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Currency competition

Traditionally, currency competition refers to competition between privately issued monies or between privately issued and government-issued monies for use as means of payments. This entry will focus on such competition. Competition between government-issued monies the pound sterling and the euro, for example is discussed in the entry on multiple currencies.

Types of Money

To understand the ideas related to currency competition it is useful to define a few terms. First, commoditymoney ismoney thathas some intrinsic value. The value is embedded in the commodity thatmakes the coin.Gold and silver coins are examples of commodity monies. In principle, it is possible to melt such coins and the resulting metal would sell for a value approximately equal to that of the coins. In contrast, fiat money is intrinsically worthless. The paper on which a $20 bill is printed is worth very little. The value of such a bill comes from the belief that other people will accept it in exchange for goods or services. Inside money is a claim on the assets of the issuer of thatmoney. It is a liability of the issuer. Traveler’s checks are an example of inside money, as the issuermust, by law, repay such a check. Another example is bank deposits. In contrast, outside money is not a claim on its issuer. An issuer of outside money does not have a legal obligation to exchange its notes against some goods or services. Government-issued notes are examples of outside money. Central banks are not required to back the notes they issue with any kind of commodity.

Hayek and Currency Competition

The economist FriedrichHayek introduced the idea of currency competition in 1976. At that time, a number of countries were experiencing high inflation. The collapse of the Bretton Woods system of fixed exchange rates in 1971 had removed a constraint on the conduct of monetary policy for many monetary authorities. It also removed any remaining link between currencies and ametallic standard (gold in this case). Freed from these constraints, many central banks increased their money supply too quickly, spurring inflation.
Although there was broad agreement that inflation was undesirable, it was not clear how to give monetary authorities incentives tomaintain the value of their currencies. Hayek reasoned that the lack of incentives came from the monopoly that monetary authorities held over the issuance of money. Competition from private issuers could force these authorities to maintain the value of their currencies. Indeed, if a money lost too much of its value, consumers and businesses would have the option to use another money. Hayek proposed to give banks the authority to issue notes that would compete with government-issued currency.
The interest generated by Hayek’s proposal led a number of economists to study historical episodes duringwhich bankswere allowed to issue notes. Such episodes typically involved commodity money, however. Since the value of commodity money is intrinsic, there is notmuch scope for an issuer of commodity money to modify the value of its currency.
Economists have also been interested in competing insidemonies. Such monies are typically denoted in some outside money, however. For example, traveler’s checks are often denominated in U.S. dollars. For this reason, it does not appear that inside money can affect the incentives of the issuer of outside money in the way Hayek intended.
What Hayek specifically had in mind was competition between outside fiatmonies.He proposed to allow banks to issue intrinsically worthless notes that would not be liabilities of these institutions.

Private Issue of Outside Money

For the kind of competition that Hayek proposed to occur, private institutions must be able to issue outside money. A number of economists have argued that a time inconsistency problem makes private issuance impossible. These economists point out that if a private institution could issue valued fiat outside money, profit maximization would induce the institution to issue money up to the point where the marginal benefit of an extra unit ofmoney equaled itsmarginal cost. That is, since the cost of producing an additional unit of fiatmoney is negligible, the institution would issue money up to the point where it was worthless. Moreover, the issuing institution would have no obligation to redeem the note for something of value since it would be issuing outside money. Anticipating this outcome, nobody would want to hold the money in the first place.
Private issuance of fiat outside money may be possible provided agents hold certain expectations. The key is to find a way to prevent issuers from increasing their supply of notes to the pointwhere the value of such notes is zero. Suppose everybody believes that the notes of a private issuer have value if the number of notes issued is less than some number. This threshold number is common knowledge. If the number of notes issued exceeds the threshold, then everyone believes that these notes are worthless. A serial number on a note indicates the quantity of notes issued previously.
Consider someone who is offered a note with a serial number that is greater than the threshold level above which notes are no longer valued. This person believes that nobodywill bewilling to accept the note in exchange for goods or services in the future. Hence, this person will not accept the note, and the belief that the note has no value is self-fulfilling. This kind of belief limits the ability of the issuer to print too many notes, which makes private issuance possible.

A Concept for the Future

Although private issue of outside fiat currencies is possible in theory, there are few examples of such currencies. Some currencies used in online multiplayer games may be the best examples of fiat outsidemoney. These currencies are almost costless to produce and are not backed by any asset. Moreover, online auction sites, such as eBay, provide a platformonwhich such currencies trade for U.S. dollars in a way that is similar to a currency exchange market. Although we are still far from Hayek’s vision of currency competition, technological progress and new information technologies could make it happen. See also discipline; dollar standard; dominant currency; money supply; multiple currencies; quantity theory of money; reserve currency; seigniorage; time inconsistency problem; vehicle currency

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