Lectures on Macroeconomics, No. 8
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.