Statement by Edward W. Kelley, Jr., member, Board of Governors of the Federal Reserve System, before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, July 13, 1994.

Thank you for the opportunity to present the Federal Reserve's views on the plans of the Department of the Treasury to further protect U.S. currency from the threat of future counterfeiting. I have attached to my statement responses to the questions raised in your letter of invitation.(1) I would request that they become part of the record. My remarks this morning will focus on the reasons the Federal Reserve fully supports the design improvements being considered by the Treasury.

Counterfeiting is foremost a serious crime--but one with a special dimension. For if counterfeiting were to take place in very large volumes, it might undermine public confidence in the genuine currency and might, in extreme circumstances, also threaten the nation's economic stability. For these reasons, our government must be ever alert to opportunities to improve both its enforcement of anticounterfeiting laws and the design of its currency.

The United States has the benefit of a vigorous, and highly effective, enforcement of counterfeiting laws by the U.S. Secret Service. We have also had a largely effective currency design, particularly with the addition in 1991 of two additional security features aimed at reducing the threat of color-copier counterfeiting. Thanks to good law enforcement and to a good design, as well as to a watchful public, the current level of counterfeiting activity is only about $20 million per year, or only about 10 cents per capita passed on to the U.S. public. Thus counterfeiting has no discernible impact on the overall economy and places no constraint on the formulation or implementation of monetary policy.

Nevertheless, the security features of the current design are probably not adequate to deal with the counterfeiting threat of the future, which seems likely to be dominated by rapidly improving reprographic technologies, especially computer-based scanners, printers, and copiers, that will be available to large numbers of people and that will require little operator skill. We are also concerned about increasingly sophisticated counterfeiting by dedicated criminals and by a greater proportion of this activity taking place outside the United States. Accordingly, the Federal Reserve strongly supports the Treasury Department's efforts to incorporate additional security features to currency now to be better prepared for threats of the future.

To provide some context for the committee's consideration of this design-improvement effort, I would like to comment on three related matters: (1) the importance to the Treasury and to taxpayers, in financial terms, of the Federal Reserve's currency-issue function, (2) the worldwide role of U.S. currency and therefore the importance of maintaining worldwide confidence in it, and (3) steps that the Federal Reserve might take to ensure prompt distribution of the newly designed notes.

Currency issuing is highly profitable for governments because the issuance of non-interest-bearing central bank currency liabilities gives rise, correspondingly, to comparable holdings of earning assets by the central bank. The Federal Reserve System's balance sheet shows currency liabilities, and corresponding earning assets, of about $357 billion. At a portfolio return of about 5.3 percent in 1993, the assets associated with currency outstanding generated about $18 billion in gross income for the Federal Reserve System and therefore accounted for most of the approximately $16 billion of 1993 net Federal Reserve earnings paid to the Treasury.

The needs of the domestic U.S. economy, however, do not account for all, or even most, of the $357 billion dollars of Federal Reserve notes in circulation. Our currency is widely accepted and used outside the United States, and in a few nations it even plays a leading role as a substitute for the domestic currency. We do not have hard data on the amount of currency held abroad, and estimates are necessarily imprecise. Research by Board staff members indicates that probably more than half, and perhaps in excess of 60 percent, of the $357 billion of U.S. currency may be in use outside the United States. Evidence also suggests that the percentage of U.S. currency held abroad has tended to increase in recent years. The worldwide demand for our currency contributes in a very important way to the direct financial benefits that taxpayers derive from the issuance of Federal Reserve notes--perhaps to the extent of 60 percent, or $10 billion annually, of the approximately $16 billion earned through currency issuance. In effect, by holding our currency, citizens of the rest of the world are making an interest-free loan to the United States.

We cannot take for granted the choice of U.S. currency as both a store of value and a medium of exchange in nations whose economic or political situations make their own currencies less attractive for those purposes. There are other currencies and other instruments that would serve the purpose. The choice of U.S. currency is most of all a consequence of the esteem and confidence in which the U.S. government, its political traditions, and its economic performance are held. Whether that esteem and confidence are maintained in the future depends primarily on the fiscal and monetary policies that are pursued here over the long term. The preference for U.S. currency abroad, however, and the associated financial benefits also depend on confidence in the Federal Reserve notes themselves and could be diminished by widespread concern about the genuineness of U.S. currency.

Against this background, the Federal Reserve is preparing now for the challenges of active distribution of the newly designed notes when they become available and a prompt replacement of the Federal Reserve notes currently in circulation--on a worldwide basis.

Let me not be misunderstood, however. The Federal Reserve would not support, and has no plans for, a recall, demonetization, cancellation, or any other cessation of legal tender status of U.S. currency. All genuine U.S. currency now in circulation, whenever issued, is legal tender and should continue to be legal tender.

For replacing Federal Reserve notes in circulation within the United States, it is likely that the Federal Reserve will follow the general approach it has used in issuing the Series-1990 $100, $50, $20, $10, and $5 notes, which, as you know, provided improved counterfeit deterrence in the form of a security thread and microprinting.

In the case of $100 and $50 notes, which have an average life of more than five years, we knew that we would need to replace the outstanding Federal Reserve notes more promptly than on a business-as-usual basis. For those denominations, the Federal Reserve began paying into circulation only the Series-1990 notes as soon as the Bureau of Engraving and Printing had shipped a sufficient inventory of them to each of the Federal Reserve banks and branches (which was in August 1991 for $100 notes and in February 1992 for $50 notes). That is, all pre-1990 $100 and $50 notes deposited at Federal Reserve Banks were withdrawn from circulation even if their quality level might ordinarily have permitted their reissuance. As a result of that procedure, Series-1990 notes now comprise more than 80 percent of the receipts of $100 and $50 notes at Federal Reserve Banks and therefore more than 80 percent of the general domestic circulation of those denominations.

Series-1990 notes of the $20 and $10 denominations were first paid into circulation by Reserve Banks in October 1992 and November 1992 respectively. Because those denominations have an average life of only two and one-half to three years, the Federal Reserve has retired the pre-1990 notes on a business-as-usual basis; that is, they are withdrawn only when they are judged to be too worn or soiled for further circulation. As a result of this procedure, we have achieved a replacement rate comparable to that of the $100 and $50 notes. Series-1990 notes now comprise about 60 percent of those denominations in deposits at Federal Reserve Banks and therefore in general domestic circulation.

For replacing Federal Reserve notes used outside the United States, a more active approach may be required for the newly designed series. In contrast with the 80 percent replacement rate domestically, we estimate, for example, that only 50 percent of the $100 notes circulating abroad and only 65 percent of the $50 notes abroad are Series-1990 notes. Even though these lower replacement rates may, to some extent, be attributable to the 1990-Series not being visibly very different from the earlier series, and the more visible changes in the newly designed notes may generate a greater public demand for them, the present replacement procedure may not be considered sufficient for the newly designed notes. The Federal Reserve is therefore considering the benefits and costs of a number of available options for expediting the replacement of notes that are outside the United States when the newly designed notes become available. No decisions have been made, except that there will be no recall or demonetization of existing currency.

In conclusion, I would like to thank the committee for this opportunity, and again let me reiterate that the Federal Reserve fully supports the design improvements being considered by the Treasury. It would further the interests of the United States to enhance its currency by making it as secure from counterfeiting in the future as it has been in the past.

(1.)The attachment to this statement is available from Publications Services, Board of Governors of the Federal Reserve System, Washington, DC 20551.