On the Nature of Physical Cash in the UK

Currently less than 3% of our medium of exchange in the UK is physical cash in the form of notes and coins. The remaining 97% plus is electronic commercial bank money. Additionally, inside the banking system and inaccessible to non-banks, is the medium of settlement – the electronic central bank money held in the commercial banks’ reserve accounts at the Bank of England (BoE.) These three forms of money are described on pages 15 & 16 of Where Does Money Come From?

At any point in time some of the cash is inside the banks’ vaults and ATMs etc., and this is usually referred to as the banks’ vault cash. Other cash is in people’s pockets, in shop tills, in private safes, under mattresses and so on. Each note or coin outside the banking system has been withdrawn previously through an ATM or over the counter from a bank account. So, despite being issued debt-free by the BoE, a public institution, and used as a medium of exchange by the public, all cash must first pass through the commercial banking system on its way into our pockets. We look in more detail at this journey.

The BoE issues new cash in response to demand from commercial banks, themselves responding to demand from bank customers. The cash is exchanged at face value for an equal amount of electronic central bank money taken from the BoE reserve account of the requesting bank, or sometimes for gilt stock owned by the bank. The commercial bank exchanges one asset for another.

The cash is printed and minted at a production cost to the BoE which is but a small fraction of its face value. The difference is a profit to the public purse and is called the seigniorage. This profit belongs by right to the state, and to pass on to HM Treasury these proceeds, the BoE creates central bank money in the Consolidated Fund, which is HM Treasury’s reserve account at the BoE. We might expect at first sight that this seigniorage, very nearly equal to the face value of the banknotes and coins recently issued, and thus to the amount deducted from the BoE reserve account of the requesting commercial bank, is passed on almost immediately to the Consolidated Fund,  but that appears not to be the case. This paper by Conall Boyle, published in Prosperity, explains the more complex reality:

Boyle shows that the sequence of cash issuances by the BoE to the commercial banks induces a related sequence of issuances of seigniorage, in the form of new electronic central bank money, into the Consolidated Fund. The first sequence drives the second but the two sequences are causally connected in a complex manner which we need not delve into for the purposes of this essay. We may say however that over time, as more cash is issued by the BoE, more seigniorage will flow to HM Treasury and that, allowing for the production costs of the BoE, the aggregates of these two sequences will tend to converge in the long term.

Another potential complication is the ‘cash in custody’ arrangement under which the physical transfer of some cash from the BoE to selected commercial banks precedes and anticipates the formal financial transfer of that cash. The commercial bank effectively safeguards the cash for its owner, the BoE, until it is needed. Again, for our purposes, an exposition of the nature of cash as a debt-free, publicly issued money supply, we may ignore this.

Pooled with other monies in the Consolidated Fund, we may think of the government then spending the seigniorage into the economy. To facilitate this, the appropriate central bank money moves from the Consolidated Fund to the BoE reserve account of the commercial bank of the governmental Department (e.g. the Department of Health) handling the associated government spending. It is an asset to that bank and, to maintain the integrity of its balance sheet, the bank creates in tandem and as a liability to itself, an equal amount of commercial bank money which it adds to the Department’s regular bank account. Thus the relevant governmental Department receives new spendable commercial bank money. Note that, like everyone else, the government uses commercial bank money to participate in the general economy – not only for its spending, but also for taxation and for borrowing by selling gilts.

Symbolically, let V, P, C and M denote respectively the aggregate quantities of physical cash held within the commercial banking system, physical cash external to the banks, electronic commercial bank money and electronic central bank money. This notation is consistent with that used in my earlier blog on the relationship between C and M.

When, as above, new cash of value N is issued by the BoE and exchanged for an equal amount of central bank money from the reserve account of a commercial bank, the values become V+N, P, C+S and M+S-N, where S is the notional seigniorage which we might associate schematically with this particular cash issuance. While, as shown by Boyle, there is in reality no specific and exact S which is in direct one-to-one relationship with N, for our purposes we may proceed as though there were. This is because over time the seigniorage aggregated into the Consolidated Fund in our idealised model will approximate ever more closely to the actual real world aggregation. Electronic central bank money (M) changes since, while the commercial bank requesting and receiving the cash loses amount N, the Treasury’s Consolidated Fund gains S, later transferred to the BoE reserve account of the bank hosting the government’s spending account. Aggregate commercial bank money (C) is increased by S, the government’s seigniorage.

Since the purpose of this essay is to demonstrate the nature of cash in the UK as a debt-free, publicly issued medium of exchange rather than to provide a detailed quantitative analysis I will make the simplification that S=N, thus ignoring the small production cost of the cash. The four quantities of money after the cash issuance then simplify to V+N, P, C+N and M.

Next suppose that the public withdraws cash of value N from the banking system. Aggregate commercial bank money is now decreased by N due to the shrinking bank balances of those taking out the cash. So, after the two events – cash issuance followed by equal cash withdrawal – the values as defined above are V, P+N, C and M. Aggregate cash outside the banking system has increased by N, while the other three quantities are as they were before the cash issuance. The overall effect is that the public has bought the new cash at par from the state using pre-existent commercial bank money which has moved from the accounts of the cash withdrawers to the commercial bank accounts of the government.

There is no new debt created by either the issuance or the withdrawal of the new cash. The state owned BoE has created the cash for free (we are approximating) and then, through the chain of events described above, the state has effectively exchanged it for some of the public’s spendable commercial bank money. The process is mediated through the commercial banking system. The total size of the medium of exchange in circulation in the economy has increased by N from P+C to P+C+N and to this extent the combination of cash issuance and withdrawal is inflationary, though only mildly so in practice.

To a very good approximation cash thus constitutes a publicly issued, debt-free money supply, albeit one that may be obtained by the public only through the privatised interface of the commercial banking system. It is as though we could access the NHS only by engaging first with profit-motivated private medicine to get a referral. Typically for business customers, banks make explicit charges for handling cash. In contrast to their debt-based commercial bank money, there is no automatic built-in profit for banks in our usage of debt-free, publicly issued cash.

As an intriguing (but unfortunately thoroughly impractical) thought experiment, suppose that we, the public, repeatedly withdraw cash and then retain and use it amongst ourselves in persistent circulation external to the banking system. As explained above, initially with each withdrawal our aggregate bank balance decreases and that of the government increases. However, as the government spends its resultant seigniorage into the economy, our aggregate bank balance is replenished. By repeating this cycle, the withdrawal of an unlimited amount of new cash is possible, at least in principle.

Taking the thought experiment arguably into the realms of fantasy, could we then build up by such iterated withdrawals a substantial debt-free, publicly issued medium of exchange, a supply of physical cash adequate to run a significant portion of our economy? Could cash backed, 100% reserve payment systems and credit unions then comprise an alternative parallel banking system which would not have to piggy-back on the existing debt-based banks? Could we thus move, at least partially, towards monetary reform, or at least demonstrate the viability of using a substantial, debt-free, publicly issued medium of exchange? For many reasons the answer is probably no, but I find that the scenario is worth thinking about.

I hope that this essay has revealed some of the desirable qualitative characteristics of our physical cash, characteristics that we money reformers would like to see true of the whole of our money supply, physical and electronic alike.