Friday, May 6, 2011

Why do we need a state-backed currency?

Anonymous commenter made this interesting comment in my previous post on the gold standard. "Also, as far as I understand it, most of the people advocating a return to the gold standard advocate it primarily as their recommendation if their must be a government mandated monopoly on currency. Most of them prefer an open marketplace in currency, where anyone could use whatever they like as a medium of exchange, and banks could print certificates tied to real assets usable as paper money (whether it be gold, silver, palladium, yap, or cigarettes, though those last two are included primarily for historical reference). This would not include the same problems you've included above, but still answer the criticism of fiat currency by allowing for currency that was backed by some tangible asset rather than being provided value through the government's power to tax."

My beef with a multi-currency system is the difficulty of ensuring orderly currency issuance. We'll have an economy with so many currencies being issued by different private banks, backed by different assets.

At least, with only one monopoly issuer, we can easily control it by making it more accountable to the people who use the currency it issues (Though this means making central banks more transparent than they are right now). If we have many private banks issuing their own currencies, it would be more difficult to manage. What happened to securitized loans issued by shadow banks could also happen to the currencies privately issued by banks. With no state backing them, privately-issued currencies could just as easily lose value during a run, and we could end up with financial crises even worse than we had in 2008.

For example, if we cannot assure that a lone central banker, whose actions are readily seen by all, will never overprint a monopoly currency, then we cannot also assure that different private bankers will never overprint a currency, to the point that they cannot back it anymore with their holdings of tangible assets.

I would probably be open to the idea of granting private banks the license to issue private money, but these private currencies should be complemented by state-backed money. Sure, there could be sophisticated investors out there who can ascertain the solvency and veracity of an issuing bank's claim, that its holdings of real assets can back its privately-issued currency. But the typical currency user, who just needs a readily usable medium of exchange, or store of value, likely will not be in a position to know which bank will still be around to give him the real assets, should he ever decide to tender his currency notes. So he should have the option of only accepting a state-backed currency, so that he at least has the peace of mind about the backing of his accepted currency (Even if this state-backed currency can be overprinted by an overzealous central banker. But that's a matter for a separate discussion.)

In as far as why a state-backed currency should not based on gold, I've already outlined it here. Plus I would add that the state's option to be able to spend more, in place of disappearing private spenders during times of escalating private sector desire to save, is an invaluable lifeline during a severe depression, and if we had a gold standard, government spending will only likely crowd out what little private spending is still there.

27 comments:

The Arthurian said...

Good post, Rogue. Amen to the "more difficult to manage" objection.

From the quoted comment: "...anyone could use whatever they like as a medium of exchange, and banks could print certificates tied to real assets usable as paper money..."

Reminds me of the Real Bills doctrine which, according to Mike Sproul, "holds that the creation of paper or credit money will not cause inflation as long as the money is issued in exchange for sufficient security."

Money backed by assets may be sound as long as the value of the assets does not fall. But as we saw with housing, asset prices can and do fall. Asset-backing is unreliable.

As you wrote on 29 April: "... having fiat money could lead the private sector to extend more credit than is prudent during a boom, and this excess lending eventually leads to a ponzi scheme where the last person holding the now bust asset is unable to pay his debt..."

However, the problem is not that money is fiat. The problem is the extending of "more credit than is prudent". The problem is imbalance in the ratio of debt to money, or debt to base money maybe.

ArtS

Rogue Economist said...

This comment from Arthurian....Blogger seems to be bouncing all comments lately...

The Arthurian has left a new comment on your post "Why do we need a state-backed currency?":

Good post, Rogue. Amen to the "more difficult to manage" objection.

From the quoted comment: "...anyone could use whatever they like as a medium of exchange, and banks could print certificates tied to real assets usable as paper money..."

Reminds me of the Real Bills doctrine which, according to Mike Sproul, "holds that the creation of paper or credit money will not cause inflation as long as the money is issued in exchange for sufficient security."

Money backed by assets may be sound as long as the value of the assets does not fall. But as we saw with housing, asset prices can and do fall. Asset-backing is unreliable.

As you wrote on 29 April: "... having fiat money could lead the private sector to extend more credit than is prudent during a boom, and this excess lending eventually leads to a ponzi scheme where the last person holding the now bust asset is unable to pay his debt..."

However, the problem is not that money is fiat. The problem is the extending of "more credit than is prudent". The problem is imbalance in the ratio of debt to money, or debt to base money maybe.

ArtS

Rogue Economist said...

This is why I think the only way to avoid financial chicanery is through regulation. Backing privatey-issued currency with real assets will not solve the problem, if there are issuers who want to commit fraud.

Mike Sproul said...

"We'll have an economy with so many currencies being issued by different private banks, backed by different assets."

Checking account dollars are issued by many private banks and backed by different assets. Same for credit card dollars. Same for the paper money issued in the US in the Free Banking Era. The history of government involvement in banking gives no encouragement to those who would put government officials in charge of the banking system.

Rogue Economist said...

Mike, the thing about checks and credit cards is that they can only be accepted by the person directly transacting with the issuer. For example, if you give me a check or pay me by credit card, I can't then turn around and use your check or your credit card to pay for my purchase with somebody else. In this sense, I don't see it as a circulating currency.

I don't think the state needs to back it because it is between two parties, and if the payor gives a bad check or he does not pay his credit card bill with his bank, it is a matter to be handled only by his payee or his bank. But if the tenth person for example to accept that check finds that it's no good, it's going to be a big mess to unravel all ten previous transactions that happened before it so that the check goes right back to the original issuer.

The state should only back circulating currency. Checks and credit cards involve private transactions involving directly transacting parties. I believe the state should back it because this is the only to make it acceptable to any party whosoever may enter this endless chain of transactions. No backing, and the chain will likely unravel.

Mike Sproul said...

Once a check or a credit card slip is signed, it can be paid directly from hand to hand, as you said yourself in your "tenth person" example below. In the 18th and 19th century, bills of exchange were routinely used this way. Conversely, we can imagine a world where paper bank notes have to be renewed at the issuing bank every time they changed hands, and they would then be just like checks. Whether a dollar exists as a printed paper transferable by hand, or a bookkeeping entry transferable by computer blip, its physical form does not affect whether or not it should be issued by the government.

If I lived in Bolivia, I would more readily accept a paper peso issued by a reputable private bank than one issued by the government.

Also: Are you saying that the state should be allowed to issue paper money? or that private banks should be prohibited from doing it? I don't have a problem with allowing the state to do it, but I don't think private banks should be prohibited from doing it.

The Arthurian said...

Gentlemen, if I may ...

Mike, you say you "don't think private banks should be prohibited" from issuing paper money.'
But in your earlier comment you write: "Checking account dollars are issued by many private banks and backed by different assets. Same for credit card dollars. Same for the paper money issued in the US in the Free Banking Era."
So according to you, private banks are NOT prohibited from issuing paper money.

What's different now, in contrast to the Free Banking Era, is that all the dollars issued by private banks are interchangeable at face value for base money. The reason is that a central authority has assumed the 'responsibility of last resort' for all those dollars.

Rogue Economist said...

Mike, as I said the post, I would probably be open to the idea of granting private banks the license to issue private money, but these private currencies should be complemented by state-backed money. People should have the choice to accept state money if they want. So there should always be state money.

I see private bank issued currency as similar to equity stocks issued by private corporations. People buy them or accept them because of the belief that they can be sold or exchanged for state-backed money. People exchange their state-backed money for stocks because of the speculation that the stocks may rise in value vs. holding onto state money. But at the end of the day, that stock could lose value or even become worthless if the company that issued it became bankrupt. I believe the same with banks and private currencies. These currencies have value only to the extent that people can redeem them from the issuing bank for state money. As Arthurian said, checks and credit cards issued by banks have value because they are interchangeable at face value for base money. People who accept checks and credit cards expect to eventually exchange them for state money, which is what they can in turn use to pay for their own purchases.

That's why only sophisticated investors should accept private currencies. There's a large element of speculation to it, and most people, who only want to get paid for goods and services rendered, will always want money they know will have acceptability when they in turn decide to spend it.

Mike Sproul said...

Arthurian:

Private banks are NOW prohibited from issuing paper money. They were not prohibited during the Free Banking Era in the US, roughly 1836-1861.

You can't really credit the central bank for the fact that private banks maintain convertibility of checking/credit card dollars into paper dollars. Banks maintain convertibility because they have enough assets that they can afford it. The central bank only steps in occasionally with a last resort loan.

Rogue:

Suppose I'm a landlord, and I collect rents of 50 oz. of silver per year, in perpetuity. At a market rate of 5%, this makes my property worth 1000 oz. When I buy groceries, I sometimes pay with a handwritten 'rent dollar', which I accept for rent in lieu of 1 oz. of silver. My rent dollars are just like stock, in the sense that they are backed by my assets. As long as my issuance of rent dollars does not outrun my assets, they will hold their value.

If I've issued 1000 rent dollars, and my property then drops to 900 oz., then I'll be forced to suspend convertibility of my rent dollars into silver, but each rent dollar will still be worth .9 oz. Note that my rent dollars are backed by rents, just like federal reserve dollars are backed by taxes.

Now suppose that other people start issuing checking account and credit card dollars, each of which is a claim to one of my rent dollars. Those private dollars are also valued like stock, since they are backed by the assets of their issuers.

This example doesn't show any real need for government supervision of money. Naturally there will be abuses and failures, just like in any market. But you'd have a hard time arguing that government supervision won't lead to even more abuses and failures. The invisible hand seems to be able to provide us with money, just like it provides us with groceries.

Rogue Economist said...

Mike, now you're taking my analogy of stocks to the next level. Your example is now of a landlord who collects rent. A landlord, just like a company, who expects to receive certain income over a certain period can always use this income stream to raise money. This is what securitization is all about, and as I mentioned in the post, this happened a great deal before the crisis with the rise of the shadow banking system.

For as long as the securities are backed by assets of value, such as rental claims, everything is hunkydory.

What happens then when the rent-backed dollar issuer is trying to grow his market share? He buys more property so he can sell more rent dollars. What happens when all other competitors are doing the same? Buying more property assuming all property will result in more rental dollar? What happens when the rent stops growing but all the landlords have already issued too much rental dollars? What happens when those who received these rental dollars now realize that not everyone will get his share of rent? What happens when there's a stampede to get out all rent income from the landlords and there isn't enough to go around?

If you're a landlord, of course you wouldn't want government interfering with your business. But what if you're the hapless person who receives the bogus rent-backed dollar without your knowing it?

And what happens when people who lose money this way stop all commerce in the economy because they've just lost everything they have to the rental dollar issuers?

This is already going ahead of your example, because this is the natural consequence of the no government supervision you propose. The solution should prevent previous crises that we know can happen to ever happen again right?

Mike Sproul said...

"What happens then when the rent-backed dollar issuer is trying to grow his market share? He buys more property so he can sell more rent dollars."

He issues a $200 bond and buys another 200 oz. worth of land. His assets rise in step with his liabilities so his rent dollars are still worth 1 oz. He then conducts an open market purchase of the $200 bond by issuing another $200 in rent dollars (just like the Fed does). One liability has been swapped for another and again nothing changes.

"What happens when all other competitors are doing the same? Buying more property assuming all property will result in more rental dollar?"

The Law of Reflux will come into play. Landlords will find that their rent dollars can only buy .99 oz. on the market, while they themselves accept them in lieu of 1 oz. in rent. They will therefore stop issuing rent dollars.

"What happens when the rent stops growing but all the landlords have already issued too much rental dollars? What happens when those who received these rental dollars now realize that not everyone will get his share of rent?"

Then you have my example from above, where $1000 has been issued, but the land backing those rent dollars falls in value to 900 oz. The market value of each dollar will fall to .9 oz. and dollar holders will take a loss. This is why most people will choose to use dollars issued by reputable, well-capitalized landlords. Of course, if the banking system were 'protected' by government officials, then our tax dollars would be used to bail out the banks at ten times the cost.


"What happens when there's a stampede to get out all rent income from the landlords and there isn't enough to go around?"

Then the wise landlords will suspend convertibility (just like troubled private banks did in the Free Banking era), and the dollars will drop from 1 oz. to .9 oz. The foolish ones will maintain convertibility at 1 oz./$. They will have enough assets to pay off the first 900 customers demanding silver, and the last 100 will get nothing.

"what if you're the hapless person who receives the bogus rent-backed dollar without your knowing it?"

The same thing that happens to the hapless person who buys a bad car. He loses. Would you trust in government officials to protect you from unreliable cars? Especially if you lived in Bolivia?


"And what happens when people who lose money this way stop all commerce in the economy because they've just lost everything they have to the rental dollar issuers?"

If the customers were $100 poorer while the dollars issuers were $100 richer, then commerce would be unaffected. But in my example, the original fall in the land from 1000 oz. to 900 oz. left everyone poorer. Government regulation could not have prevented that. In fact, Fannie and Freddie have shown us how to make it much worse.

Rogue Economist said...

"He issues a $200 bond and buys another 200 oz. worth of land.... He then conducts an open market purchase of the $200 bond by issuing another $200 in rent dollars"

Why issue the bond when you're just going to turn around and buy it with rent dollars? Why not just issue the rent dollars directly to buy the land? The extra setp is irrelevant, for as long long as rent dollars issued are backed by actual rent.

"The Law of Reflux will come into play...They will therefore stop issuing rent dollars."

What mechanism stops unscrupulous landlords from issuing more?

"This is why most people will choose to use dollars issued by reputable, well-capitalized landlords."

How do people know which landlords are reputable, and well-capitalized? People already have a lot on their plate working and ensuring they're paid their worth, without also having to research the credit of the private issuer of the dollars they receive. And in an economy with tens of thousands of private issuers, you could be researching tens of thousands of issuers over the course of receiving various payments for goods and services. In a popluation of tens of thousands, you could have a population of hundreds or even thousands of unscrupulous issuers who can undermine the whole system.

"Then the wise landlords will suspend convertibility (just like troubled private banks did in the Free Banking era)...They will have enough assets to pay off the first 900 customers demanding silver, and the last 100 will get nothing."

Allowing for instances of suspension of a currency that has been allowed to circulate publicly is an assurance that this currency will fail. Currency allowed to circulate among the public always has to redeeemable and convertible into the asset it has promised to convert to, or it is not acceptable currency at all.

"The same thing that happens to the hapless person who buys a bad car. He loses. Would you trust in government officials to protect you from unreliable cars?"

Government does not always protect people who buy unreliable cars, but it will always protect people who receive unreliable currency. Counterfeiting is a crime.

"If the customers were $100 poorer while the dollars issuers were $100 richer, then commerce would be unaffected."

If currency recipients are poorer and issuers are richer because of a suspension of convertibility, then fraud has been committed, and the issuer doing so needs to go to jail.

"But in my example, the original fall in the land from 1000 oz. to 900 oz. left everyone poorer. Government regulation could not have prevented that."

Government regulation should always prevent fraud and counterfeiting. A failure of government regulation means a need to change the regulator, not a complete stop to regulation itself.

Mike Sproul said...

"Why issue the bond when you're just going to turn around and buy it with rent dollars?"

I added the extra step because that's what the Fed does. The dollars could have been spent directly.

"What mechanism stops unscrupulous landlords from issuing more?"

Reputation, brand names, even threat of government prosecution for fraud. Bad guys can be handled either by the government or by private mechanisms---whichever is more efficient.

"How do people know which landlords are reputable, and well-capitalized?"

How do you know your grocer isn't selling you poison food? Brand names, reputation, threat of prosecution, etc.

"Currency allowed to circulate among the public always has to redeeemable and convertible into the asset it has promised to convert to, or it is not acceptable currency at all."

Historically, many currencies have had convertibility suspended. They continue to trade, but at a discount. Then along comes some other currency that holds its value better, and people switch to the better currency.

"Government does not always protect people who buy unreliable cars, but it will always protect people who receive unreliable currency. Counterfeiting is a crime."

I'm not talking about counterfeiting. I'm talking about moneys that lose backing and therefore fall in value. That's regrettable, but it's not a crime.

"If currency recipients are poorer and issuers are richer because of a suspension of convertibility, then fraud has been committed, and the issuer doing so needs to go to jail."

The landlord had 1000 oz of land backing $1000, and each dollar was worth 1 oz. Then the land fell in value to 900 oz., so the dollars fell to .9 oz. each. In this case the holders of dollars are 10% poorer, but the landlord is no richer. That's not a criminal act.

"A failure of government regulation means a need to change the regulator, not a complete stop to regulation itself. "

Government officials are not always wise, selfless, and virtuous. If you lived in Bolivia or Botswana, would you trust the government more than you trust the banks?

Rogue Economist said...

"I added the extra step because that's what the Fed does. The dollars could have been spent directly."

So you belive in Fed-backed currency then? I'm not saying I agree with with the usefulnes of what the Fed is doing in swapping liabilities, but I'm saying you're finally acknowledging the Fed as the currency issuer. I had thought you were referring to a private issuer.

"Reputation, brand names, even threat of government prosecution for fraud. Bad guys can be handled either by the government or by private mechanisms---whichever is more efficient."

So you agree to the usefulness of regulation then? Without regulation, there are no laws violated, and the government has no business proecuting anyone.

"Historically, many currencies have had convertibility suspended. They continue to trade, but at a discount. Then along comes some other currency that holds its value better, and people switch to the better currency."

As I said, if anybody wants to accept currency that can be suspended at will by a private issuer, then that's their business. But people who want to accept only state-backed currency should be free to do so. We should not impose on them a world where only privately-issued suspendable currency exists. The state should continue issuing state-backed currency.

"The landlord had 1000 oz of land backing $1000, and each dollar was worth 1 oz. Then the land fell in value to 900 oz., so the dollars fell to .9 oz. each. In this case the holders of dollars are 10% poorer, but the landlord is no richer. That's not a criminal act."

It is a criminal act if this money was paid to someone as a currency, meaning that someone provided a good or service on the basis of being paid in a fixed value he can then turn around and use elsewhere. If he was paid something that can lose value, or be suspended, then this is a crime. If you think the fed is doing a crime devaluing the currency, you should be leery of a private issuer with a profit motive doing the same.

"Government officials are not always wise, selfless, and virtuous. If you lived in Bolivia or Botswana, would you trust the government more than you trust the banks?"

And banks are also not always wise, selfless, and virtuous. Given a choice between accepting a circulating currency issued by the government and a private bank, I would still choose the government's. Would you trust currency issued by some random bank in Botswana or Bolivia?

Mike Sproul said...

"So you belive in Fed-backed currency then?"

Not sure we are talking about the same thing, but I have no objection to the Fed issuing paper money. What I object to is prohibiting private banks from issuing paper money. On the other hand, the losses we suffer from this prohibition are probably small. After all, Wells Fargo could, if it wanted, open a cayman islands branch and issue eurodollars. Those eurodollars could be issued as printed pieces of paper, and those pieces of paper could circulate (illegally) inside US borders. The fact that this hasn't happened tells me that people in the US aren't starved for paper money.

"So you agree to the usefulness of regulation then?"

Like most economists, I prefer to see resources allocated by the invisible hand, rather than by government officials, though we all recognize that lighthouses, disease control, and police protection are often provided more efficiently by the government. I think that money is very much in the realm of things that are better provided by private enterprise, with the government serving only to punish evil-doers.

"if anybody wants to accept currency that can be suspended at will by a private issuer, then that's their business."

"If he was paid something that can lose value, or be suspended, then this is a crime."

Whoa! Contradiction city!

"Would you trust currency issued by some random bank in Botswana or Bolivia? "

If I were in Botswana, and I found a branch of Wells Fargo, then I would gladly accept any paper currency that was issued (and backed) by Wells Fargo. I wouldn't care if that Wells Fargo branch had a sticker in the window saying it was insured by Botswana's FDIC. In this case, Botswana should stay entirely out of the banking/currency business, and leave it to private banks.

Rogue Economist said...

"Not sure we are talking about the same thing, but I have no objection to the Fed issuing paper money. What I object to is prohibiting private banks from issuing paper money. On the other hand, the losses we suffer from this prohibition are probably small. After all, Wells Fargo could, if it wanted, open a cayman islands branch and issue eurodollars."

On the issue of Fed-issued money, we're finally on the same page.

"Like most economists, I prefer to see resources allocated by the invisible hand, rather than by government officials, though we all recognize that lighthouses, disease control, and police protection are often provided more efficiently by the government. I think that money is very much in the realm of things that are better provided by private enterprise, with the government serving only to punish evil-doers."

Ditto, except for the part where money that's considered circulating currency is better left to private enterprise. I still believe it should be in the realm of the state. I could have no qualms about accepting private bank-issued money, but only as long as I am directly dealing with the bank issuer. I would never accept private bank-issued money from someone else who dealt with the issuer himself. Not without guarantees of that other person himself. And no other person should be influenced to accept private-issued money on the argument that it's better than state-backed money.

"if anybody wants to accept currency that can be suspended at will by a private issuer, then that's their business."
"If he was paid something that can lose value, or be suspended, then this is a crime."
"Whoa! Contradiction city!"

Well, if you were to choose to accept something from a potential criminal then that's your business. If you lose money, you should accept it. But doesn't change the fact that it's a crime. And if it were done to other people who do not know any better, and were misinformed, the more it should get punished. No contradiction there, except perhaps if you were to find yourself the one swindled out of money, you might yourself want the government authorities to go after the criminals.

"If I were in Botswana, and I found a branch of Wells Fargo, then I would gladly accept any paper currency that was issued (and backed) by Wells Fargo. I wouldn't care if that Wells Fargo branch had a sticker in the window saying it was insured by Botswana's FDIC. In this case, Botswana should stay entirely out of the banking/currency business, and leave it to private banks."

If you were an American in Botswana and found a Wells Fargo, you might not have any qualms accepting currency from it. I doubt a lot of Bostwana natives who never think they will ever leave the land will want to accept paper from a foreign bank that could leave at a moment's notice, and suspend redemption of its currency.

Mike Sproul said...

I think anyone would have to agree that if the government is bad, (Botswana, etc) and there are good banks around (Wells Fargo, Chase, etc), then it's best to leave the government out of the money and banking business and leave it to the banks. So at the very least you'd have to admit that state-backed paper money is not universally desirable.

Banks can issue paper money, convertible or inconvertible, and people will use it based on the bank's brand name, just like with any commodity. I think the average person carries about $75 in paper money with him, so even if the paper money loses some or all of its value, it's no big deal. Things like checking accounts that are convertible into the paper currency can be indexed to inflation, so even if paper money loses value, checking account holders will not lose. Naturally there will be frauds, counterfeiters, and other unpredictable losses, but there's no reason to think that this will be less common with the government in charge of money production. The invisible hand tends to make bad banks go out of business. not so with governments.

A note on the Law of Reflux: Suppose people use silver coins. It's clear that if people need more coins, then someone will find it profitable to stamp silver bullion into coins. If coins are too common, people will melt them and they will reflux to bullion. (I have a paper called "The Law of reflux") That's how the invisible hand is supposed to work, and putting the government in charge of minting will only suppress the efficient workings of the market. It's the same with paper money. Private banks will issue it when it is wanted, and soak it up when it's not wanted. Government interference in paper money will also suppress the efficient workings of the market.

Rogue Economist said...

Ok, let me engage you on your terms. Supposing we had a market of different private curencies. Bank A issues one backed by gold, Bannk B by silver, Bank C backed by coconuts, Bank D by grains. There's a competitive market for all these currencies and all individuas engage in commerce using these currencies. What happens then if:

1. You bank with Bank C so you pay your transactions with coconut-backed currency. It happens that this month, a group of coconut farmers try to corner the coconut market. As a result the price of coconut commodities rises, and with it the price of coconut currency. Then the folowing month, this same group dumps all its commodity holdings in the market, slumping the price of coconuts, and along with it, the coconut currency.

What happens if you happened to enter a contract to buy a house this month, and you close this sale next month. The value of your coconut currency is no longer the same value when you entered into the transaction as when you are due to pay the house seller. Obviously, the house seller will think your contract is no longer valid. What happens to similar transactions throughtout the economy when this type of event becomes an everday occurence? Does your economy have a mechanism to compensate for the instability caused by all those transactions that are never ironclad because the value of people's payment currencies fluctuate on a day to day basis, depending on the weather, industry dynamics, or actions of people from across the globe engaging in market manipulation of the commoduty that backs each currency?

2. What happens if for example this market manipulation by a group of coconut farmers results in a 70% (it can happen) depreciatioon of your currency in a year's time? And you're due to retire that year? And you find that your 30 year's worth of savings has just lost a third of its value? (And you didn't even speculate in the market. You were prudent, and you kept your savings in currency, but the real value of your currency just disappeared when you were needed it for something) What do you do?

3. Since everybody's currency is fluctuating, how does the government decide what people owe it? To pay for tolls, registartions, income tax, property tax? For sure, it needs to still declare your tax obligation in a currency whiose value remain fixed and stable, as far as the government is concerned? There would still be a state-backed currency whose value is determined by what the governemnt says it's worth right? Now suppose your coconut currency is worth only 50% of its value today in terms of the state currency by the time you are to file your taxes, and only 40% by the time the government actually debits your account for the payment. Does the government now assesses you for more coconut money?

Notice I'm not even talking about acts of willful deceit by the issuing banks yet. My questions revolve around the difficulties of having multiple currencies in an economy, each having different values, and each constantly fluctuating in value. How does this economy function effectively?

Mike Sproul said...

One solution to the stability problem would be for each bank to back its currency with a bundle of assets (gold, land, wheat, etc).

In the old days, when gold and silver were the most stable things around, private and public moneys were both made convertible into gold or silver, which worked well enough in normal times. But say a bank had issued 100 currency units (dollars), each convertible into 1 oz. of silver. But the bank had only 10 oz. of silver in reserve, with the other 90 oz. worth of its assets spread between land, wheat, bonds, etc. If the bank's assets fell to only 90 oz. worth of silver, then the bank would be insolvent, and any attempt to maintain convertibility at 1 oz/$ would result in a bank run. The best choice at this point is to suspend convertibility. Then the value of the dollar will be .9 oz/$, and the value of the dollar will always reflect the value of the bank's various assets. The trick is done. The inconvertible currency is now backed by a bundle of assets.

On uniformity: Private banks have every incentive to make their various currencies uniform with those of other banks.

Rogue Economist said...

"If the bank's assets fell to only 90 oz. worth of silver, then the bank would be insolvent, and any attempt to maintain convertibility at 1 oz/$ would result in a bank run."

This fails my strong requirement that the issuer never be solvency-constrained. People will have always have to monitor the solvency of the issuer of the currencies they hold, and when they have reason to believe that an issuer is about to become insolvent, they will all reach for the exits, falling over each other trying to get rid of the currency. This in turn facilitates the run even further.

"The best choice at this point is to suspend convertibility"

But this too fails again in one of my strong requirements for a currency - convertibility, at any time, at its promised rate.

"Then the value of the dollar will be .9 oz/$, and the value of the dollar will always reflect the value of the bank's various assets."

I don't get what you're saying here. Are you saying when the issuing bank's assets fall, it will just increase it's conversion rate to the dollar to make up for its fall? This means the most insolvent ones get the most advantageous conversion.

"On uniformity: Private banks have every incentive to make their various currencies uniform with those of other banks."

How can they be uniform if one bank has more silver in its assets, another has more gold, and yet another mostly coconuts? Each bank will have different strengths, and different assets accumulated. And still, as people come in and out as receipients of its private currency, it would have to buy and sell its assets, to back the currency, but not always at the best price for itself.

I know you're allergic to government issuing the currency since it can debase the currency. But so can private banks. Private banks with a profit motive even more so than the government. And if the banks find themselves insolvent, which is possible being private companies, they have every reason to debase their currency.

Mike Sproul said...

Not sure how solvency and convertibility can be a 'strong requirement'. Governments and firms become insolvent all the time, and their liabilities generally become inconvertible as a result. So it sounds like you are requiring the impossible.

"Are you saying when the issuing bank's assets fall, it will just increase it's conversion rate to the dollar to make up for its fall?"

If bank A's assets fall to 90 oz, and bank B's fall to 80 oz., then A's dollars will be worth .9 oz. and B's dollars will be worth .8 oz. Regrettable, but there's no getting around it, whether the bank is run privately or publicly.

"How can they be uniform if one bank has more silver in its assets, another has more gold."

Because banks have stockholders' equity to cushion the ups and downs in the values of their assets. Only when assets drop enough for stock equity to be negative will the value of its currency move in step with the value of the bank's assets, as if it were a share of common stock.

BTW: There are lots of historical examples of privately-issued paper money with little or no state involvement. I would think that alone would undercut your argument that we need a state-backed currency.

Rogue Economist said...

"Not sure how solvency and convertibility can be a 'strong requirement'. Governments and firms become insolvent all the time, and their liabilities generally become inconvertible as a result. So it sounds like you are requiring the impossible."

Mike, if you've been paying attention to all my points, you know that a circulating currency for me needs to always be redeemable/convertible. People shouldn't worry that the bank that issud their currency will no longer be around when they're stuck with its currency. How are they goping to spend it then? I'm sure you take this for granted now, because your statebacked currency has always been accepted anywhere, but this is very important. You cannot just take this requirement away. And no, governments don't become insolvent all the time. Tell me the last ten times this has happened.

"If bank A's assets fall to 90 oz, and bank B's fall to 80 oz., then A's dollars will be worth .9 oz. and B's dollars will be worth .8 oz. Regrettable, but there's no getting around it, whether the bank is run privately or publicly."

This won't happen with the state issued the currency. It would at least keep its value within the currency area that issued it. Not so with private currency. Your bank may become insolvent, which means your currency loses its value while all your neighbours' currency keeps theirs.

"Because banks have stockholders' equity to cushion the ups and downs in the values of their assets. Only when assets drop enough for stock equity to be negative will the value of its currency move in step with the value of the bank's assets, as if it were a share of common stock."

Most banks only have 10% equity at the most. When the price of commodities backing your currency loses even just this amount, your issuer is already insolvent. And don't tell me just require banks to put up 100% equity. No private investor will put money in it. There's barely any earnings in issuing currency, unless you plan on counterfeiting it.

"BTW: There are lots of historical examples of privately-issued paper money with little or no state involvement. I would think that alone would undercut your argument that we need a state-backed currency."

How does this undercut the need for state-backed currency? You have it backwards. Private currencies never get enough traction because people prefer the statebacked one. Name me one country where the privateissued currency dominates the state backed one.

Unknown said...

I just spent a year living and working in Ghana. In 2008 they redenominated their currency from 10000 cedi notes to a 1 cedi note. "There is no change in value the value is the same" was a tv commerical jingle at the time. Now the old notes are no longer convertible.

What is the difference between this action taken by the Ghana Central Bank and notes privately issued by a bank that later goes bust? There is none except the mechanism by which the currency became unconvertible. ;-)

Rogue Economist said...

if Ghana redeneominated its currency, then i see no difference between its notes and that of a bank that devalues its privately-issued notes. I guess that's why it's a third world country.

Are you going to use this as a reason to abolish all state-backed currency everywhere and to start forcing people to accept private bank-created notes?

Put another way, are you going to be happy to know that starting tomorrow you have to exchange your currency with currency issued by a few accredited private banks, as the state will no longer back its previous currency? Which bank would you choose?

Calgacus said...

There is a huge difference between a redenomination & a devaluation of bank notes of a bank that goes bust.

Redenomination is a convenience which means nothing. It's just lopping off zeros. If one consistently changes all credits & debts, all contracts by the same factor, one changes nothing real. France did it around 1960. It's just counting the number of ten dollar bills & ten dollar debts you have, rather than the one dollar bills & debts. The jingle is right.

It is just like a country changing from Imperial units to metric. Old notes becoming nonconvertible is a real change - a bit like old wrenches becoming useless on new cars, and yes, like discounting notes of bank gone bust. But if there is a reasonable period to exchange old for new, well, so what?

It's like everyone being subjected to a magical shrink-ray that decreases dimensions by a factor of 10. Nobody would notice. (In a classical universe.)

A bank going bust means its debts do not trade at par, its one dollar debt being worth one cent - while other debts & credits DO trade at par. It's like the bank & only the bank being subjected to the shrink-ray. Everbody would notice the bankers became dwarves.

Ellen1910 said...

Now the old notes are no longer convertible.

Presumably, unknown isn't complaining about devaluation. He's complaining about having been too lazy to get the old "10,000 cedi notes" converted into the new denomination before the window (open for three years?) closed.

Well, there's always that 2% who never seem to get the word.

Rogue Economist said...

"It's like everyone being subjected to a magical shrink-ray that decreases dimensions by a factor of 10. Nobody would notice"

While my position is that state-issued currency is miles more preferable to privately-issued money, I would take exception to the position that nobody notices when the government adds zeros to the currency. This cannot go unnoticed in a global world. For example, the Canadian dollar is equal parity with the US dollar. Suddenly Bernanke decides to put an additional zero to the price level in the US. Now the US dollar will be worth 10 Canadian cents. People will notice, and Americans will strive to flee to the canadian currency ahead of such a move.

Privately-issued or state-issued, you cannot just arbitrarily change the value of your currency or people will not trust it anymore to hold it. That's primarily my beef against private issued money. A bank with more liabilities than assets will devalue its currency. I prefer state-backed because I want to believe that the state will normally have more assets than liabilities, and will not just devalue its money like a private bank with scarcer resources would.