RDP 2015-05: The Social Costs of Currency Counterfeiting 2. Counterfeiting and Confidence

Counterfeiting can affect the demand for currency through a loss of confidence in the use of currency. For example, counterfeiting can affect a currency's functions as a store of value and a medium of exchange. It is the perception of risk that affects confidence. Confidence weakens if the public perceives that there is a greater risk that they could unknowingly accept a counterfeit as payment. For example, heightened media coverage of counterfeiting activity could increase the perceived risk of counterfeiting, even if the level of counterfeiting activity is low.

The idea that confidence weakens with perceived risk has been established in theoretical literature on counterfeiting. A striking finding in search-theory models has been that the threat of counterfeiting can, in the extreme, eliminate the use of currency altogether (Nosal and Wallace 2007; Li and Rocheteau 2011; Shao 2013). These models have only two types of money: genuine fiat money and counterfeits. A deterioration of the use of currency can have an impact on output and welfare. The threat of counterfeiting in these models materialises through low production costs of counterfeits and their effect on the steady state of the economy. Low production costs (for a given quality of counterfeiting) can affect the equilibrium outcome even in the absence of counterfeiting. For example, Li and Rocheteau (2011) find that the threat of counterfeiting can affect the value and velocity of money, as well as output and welfare, even when counterfeits do not actually circulate. Moreover, Monnet (2005) suggests that counterfeiting can be inflationary if the production costs of counterfeiting are low enough.

Another insight into the effects of counterfeiting on confidence is drawn from the canonical model of money as a medium of exchange (Kiyotaki and Wright 1993). Kiyotaki and Wright show that a ‘tipping point’ can materialise where currency will be abandoned in favour of other payment mechanisms. This implies that at sufficiently high levels of counterfeiting activity, it is possible that the public could abandon the currency altogether, or at least particular denominations.

The literature on the economics of crime and punishment offers insights into the optimal public policy response to counterfeiting activity (see Becker (1968)). For example, one way to think of an individual's decision to produce counterfeits is as a trade-off between the expected benefits and the expected costs from production. In this simple stylised framework, one could think of a counterfeiter's expected costs as the probability of detection multiplied by the size of the punishment if caught, plus production costs. A counterfeiter's expected benefits could be thought of as the probability of avoiding detection multiplied by the notional value of counterfeits produced.

This framework suggests that measures taken to increase the expected costs or decrease the expected benefits of counterfeiting will lower the incidence of counterfeiting. Increasing the probability of detection both increases the counterfeiter's expected costs and decreases the expected benefits. For example, issuing a new banknote series with harder-to-counterfeit security features would work to both raise the counterfeiter's production costs and increase the probability of detection. Public education campaigns also increase the probability of detection and are a critical communication strategy used in Australia. Finally, measures taken to increase the allocation of police resources to detect counterfeiting also act as a deterrent.

Similar conclusions have also been made in the theoretical literature on counterfeiting. Kultti (1996) finds that counterfeiting does not occur in equilibrium if the probability of detection is high enough. Combinations of anti-counterfeiting efforts are found to be more effective in reducing counterfeiting than single measures (Fung and Shao 2011a). Quercioli and Smith (forthcoming) find that the maximum social costs of counterfeiting are lower when prevention efforts are greater. Green and Weber (1996) find that the introduction of a new banknote series can reduce counterfeiting activity and lower the level of law enforcement required to mitigate counterfeiting further. However, notwithstanding the large theoretical literature on counterfeiting, and some measures of the average levels of counterfeiting, there is almost no literature that attempts to quantify the social costs of counterfeiting.