Lithuanian Free Market Institute // 17 July 2017

The European Commission has launched a legislative initiative on cash payment restrictions aimed at exploring the rationale for the introduction of upper limits on cash transactions. The Lithuanian Free Market Institute presents its position on the issue of restricting cash payments as a measure to fight against criminal activity, terrorism and the shadow economy.

1. Restrictions on payments in cash are not efficient in the fight against criminal activity and the shadow economy

Although cash is used in criminal activity and the shadow economy, restrictions on cash payments have a very limited impact on them primarily because the availability of transactions in cash is not among the causes of criminal activity and the shadow economy. Research[1] shows that people choose to engage into undeclared activity to avoid taxes and/or regulations. Cash only plays an intermediary role in providing a sufficient level of anonymity. Therefore, though restrictions on payments in cash may affect the use of the intermediary to a certain extent, they will have no effect on the primary motivation behind the shadow economy.

Cash restrictions may have an impact on illegal activity or the shadow economy only when one party of a transaction is passive, i.e. the party is not interested in and is unaware of having engaged in an unlawful activity (e.g. when a transaction in cash is not accounted for in accordance with the law and the payer is unaware of this.) However, cases of passive participation are few in number as compared to instances where both parties are willing to and are aware of their involvement in an unlawful transaction. Since active participants are consciously engaged into illegal activity, an additional restriction would not have a deterrent effect.

Nevertheless, in some cases restrictions on transactions in cash may hinder transactions. For example, cash payment restrictions might work in transactions that are legal per se, i. e. one counterpart respects the law and the other party is willing to buy a good using illegally obtained cash. Yet, two arguments should be taken into account here. Firstly, since restrictions would only apply to high value transactions, their impact will be very limited. Secondly, money would either be laundered allowing for an electronic transaction or buyers would have to find a counterpart willing to violate the law. In the first case, cash payment restrictions would pose a minor burden on illegal activities and might even broaden their scope as cash transaction that used to be legal (illegal source of money, but a legal purchase) will become illegal. Therefore, restrictions on payments in cash would have a very limited effect on criminal activity and the shadow economy, if any.

2. Restrictions or a ban on transactions in cash would have long-term negative consequences

The restriction on cash payments is the first step towards a cashless economy. Importantly, the path towards a cashless economy would entail certain risks which must be investigated and evaluated prior to limiting cash transactions.

Cash payment restrictions would limit competition between different means of payment

Competition between different means of payment is crucial for the development of the market for payments. Market participants compete with each other by providing different types of payment and trying to offer more convenient and cheaper services. Therefore, transactions in cash compete with electronic payments thus limiting the possibilities of electronic payment service providers to increase their prices.

The usefulness of cash as opposed to other means of payment should also be considered. Kari Takala and Matt Viren[2] claim that cash transactions are important for at least two reasons. First, payments in cash provide an alternative to credit and debit cards, preventing the banking industry from gaining a monopoly in pricing the use of cards. Second, cash has turned out to be extremely secure in the payment industry as there have been no large-scale payment failures due to misuse or forgery of cash. Electronic transactions, on the other hand, pose a large-scale systemic risk arising from, for example, identity theft; therefore, cash also serves as a back-up system in case of a systemic failure. Consequently, cash payment restrictions of any kind would limit the necessary competition between different types of payment, harming the consumer in the long-term.

Cash payment restrictions would increase the fragility of the financial system

Cash payment restrictions would increase the systemic risk and fragility of the financial system in the long-term. In the current system of fractional reserve banking, central banks are not the only entities that have the power to create money. Commercial banks also create money through advancing new loans in the market on top of the reserves. In fact, commercial banks in Eurozone are responsible for the creation of about 80 per cent of M2 money supply. This process of money creation by the commercial banks creates systemic risk and contributes to the fragility of the banking system. The systemic risk of the banking sector manifests itself when people lose their trust in the banking system and demand for their money in cash (bank run).

The use of cash in transactions restricts the ability of commercial banks to create money and increase the money supply independently, because banks have to provide people with cash instead of electronic money if they so desire. If people are forced to use only electronic payments, this safeguard against the creation of electronic money will become invalid. Therefore, commercial banks would create more money and increase money supply more rapidly, creating inflation and increasing the fragility of the financial system.

Conclusion

Restrictions on payments in cash would have very limited impact on illegal activities, because most of them manifest in situations where both parties are motivated to break the law. However, restrictions would hamper competition between different means of payment and contribute to the fragility of the financial sector. Moreover, while having limited effect on illegal activity and the shadow economy, they will have unintended long-term negative consequences. Therefore, restrictions on payments in cash should not be introduced as a measure against criminal activity or the shadow economy.

References

[1] Feld, L. P., and Schneider, F. (2011), Survey on the shadow economy and undeclared work in OECD countries. In F. Schneider (Ed.), Handbook on the Shadow Economy (pp. 78-131). Cheltenham, UK; Northampton, MA, USA: Edward Elgar Publishing

[2] Is Cash Used Only in the Shadow Economy? Kari Takala, Matt Viren. p. 539: http://ideas.repec.org/a/taf/intecj/v24y2010i4p525-540.html

This article was first published on the Lithuanian Free Market Institute’s website.