RDP 2015-05: The Social Costs of Currency Counterfeiting 3. The Social Costs of Currency Counterfeiting

In this section, we present some statistics on the social costs of counterfeiting, and compare the Australian experience to some other economies. Chant (2004a) identifies three types of costs: the implied transfer from households and businesses to counterfeiters; prevention costs; and loss of confidence. Redistribution effects are transfers of wealth. They imply a gain to a counterfeiter at the expense of the household or firm who holds the counterfeit at the point of detection. This redistribution has no net effect on the economy as a whole, and is in this sense not a social cost (but could be seen as undesirable by society). In contrast, prevention costs and a loss of confidence are deadweight losses. They imply a loss of production or forgone income that would have otherwise occurred in the absence of counterfeiting, and are in this sense a social cost. Deadweight losses affect all agents in the economy as they draw resources away from their most productive use.

3.1 Counterfeits Passed into Circulation

Counterfeits falsely exchanged for goods and services result in the transfer of wealth from private agents, either households or businesses, to counterfeiters. If a counterfeit is passed more than once in circulation, the loss is borne by the last holder of the counterfeit.^[3]

Many central banks and law enforcement agencies collect data on counterfeits detected and removed from circulation. The total notional value of counterfeits detected in these data provide one measure of the redistribution of wealth. In absolute terms, the levels of counterfeiting experienced in these economies are low (Table 1). For example, the euro area, which exhibits the highest level of counterfeits detected in circulation in our sample of economies for which comparable data are available, only detected the equivalent of A$45 million of counterfeits in 2013.

Nevertheless, when measured in terms of redistribution per person, there is still considerable variance across economies. The notional value of counterfeits detected per capita in Australia in 2013 is relatively low at A$0.05 compared with some other economies in our sample. This contrasts with the United Kingdom, for example, which has experienced relatively high levels of counterfeiting per capita over recent years (though it is still low in absolute terms).

The data suggest that businesses detect more counterfeits than the general public in Australia. Of the counterfeits detected in these data in 2013, the general public detected approximately 10 per cent, businesses detected around 34 per cent, the RBA, banks and other cash management companies detected another 32 per cent, while the remainder is not specified in the data.^[4]

The impact of fraud loss from counterfeiting can be a significant cost for some agents in the economy. Low-income households use cash more than other payment methods and could be exposed to fraud losses from counterfeiting more than other households. For low-margin businesses, it is possible that the loss from receiving a counterfeit could exceed daily profits. For example, as highlighted by the Bank of Canada, grocers operating on margins of 1 to 2 per cent would have to sell up to C$5,000 worth of goods to recoup the loss from accepting a single C$50 counterfeit (Bank of Canada 2015).

The incidence of counterfeiting also varies by industry. The detections data suggest that the most common businesses to receive counterfeits in Australia are supermarkets & grocery stores and restaurants, cafes & fast food outlets which receive almost half of all counterfeits by businesses (Table 2). This could be explained by high-frequency, low transaction value payments in cash being made in these stores, making them potentially more susceptible to the passing of a counterfeit. In contrast, clothing, hardware and entertainment stores receive less counterfeits, which could be explained by a greater prevalence of electronic payments and less frequent transactions made in cash, as well higher transaction values when purchasing the goods sold.

3.2 Prevention Costs

Prevention costs are incurred in efforts made by private agents, law enforcement agencies and the central bank to reduce the risk of counterfeits being passed into circulation. We consider the costs incurred by each of these agents in turn.

Some private agents take time to authenticate each banknote at the point of exchange. The authentication of banknotes often involves checking for security features embedded in the banknote. On Australian banknotes these could include microprinting, raised print, a see-through registration device or a shadow image. Some features are only machine-readable and require the purchase of equipment to authenticate them. The authentication process takes additional time at the point of exchange, which is costly.

Law enforcement prevention costs include the policing and judicial expenses involved in shutting down and prosecuting counterfeiting operations. As law enforcement agencies are typically resource-constrained, the opportunity cost of resources used to curb counterfeiting can be significant. For example, counterfeiting can draw resources away from investigating other criminal activity. However, it is also possible that law enforcement efforts allocated across different types of crime are not necessarily substitutes for one another, but can also be complementary. For example, in Australia, there have been illegal drug operations or episodes of organised crime that have also been associated with seizures of counterfeit notes.

Central bank prevention costs include conducting research into improving security features for banknotes, developing and issuing new banknote series, monitoring and analysing counterfeit activity, conducting information programs for the public and the police in counterfeit detection, and developing programs with the police to deter counterfeiting. In Australia, significant resources are allocated to these areas to keep counterfeiting activity at low levels.

The issuance of a new banknote design can also help mitigate counterfeiting activity. However, the costs of production and issuance of a new banknote series can be significant. Published estimates of these costs are scarce. The US Bureau of Engraving and Printing (2004, 2005, 2007, 2009, 2011, 2014) indicates that the average research and development expenditures between 2003 and 2013 were over US$11 million per year. The Bank of Canada reportedly spent close to C$20 million in recent times developing a new polymer series of banknotes (Bank of Canada 2015). The non-production costs of issuing a new banknote series are, therefore, likely to be a substantial share of the total replacement cost of the stock of banknotes in circulation.

3.3 Loss of Confidence

The most difficult effect to quantify, however, is the effect on the public's confidence in currency. With large counterfeiting episodes, there can be reduced use of currency when making transactions and thus a decline in the overall demand for banknotes. This gives rise to two additional sources of social costs.

First, currency issuers generate revenue through the issuance of banknotes, otherwise known as seigniorage. Seigniorage is the difference between interest earned on banknotes issued into circulation and the costs of producing and distributing banknotes. Profits from seigniorage are typically a large part of a central bank's revenues.^[5] Hence, a reduction in the stock of banknotes in circulation, due to a loss of confidence, can result in less seigniorage revenue available for use by the public sector. Other things equal, less seigniorage revenue could mean that more taxation revenue is required elsewhere. If the new taxation distorts economic incentives, this could have an effect on the level of output in the economy, which would be considered deadweight loss.

The second source of increased social costs is the effect on the public's choice of payment methods in transactions. A decline in the demand for banknotes following a loss of confidence could mean that private agents substitute cash for other payment types. If the social costs of conducting a transaction are higher for other payment types, this is an additional source of deadweight loss.^[6]

Studies from Australia have estimated the resource costs of using different methods of payment.^[7] These include fixed costs, such as the provision of bank infrastructure and ATMs, and variable costs, such as the time required to complete a transaction. In Australia, studies have found that the average-sized cash transaction incurs lower social costs than average-sized credit card and debit card transactions (Schwartz et al 2008; Stewart et al 2014). In another Australian study, cash is still found to be the most common payment method used, despite the rise in the use of electronic payments over recent years (Meredith, Kenney and Hatzvi 2014).^[8] These results suggest that if an increase in counterfeiting causes a shift away from cash, the aggregate social cost of the payments system could increase.

Footnotes

It is illegal in Australia under the Crimes (Currency) Act 1981 to knowingly ‘utter’ (pass) a counterfeit. [3]

These gaps in the data are often due to unfamiliarity with the paper form that is required to be submitted with counterfeits to the Australian Federal Police. [4]

See RBA (1997) for a description and estimates of seigniorage in Australia. [5]

There are other private costs involved that are more difficult to quantify because they take the form of losses in consumer utility. Private agents lose their anonymity when conducting many types of electronic transactions (Brits and Winder 2005). However, some consumers will value the benefits of credit card loyalty programs. [6]

The social cost of conducting a transaction can be measured using resource costs, which capture the resources required to facilitate a transaction. [7]

Ossolinski, Lam and Emery (2014) provide some evidence that the share of payments made using cash is declining. [8]