A model of parallel currencies under free exchange rates

Money is one of the most studied and truly complex phenomena in Economics. How money is created? And how is it destroyed? ‘What constitutes money and what doesn’t? Is money only the means of payment sanctioned by law, by the State? In our current monetary systems, can we ‘create’ as much as money as we like? If so, wouldn’t it be inflationary? These are some of the questions Economics students frequently ask at the start their degrees. Today I am only going to focus, if only timidly, on one of them; the absence of competition in the national currencies markets in our days. Of course, the absence of competition in this market is not the result of the application of the conventional laws of Economics; quite the opposite, as masterly explained by Vera Smith in her ‘Rationale of Central Banking and the Free Banking Alternative’ in 1936, the granting of the legal tender clause to a single currency, that issued by the State, has been an explicit decision made by the government (the relation between the State and the central bank has always been problematic to say the least, you can find more details on it here). F. Hayek also explains marvellously the abolishment of the laws of Economics as regards money in his ‘Denationalisation of Money’ in 1976. More recently, my colleague from the Institute of International Monetary Research (IIMR), Tim Congdon, discussed this issue in his ‘Money in a Free Society’ in 2009 and makes the case for a privatised and truly independent central bank, detached from the political agenda or the economic needs of the government.

Following this debate, two colleagues of mine, Pedro Schwartz and Sebastian Damrich, and myself have reflected on these issues in a working paper just published by the Applied Economics Centre of the John Hopkins University (‘A model of parallel currencies under free floating exchange rates’. In Studies in Applied Economics, Num. 160, June 2020). In the paper we assess the feasibility of a parallel currency system under different macroeconomic scenarios. We first offer the rationale for the introduction of more competition in this market and then develop a model to see wether (and under which conditions) a parallel currency system ends up in the running of a single currency economy, or rather in two currencies competing for the market. We draw policy implications and use the the eurozone as a case-study, but the model could well be applied to any other set of countries sharing a currency or willing to access a different currency area. In a nutshell, what we show in the model is the conditions for the issuer of each currency to gain a higher market share and benefit from it. We make a distinction between (1) a macroeconomic stable scenario, defined in the paper ‘as one in which the sensitivity of the market share of the currencies to changes in prices in both currencies is not high (as we presume changes in inflation in both currencies will be rather small)’ (see page 25). In this scenario, it is ultimately the supply of each currency what determines their market share (the less inflationary currency will gain more market share over time); and (2) a highly unstable macroeconomic scenario, ‘where agents’ demand of each currency is very sensitive to changes in relative prices in both currencies. In this high price sensitive scenario, an increase in the switching costs to favour the use of one of the currencies (i.e. the government’s preferred currency) would only lead to inflation in that favoured currency and very quickly to its expulsion from the market’ (see page 25). The model can thus be applied to well-established economies, where both the national currency and the common currency circulate in the economy and to highly inflationary economies, where the government favours the use of its currency and uses the currency as a source of revenues (i.e. seigniorage).

This is the abstract of the paper, which you will be able to access in full here:

‘The production of good money seems to be out of reach for most countries. The aim of this paper is to examine how a country can attain monetary stability by granting legal tender to two freely tradable currencies circulating in parallel. Then we examine how such a system of parallel currencies could be used for any Member State of the Eurozone, with both the euro and a national currency accepted as legal tender, which we argue is a desirable monetary arrangement particularly but not only in times of crisis. The necessary condition for this parallel system to function properly is confidence in the good behaviour of the monetary authorities in charge of each currency. A fully floating exchange rate between the two would keep the issuers of the new local currency in check. This bottom-up solution based on currency choice could also be applied
in countries aspiring to enter the Eurozone, instead of the top-down once and for all imposition of the euro as a single currency that has turned out to be very stringent and has shown institutional flaws during the recent Eurozone crisis of 2009 – 2013. Our scheme would have alleviated the plight of Greece and Cyprus. It could also ease the entry of the eight Member States still missing from the Eurozone.’

All comments welcome. We still have to work more on the paper and suggestions for change and further references will be most appreciated.

 

Juan E. Castañeda

PS. A previous study on parallel currencies by P. Schwartz, F. Cabrillo and myself can be found here; where we put it forward as a solution to ease and expedite the adjustments needed to apply to the Greek economy in the midst of the so-called euro crisis.

 

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Two competing, free floating, currencies

My colleague and friend, Prof. Pedro Schwartz (President, Mont Pelerin Society), recently published a letter in the ‘Financial Times’ (‘Three conditions for a two-currency system’ praising the monetary system in Peru. Rather than a purely dollarised economy (either de facto or de iure), Peruvian authorities allow for the circulation of two currencies; the national currency (the ‘Sol’) and the US dollar. As Prof. Schwartz specifies in the letter, the system has been working rather well since its introduction in 1990, provided that three main conditions are met:

– Free movement of capital so Peruvians are free to put their income in either currency and take their money out of the country if they didn’t trust the national authorities.

– Both currencies freely float in the market, so their value clearly reflects the confidence of money holders on the issuer.

– And, in order to avoid the expel of the national currency from the market, the national central bank conducts an independent monetary policy focused on maintaining the purchasing power of the currency; which has resulted in a quite moderate rate of inflation in the last years. Doing so will foster the demand for the national currency on long term basis and thus make it attractive for the public.

Nothing really new so far; this type of two or even more currency systems worked well in the past all across the world: one currency was used for international trade, another for savings and possibly another for small transactions.  The government usually tried to control the parities but the price of the different currencies fluctuated in the market according to their purchasing power.

Those familiar with this blog won’t be surprised when I say that I do find this alternative monetary system a more desirable regime to both introduce more competition in the monetary system and thus discipline money issuers more effectively, as well as provide a convenient institutional tool for Euro zone member states in trouble to timely adjust their local costs and prices without the need to be expelled from the Euro (more details on this question here and here). Of course, this doesn’t mean that a devaluation of the local currency will solve all the problems, if not followed by credible and sound monetary and fiscal policies in the future under the three-condition system set out above.

Juan Castaneda

PS. I am currently working on a research paper with Prof. Schwartz to apply this system to the Euro zone (to be continued … soon).

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A market solution for the Euro crisis

This month the Institute of Economic Affairs (London) has published a new book with a collection of essays of different authors on the crisis of the euro, edited by Philip Booth: “The Euro- the beginning, the middle … and the end?“. In these troubled times, dominated by those who only see more fiscal centralisation as the single way to overcome the euro crisis, this book is a true rarity; as, amongst others, it has several chapters with practical proposals to foster the introduction of more monetary competition to address and finally tackle some of the major problems affecting the European Monetary Union. And yes, I said “practical” proposals because, some of the chapters of the book do contain not only a description of the benefits of having more monetary competition in order to achieve more monetary stability in the medium to the long run, but also the institutional and market arrangements needed to be implemented in the current scenario in Europe.  A novelty indeed! In this regard, the proposal I support in the book (chapter 6), which consist of (1) at least the elimination of the legal tender clause and (2) the competition of the euro with the former national currencies, could be just a starting point in the right direction. Even more, we (profs. Schwartz, Cabrillo and myself) have calculated the costs of this alternative (more open) monetary regime and they are by far less than the costs we are all still paying just to maintain the current (flawed) system.

The publication of the book (12th April) was accompanied by the following (joint) statement of the contributing authors (see their names and  affiliations here):

“The euro zone as we know it must end or be radically reformed. Current mechanisms being used to manage the euro crisis are inadequate at every level. And as Cyprus shows us, the euro-zone crisis is far from over.

In new research from the Institute of Economic Affairs, The Euro: The Beginning, the Middle … and the End?, leading economists in this field, analyse the problems with the current approach being taken to resolve the euro zone crisis and argue:

• Product and labour markets in euro-zone member states are far too rigid to respond adequately to economic shocks. The result has been high unemployment and prolonged recession in a number of euro-zone countries.

• The EU must therefore face up to the inadequacies of its policies both in terms of the long-term structural errors in policy and of the short-term management of the euro-zone crisis.

• There should not be a debt union of any form. Governments must be responsible for servicing their debts without bailouts.

• Euro-zone countries must deregulate their labour markets and reduce government spending. Decentralisation and the promotion of a market economy must be at the heart of EU policy.

The report outlines several options for radical reform of monetary arrangements within the euro zone, including:

• A complete and orderly break-up of the euro and a return to national currencies combined with the vigorous pursuit of free trade policies.

• The suspension of Greece, and possibly other failing euro members, from all the decision-making mechanisms of the euro. These countries could then re-establish their own national currency to run in parallel with the euro. Both would be legal tender currencies with free exchange rates. Such an approach should be part of a more general agenda for decentralisation in the EU. This proposal mirrors the “hard ecu” proposal of the UK government before the euro was adopted as a single currency.

• The enforcement of strict rules relating to government borrowing and debt that all member countries would have to meet. Member countries who did not obey the rules would not be able to take part in the decision-making mechanisms of the ECB. Furthermore, the ECB should play no part in underpinning the government debt of member countries.

• A system of liberalised free-banking within which businesses and individuals choose the currency they wish to use.”

You can find more details on the book (and the full book free online) here, at the IEA website. The book will be presented at the IEA on the 9th of May (18:30); see more details here if you wish to attend.

I hope you find it interesting to promote the discussion on these important issues. All comments on our proposal on parallel currencies for the Euro zone will be very welcome.

Juan Castañeda

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