publicly known information. Everyone suffers from asymmetric information from one degree to another, we are all biased, and we all tend to act emotionally. And one of the most powerful emotions that dictates how people think and act is fear.

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Theoretically, a negative interest rate will drive individuals to make the necessary cost-benefit analysis and decide that spending one's money would be more profitable than saving money at zero percent interest. However, the theory discounts humans' fear of the future. Though we do not possess all publicly known information, we are a species that is aware of our own frailty and mortality. Barring any unforeseen circumstances that could potentially snuff out our lives at any given moment, we will all some day grow old. Our bodies will become weak, our minds will become feeble, and we will all die. That is ultimately why we save our money and not spend every penny that comes our way (if you do spend your money like this, STOP IT!).

Negative interest rates could potentially wreak havoc on people's retirement plans. If the interest rate is above zero, we can save our money with the full knowledge that the balance that we end up with at the time of our retirement will be greater than the principal that we started out with (assuming that our savings are not canceled out by inflation). Unlike interest rates that can be changed at will, however, assuming there is no sudden medical breakthrough that will cure everything, the aging process does not change. So even if the interest rate is at zero percent, it will not change the fact that we still have to plan for retirement. But zero percent compounded for X years is still zero. That means that in order to reach our targeted savings goal for our retirement, we need to save more money than we would have to had the interest rate been above zero.

This is one of the possible reasons that might explain the ineffectiveness of keeping interest rates low.

So especially in aging societies like Korea and Japan, it is possible that imposing negative interest rates could lead to drastic unintended consequences (not to mention the fact that lower profit margins that negative interest rates would impose on banks in general could drive a lot of smaller banks out of business, thus inadvertently exacerbating the "too big to fail" phenomenon).

So imagine what you would do if you were planning for retirement but the bank is basically telling you that it will do nothing more than simply hold your money. What would you do? The more risk averse among us would still likely keep our money in our bank accounts despite the zero percent interest. After all, the money in the banks are insured by the government. But for those who are more prone to taking risks for whatever reason, it is likely that they will pull their money out of the bank and invest it in something that will give them a greater long-term yield. That is why so many people who can afford to do so buy property (though everyone should always keep an eye out for economic bubbles).

But if enough people pulled their money out of their banks to look for greener pastures, couldn't that lead to a bank run and wouldn't that be catastrophic? Yes, it would certainly be catastrophic. But what if there were no cash to withdraw from the banks to begin with? When there is no physical money that you can hold in your hands or literally stuff under your mattress, when the only money that you can use is all digital e-money and, unlike cryptocurrencies like Bitcoin, it can all be tracked by the central bank, then you literally cannot flee from the banks. Or at least it would be really hard to do so.

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That is because it would become much easier for the government to "direct" people from deciding against "hoarding" their money upon the imposition of a negative interest rate after cash has been eliminated. To explain, in order to have better returns, individuals may desire to take their money out of their bank accounts and invest it in private asset markets such as property or what have you. However, unlike banks, other private asset markets are not guaranteed by the state, and thus not safe for investors. At least not as safe as banks. That way, there will be incentive for people who prefer safety and risk-free investments to keep their money invested in state-guaranteed banknotes, even if all of those banknotes are purely digital.

In other words, a cashless society transfers absolute control of the money supply to the central bank. Combine that with negative interest rates and the central banks have the perfect mix of ingredients necessary to incentivize spending, disincentivize savings, AND prevent bank runs that could offset the stimulative goals of the negative interest rate. Theoretically, assuming everything goes according to plan, the macroeconomic outlook will become less dire and might be a winning strategy to overcome negative economic growth. But what will that do to individuals' savings? How will this effect retirement plans?

So why not go cashless from the get go?

Like the case in Germany, though many people prefer to use other methods of payment, cash still has a special place in everyone's hearts for various reasons (see here, here, here, here, and here).

So, a sudden abandonment of cash would be met with great resistance. It would make a lot more sense to gradually acclimate the public to going cashless.

The government has stated that people will be issued special cards for them to store their e-change. For example, if someone buys ₩9,500 worth of goods and handed over a ₩10,000 note to the cashier, instead of receiving a ₩500 coin as is done right now, the cashier would digitally wire that ₩500 worth of change to the card that the customer carries. This is perfect in many ways. That is because eventually, all the change that gets digitally wired to individuals' cards will begin to accumulate over time and once that happens, that accumulated money in people's cards will be used for transactions side by side with paper money (for as long as paper money is still circulated).

This means that the continued use of e-money could be further incentivized. Doing so would just be a matter of imagination. For example, the government could provide a favorable rate environment for e-money, or by an enticing exchange rate for swapping out of paper money for e-money via credit or point systems or special offers in partnership with Korean conglomerates.

Combine that with a a steady campaign to stigmatize the use of paper money -- as has already been done throughout Europe -- and the Korean government would be able to gradually shift toward a cashless society while facing minimal resistance. It's actually quite brilliant.

What it would mean to live in a cashless society

As I mentioned earlier, a cashless society could wreak havoc on people's retirement plans. And this is no small matter especially when we take into account how much debt the average Korean household has

There are other possible outcomes that could arise from going cashless. For one thing, a cashless society would certainly reduce privacy for the average person as our money could easily be tracked, thus making it incredibly difficult to hide our money from the Tax Man. However, it is not just the government that people will have to worry about. Once e-money is "printed" by the government and administered to the general public by private financial institutes, it could become much easier for our spending habits and history to be tracked by others such as insurance companies and marketers.

As usual, the rich will still be able to benefit. They can buy anonymity via shell companies or charities. However, for average people, anonymity would be a thing of the past. However, those who would be hit most are those who currently do not have bank accounts because of poor credit scores. Once cash becomes a thing of the past and they are still barred from banks because of their poor credit scores, their lives could become much more difficult. It would not be a stretch to conclude that this could potentially exacerbate the wealth gap.

If you're rich
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Further, it could also make life miserable for those who are deemed immoral by societal standards. Take the porn industry for example. In 2014, it was reported that Chase Bank had shut down a number of bank accounts that were discovered to have been used by porn actors. Porn is already illegal in Korea and those who are apprehended are usually prosecuted to the fullest extent of the law. Pornographers may be difficult to defend, particularly if they might also peddle revenge porn. However, other possible victims of the morality police are sex workers who already face a lot of discrimination in their lives as they might get locked out of banks, too.

Also depending on how well the relevant laws are enforced, it could also make it impossible for businesses to pay people anything lower than the minimum wage. Many people might think that this is a good thing. However, it could potentially make life much harder for marginal workers as it is possible that people might not even bother to hire them at all.

However, all of those problems pale in comparison to the much bigger issue -- what if going cashless and imposing negative interest rates on top of that still do not help to spur economic growth? What happens then? That is what people should be pondering.