Last week, Paul Krugman offered a different reason than I had suggested for why the amount of U.S. currency in circulation has been skyrocketing. Rather than fear driven by financial uncertainty – as I argued, based on an essay by San Francisco Federal Reserve president John Williams and other research – Krugman suggested the driving factor is low interest rates.
“What has changed is that with zero interest rates, the opportunity cost of holding cash has gone way down,” Krugman wrote. “[I]t’s not fear, it’s despair: there’s nothing to invest in, so why not keep stuff under your mattress?"
It makes sense that both low interest rates and fear are driving holdings of U.S. currency - namely in the form of $100 bills - to historic levels. And the whole dynamic seems self-reinforcing, as economic uncertainty or financial duress in the world tends to push down interest rates in the United States. So, yes, as Krugman says, interest rates are probably an important factor.
But I'm not so sure they're the most important factor -- for a few reasons. For starters, a lot of the demand for U.S. currency is coming from abroad. If you’re in another country with high inflation or severe instability, one of your main concerns is going to be preserving your purchasing power. When you're worried about your local currency rapidly losing value, or getting access to your cash if your banks fails, it seems unlikely that a major factor in your decision-making will be whether you get a modestly higher return on your cash holdings in a U.S. account or investment. Many of these savers (particularly those who come by their dollars illicitly) likely don't even have access to interest-paying forms of dollar savings such as Treasury bonds or U.S. bank accounts.
About 70 percent of U.S. currency today – in the form of $100 bills – is abroad, compared to about 50 percent two decades ago, according to this landmark paper on this topic by Ruth Judson of the Federal Reserve.
And here’s a starker way of looking at it. While the total level of $100 bills outstanding in the United States has a little more than doubled over 20 years, the growth in $100 bills abroad has increased by far more.
The evidence suggests that a lot of these $100 bills are being accumulated in countries where worries about purchasing power run high. As you can see in this chart from Judson’s paper, which measures “official” shipments of currency from the United States abroad, Argentina and countries in the former Soviet Union, which have been victims of notoriously high inflation, have been the source of much of the demand for U.S. currency.
And finally, there’s the case of Canada. Like in the United States, interest rates in Canada have come down sharply in recent years. But nobody's been that hungry for Canadian currency, compared to the global pangs for U.S. bills.
The blue line is total large-denomination U.S. currency in circulation, as a percentage of nominal U.S. gross domestic product. The red line is total large denomination Canadian currency in circulation, as a percentage of nominal Canadian GDP.
You can see that demand for U.S. currency has far outpaced the growth of the U.S. economy, while demand for Canadian currency has kept par with Canadian economic growth.
But the dashed purple and green lines, with the corresponding interest rate on the Y axis, show the sharp decline in short-term interest rates, as measured by each country's three month Treasury bill.
If interest rates were the primary driver of currency demand, there should have been a much larger growth in Canadian currency.