The zero bound and the next currency system

Exchanging tweets with Steve Williamson and JP Konig prompted the following set of thoughts.  Though they cannot be blamed for any silliness or errors below.

The basic theme is that if currency arrangements are sufficiently messed up by the public authorities, society may coordinate on better ones.  We’ve seen this with basket-case countries in Latin America, or like Zimbabwe, which abuse the printing presses to pay for government outlays, and suffer hyperinflation, leading to the populace, or those that are able, resorting to using US dollars instead.  But perhaps the new world of negative rates, deflation and unconventional monetary improvisation [read floundering] is another example.

Suppose that the authorities set significantly negative rates, and this prompts people to withdraw their money from their deposit accounts as cash.  Initially, these get stored in safe-deposit boxes individuals buy for themselves.  As time goes on, the private sector starts to consolidate these cash holdings in larger vaults where economies in the scale of protection can be realised.

These institutions develop a reputation for being sufficiently reliable that people stop exchanging for things with cash, and instead use IOUs, which are claims on their small piles of cash.  The switch involves a leap of faith, because there is always a risk that the IOU won’t deliver what they promise the bearer on demand.   But the occasional disappointment is more than compensated for by the convenience of not having to pay someone to take cash out of one box, and move it or truck it to another.  And the centralised cash-vault management means that the trucking is kept to a minimum, and, eventually, when the vault managers work perfectly in concert and merge, eliminated entirely.

Over time, the convenience of the IOUs leads the cash-owners to wonder if they shouldn’t agree that their delegated vault manager should have the power to issue the IOUs itself.  Why not?  Much time passed with hardly any break-ins, and few notes lost to fire or flooding.  Once that step is made, it’s a short time before an agreement is struck that the central cash vault manager is allowed to relax the promise to exchange the IOUs for cash on demand.

Although this seems like a dangerous and revolutionary development, one that will over decades generate a vibrant subculture of resentful ‘cashbugs’, the cash-vault customers realise, collectively, that it has the advantage of allowing the delegated cash-vault manager to regulate the inflation rate  of the value of IOUs in terms of the goods and services they are used to buy, at the expense of fluctuations in the inflation of the value of IOUs in terms of cash and goods.  But, with prices increasingly posted in terms of IOUs, what does that matter?  And, after all, the former cash-vault customers conclude, since the authorities were floundering at the zero bound, this inflation rate had anyway become too low and unpredictable.

A bright spark at the central IOU-issuer realises that with prices initially pretty flexible in terms of IOUs, it can issue them at a pace that produces, straight away, an interest rate on securities promising IOUs that is well above the zero bound.  Over time, the sacrifice in terms of anxiety in allowing the unpredictability in the cash-goods inflation rate starts to seem insignificant, since most, if not all, of the functions of cash have been subverted by the new IOUs.  Soon, all that matters is the inflation rate between IOUs and goods.

In the early days of the new system, there are times of panic, when demand for the old ‘cash’ surges.  But mostly, time passes such that the notion that these old pounds, in cash form or otherwise, were necessary for the monetary system is as quaint as the notion that a household or government needed gold.  This quaintness advances to the point where some find the cash attractive, and are drawn, perceptibly, to the complex art work and richly manufactured substance of the notes, such that in some circles, cash becomes a medium for decorative jewelry and ornaments.  The IOU issuer cottons on to this, and, as a public relations effort, to try to encourage interest in its almost unfathomable acts of monetary and technical magic, holds open days where it takes schoolchildren down into its vaults to look at rooms staked high with the old cash.

In this fable, the currency shift comes about because the authorities force society to manage their own hoards of cash, rather than doing it themselves.  You might well complain that no such switch would ever happen.  Hyperinflation caused the value of cash to collapse, and people naturally flew from that.  The current problems amount to the authorities failing to erode the value of cash, and, in fact, in the case of Japan and Switzerland, unavoidably increasing its value.  Why would anyone run from that?  Well, perhaps they wouldn’t.  But the usefulness of something as money isn’t just about its use as a store of value, and the expected capital gain or loss.

You might well point out that the authorities could – indeed are typically instructed to – prevent this transition from coming about.  After consulting histories of the Jacobin government’s attempt to enforce the use of the increasingly worthless Assignats in after the French Revolution, they might be encouraged to employ heavies to sieze IOUs issued by the delegated central cash-vault-protector-cum-IOU issuer.  Or they could instruct the courts to refuse to recognise debts as settled in terms of IOUs.  Or ban individuals from posting prices in terms of IOUs.

But then, why should the authorities act like this, really?  If the new IOU authority can be regulated to operate along the lines of the old central bank, and obviate the zero bound, why not let it happen?

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6 Responses to The zero bound and the next currency system

  1. Nick Rowe says:

    Good. You followed up on those tweets. They were worth it.

    “Cashbugs” is good.

    If prices are sticky, are they sticky in IOU’s, or sticky in cash? We have two possible Schelling focal points: everyone coordinates on pricing in IOU’s; everyone coordinates on pricing in cash. We only see the difference when the exchange rate changes. Pricing in IOUs seems more plausible if nearly everyone really does in fact use IOUs as the medium of exchange.

    • Tony Yates says:

      Good points. To get the result that the central bank could effortlessly achieve the new inflation target in IOUs, I needed to assume that prices were flexible in IOUs initially. But we could do away with that. In the fable, the price of goods in terms of money becomes irrelevant, and no longer posted.

  2. Steve Williamson says:

    Historically, private monetary systems existed in tandem with government-issued currency. For example the early Scottish banking system, or Canada pre-1935. In those systems, banks issued paper notes which were redeemable in gold. The Canadian system featured a system of clearing and settlement, with the Bank of Montreal acting as a quasi-central bank. Now, suppose you set up such a private money system in a modern context. The liabilities of the private banks could be more sophisticated than just paper notes, but could include those too, with a private system of clearing, settlement, and credit among banks. Could such a private system divorce itself from any connection to central banking – no need to hold “reserves” in the form of government currency in the vault or central bank balances? Obviously there would be an attempt to regulate it, but how, and would that be necessary?

    • Tony Yates says:

      I suppose my contention is that I don’t see why such currencies could not come about. After all ‘private’ and ‘official’ are both sorts of collective action, so if one is an equilibrium, why not the other? But perhaps I didn’t convince you. The attempt to regulate the new currency would be to achieve what the regulators were trying to achieve with the old one. A new FOMC would emerge to impose an inflation target in IOUs, using the same justifications. What do you think?

      • Steve Williamson says:

        Yes, it’s hard to distinguish public from private. Technically, the Bank of England was “private” before 1946. But during that period, who appointed the Bank of England’s officials, and in whose interest did they think they were acting?

  3. BJH says:

    This is a very nice post

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