The vast majority of the world’s central bankers are honest, hard-working, deophobic bureaucrats, with families and pets, who are trying just as hard as they can to do both well and good. Since the 2008 global financial fiasco they have endured an extraordinary torrent of criticism, only about 80 to 90 percent of which is justified. I certainly don’t wish to pile on. Still, if you simply must loathe them, along with Treasury Secretaries and Finance Ministers, there just happens to be one more reason to do so: In addition to everything else they have been doing, these fine furry creatures have also been providing a steady supply of essential, highly secure, “anonymous media of exchange” and “stores of value” for the world’s worst international criminals, tax dodgers, racketeers, and kleptocrats. I’m talking about good old-fashioned cash, the sort that comes in large bills.While more than 200 countries now issue their own banknotes, and a few innovative denizens of the global underground have recently tinkered with “e-currencies” like Bitcoin, by far the most desirable banknotes are a handful of relatively stable, internationally accepted “quasi-reserve” currencies. These include the American $100 bill, the €200 and €500 notes, and the 1,000 Swiss franc note. To a much lesser but growing extent, the paper currencies of mineral-rich First World countries like Australia and Canada now count, too.Thanks in part to the permissive policies of these “quasi-reserve” countries’ central banks and treasuries, these larger denomination bills are all freely available in highly liquid global markets. Even though big bills serve no purpose for ordinary retail transactions back home, for decades the world’s key central banks have behaved as if the international criminal class were a kind of premium customer segment whose special money-diet needs they had studied in detail. Accordingly, they happen to have issued notes in just precisely the denominations that are most convenient for international transport, safe storage, bulk payments, and anonymous, untraceable exchanges of value. Indeed, partly because “tier one” reserve currencies are so popular, central banks have recently been forced to stay on the cutting edge of anti-forgery technology in order to avoid banknote fiascos like the recent ones in South Africa and Zambia. That, in turn, has helped to perpetuate the relative demand for these “tier one” big bills.These days there is about $1.7 trillion in “hidden”, untaxed, largely offshore wealth outstanding that consists entirely of “strong currency”, high-denomination banknotes. Of this sum, about three quarters of it, some $1.3 trillion, is held by non-residents of the states issuing the notes. These big bills are almost entirely useless for the vast majority of us who pay our taxes, make our retail purchases in $10s and $20s, have bank accounts and credit cards, and don’t launder money except by accident when we leave spare change in a shirt pocket in the washer. They really only facilitate a huge volume of funny business, as well as some “mattress-money saving” behavior outside the financial system that is socially irrational. So what explains this peculiar custom?A Short History of a MisdiagnosisBefore turning to that question, let’s look at the history of this topic, because while the numbers are now larger than ever, the phenomenon itself is hardly new. As it happens, the very first analysis of this curious “big bill” demand phenomenon was my May 1976 Washington Monthly cover story. At the time I was a young graduate student in economics. In the article, I noted the extraordinary growth of demand for $100 bills outstanding relative to U.S. GDP and reported the results of a simple regression model that explained it as a function of per-capita income, tax rates, and domestic criminal activity. Other analysts soon joined in, eager to support the attribution of this phenomenon to the U.S. “underground economy”—the “informal” sector supposedly populated mainly by the small fry—small business, the self-employed, and off-the-books workers, including undocumented immigrants. In the conventional economic models of that period, still employed by many studies today, currency demand was estimated as a function of the same exclusively domestic factors that I used in my 1976 essay: tax rates, per capita GDP, proxies for domestic corruption levels, attitudes toward tax compliance, and the stringency of business regulation, among others. More than thirty years later, there is a huge literature on the supposed relationship between currency outstanding and the domestic underground economy.Unfortunately, it turns out that much of this literature is simply wrongheaded. It ignores several key facts about currency demand that have been in plain view all along, but were only really brought into relief during the 1980s and 1990s, as we paid more attention to that period’s Third World debt crisis. These included the importance of unrecorded capital flows and stocks, the key role that unstable local currencies play in the demand for international assets, and, especially, the tremendous rise of the global underground, which is to say the offshore criminal or para-criminal economy.The most important recovered “facts” about international currency demand are the following. First, most of the increased demand for “reserve” currencies since the 1970s has consisted of the aforementioned “big bills”: U.S. and Canadian $100 notes, 1,000 Swiss franc notes, and, ever since the ECB’s dubious decision in 2002 to enter this market aggressively, €100, €200, and €500 notes. Indeed, these big bills now account for at least 51 percent of all Canadian banknotes outstanding, 55 percent of all euro banknotes, 77 percent of U.S. dollars, and 92 percent of Swiss franc notes. One Federal Reserve analyst recently argued that Canada’s mix of denominations could be taken as a baseline for purposes of determining the share of American $100 bills that is offshore—on the assumption that Canadian $100s are not hoarded by foreigners. In fact, paper Canadian $100s are quite commonly held outside of Canada by wealthy investors, including Americans. For example, even though no new Canadian $100 bills have been issued since 2000, more than one million of them have never been turned in.Moreover, the demand for such big bills has been growing robustly, at 8.4 percent per year from 2002 to 2013. Unlike the demand for smaller denominations, this demand has also grown relative to GDP. This is odd, given the fact that big bills are not widely used for ordinary retail transactions even in the regular economy, let alone the informal one. In the United States, for example, 94 percent of households now have at least one bank account, 77 percent have debit cards and 72 percent have credit cards: only about 40 percent of in-store retail purchases are made with cash.1 Even in the informal sector, checks made out to cash are much more common media of exchange for merchants, gardeners, fruit-pickers, artisans, carpenters, and plumbers. Nor are most off-the-books restaurant workers taking home $100 bills. Even after allowing for underreporting, the latest U.S. consumer payments study identified a median level per household of just $78 in currency holdings, and an average level of just $274. That represents just a tiny fraction of the nearly $10,000 per household of cash implied by the latest Treasury data on U.S. currency outstanding.Third, most of the demand for big bills comes from “offshore”—not necessarily physically offshore, but from non-residents of the issuing countries. (This distinction is especially important in the case of Switzerland, where more than 90 percent of its currency outstanding is in the form of 1,000 Swiss franc notes. Much of this belongs to non-residents, but it is often in safe deposit boxes and storage vaults that remain physically in Switzerland.)The importance of the transnational factors in currency demand first became apparent in 1978, when I obtained access from the U.S. Federal Reserve to unpublished data on interregional currency flows among Federal Reserve banks. This data revealed that, since the early 1970s, banks in Florida, Texas, and Southern California had been recording multi-billion dollar surpluses of U.S. physical currency from abroad, especially in $100 bills. Those surpluses, in turn, resulted from a combination of soaring international drug traffic and the fact that private capital had begun to pour out of key heavily indebted Latin American countries like Venezuela, Mexico, Argentina, and Brazil. The early fruits of this research were several congressional hearings and articles, new reporting requirements on cash transactions with banks, and a new focus by U.S. law enforcement on the role of money-laundering in the drug trade.2Taken together, this evidence suggested that to account for the surge in big bill demand, we really had to pay attention to the relative growth of two essentially transnational pathologies of the international system since the mid-1970s: the growth of “capital flight”, “pirate banking”, and the demand for unrecorded liquid foreign wealth, much of it from the residents of developing countries; and the growth of transnational criminal activity, including the theft or diversion of public assets and the bribery of public officials.Capital flight from developing countries surged from the 1970s to the 1990s, thanks to a plethora of wasteful loans, careless privatizations in countries like Russia and Brazil, and the proliferation of unstable currencies. That helped to produce the global pirate banking industry, which helped the wealthy citizens of countries with higher tax rates, weak banking systems, uncertain domestic currencies, or risky political systems accumulate more than $21–32 trillion offshore, beyond the reach of domestic authorities. For those who could not afford to use the wealth management services provided by UBS, JPMorgan, or Citibank, “home-grown” pirate banking appeared, in which stockpiles of “big bills” in reserve currencies were accumulated as a simple alternative to setting up offshore bank accounts. Furthermore, many high-net-worth investors, especially from countries with a history of banking crises, expropriations, and political instability, also preferred to keep a share of their diversified portfolios in relatively tangible, transportable physical assets like these reserve currencies, plus gold, precious gems, and art.The other key factor in the rise of offshore currency demand has been the globalization of organized crime. Side by side with the rise of bank-assisted capital flight and tax-dodging, transnational criminal enterprise has mushroomed since the 1970s. The rise of lawlessness has been spectacular; the list of global criminal enterprises is now almost endless: illicit drugs, stolen art, forged IDs and passports, piracy and kidnapping, weapons, rare species, body parts, contraband cigarettes and CDs, illegal gambling, trade secrets, trafficked labor, and fraudulent finance, to name a few. In at least two dozen countries, criminal gangs now control whole regions, holding sway over judges, police, military, and senior officials at the national level.Almost as widespread is “kleptocracy”, the theft of public assets by public officials, and the corruption of public officials through bribes and insider deals. Big bills are frequently the preferred media of exchange for such off-the-books transactions. Indeed, it is not uncommon for leading multinational corporations, in hot pursuit of the golden opportunities that weak states offer, to rely on bribery, using a combination of direct, offshore payments in cash and other valuables, and deposits to secret bank accounts to hide their payoffs. To their credit, U.S. authorities have led the way in prosecuting this behavior, although most of the prosecutions so far seem to have involved non-U.S. companies. Other OECD countries still lag far behind; they seem to be more sympathetic to the traditional justification for foreign bribery as a competitive necessity.In any case, physical currency is of course not the only medium of exchange for criminal markets, but it is very convenient for large, one-off payments. One million dollars in $100 bills weighs just 22 pounds and can fit in a typical microwave; in 1,000 Swiss franc notes it weighs just 2 pounds; in €500 notes just 3.5 pounds. Where there is a wholesale-to-retail value chain, as in the drug industry, the prevalence of currency at the street level also makes it difficult to avoid having to “smurf” it upstream.At the wholesale level, pre-credit cards, wire transfers to shell-company bank accounts, and debit cards have lower transportation and hence transactional costs, but they are also more susceptible to snooping, identity theft, and management complexity. Most traffickers are not that financially sophisticated. Informal, relatively untraceable “hawala”-like credit and barter systems can also work in certain trusted communities, with traffic paid for by swaps of commodities or financial products. (Somalia is a good example.3) But the levels of trust required for such transactions is high. Anonymous, “digital” alternatives like Bitcoin have also arisen to serve the underground economy, although these have quickly attracted the attention of law enforcement. In a post-Snowden era, digital anonymity is at best a risky gamble.All told, therefore, so long as big bills remain freely available and widely accepted, they appear to have a very bright future in the global underground economy. Unless policymakers intervene to make currency less anonymous or much more costly to use, they are likely to retain a comparative advantage for underground savings and illicit transactions.Nearly four decades on, therefore, we have finally solved the mystery: Domestic factors alone cannot account for the “big bills” phenomenon. In 2006, the U.S. Treasury reported on a ten-year study designed to refine its anti-counterfeiting strategy. It found that more than half of all U.S. currency outstanding (in dollar totals) resided offshore, including at least 65 percent of all $100 bills. Surveys of foreign holdings of U.S. big bills for the Treasury’s International Currency Awareness Program (ICAP) also confirmed the importance of demand from emerging markets like Argentina and Russia. The latest Federal Reserve internal analysis of this issue has reconfirmed these estimates.For enthusiasts of the original “domestic underground economy” estimation technique, however, these estimates still leave room for about $1,000 per capita of unexplained $100 bill demand: about ten $100 bills per person. Personally, I don’t carry that much cash, but then I’m also not a young Wall Street bond trader.The Curious Case of Big Euro Bills What about the big bills of other currencies? In particular, as already noted, as of 2014 there are nearly $400 billion in €500 notes outstanding. I find this extraordinary. Of course, back in 2002, when first it issued euro currency, the European Central Bank might have decided not to follow the U.S. Treasury’s bad example; it might studied the literature described above, understood where the demand for large bills comes from, and refused to compete for this shady business.Instead, the ECB did something remarkable. It decided to compete more aggressively than ever for it by approving the issuance of much larger denominations than the $100 bill and the €200 and €500 notes. (If you think these notes are widely used for retail transactions in Europe, just try spending one in a shop, even in Paris.)The ECB also adopted a peculiar rule that allowed the central bank of each and every Eurozone country to decide what mix of denominations to issue. At least this rule has provided us with some interesting details about where all the €500 notes are actually ending up. Data available for cumulative net issues of €500 notes by central banks for the 2002–10 period show that Spain’s Central Bank issued nearly 20 percent of them, way above its proportion of small euro notes issues. Spain’s GDP is about 11 percent of the Eurozone total. The runners-up for issuing €500 notes were the central banks of Luxembourg (12 percent of net €500 notes issued, 0.5 percent of Eurozone GDP) and Austria (15 percent of net €500 notes issued, 3.5 percent of Eurozone GDP). These three countries accounted for more than 46 percent of all €500 notes issued (on net), by Eurozone countries during this period, countries with less than 15 percent of Eurozone GDP between them.Why do you suppose they have done this? Here’s a hint: Pay close attention to the relationship between key Spanish banks and drug-exporting countries like Mexico. I’m told that the Spanish port of Malaga is a key entrepôt for cocaine. So we may have a close parallel to the Florida currency inflows of the late 1970s. Of course, banks in Austria and Luxembourg also have important links to the global private banking industry.If we really wanted to (“we” meaning duly elected or appointed officials in Western countries), we could fix this problem rather easily, as public policy problems go. Ordinary, respectable citizens and taxpayers have little use for all these big bills. There’s no reason to provide the convenience, anonymity, and value of these big bills to the criminal community, tax evaders, payers and takers of bribes, do-it-yourself currency speculators, and any number of other ne’er-do-wells. So we should just stop printing them. If derelicts want to use currency to hide their transactions or to store value, let them take their chances with $100 trillion Zimbabwean banknotes.Ah, but U.S. Treasury Department officials know something the average citizen does not: Foreign currency demand represents a kind of interest-free loan to the United States, and specifically to the U.S. government. The value of the liability also decreases at the rate of inflation, so that a bit of “seigniorage” inheres to “tier one” central banks on the $1.2–1.3 trillion of big bills that are offshore. However true this may be, it remains downright unseemly for these institutions to be effectively subsidizing all this nefarious activity in exchange for, at most, a mess of potage worth about $20 billion per year.The fact is that big bill stocks, currently wielded for the most part by unsavory characters and mattress-money savers, actually provide us with a rare opportunity. We can boost the transnational criminal sector’s longer-term costs of operation, encourage people to have bank accounts, and administer a short term “wealth tax” to the underground economy, all through a big bill recall, in which all existing big bills would be called in and exchanged for other denominations on short notice, on pain of having to show identification.When I first suggested doing this three decades ago, it would have been relatively easy to implement; $100 bills were much less widely used then and large euro notes simply did not exist. Nor was the idea unprecedented. The United States and its allies successfully implemented something similar back in the late 1940s in order to drain black market profits in Germany.Apparently in the late 1970s, the U.S. Treasury and the Federal Reserve actually took my proposal seriously…for about five minutes. But then this idea was quietly returned to the shelf, partly because of sheer bureaucratic inertia, partly because the big banks didn’t want the hassle, partly because of seigniorage, and partly because of irrational fears that it might somehow undermine confidence in the dollar.And then, eventually, an even more unfortunate thing happened. Because the U.S. Government decided to remain a service provider to this dodgy end of the currency market, other players were tempted to join in. In particular, rather than join together in a concerted effort to attack the shadow economy, in 2002 the ECB decided to enter the fray. Once €200 and €500 notes were deployed, it became even more infeasible for the United States to launch a unilateral big bill recall on its own, because it would simply drive demand to hot-blooded players like ECB and the Swiss Central Bank.So what we have now is the reserve currency equivalent of “tax competition.” Without international cooperation, a big-bill reform would now be impossible. Without such cooperation, however, the global criminal community will continue to laugh all the way to the bank, eagerly anticipating the day when when China issues paper ¥10,000 banknotes. All told, therefore, so long as they remain freely available and widely accepted, it looks like big bills, if not e-currencies, will have a very bright future in the global underground economy. I will return to this subject again in forty years and let you know.
1See Kevin Foster et al., “The 2009 Survey of Consumer Payment Choice”, Federal Reserve Bank of Boston, 2011.2See James S. Henry, “Why the Underground Economy Is Booming”, Fortune (October 1978); Statement, “Hearings on the Underground Economy”, U.S. Congress, Joint Economic Committee (November 15, 1979); and “How to Make the Mob Miserable: The Cash Connection”, Washington Monthly (June 1980).3See Armin Rosen, “Banking on Somalia”, The American Interest (January/February 2014).