Physical Cash is Tail Risk Hedging

Not only physical cash should not be terminated but there should be enough around in case of an extreme event for hedging purposes. I explain below.

Lately there are signs of a push towards digital currencies mainly by the European Central Bank but also from some groups that believe these currencies free them from government control. If digital currency is issued and implemented, the next step will be termination of physical cash. There is also talk in USA and Fed has announced they are working on this area.

In my opinion it is weird the strongest argument against physical cash is that it may transmit viruses. Physical cash existed during many previous pandemics and it it not the only exchanged quantity that can transmit viruses; everything exchanged from food to merchandise can do that.

The best case in favor of never terminating physical cash is in the extreme case of a tail event such as a man made or natural Electromagnetic Pulse (EMP) that will interrupt communications for weeks or even months. Note that there are EMP weapons to be used in case of global wars. I do not expect communication networks to function in case of the low probability event of a global war. Although a global war is highly unlikely, many people make the mistake to try to rationalize why such event can never happen. But global wars can happen by accident when there are unknown unknowns.

In case of inability to exchange digital currencies, a physical store of value will be required to allow commerce to continue at the local level and avoid chaos and unrest on a global scale. The minimum amount of physical cash that should be available should be proportional to daily exchanged value for basic goods at hyperinflation price levels. Basically people need food, water and meds but the prices during a global tail event may skyrocket.

But why do people not think of tail events and especially the people at key positions? One answer is they are preoccupied with a utopian view of the future and are surrounded by “advisers” who feed then what they want to hear and never clash with them to retain their positions. Since I am no adviser to anyone in high position, I can express my opinions about physical cash without fearing of losing an adviser position and the perks that come with it.

Next, I think it is important to understand why the European Central Bank is leading the race for digital currency. What could the main reason be?

First, I remind you that Euro notes are signed by the ECB president whereas Dollars are signed by the Secretary of the Treasury. Does this mean anything? In my opinion it does. The people elect the government and the government signs banknotes empowered by people. This is not the case in Europe as the person that signs the banknotes is not part of a government.

Next, I remind you the difference in mandates: Fed has a dual primary mandate of price stability and maximum sustainable employment but ECB’s primary mandate is to achieve price stability through low inflation. There are substantial differences here and this is one reason ECB was taken to German courts when started quantitative easing in Europe. Digital currencies will make it easier to control inflation since it is easy to add/remove cash digitally based on advanced monetary models and this can be done almost instantaneously.

However, in my opinion, and this is only speculation here, the ECB push for going digital is due to fears of future exits from the union. When a country exits the union there is nothing in the treaties about the euros that remain in that country. With Brexit that was not an issue since the UK has its own currency. But suppose Italy wants to exit; what will happen to the billions of euros in the country in both physical and bank accounts? If they keep the money, it may be used as reserves to support their new currency and that will create a false impression of a successful exit but also interfere with foreign exchange policies of ECB. For example, the country that exited may be selling euros to support its currency and that could impact monetary policy in EU. Therefore, if the objective is no country should be allowed to keep currency after leaving EU, digital currency is way of achieving that.

Which takes as to the next chapter: Will digital currencies have encrypted certificates to expire if not renewed by the central bank? For example, if a country, or even state in USA, wished to separate from a union, then the currency is let to expire. This means that there is no foreign reserves left to support own currency and the separatists get a taste of the cost of independence. With physical currency this cannot be done. In addition, this cannot be done with naïve schemes such as bitcoin and other cryptocurrencies that have limited supplies and consume tremendous amounts of energy for transactions. A successful digital currency that can be used to exercise total financial control and monetary policy will be centrally generated and controlled. Note I describe the possible system, I do not express my own views about which system will be more successful for the future.

The conclusion is that having physical currency is a necessary hedge against the tail risk that comes from natural or man made disasters that could damage communication networks for an extended period of time. In my opinion digital currencies are useful but there should be strict limits on how much and in what proportion can be issued in relation to physical currencies.

About the author

Quant trader, blogger, trading book author and developer of DLPAL machine learning software. No investment advice. #trading #finance Website