The Economics of Counterfeiting

This paper develops a new tractable strategic theory of counterfeiting as a competition between good and bad guys. There is free entry of bad guys, who choose whether and what note to counterfeit, and what quality to produce. Good guys select a costly verification effort. Along with the qual ity, this effort fixes the chance of finding counterfeits, and induces a collateral "hot potato" passing game among good guys — seeking to avoid counterfeits passed around. We find a unique equilibrium of the entwined counterfeiting and verifying games. With log-concave verification costs, counterfeiters producer b etter quality at higher notes, but verifiers try sufficiently harder that the verifica tion rate still rises. We prove that the unobserved counterfeiting rate is hill-shap ed in the note, vanishing at extremes. We also deduce comparative statics in legal costs and the technology. We find that the very stochastic nature of counterfeiting lim its its social cost. Our theory applies to fixed-value counterfeits, like checks , money orders, or money. Focusing on counterfeit money, we assemble a unique data set from the U.S. Secret Service. We identify key time series and cross-sectional patterns, and explain them: (1) the ratio of all counterfeit money (seized or passed) to passed money rises in the note, but less than proportionately; (2) the passed-circulation ratio rises in the note, and is very small at $1 notes; (3) the vast majority of counterfeit money used to be seized before circulation, but now most passes into circulation; and (4) the share of passed money found by Federal Reserve Banks generally falls in the note, as does the ratio of the internal FRB passed rate to the economy-wide average. Our theory explains how to estimate from data both the street price of counterfeit notes and the small costs of veri fying counterfeit notes. This paper has taken a long journey from our 2005 manuscript "Counterfeit $$$" that made re- strictive functional form assumptions and assumed a fixed qu ality of money. We have profited from the insights, data, and broad institutional knowledge about co unterfeiting of Ruth Judson (Federal Reserve), John Mackenzie (counterfeit specialist, Bank of Canada), Lorelei Pagano (former Special Agent, Se- cret Service), Antti Heinonen (European Central Bank, Counterfeit Deterrence Chairman), and Charles Bruce (Director, National Check Fraud Center). We have also benefited from seminar feedback at I.G.I.E.R. at Bocconi, the 2006 Bonn Matching Conference, the 2006 SED in Vancouver, the Workshop on Money at the Federal Reserve Bank of Cleveland, Tulane, Michigan, the Bank of Canada, the 2007 NBER-NSF GE conference at Northwestern, the 2008 Midwest Theory Conference in Columbus, and especially the modeling insights of Pierre Duguay (Deputy Governor, Bank of Canada).