In the UK, Like America, Cash is King—of the Growing Shadow Economy

In an age of digital transactions, demand for British banknotes and coins continues to grow to satisfy off-the-books work.

Americans are not alone in hoarding old-fashioned cash and in their taste for using the stuff for under-the-table transactions beyond the reach of intrusive officials. Britons, it turns out, love their notes and coins just as much, and for the same reason: the untraceable anonymity the stuff offers. In fact, even as we supposedly enter a digital age of payment apps and electronic transactions, the demand for banknotes continues to increase. That's almost certainly because the portion of the economy taking place of the books is growing, driven by taxes and regulations.

Perhaps unsurprisingly, the increasingly popular "solution" to the situation does not feature any changes to the policies driving people to hide their activities.

What's impressive about the latest estimates of cash circulating in the U.K.'s underground economy is that they're from the Bank of England–the U.K.'s central bank. Official U.S. sources have published papers on off-the-books activity, but an occasional moan about tax evasion is the closest a government institution in the country born out of smuggling and tax revolt has come to admitting that there's a whole lot of greenbacks stuffed under the nation's mattresses. The best American numbers on the subject come from Edgar L. Feige, an emeritus professor of economics at the University of Wisconsin–Madison. His research suggests that domestic holdings of cash dollars add up to $2,300 for every man, woman, and child in the country.

The Bank of England, in its latest quarterly bulletin, says "there is now the equivalent of £1,000 [about $1,500] in banknotes in circulation for each person in the United Kingdom."

The bulletin goes on to parse that a bit more finely.

"The evidence available indicates that no more than half of Bank of England notes in circulation are likely to be held for use within the domestic economy for transactions and for 'hoarding'. The remainder is likely to be held overseas or for use in the shadow economy. However, given the untraceable nature of cash, it is not possible to determine precisely how much is held in each market."

As the BofE points out, there's no easy way to get a handle on how many pound notes are held overseas vs. those fueling un-taxed work and business. But Feige arrived at his U.S. numbers by working out that usual assumptions about overseas holdings of dollars—a currency widely favored over local funny money—were exaggerated. The British pound doesn't enjoy the same worldwide don't-leave-home-without-it status as the dollar, so it's a fair bet that most of the U.K.'s banknotes are back home, keeping the local economy healthy and hopping.

And demand for banknotes is increasing faster than the size of the official economy.

The BofE downplays the idea of a growing shadow sector, but economists aren't convinced. Last year, in a column for the Centre for Economic Policy Research, Charles A.E. Goodhart and Jonathan Ashworth pointed to the growing ratio of physical cash to GDP in the U.K. as evidence that off-the-books transactions are increasing relative to the official economy.

"The grey economy, defined as otherwise-legal activities that are deliberately not recorded in order to avoid or to evade taxation, has almost certainly been expanding, and probably quite fast."

The reason is no surprise to anybody who has ever filed a tax return or negotiated a favorable cash price with a plumber. Goodhart and Ashworth point to a desire to avoid VAT, National Insurance (social security) contributions, and income tax as the reason "the size of the grey economy has expanded by around 3% of UK GDP since late 2007."

Feige agreed when he described the ravenous demand for cash in the U.S. as evidence "individuals and  firms prefer to hide from the government either to avoid taxes, regulations or punishment for illegal activities."

And the BofE bulletin points out the commonly accepted wisdom that people hide in the shadows to "circumvent or otherwise avoid government regulation, taxation, or observation."

So…What to do?

Just a thought, but if people find taxes and regulations so burdensome that they would rather work off the books, could we pull many of them back into the official economy by reducing that burden?

Silly me.

Writing in The Guardian, Dave Birch, of secure electronic transactions consultancy Consult Hyperion and the Centre for the Study of Financial Innovation, suggests what seems to be a popular "solution" among right-thinking pundits and economists: get rid of cash. He warns that "cash is a mechanism for greatly reducing the cost of criminality" and insists "it is time for Bank of England to develop an active strategy to start reducing the amount of cash in circulation."

It would be easy to scoff at the idea if Birch was alone in his suggestion that the problem of taxes and regulations can be ignored if we leave people no means to escape from them, but he's not. It's the same lock-the-exits approach favored by German government economic advisor Peter Bofinger, Citibank chief economist Willem Buiter, and Harvard University's Kenneth Rogoff.

Bofinger's colleague, Lars Feld, immediately objected that notes and coins are "printed freedom" that allow people to escape from state control—which he characterized as a good thing.

That is a good thing—both for the freedom itself, and for the signal that mass escape provides to policymakers that maybe they need to rein themselves the hell in.

But there's also an impractical side to unilaterally eliminating cash. People are pretty good at finding substitutes for all sorts of things—British currency included. Faced with a shortage of currency from the home country, early American colonists used tobacco as money, both physically and in terms of drafts drawn on warehouse stores of the stuff. Why would modern Britons be any less creative? 

In an email to Birch, I asked him the same questions I posed months ago to Bofinger, Buiter, and Rogoff: Wouldn't people denied locally issued notes and coins simply turn to foreign currencies, or eternally popular gold and silver? The modern world now offers new options in the form of bitcoins, which can be used across distances.  Isn't there a risk (if you want to call it a "risk") that eliminating cash would further reduce government control over much of the economy and increase reliance on alternatives to official currency?

Maybe the cash-haters are all sharing notes, but Birch emulated the other would-be banners of notes and coins in ignoring my questions.

Or maybe—and I suspect this is the real answer—they just can't come up with answers that they find palatable.

Pundits and big-government-friendly economists may not like it, but cash is popular in Britain and the United States alike because it helps people hide their activities from the authorities. Those authorities can change the tax and regulatory policies that turn off so much of the population—or they can continue to watch the economy trickle away into the shadows.