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Notes for an Essay on Currency Competition and Counterfeiting

I’ve long been meaning to write something about the bearing of free banking on the problem of counterfeiting—a topic I addressed only very briefly in Theory of Free Banking. Since that time, although quite a lot has been written about the general subject of counterfeiting, hardly anything has been said about whether or not having competing banks of issue would make matters worse.

Conventional wisdom has it that having many banks of issue instead of just one makes life easier for counterfeiters. This wisdom draws heavily on the United States’ antebellum experience, while overlooking the experiences of arrangements more representative of genuine free banking, including those of Scotland between 1770 or so and 1845 and of Canada during the late 19th and early 20th century. Evidence from these other episodes points to a rather different conclusion, while suggesting that extant theoretical models of counterfeiting overlook ways in which competitive note issue can actually make counterfeiting less rather than more lucrative than it is when currency is supplied monopolistically.

I hope readers of this forum will forgive my setting forth, as a framework by which to gain a better understanding of the ways in which plural note issue bears upon the problem of counterfeiting, a very simple formal representation of a prospective counterfeiter’s anticipated profit, π. Let

π = ND – CcN – FP,

where P = g(Cc, Ca, N, D, T, B), Cc = c(Ca), F = f(N,B), Ca = d(B), and T = t(B). Here N stands for the number of counterfeits placed into circulation, D for their denomination, Cc for counterfeits’ average unit cost of production, F for the penalty or a counterfeiter incurs if caught (which may depend on the number of counterfeits he is found guilty of having uttered), P for the probability of detection, Ca for the unit cost of a genuine note, T for a note’s average “turnover” time, that is, time spent in circulation before returning to its (purported) source, and B, finally, for the number of legitimate banks of issue. The presumed derivatives are Cc’ > 0, f’(N) > 0, f’(B) < 0, g’(Cc) < 0, g’(Ca) > 0, g’(N) > 0, g’(T) > 0, g’(B) < 0, d’ > 0, and t’ < 0.

Standard treatments of the counterfeiting problem, to the extent that they allow for the possibility of plural note issue at all, have tended to treat the number of banks of issue, B, as increasing the anticipated profitability of counterfeiting by directly reducing the likelihood of prosecution, an effect allowed for here by the last element in P: this effect stems from the extra information costs that must be incurred by persons seeking to distinguish genuine from counterfeit notes as the variety of genuine notes increases. The practically exclusive emphasis upon this influence reflects the tendency of researchers to look upon antebellum U.S. experience, with its huge numbers of relatively small banks, and consequent need for “Counterfeit Detectors” to keep bankers and retailers informed of the correspondingly large numbers of known counterfeits, as representing the typical consequences of plural note issue.

As anyone who is familiar with the free banking literature, or simply with more informed writings on U.S. banking history, knows, the U.S. case was a by-product of legal restrictions, chief among which were laws prohibiting most banks from having branches, while prohibiting banking altogether in some states and territories. These circumstances turned under-banked regions into dumping grounds for the worst of the authentic banknotes from other parts of the country, while in turn creating easy opportunities for counterfeiters to add their products to an already disorienting melange.

But the U.S. experience was unique. Other plural note issue systems, like those of Scotland and Canada, involved not thousands or even hundreds but no more than a few dozen banks of issue, most of which had extensive branch networks. The number of distinct banks was small enough to allow retailers to familiarized themselves with legitimate note varieties. Yet in combination with branching it was more than large enough to provide for notes’ active redemption, that is, for their regular absorption by the clearing and settlement system, by which they were sent back to their reputed sources. In the Scottish system, for instance, it took eleven days or so for a note to return to its source after having first been paid out—a speed not so different from that for modern checks. This translated into a high annual turnover (T) of about 33. In contrast, notes of a monopoly issuer might remain in circulation for several months, if redeemable in specie. If not, they might remain afloat until too badly worn to circulate, which could mean years.

What difference does turnover make? That it matters a great deal becomes apparent as soon as one considers that in the vast majority of instances counterfeits are discovered, or at least discovered and then reported, not by members of the general public or by non-bank merchants, but by bankers themselves, and especially by the banks whose notes have been counterfeited. There are two simple reasons for this. First, the tellers at these banks are the persons best equipped to distinguish their banks’ authentic notes from even clever counterfeits. Second, they have the strongest incentives both to be on the lookout for fake notes and to report fakes that they discover instead of merely refusing them or attempting to fob them off on others. The last point is true in part because, if persons other than a bank's employees report a counterfeit of a bank’s notes, they may suffer a loss equal to the value of the reported notes. (Importantly, although this last deterrent has generally been in effect in monopolistic currency arrangements, it was sometimes absent in competitive ones.)

The significance of turnover, then, is that, the higher the rate of turnover of any bank’s notes, the greater the risk a counterfeiter faces of having, first his counterfeits, and then himself, discovered. High turnover means a greater chance that counterfeits will be detected within any given span of time, and consequently a greater chance of them being detected after a small number of transfers only, which increases the odds of their original “utterers,” and therefore the counterfeiters themselves, being caught.

A second, indirect way in which currency competition deters counterfeiting, which also has something to do with turnover, is by inducing note issuers to devote more resources to making their notes counterfeit-resistant. This follows from the fact that especially convincing counterfeits can fool even a bank’s own expert tellers, causing it to suffer losses by redeeming counterfeits. The extent of such losses will be greater, for any given volume of counterfeiting, the greater the turnover (and hence the lower the float) associated with an issuer’s currency. In the extreme case of a monopoly issuer of fiat money, which is of course never called upon to redeem its notes, the risk in question is nonexistent, and the incentive to invest in counterfeit-resistant notes is correspondingly low.

Finally, the presence or absence of competing issuers can influence would-be counterfeiters’ expected profits in at least one other way. This is by having some effect on the penalties or fines to which successfully prosecuted counterfeiters are subject. Here the difference is not so much economic as political, consisting of the fact that counterfeiting of the notes of a monopoly bank of issue has often been treated as a crime equivalent to the counterfeiting of official coin, and often, therefore, as a capital offense, whereas the counterfeiting of competitively-supplied banknotes has in contrast generally been a misdemeanor, if indeed it has been considered a crime at all.

The upshot of all this is that competition in currency can serve either as a deterrent or as a stimulus to counterfeiting. Whether it serves one way or the other depends on the importance of the “turnover” and “anti-counterfeiting investment” effects on one hand and those of “information cost” and “reduced penalty” effects on the other. Theory alone—at least the sketch of a theory considered here–therefore doesn't warrant the conventional conclusion that currency competition means more counterfeiting. The matter calls for a closer look into the historical evidence, to which I will turn in a second installment of these “notes.”