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SCOTT SUMNER WRITES:
Surprisingly, despite the increasing use of credit cards, cash holdings are about 8% of GDP, which is actually a larger share of the US economy than a decade ago, indeed even larger than 90 years ago.
The amount of cash in circulation (paper currency and coins) is roughly $4500 for every man, women and child in America. It is believed that roughly ½ that total is held overseas, but even $2000/person would be a surprisingly large figure, far higher than people admit to in government surveys.
Ironically, it is this increasing popularity of cash holdings that helps explain why governments are so anxious to discourage the use of cash.
Economists study cash holdings with a model that looks at the costs and benefits of currency. Even back before 2007, people held fairly large quantities of cash, despite the fact that perfectly safe assets such as bank CDs and Treasury bills offered 3% to 5% interest. Of course cash earns no interest, and if you hold large quantities in safe deposit boxes, there’s even a small negative return on cash.
Therefore economists view the risk-free interest rate as the opportunity cost of holding cash, what you forego by not choosing a more traditional investment.
This helps to explain the recent surge in cash holdings. Since 2008, the interest rate on safe assets has been close to zero, and so there is no longer a substantial opportunity cost of holding cash. When the cost of something declines, people demand more of it. But what about the benefits of holding so much cash; why were cash holdings fairly large even back in 2007, when interest rates were well above zero?
One clue is to look at currency in circulation by denomination. The vast majority of currency (by value) is composed of $100 bills. And yet in ordinary transactions, people tend to use smaller bills, such as $1s or $20s. This is confirmed by the fact that small bills wear out pretty quickly, and need to be replaced often with newer versions at the Federal Reserve. In contrast, $100 bills wear out very slowly, suggesting they are mostly hoarded, and used only infrequently for transactions. So why is it that even back in 2007 most currency consisted of $100 bills being held for long periods, when better investments were available?
Cash has one big advantage over other investments — anonymity. There is evidence that cash is often used as a way of evading taxes. When people first hear about cash and the underground economy, they often picture gangster films with drug dealers swapping briefcases of cash. But the truth is often more mundane. Lots of cash is hoarded by people in otherwise legal businesses, who are simply trying to hide wealth from the IRS, or perhaps even their spouse. When interest rates fall to zero, cash becomes an even more appealing option.