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 does 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 will deposit the excess cash in bank accounts where it adds to vault cash, and thereby increase the aggregate reserves of the banking system.  Since banks don't earn interest on cash, they will swap the excess cash for deposits at the Fed in order to lend in the Fed funds market or to purchase interest-earning assets like T-bills.

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 perfect counterfeit notes spent into circulation will increase the public's holding of Treasury securities, and thereby increase the interest payments due to the public from the Treasury.

Does the Treasury therefore take the hit?  No, that implies the Treasury is a profit-seeking enterprise, no different in that respect from the subway company.  The Fed is the source of the government money, and Treasury simply recycles what the Fed has previously issued. 

Who takes the hit?

In a primitive all-cash economy, counterfeiting would indeed increase the cash in circulation and dilute its value.  The holders of cash would then take the hit.  But modern economies operate mainly on bank-issued credit, not cash. 

The additional interest payments owed to the public by the Treasury resulting from the counterfeit notes must ultimately be covered by increased taxes.  That's a wash for the public as a whole, but not for those who pay more in taxes than they receive in interest payments.  The net effect is a redistribution of financial wealth within the private sector.  It's fair then to conclude that the public takes the hit on counterfeit notes in approximate proportion to the taxes they pay.

The Fed estimates that over one-half of the Federal Reserve notes in circulation have migrated overseas for use as a trusted medium of exchange.  It is interesting that if, on balance, genuine Federal Reserve notes return to the domestic economy from overseas, they would have exactly the same effect in the U.S. as would new perfect counterfeit notes.