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On the Stabilizing Role of Cash for Societies

Categories : Cash and Crises, Cash generates security, Cash is a public good
July 22, 2022
A new paper analyses the stabilizing effect of cash on the money supply in times of crisis. It concludes that supply-driven reductions of cash in circulation (by demonetization or capital controls) destabilize the economy if electronic payment substitutes are not instantly available.
Gerhard Rösl & Franz Seitz

This post is also available in: Spanish

It is uncontroversial that there should be an adequate supply of money in the economy without any inflationary or deflationary pressure. However, it is less clear what components the money stock should consist of: Private money (usually in the form of bank deposits) and public money in the form of cash or even Central Bank Digital Currency (CBDC) in the future?

The last crises (e.g., the 2008 financial crisis, the 2020 Corona pandemic, and the war in Ukraine in 2022) have shown that a sufficient elastic supply of cash, in total and by denomination, always stabilized the economic situation. This is true worldwide, but even more so for less developed countries. The general population and especially the poor benefit if cash is available. In an IMFS Working Paper, “On the Stabilizing Role of Cash for Societies,” Gerhard Rösl and Franz Seitz focus on the stabilizing role of cash from a society-wide perspective.

The Negative Impact of Supply-Driven Reductions of Cash in Circulation

After some conceptual remarks on the importance of money for the economy in general, the paper pays special attention to the unique characteristics of cash. The Great Depression (1929–1933) and the Great Recession (2008–2009) show the devastating effects of a severe monetary contraction and how a fully elastic provision of cash can help to avoid such a situation. Central banks can help stabilize the total money supply not only in times of confidence crises but also in times of general turmoil and therefore assist in avoiding a possible economic downward spiral and vicious circle.

The authors find interesting similarities to both crises in two separate case studies, one on the demonetization in India in 2016 and the other on cash supply during various situations in Greece since 2008.

The section on India concludes that unnecessary and supply-driven cash withdrawals from circulation in a largely unbanked economy will quickly devastatingly affect the real economy. Essentially,  the Indian government achieved none of the promoted goals by this fatal experiment of an ill-prepared demonetization.

The results of the analysis of Greece concerning the cash supply by the Bank of Greece during various crises are mixed.

Cash As Public Insurance

The paper concludes that supply-driven cash withdrawals from circulation (either by demonetization or by capital controls) destabilize the economy if electronic payment substitutes are not instantly available. It turned out that cash is like a universal medicine to attenuate the economic effects of crises regardless of the type of crisis. Therefore, cash can be seen as a public insurance central banks deliver if the overall situation becomes dire. However, as there is no perfect substitute for cash due to its unique properties, from the viewpoint of society, an efficient payment mix necessarily includes cash.

The conclusions to be drawn and lessons learned from this analysis are manifold:

  1. Private electronic money (in the form of bank deposits) is no perfect substitute for cash. The particular uses of cash make this (nearly by definition) impossible.
  2. An efficient payment mix necessarily includes cash for psychological as well as economic reasons.
  3. Cash is still essential for societies due to its stabilizing role, independent of the government in place. The general population, as well as businesses, always profit from having cash available. It stabilizes non-bank liquidity in times of turmoil and consequently the general economic development if central banks provide cash in a perfectly elastic way, both in total and by denomination.
  4. Cash is part of successful crisis management as it is the physical form of the safest asset in a currency area.
  5. Cash has to function regularly to fulfill its stabilizing functions in times of crisis, implying that it should be the task of central banks to guarantee the cash infrastructure even if cash used for daily transactions declines more and more.
  6. And finally, supply-side driven problems for the cash circle should be avoided, as the experiences of the demonetization in India and cash withdrawal restrictions in Greece have unambiguously shown.

Are CBDCs an Alternative to Cash?

Currently, only cash enables private nonbanks to access central bank money. However, central banks all over the world are thinking intensively about also issuing CBDC. The reasoning of the present paper implies that such a CBDC should mirror the characteristics of cash as closely as possible. This might be difficult to attain due to a CBDC’s digital form and regulatory framework (see, e. g., offline functioning, ease of use, and anonymity).

Consequently, a co-circulation of cash and CBDC might be the preferred solution. If money might be out of circulation for whatever reasons in the future, and if there is an increasing demand for CBDC in times of crisis, the central bank should also provide it in a perfectly elastic way. Four essential questions arise in this respect: How does the concrete CBDC look like? Related to that, will there be a demand for it? Can the non-transactional demand for cash be fully transferred to a CBDC? And will a CBDC also stabilize in times of turmoil, or does it introduce new problems, e. g. financial imbalances?

This post is also available in: Spanish