What happens in a cashless economy?

Cashless economy has become a buzz word especially amidst the FinTech groups and digital currency aficionados.

WHAT IS A CASHLESS ECONOMY?

A cashless economy is one where more and more people use credit cards & digital means to pay rather than with good old paper money.

It has its obvious benefits – when we don’t use cash there is no chance a pickpocket will find anything of worth in our wallet, less money is spent overall to print notes & coins, fewer chance germs and viruses have in spreading through currency notes, etc.

But we will not talk about the obvious. We will dig the surface deeper to really understand what a cashless economy has in store for us as individuals, communities and nation-states.

WHAT HAPPENS IN An all-cash-economy?

To imagine what would happen in a world where there is no cash, we need to invent a world where there is only cash and no digital currency at all. In such a world, banks will not exist – people will simply lock up cash at their home. We need to analyse and understand the characteristics of that alternate world. Through this, we will be able to better grasp the implications of a future without hard currency. And the easiest way to comprehend an alternate world where there is only hard currency is to actually look for a time in history when this was true. Fortunately, we do not have to go very far down in time to find one.

The Spanish empire of the 16th century was a raging success because of what they found in their colonies in South America (Incas empire) – An awful lot of gold and silver deposits. The Incas did not get why the Spaniards were so madly after the precious metals because they did not understand the concept of money as well as the Europeans did. Silver and gold were not just glittering metals for them, it was a store of value, a medium to exchange goods. But in spite of digging up much gold and silver, the Spanish crown defaulted on its debt 14 times between 1550 and 1700. Why was that? – because Spain failed to establish a reliable banking and credit system like the one which was starting to take shape further north at Amsterdam.

The Netherlands had the exact opposite system compared to Spain and it was flourishing. The Amsterdam Exchange Bank’s money in circulation mostly took the shape of rows of figures in the bank’s ledgers. Their money had little to no physical existence. Amsterdam’s financial system came up with the first stock market, one of the first traded options & futures markets and created credit for people who wanted it – All of this was made possible because of how little they relied on physical cash to transact.

When people switch from holding cash to depositing it in banks and transacting digitally, credit creation increases in the economy.

This credit creation is the fundamental difference between an economy with only cash and one that is cashless. A cashless economy enables financial institutions to create credit in society. And this credit increases economic activity.

If you are interested, we wrote earlier about how India is about to go through a credit revolution.

HOW DOES CREDIT WORK AND WHY IS IT SO IMPORTANT?

Check out this graph comparing the growth rate in bank deposits in India and the overall money supply. There is an almost 1:1 relationship between the two. As the growth rate in bank deposits goes down, credit growth slows down and consequently, money supply growth reduces.

ARE THERE ANY DOWNSIDES TO CREDIT AT ALL? OR IS IT A MAGIC PILL?

Turns out there are downsides to credit.

Let’s go back to Lulu Land. Do you remember the painter who borrowed 81 Lulu dollars to buy supplies? Let’s say that nobody wants their house painted anymore. On the repayment date of his loan, ‘Bank 2’ knocks on his door to collect the money. But he can’t pay. What happens then?

Bank 2 loaned him money from the deposit the farmer made. So, they can’t repay the farmer.

But the farmer needs his money to be able to buy seeds for the wheat grains he promised to deliver to the baker. So, he defaults on his promise to the baker. Without grains, the baker has nothing bake and nobody to buy his produce – he defaults on his $90 loan to Bank 1, the place you deposited your $100 in the first place. In turn, your hard-earned money is lost too.

BUT OUR CENTRAL BANKS CAN FIX THIS! HOW?

Do you see how default by a single person sets off a chain reaction in the financial system? This is called a financial contagion and causes what is so frequently referred to as liquidity stress/constraint. But central banks can step in to solve the problem and they have done so for hundreds of years. They create new money and inject it into the banks who then honour their commitments.

Read about how central banks have supported and governed the banking sector in our equity wednesday newsletter here.

But what does any of this have to do with a cashless economy?

You see, a cashless economy puts central banks and governments in a position of significant authority.

Cashless economies give central banks the power to interfere and actively moderate the monetary system by injecting or removing excess liquidity to stimulate or reduce economic activity.

There is more – a cashless state provides central banks with the ability to force you to spend money. That’s right – they can force you to spend money. How?

  • What would you do if what you want to buy today for $100, could be selling for $98 tomorrow? – You’d hold on to your money and wait.
  • What would you do if what you want to buy tomorrow for $98, could be selling for $96 the day after tomorrow? – You’d hold on to your money and wait.
  • As more and more people wait, economic activity keeps dwindling down causing further reduction in prices leading to what is referred to as a deflationary spiral.

At this stage, central banks will step in and force you to spend this money you have in your bank accounts through negative interest rates! When they charge you, say 0.5% on your bank deposits every month, you are really left with only two choices – either spend the money or withdraw it in cash. This is exactly what has been going in Japan. The country has seen deflation for well over 2 decades. Not by coincidence, Japan also has one of the highest rates of hard currency in circulation – people are hoarding it. See graph below.

Source : Bank of international settlements

And there is even more – In a cashless state, central banks can better monitor illegal transactions like bribing, money laundering and drug sales. Governments can better monitor your spending trends and crush tax evasion. Do you see why this is all such a promising value proposition for governments and reserve banks across the world? More than the PayTMs and Google pays of the world, governments and central banks want this transition to happen. They stand to benefit the most.

BUT WHAT ABOUT US?

Do we stand to gain something out of this transition to a cashless society? Sure, life is more convenient. But given all the privileges we are about to lose to our central banks and governments, is ‘convenience‘ really worth it? We don’t know yet.

There is however ONE important possibility that we need to explore. Consider this – The cost of printing a 2000 rupees note is a mere 3 rupees 54 paise. That’s it! It is not backed by gold or any other precious metal. It is worthless if the government decides to demonetise it tomorrow. Why then do we attach any value to it at all? – Simply because you believe in it, I believe in it and everyone else too. We all fully accept the words, “I promise to pay the bearer the sum of two thousand rupees” written on it. In other words, it has value NOT because it is intrinsically valuable (like a kilo of potato) but because it has value in our collective imagination, in our collective belief system. And that belief system is such a fickle thing.

A few decades from now, our collective belief system could change. It could change to believing in cryptocurrencies more than currencies backed by central banks. We might collectively decide that we will no more transact in Rupees, but only transact in Bitcoins. A virtual banking exchange might arise, and this banking exchange might end up offering higher interest rates than rupees deposits. Our world’s primary medium of exchange and reserve currency could become Facebook’s Libra and not the US dollars. And if that happens, central banks will have ABBB-SOH-LOOTLY no role to play at all in our financial lives. RBI and the US Federal Reserve can turn the lights off and go home. And, THIS scares them. So much. And therein lies a way a cashless state could provide people with the power.

Governments and central banks across the world have punished savers for well over a decade with artificially low interest rates by creating extreme amounts of new money. People whose livelihood depends on monthly interest payments have and continue to struggle. But a cashless economy opens up new possibilities for commoners like us to be able to completely change the way we store our hard-earned wealth. A cashless society offers us a way through which we can take our financial lives back under control, away from the musings of our governments and central banks if we so desire.

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