Arnold Kling  

Lectures on Macroeconomics, No. 8

Morning Commentary... Depression Mania...

This lecture looks at private monetary instruments and their relationship to government monetary instruments.

In the previous lecture, I suggested that there is a close connection between money and government. Historian Niall Ferguson has drawn this connection in The Cash Nexus and The Ascent of Money.

Note how unusual it is for government to exist without issuing money and for money to exist without a central government. Examples of the latter might include the seashell economies of primitive tribes or the cigarette economies among prisoners. But both are very small, limited, incomplete economic systems.

Prisoners are not producing goods for trade with one another. They are receiving gifts and rations. Also, they operate under strict rules and supervision, even though they have not formed a government. The prison economy is not representative of society at large.

Tribes that use seashells and similar media of exchange seem to me to engage in trade for ceremonial purposes, such as weddings. I don't think of them as organizing their economies around trade and monetary exchange.

For government to exist without printing money is just as unusual. In theory, another country, call it A, could outsource its monetary system by using dollars or euros as money. There are two problems with taking this approach.

First, the money supply depends a great deal on what goes on with international transactions. If foreign investors take a liking to A's investment prospects, they will flood A with money. Conversely, if investors decide to take their funds out of A, the money supply in A will contract sharply. Not being able to control when your money supply is growing or shrinking dramatically is a problem.

(There is a well-known proposition in international macroeconomics that if you are a small country with a fixed exchange rate and no controls on foreign exchange, you have little or no control over your own money supply. If foreign investors like your investment projects, they will bid up your currency, and to offset that you have to print money. Conversely, if investors are fleeing your country, then in order to maintain the value of your currency you will have to take money out of circulation. A small country with a fixed exchange rate is only one step removed from outsourcing its monetary system to a foreign currency.)

Second, a country that outsources its monetary system will be giving away its seignorage. When the demand for money increases, people are effectively paying a "tax" to the authority that prints the money. For example, if the amount of money in circulation rises by $1 million but prices do not change, then that increment of $1 million acts like a tax. The value of the tax is equal to the value of what the government obtains for the additional $1 million, minus the cost of printing the $1 million. If country A produces its own money, then country A collects the tax. On the other hand, if country A uses dollars, then an increase in the demand for money in country A effectively creates a tax on country A's residents that goes to the U.S. government.

So, for all practical purposes, we do not see money without government or government without money. Let us consider another possibility--private money existing along with government money..

There are some interesting examples of financial instruments that act like money, even though they are not created by government. For example, thirty years ago, if you were going to travel overseas for more than a few days, you might have obtained Travelers' Checks, most commonly from American Express. You might withdraw, say, $1000 in cash from your bank and exchange this for $1000 in Travelers' Checks. In your country of destination, every once in a while you would go to a bank and exchange some of these Travelers' Checks for local currency, in order to pay for hotel bills, meals, and other expenses.

The advantage of Travelers' Checks over paper dollars is that they required your signature to be used. If they were lost or stolen you would not have forfeited your funds. Instead, you could obtain new Checks at an American Express office in the country that you were visiting.

Suppose that you spent only $800 on your trip. When you returned, you could come back to your bank and exchange the remaining $200 for cash, to re-deposit into your account. Between the time that you buy the Checks and the time that all of them have been used, the issuer of the Checks has earned interest on your money. In addition, sometimes the issuer would charge a fee of, say, one percent of the face value of the Checks.

It is interesting to think about what had to happen in order for American Express to build this business. Foreign banks had to be willing to accept the Checks. This meant that American Express had to have offices in foreign countries that were known and trusted by the local banks. Those banks also had to trust that American Express was financially sound, so that the local bank would not honor a Check and then find that American Express did not have the funds to back the Check.

Nowadays, credit cards and ATM cards have replaced travelers' checks. With current communication systems and computer databases, it is relatively inexpensive for banks and merchants in one country to verify a bank account or credit card account belonging to a person from a different country. As a form of substitute money, credit cards have expanded and Travelers' Checks have declined.

Another interesting form of substitute money is frequent flyer miles (FFM). FFM are issued by airlines and backed by their services. That is, FFM can be redeemed for tickets on flights, for upgrades to first class, or for other services. Many credit cards offer rebates in the form of FFM. Some hotel chains also offer rebates in the form of FFM. It is my understanding, however, that FFM in general are not readily transferable across individuals--I cannot get your FFM nor can you get mine.

There are a number of ways in which airlines can devalue FFM. An airline can restrict the availability of seats that are eligible for FFM. An airline can increase the number of FFM needed to purchase a seat. Or the airline could go out of business, potentially rendering customers' FFM worthless (although often in an airline merger the new owner will honor FFM issued by the defunct carrier).

I wonder why an airline does not decide to allow individuals to exchange FFM with other individuals. If this would cause FFM to be redeemed more frequently, then the airline could offset that by raising the number of FFM needed to purchase a ticket. Perhaps what the airlines are doing is engaging in price discrimination. The "frequent redeemers" get good deals, subsidized by those of us who rarely redeem our FFM. If we could exchange, then those of us who are rare redeemers would sell our FFM to frequent redeemers, taking away the price discrimination. I guess that's why the airlines don't allow transfers.

I have to admit that the whole phenomenon of FFM makes very little sense to me. Basically, I hate every airline except Southwest, so I regard the prospect of taking an extra trip on another airline as a punishment, not as a reward.

The point that I am making with Travelers' Checks and frequent flyer miles is that private currency is possible. Technically, I think if I printed up blue pieces of paper with my picture on them, called them money, and convinced merchants to accept them, I might be in violation of some law. But in practice, a lot of instruments that come close to that are quite legal. The fact is that the cost of bringing an alternative financial instrument up to the status of pseudo-money is very high, for reasons having to with gaining acceptance, not legal prohibition. The monopoly that a government enjoys in creating currency that is accepted within its own country seems quite secure.

When one country's money is really distrusted by its residents, the solution is never for a private entity within that country to develop a money substitute with more widespread acceptance. Instead, residents will attempt to hold their wealth in foreign currency. They may even prefer to accept foreign currency in ordinary transactions.

Within any one country, the trust that people put in government money usually represents an upper bound on the trust that they put in any financial instruments issued within that country. As far as I know, there are no instances in which you will find people saying, "Country X's currency is almost worthless, but they have a bank whose liabilities are a really safe investment."

Again, I see a close connection between confidence in government and confidence in money. Where people are confident in one, they tend to be confident in the other.

There is also a correlation between military hegemony and monetary hegemony. You tend to find that where a country's armed forces are feared, its currency is accepted. For countries whose armed forces are not feared, acceptance of currency is ultimately at the discretion of the hegemon. Perhaps the currency of Cuba is no worse than that of Argentina, but the fact that the United States is willing to honor the latter but not the former has a broad impact.

Private financial instruments that serve as money tend to come from the United States. This suggests that companies like American Express and the airlines are riding on the U.S. government's credibility. In fact, I think that financial institutions and financial instruments can be viewed as consisting of layers, in which one institution rides on the credibility of another, which rides on the credibility of another, and so on. Resting on the bottom of all of these layers is the credibility of the government. This idea will be developed further in a subsequent lecture.

To see previous lectures, go to the end of the last lecture.

Comments and Sharing

CATEGORIES: Macroeconomics , Money

COMMENTS (9 to date)
E. Barandiaran writes:

You say "So, for all practical purposes, we do not see money without government or government without money." Sorry, everyday I see money without government in the form of what E. Fama called an accounting system of payments (today much larger than what he called the monetary system of payments) and I see government without money in at least 50 states, including one that is larger than most UN members.
May I suggest that you focus your analysis on the performance of the accounting system of payments and the conditions under which any government--including US state governments--should issue a currency.

D Wright writes:

How does the system work in two-hegemon world?

Was it the case that during the cold war, the Soviet currency was accepted in its fellow communist states and vice versa and not anywhere else in the world?

Sytse Sijbrandij writes:

I think it is possible for private entity within a country to develop a money substitute with more widespread acceptance.

This can be seen with mobile credit used as currency in Africa.

Although the mobile carriers that facilitate this are not restricted to one of the countries it still strikes me as an example of a viable alternative private currency.

Joe Teicher writes:

I don't know if this was your intention, but you are making me a lot more comfortable with all the government's recent financial meddling. I no longer care if the government nationalizes the banking system, because it is just reinforcing a relationship that has always and will always exist. Anyway, I really like the series and thanks for cheering me up!

Alex J. writes:

Tribes that use seashells and similar media of exchange seem to me to engage in trade for ceremonial purposes, such as weddings. I don't think of them as organizing their economies around trade and monetary exchange.

There are two claims here:
1) Tribes that use seashells use them only for ceremonial purposes.
2) Tribes that use seashells don't organize their economies around exchange.

They don't have to go together. A group could be 98% subsistence farmers and 2% traders. They could have commodity money that they use as a medium of exchange and a store of value. It need not be ceremonial, just because it's not a large part of their economy.

All of the tribes shells (or beads or amber or stone rings or flint or ermine...) might not be worth much in toto, but such a society doesn't have much demand for cash either. Nonetheless, it's easy to imagine such people being just as grasping as a flea market vendor and for exactly the same reasons.

Or am I missing something important about your position?

Alex J. writes:

So, for all practical purposes, we do not see money without government or government without money.

Money issue and the state certainly correlate. (Though not perfectly, there was Scottish free banking, and Somali shillings continued to be used for some time after the collapse of the Somali state.) But which causes the other? You suggested before that it's in the state's interest to issue money. But I think that it's more likely the case that money issue by private actors is easy for the state to disrupt. Given the winner-take-all nature of money issue, this means implies that states will tend gain a monopoly on the issue of money.

That's why private issuers don't appear when the state's money is bad, they are subject to the same disruptive monopoly-seeking state that can't issue sound money. Contrarily, the same relatively rule-of-law-obeying American state whose dollars are widely accepted is also the source of private monies because foreigners are relatively less afraid that some short sighted tyrant will try to squeeze either kind of institution for all the short term gain he can.

Disruption by states also explains why military and monetary hegemony can go together. Small states are at risk of conquest by strong ones, they might inflate to raise an army to resist catastrophic war. Their revenue generating pipelines might get snatched. (PS, Cuban money isn't accepted inside Cuba either. You need dollars there too.)

quadrupole writes:

I'm just curious how the Euro fits into your argument about governments without currency. Your basic point about why one wouldn't adopt another sovereign's currency has to do with monetary policy not being tailored to your countries needs.

How would this apply if you thought of the states in the US? Is Michigan suffering from deflation because of its needs being out of sync with the rest of the country (for example)?

quadrupole writes:

Also, re private money...

I remember observing in the late 90s when the pooling of interest rules made it very attractive for one company to buy another with stock (and the rapid inflation of stock made stock attractive as payment for things like the rent of a startup) that *stock* was very much like private money.

This was particularly driven home by AOLs purchase of Time Warner on their wildly inflated stock. Or Worldcom's purchase of valuable real assets with their fraudulently inflated stock.

So what do you think of stock as private currency?

Isaac K. writes:

I have to day, Dr. Kling, I am a bit disappointed - you happened to ignore one form of currency that's rather prevalent in some sectors of American culture: scrip [or script]. Primarily scrip is used as a revenue generating agreement between schools and retail chains [grocery stores and the like], who kickback some of the sales revenue to the school when the scrip is used. Or, more accurately, the stores sell giftcards at discount to schools, who then use policy to require parents to purchase a certain amount, later to be spent in said stores.

In some areas, though, it becomes a de-facto form of currency. For instance, in certain Baltimore communities, those "blue pieces of paper with your face one them" DO exist, and are printed by a central "authority." People use them just as they would real money in a rather large number of local stores, who [I believe] convert or exchange them for dollars wih the original printing authority.
It's doubtful that anyone outside that circle would accept that currency, and even more doubtful that the government would take umbrage at the manufactured replacement.
Basically, any culturally bounded group can find a means of implementing a localized currency, regardless of an overall government imposing its own market control.

Tribes that use seashells and similar media of exchange seem to me to engage in trade for ceremonial purposes, such as weddings. I don't think of them as organizing their economies around trade and monetary exchange.

Yet the Tyler Cowen article you pointed out directly makes reference to the use of wampum within the American colonies even by the English Bank. These colonies were known to trade excessively with Indians. I am not sure that you can label the colonies as failing to "organize their economies around trade."

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