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Counterfeit Money, Who Takes the Hit?

Suppose someone produces perfect counterfeits of subway tokens and uses them to ride on the subway. Who takes the hit? Obviously the subway company because it will sell fewer tokens as a result. Its net profit will decrease by the price of the subway rides bought by those counterfeit tokens, less the cost of producing them because that reduces the number of tokens it has to produce itself.

A Counterfeit Money Scenario

Now suppose someone produces perfect counterfeits of Federal Reserve notes and spends them into circulation. Is this analogous to the scenario for counterfeit subway tokens? If so, who takes the hit? As we will see, the case of counterfeit notes is quite different and much more complex.

It is virtually impossible to produce perfect counterfeit notes, but some are good enough to circulate for long periods before they are detected. One million dollars worth of counterfeit notes would have an imperceptible effect on the economy. So let's assume an amount large enough to have a measurable effect, say five billion dollars worth. That's only about 1% of the cash in circulation, but more significantly it is about 20% of the cash that banks hold.

What Happens to the Excess Cash?

As the counterfeit notes are spent into circulation, the public will find it has more non-interest-earning cash than it wishes to hold. So it deposits the excess cash in bank accounts where it adds to vault cash, and thus increases the aggregate reserves of the banking system. Since banks don't earn interest on cash, they will swap the excess vault cash for deposits at the Fed, which they can loan in the Fed funds market or use to purchase interest-earning assets.

The Effect of Increased Bank Reserves

The increase in banking system reserves will create an imbalance in supply and demand and apply downward pressure on the Fed funds rate. In order to maintain control of that rate, the Fed will have to soak up the excess reserves by selling some of its own Treasury securities to the public. Thus one effect of the perfect counterfeit notes is to increase the public's holding of Treasury securities. That in turn will increase the interest payments due to the public from the Treasury.

Does the government therefore take the hit? No, that implies the government is a profit-seeking enterprise, no different in that respect from the subway company. The government has no need to seek a profit in its own currency. In fact the government must issue enough of its currency to ensure the liquidity of the banking system. The Fed is the source of the currency, and Treasury operations simply recycle what the Fed has previously issued.

Recycling the Currency

The Treasury recaptures the money it spends through taxes and the sale of bonds. Both must be paid in currency or its equivalent in bank deposits at the Fed. By widely enforcing tax collection, the government insures that its currency will be in demand and valued by the private sector. If there is a shortfall in tax revenues, the Treasury can borrow back its deficit spending because the private sector will always prefer to hold interest-earning securities rather than the cash that exceeds its current needs.

Where Some Go Astray

In a primitive all-cash economy, counterfeiting would indeed increase the cash in circulation and dilute its value. But modern economies operate mainly on bank-issued credit, not cash. Most of the money changing hands involves payment by check or by wire transfer, as in credit card systems. When the private sector has more non-interest-earning cash than it wishes to hold, the Fed will swap Treasury securities from its own portfolio for the excess cash.

The basic monetary function of the Treasury is to balance inflow from taxes and bond sales against outflow due to spending. The increase in interest payments that results from counterfeiting will therefore have to be matched by increased tax revenues, more borrowing, or reduced spending. Ultimately it is the taxpayer who takes the hit, and in particular those who pay the bulk of the taxes.

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