Scott Sumner  

Currency and lotteries: Is there a free lunch?

Investing: A Weekend Thought... Happy Birthday, Leland Yeager...

In a recent post I criticized the "free lunch" view of printing money. However I did acknowledge that there was a sort of free lunch aspect to having a monetary system, but only to the tune of a bit over 1% of federal revenues. A commenter correctly pointed out that someone must pay for any revenue received by the government.

Let's explore this issue by comparing currency to state lotteries, which are often claimed to be a sort of "voluntary tax," and hence not harmful. Readers of this blog surely understand the fallacy of that claim; the government keeps at least 1/2 of the total money bet, and that's a tax of betting. But there is something different about lotteries, even when compared to other products for which the tax is falsely claimed to be "voluntary," such as cigarettes. Lottery consumers applaud when states create lotteries, whereas smokers are unhappy when the state imposes cigarette taxes.

The explanation is simple; a new lottery does two things simultaneously, it legalizes gambling and it taxes gambling. Revealed preference tells us the lottery buyers gain more from legalization than they lose from the tax, whereas in the case of cigarettes the product was already legal. If they legalize and tax marijuana, that would be a good analogy for the lottery.

Now let's consider currency, and assume we start from a state of nature with no private currency provided by free banks. In that case even a libertarian would probably acknowledge that fiat money is a useful thing to have around, even if it loses a bit of value through inflation. So the combined decision to create a currency and deliver seignorage revenue to the government may be a plus for currency holders in the same way a lottery benefits gamblers.

But of course this begs the question of whether a free banking alternative is plausible, as private lotteries clearly are. I think free banks are feasible, but I'm a bit of an agnostic on the question of the efficiency of free banking. That may be surprising, as I want to privatize just about everything the government does, except the most very essential core functions (and I'm not an expert on what those are, good (Chicago/GMU) microeconomists can better answer that question.) So why am I agnostic about free banking?

Currency is different from other goods in one important respect; its value largely flows from its fixed nominal price. If currency were interest-bearing zero coupon bonds with market prices than changed minute by minute, then it would be very complicated to use in transactions. You'd have to calculate the value of a bill with a $20 maturity value every time it was spent. This market failure, if it is one, is so rare it doesn't even appear in textbooks (along with the conventional market failures like externalities, monopoly and public goods.)

So I'm going to assume currency must have a fixed nominal value. That fact by itself doesn't rule out free banking---they'd have an incentive to produce the sort of currency consumers want. Indeed I believe (and will later argue) that the private sector might do a better job than the government in meeting consumer taste in money.

But there is another problem. Because we assume the price of currency is fixed, that means free bankers could not use price competition to compete for customers. Free banking advocates will respond that if non-price competition is better, then it's efficient for free banks to provide non-price competition. I'm not so sure. I worry that this might be an example of the "toaster problem," which does not refer to bread getting caught in the toaster.

Younger readers may not recall that when banks were not allowed to pay interest on checking accounts (prior to 1980), they engaged in non-price competition, such as offering free toasters to depositors. Economists of all ideologies argued that this was inefficient, and that price competition was better. I worry this could occur under currency competition, even though the reason for the lack of price competition would be technical, not legal. I think it's actually possible that a monopoly currency issuer could be more efficient, by avoiding wasteful price competition. Most debates stop there, with the anti-libertarians claiming QED, the government is better than free banking in currency issuance.

But in 1995 I did a paper (JMCB) that went one step further. Markets really are more efficient than government. So why not allow markets to at least play some role in the process? Why not auction off the rights to issue the following five denominations, to five different companies:

Up to 99 cents.


$1.10 to $10

$11 to $90


Companies would then have an incentive to maximize seignorage after winning the license. They would have an incentive to adopt optimal denominations. Thus they might drop the penny, saving hundreds of millions. They might replace the dollar bill with a dollar coin, which would save manufacturing costs. They might follow the post office and put the picture of pop stars on the bills. Perhaps a hip hop star could go on the $100. Or maybe money would become beautiful, as it once was.

Younger readers will notice that my obsession with old-fashioned currency makes me a bit of a dinosaur. We are rapidly moving toward an electronic money regime, which will eliminate all my arguments against free banking. Price competition would immediately become efficient. And yet, while I agree that we are rapidly approaching an all electronic regime, while we are doing so paper currency use is actually increasing rapidly, even as a share of GDP. It will be highly controversial when the Feds ban paper money. And (ironically, given how libertarians hate fiat money) it will be a loss for liberty. It's all part of the Federal government's "1984 project," a panopticon state that the public is meekly acquiescing to.

BTW, some have argued that paying interest on currency is efficient via lotteries (another connection!), with one serial number winning each week. But this would cause massive time wastage, as the public kept checking serial numbers. Another issue is whether we want to make currency more convenient, as today it is mostly used for tax evasion, and hence the cost in foregone income tax revenue probably exceeds the gains in seignorage. And there are many other issues to consider. So the question of whether there is any sort of free lunch aspect to currency is surprisingly complex, and has links to seemingly unrelated issues like "voluntary" lottery taxes and the toaster problem.

PS. When interest on money does become feasible it should equal the fed funds rate, plus or minus the difference between actual NGDP and target NGDP. Then currency demand would fluctuate in such a way as to automatically stabilize NGDP. I am indebted to Robert Hall (JME, 1983) for that idea. Miles Kimball would love the idea.

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CATEGORIES: Free Markets , Money

COMMENTS (9 to date)
Lorenzo from Oz writes:

We know free banking works -- Scotland in the C18th and early C19th and Canada from the early C19th to early C20th had free banking regimes that worked better than the contemporary banking regimes of England and the US respectively.

We know it almost certainly won't happen again -- governments will not give up the source of emergency financing central banks provide. Both Scotland and Canada were subordinate/associated jurisdictions protected by the Royal Navy funded (in war) via the Bank of England.

We also know there was some discounting of bank notes, including depending on how far from the nearest bank branch one was. (Not a problem in Scotland after it pioneered branch banking.)

But surely the issue is not the demand end, but the supply end. Banks provide banknotes because it is profitable. Apparently, consumers could cope quite well with a bit of discounting. Just as folk in countries where they prefer, say US$ to the local currency could/can. So I am not sure we have much reason to accept that currency "must have a fixed nominal value".

Scott Sumner writes:

Lorenzo, Those are good points. But I do think that currency used in transactions is much more efficient if its nominal value is fixed. I don't know much about the Scottish example, but I'd guess that even there most currency and coins traded at par value.

Lots of currency (most) is now held as a store of value. In that case a fixed nominal value is much less important.

And I obviously agree that free banking is feasible, and often would perform better than central banking.

vikingvista writes:

You write about what *would* happen under free banking as though it doesn't have an extensive history. Why not test your theories by writing about what *did* happen?

Also, just because the violent suppression of gambling or currencies is the status quo, doesn't mean that that suppression isn't costly.

Lorenzo from Oz writes:

Scott, absolutely, the precision value of money is a significant part of its benefit. I was simply demurring about the "must" claim.

RogC writes:
Currency is different from other goods in one important respect; its value largely flows from its fixed nominal price
I understand your intention but suggest you find a different way to convey it. This is a meaningless statement. In nominal terms the value of anything must always equal to itself. It only makes sense to think of a 'price' in relational terms to something besides the item in question.

Your general points are good but you navigate to them via assumption that the value lies in the currency and stumble over the real relationship that the currency is just a convenience for trading.

Even a short visit to an area experiencing very high inflation will demonstrate that it is indeed necessary to constantly be recalculating the price of the bills in your pocket.

Scott Sumner writes:

Vikingvista, That's what comments are for.

Lorenzo, Good point.

RogC, You said:

"In nominal terms the value of anything must always equal to itself."

You've lost me. Surely the nominal prices of stocks, bonds and houses fluctuate. Perhaps I misunderstood you.

Floccina writes:

Why aren't the great depression and recession (along with some small costs due to inflation in the 1970s) the true costs to current monetary system (assuming free banks would float more notes to meet demand but not enough to cause inflation)?

J.V. Dubois writes:

This is a good post and it contains three main points why I think "free banking" is not a big issue:

1) The extent of influence is very small. If we assume that NGDP grows 5% a year and on average people hold 5% of GDP as currency then the extent of seignorage is 0.25% of GDP. This is very tiny portion of government taxation. I think any feasible government will have taxation needs far exceeding this ammount. And given how efficient this tax is I would say it is not worth discussing how to abolish it.

2) The problem of nominal fix: in all the historical examples Lorenzo mentioned it was some kind of metal standard that was serving as nominal anchor for bank currencies. Which is for me bigger problem for macroeconomic reasons than tiny seignorage.

3) The electronic transactions: This is a good point as I do not think that there is any substantial difference between "free banking" and what we have now when it comes to electronic transactions. The only difference compared to historical examples is that instead of having silver or gold as anchor for nominal price we have a new thing - a government currency serving as such.

The banks compete for customers purchasing their electronic bank notes (called deposits) that may be also used for paying for things via wire transfer/debit card technology. Banks compete for customers on bank money market by offering interest for bank monies that basically protect holders of bank money from seignorage at the expense of some risks of bank failure and devaluation of bank notes (inability to withdraw all the money deposited).

Can anybody tell me how is this different from "free banking"? We have all sort of electronic bank monies from different banks on the market plus one additional state run money that also serves as currency - and nominal anchor due to networking effects. But we now live in a world where any freedom loving libertarian can go without ever holding any currency - he may use "free" electronic bank money virtually all the time.

J.V. Dubois writes:

Lorezo: "We know it almost certainly won't happen again -- governments will not give up the source of emergency financing central banks provide."

My view on this that any freedom in bank currencies was superficial at best. The reason is that if and when to a situation where State needs seignorage to fund its activities (war, revolution etc.) then no previous legal guarantee will be worth much.

A paradox here is that the best protection for people in such a situation is not some legal barriers - but other currencies which are protected by sovereign states. Hence dollarisations of unstable economies.

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