The monetary policy of last resort -- currency reform.

The monetary policy of last resort is to get rid of the old money and start a new one. "Currency reform".

I can just remember this policy being mooted in the 1970's. What happens if tightening monetary policy fails to break entrenched inflationary expectations and an ever-increasing inflationary spiral? It was the ace in the back pocket. Not to be played unless all else had failed.

Today's problems are the exact opposite of the inflationary 1970's. But the solution -- the monetary policy of last resort -- might be the same. If you can't loosen monetary policy to break entrenched disinflationary expectations, then maybe it's time to think about currency reform.

The 1970's problem was that people had too little belief in the value of the currency. Real goods looked good in comparison. Today's problem is that they have too much belief in the value of the currency. Real goods look bad in comparison.

It's easier to think about currency reform in the Eurozone. In fact, currency reform is probably coming, whether anyone wants it or not. Eurozone governments and banks that cannot pay their obligations in Euros may end up paying their obligations in a scrip that is not pegged to the Euro. A scrip issued by each national government that is worth whatever people think it is worth. And if people start using that scrip as a medium of exchange, and medium of account, it becomes a new money. Sure, Greek supermarkets might prefer payment in Euros, but if their customers can only pay in New Drachmas, then it's either accept New Drachmas or let the vegetables rot on the shelves. And the supermarkets' suppliers might prefer payment in Euros, but it's either accept New Drachmas or let the vegetables rot in the fields. And the workers picking the vegetables might prefer payment in Euros, but it's either accept New Drachmas or nothing.

In the Eurozone, if pessimists like me turn out to be right, currency reform will happen volens nolens. Though it would probably be better if governments recognised the inevitable, and adopted currency reform sooner rather than later.

It's harder to envisage currency reform in countries like the US or Japan.

What's the point of introducing a New Dollar or a New Yen? How can a change in names, a purely nominal change, make a difference? Well, money is a nominal variable. If purely nominal changes didn't make a difference, we wouldn't be needing to have this discussion about monetary policy, now would we?

When a company's brand starts to convey the wrong image, it may be hard to change the image. Sometimes it's better to scrap the old brand and start a new one.

But how exactly does a government scrap the old money? It's not as obvious as it sounds. How can it stop people measuring prices in "old" dollars, and using old dollars for their shopping? (It's easier in the case of hyperinflation, when the old money is already heading for extinction anyway).

First, the government starts doing its own shopping in New Dollars. The government is a big shopper. Just as we tend to use the same language as those around us are using, so we tend to use the same money as those around us are using.

Second, the government stops enforcing new contracts requiring payment in old dollars, and lets old contracts be paid in New Dollars.

Third, the government stops making change in old dollars. The reason a $20 bill is worth two $10 bills is that the central bank is willing to convert one into the other. And that mutual convertibility makes $20 bills and $10 bills fungible and easy to use as money.

Fourth, as a final resort, stop enforcing laws against counterfeiting old dollars.

It's entirely possible (as long as counterfeiting is not a big issue) that the old dollars could retain their value, and continue to be held. If so, they might even rise in value against the New Dollar. That's not a problem. People hold antique furniture, and old masters too, and they may rise in value too. But a rising demand to hold antique furniture or old masters does not cause a recession, unless people start using antique furniture and old masters as a medium of exchange (because then people stop buying other goods because they don't want to spend their stocks of antique furniture and old masters). Who cares if old dollars become a new gold -- continuing as a store of value but defunct as a medium of exchange?

It's no good introducing a new beer with a new name if people think the new beer is going to taste the same as the old beer. So sure, announce a new monetary policy regime, like price level path targeting, or NGDP level path targeting, at the same time as you change the name of the currency. But the nominal nominal change matters, probably more than the real nominal change. You need a new focal point for people's expectations to coalesce around. So you had better give it a new name.

Just back from four days in another world at a friend's cottage. Read the news, got depressed, then wrote this.

Comments

[Determinant]

I agree our problem is that we are 180 degrees from the 1970's. The second part of that problem is that the leadership in central banks, finance ministries and government generally we now have was formed by their experiences and the analysis that came out of that time and now seems incapable of implementing a policy with different goals and justifications. That's why we see inflation under every bed and scare ourselves silly about deficits.

You once posted Nick if economists have lost the faith that inflation can be drummed up when needed. Well, they have lost the faith that they can control that tool so they won't even touch it, even if that abstinence chokes the economy. Economists, monetary and fiscal leaders just seem to cower in a corner scared stiff of the Inflation Boogie Monster.

My objection is that we haven't even tried seriously inflating our present currency so why should be try a new one? We've just been tweaking the inflation lever, we haven't given it a good hard yank.

Besides, while European countries have reformed their currencies often enough over the years, Anglo-Saxon countries have maintained a steady regime. The only change was when Australia and New Zealand left the Sterling Area and created their own dollars. Canada, the US and the UK haven't changed the dollar and the pound in the 20th Century. New Pence was small potatoes.

[Min]

Do we call you Nick the Greek now? ;)

[Nick Rowe]

Determinant: "My objection is that we haven't even tried seriously inflating our present currency so why should be try a new one? We've just been tweaking the inflation lever, we haven't given it a good hard yank."

My guess is that Scott Sumner, for example, may say something very similar. At least half of me agrees.

Min: I expect so! I've also been struck how the disconnect between the "printers" -- countries with their own money -- and the "non-printers" -- is widening further. Greek, Italian, Spanish etc, government bond yields up, and UK and US bond yields down over the weekend.

Is Germany really a "printer" too? Is the Euro the New Deutchmark?

[Joe]

Nick,

Have you ever read the literature of free banking? They argue for privatizing the currency. Here's a link from Bill Woolsey... http://monetaryfreedom-billwoolsey.blogspot.com/2009/12/how-to-privatize-currency-in-three-easy.html

Theoretically, they argue, such a system would maintain full monetary equilibrium because market forces would automatically cause the money supply to go up when money demand goes up. They argue that the chief problem of the business cycle is that the government central banks have a "monopoly" on the money supply.

[Determinant]

They speak absolute, unredeemed nonsense.

Canada had no central bank and no central currency until 1935. Before then we had private notes drawn on chartered banks. Even with this setup, the Bank of Montreal acted as a "banker of last resort" as it was the Government's fiscal agent and handled Government deposits. The Finance Ministry also had an increasing role since 1914.

Even with this free banking paradise we still didn't avoid the Great Depression of the 1930's. Nor, I should point out, did it remedy the many economic slumps Canada experienced before then.

General equilibrium my foot. Those who speak of such foolishness are assuming the answer. It is poor math, poor logic, poor method and poor economics. And it makes everyone poorer.

[Max]

"Is Germany really a "printer" too? Is the Euro the New Deutchmark?"

Yes. German bonds are implicitly backed by the ECB, just as U.S. bonds are implicitly backed by the Fed, UK bonds are implicitly backed by the Bank of England, etc.

[Ralph Musgrave]

If the incompetents who got us into the credit crunch can’t run existing currencies properly, what chance their running a new currency any better? None, I think.

Getting out of the current “disinflationary” hole we are in (if indeed we are in one) should be easy: dish out money to the people likely to spend it. That’s the average income, underwater or near underwater households.

But instead, the incompetents in charge dish out money to the fraudsters and criminals on Wall Street and holders of government debt (QE).

[Jacques René Giguère]

Joe: The first time the Bank of England intervened not as a lender of last resort to country banks but as engineer of monetary policy was in 1815,by muddling through what was needed, and by design in 1825. The Banque de France did the same in the late 1830's. They did so in reaction to recessions, a new phenomenon they had never envisionned. Modern central banking emerged only after modern business cycles ( as opposed to drought induced famines say) appeared.

Nick: This week, I am in the heart of the U.S. Midwest ( Dayton,OH). The political and economic talking is an insult to neurons. I'll go back next week to camping in the Mauricie to recover before the next term begins.

[RebelEconomist]

If, say, Greece did try to leave the euro, I suspect that they might find it difficult to get a new currency accepted. International Greek enterprises (shipping?) would be reluctant to do business in what would be regarded derisively as monopoly money, and the tourist industry would be only too happy to be paid in euros at every opportunity. It might prove a good test of the taxes-drive-money view though.

I would question the idea that the present (US) problem is that people have too much belief in the value of the currency anyway - look at the price of gold!

Although it is not quite on topic in this post, Nick, I would be grateful if you would answer the question that I asked late in your taxes drive money post. To save you looking there, my question was whether any mechanistic / theoretical explanation of the "hot potato" effect of money exists. While I am not entirely convinced by Mike Sproul's defence of the real bills doctrine, it seems to me that the argument against it depends on the existence of a hot potato effect. Thanks.

[Guillaume]

Very interesting post Nick. Don't you worry, I have a feeling this mess will come to its logical conclusion in the next few months. It will most likely one grand man-made "experiment" in the nature of money...

[Paul Friesen]

I think I like your idea of the way the Euro could break up. Actually, I think it could solve their problems if that happened. The fundamental problem is a lack of money in the economy, and that would create a lot of new money. plus it would end the common currency experiment which, I think, must be judged a failure.

I don't think that there is any point, though in the U.S. switching currency as you suggest. The problem there has a very simple, easy, painless solution if people would just do it. The government should implement a real stimulus package the way China did. It simply doesn't need to worry about the bond market, because the FED should just buy up the bonds as fast as they are issued. China's stimulus at the beginning of the crisis was about 15% of GDP, and it worked.

[John]

Why doesn't the ECB just print REAL euros? No reason to farm it out to criminals...

[Nick Rowe]

Joe: yes. I have read some stuff on private money over the years. And Bill does some very good posts. My own (tentative) view is that there are no important legal restrictions on private money; and that network effects make money a natural monopoly. So I'm a bit of a skeptic in general. But right now a bit of private media of exchange, even if it is like LETS and produced by crazed localist/communitarian (but harmless because they don't force anyone to use it) hippies, would be a good thing.

Determinant: yes, Canada did avoid bank failures but didn't avoid the Great Depression. Those "private monies" were still convertible into gold, so they weren't genuinely different, like the inconvertible hippy monies. Imagine that those who couldn't sell their labour and goods for "regular" money could easily set up their own trading systems to trade among themselves? They do, to a certain extent, with barter networks, but barter gets very hard if you don't have double-coincidence of wants, plus trust. I would say the jury is still out on that question.

Max: "German bonds are implicitly backed by the ECB,..."

That theory fits the facts. But I don't really understand the mechanism.

Ralph: "If the incompetents who got us into the credit crunch can’t run existing currencies properly, what chance their running a new currency any better? None, I think."

That's a problem. If people think that nothing's really changed, then re-branding won't work.

Jacques: "Modern central banking emerged only after modern business cycles ( as opposed to drought induced famines say) appeared."

I would say later than that, because it was still tied to a fixed price of gold. (But it depends what you mean by "modern", of course).

Have fun, both places!

Rebel: I doubt that New Drachmas would totally replace Euros in circulation. My image is more messy, like Latin American countries where people may use local currency and also US dollars? Most external trade, and tourist trade would probably be in Euros. If the Euro still exists, which it won't if too many countries go the same way as Greece. Perhaps that is Max's view. Only Germany left using the Euro? So the ECB is indeed the German central bank.

A formal model of the hot potato? I am always the worst person to ask, because my memory is so bad. One problem is that the verbal hot potato story is a story of a disequilibrium process. And most formal modelling is of equilibrium states. Maybe someone else can give a better answer.

Guillame: thanks! But it could be a very ugly and long conclusion.

Paul: Yes, the US problem is more solvable than the Euro problem. I can't think of a way I would propose to "save the Euro".

John: what does it do with those Euros? What does it spend them on, or who does it give them to? What happens if it needs to get them back at some future time?

[JFL]

Nick,

Not to reignite the debate from your previous post concerning the "taxes-drive-money" debate (which in turn was probably a residual of the MMT debate), but wouldn't logically, the only thing the government have to do to introduce a new currency is a)announce that all taxes would be payed with the New Dollar and b)conduct all forthcoming business in said New Dollar?

I mean just think about it: Obama comes on TV one night during a press conference and announces that the only thing that will be accepted in payment of taxes will be "ObamaBucks". Just like before, if you don't pay your taxes you go to jail. In order to satiate the new found demand for ObamaBucks the government will begin exchanging ObamaBucks for delivery of real goods and services to the government.

Obviously there are both legal and logistical issues with the example but just as a matter of a thought experiment, wouldn't this basically supersede steps 1-4 stated in your post above? I mean I'm sure it might work your way as well but I think you miss something in your argument concerning the fact that supermarkets will have to accept payments in a New Currency if that's all that's offered or else their produce will rot and so on down the chain until everyone in the economy is using the New Currency apparently because that's all there is to use. The thing your argument is missing is the beginning of the chain! Where does the new currency come from and how does the whole process get kicked off? I think an analysis of this situation goes wrong unless it begins with the idea that at the end of the day the highest "claim" on your money is the "claim" by the government to extinguish tax liabilities and the ensuing legal action if said liabilities aren't extinguished.

-JFL

[scepticus]

The problem with currency reform is that you really can't do it unless all the other nations also do it, at least if one plans to keep freely floating exchange rates without very significant capital controls.

After all, when the FED prints dollars it doesn't just affect demand in the US does it? Perhaps all fiat currencies are destined to end up at zirp and if so then I would say that at that point they'd all merge more or less into one, but with many hands on the printing press.

And if we're talking capital controls and all that jazz, then its not just currency reform is it...

[Nick Rowe]

JFL: If the government insists that people pay taxes in New Dollars, and insists on only spending New Dollars, then that is step 1 in my above. The government has decided to do its own shopping in New Dollars. That does make it more likely that others will want to use New Dollars for their shopping too. But I don't think it makes it certain.

(And reverting to my old post, if others don't decide to use the New Dollar for their own shopping, and if the government spends more New Dollars than it collects in taxes, so the stock of New Dollars is increasing over time, then New Dollars are not scarce, and will have zero value in equilibrium. BTW, many economists, not just the tiny subset of MMTers, think that paper money has positive value because the government demands it in taxes. And I think my argument on that last post shows that they are *all* wrong!)

[JP Koning]

I agree with RebelEconomist.

Your currency reform reminds me of various junior gold mining schemes. A junior's stock falls from $1.00 to $0.20, so it changes its name and reconsolidates its shares to $1.00. A few people are fooled and get sucked in to buying, but just as quickly the shares continue their fall. Tricks like these hurt the informationally-disadvantaged, those like widows & orphans. Same with a plan to give a currency a superficial face-lift (or in your case, face-drop?). The disadvantaged who are fooled by the change will always lose.

[JFL]

Nick,

Why wouldn't it make it certain? I mean if we're talking about a country with a generally rational population, then knowing that if you don't do "something" to get the New Dollars or ObamaBucks or whatever then you're basically making a voluntary decision to go to jail. Again, I'm suspending the logistical difficulties for the sake of the thought experiment but the ultimate implication of what you're saying is a significant proportion of the working age population incarcerated.

I guess an alternative is a situation in which the political fabric of the country breaks down and all the southern states secede from the union or something but its hard to try to work through economics problems when you're starting with the assumption that civil society as we know it is ceasing to exist. :)

-JFL

[scepticus]

It seems to me what matters in the new/old dollar debate is the debt that is denominated in the two that is held by the private sector. Really for government issued fiat to have value in a peacetime situation the private sector needs to have a good deal more total debt in that currency than the government has.

I'm not sure you could easily introduce a new currency into a situation in which total private debt is very low.

Hypothesis: There are no examples of hyperinflations that occurred when the private sector was much more indebted to itself than the government was indebted to the private sector regardless of percentage-of-gdp values?

I suspect but don't have any evidence that zimbabwe, argentina and hyperinflations in earlier centuries probably fit this hypothesis.

[Nick Rowe]

JFL: suppose each person needs 10 litres of water per year to avoid death. But needs no more than 10. So the demand curve for water is perfectly inelastic at 10 litres per person. Suppose there are springs that produce 11 litres of water per year per person. So the supply curve of water is perfectly inelastic at 11 litres per person. The supply and demand curves don't cross. Water is a free good. Its equilibrium price is zero. The pool of water on the ground grows at 1 litre per person per year. Anyone who wants water just picks it up off the ground.

Same if the government prints New Dollars and insists you use them to pay taxes. If the stock is growing (which it does), and if people don't use them for their own shopping. You just pick them up off the ground.

All those economists for all those years saying "paper money has value because you need it to pay taxes". All wrong.

[Max]

"And reverting to my old post, if others don't decide to use the New Dollar for their own shopping, and if the government spends more New Dollars than it collects in taxes, so the stock of New Dollars is increasing over time, then New Dollars are not scarce, and will have zero value in equilibrium."

If people are confident in the government's power then they will want to hoard the government's money, and the government will never get a chance to demonstrate its power to make its currency "scarce" in your sense.

As for old currencies having value...are you aware of any case where the paper money of a defunct government has retained value?

[JFL]

Nick,

Your argument seems to hinge on the idea that the rate at which the private sector accumulates New Dollars is always above the rate at which the private sector wishes to save those New Dollars:

"If the stock is growing (which it does), and if people don't use them for their own shopping. You just pick them up off the ground."

I suppose this would be true if the only thing that people could do with the New Dollars is spend them, but they can also hoard them and regularly do so even when we are in an equilibrium. I think this can coincide with a period during which the government expends more than it taxes (assuming the external sector is a net drain on those same claims).

-JFL

[Gregor Bush]

"If you can't loosen monetary policy to break entrenched disinflationary expectations, then maybe it's time to think about currency reform."

If it really were true that unconventional monetary policy had no effect, it would be a godsend for the United States. The public's unshakable confidence in the "old dollars" would present it with the ultimate free lunch.

Instead of "currency reform", policymakers could take the opportunity to eliminate the government's debt burden by having the Fed buy up all outstanding US debt and then retire it. Come to think of it, why not lower all tax rates to zero and have the Fed finance all future government purchases? Actually it could set all tax rates below zero and give every American a large subsidy for each additional dollar of income (think of the effect on labour supply!). Wait, why stop there? Why not have the Fed buy all outstanding foreign stocks, bonds real estate and remit them to the Treasury? Americans could literally acquire every asset in the world at zero cost. If the "QE doesn’t work" crowd is right it’s a golden opportunity for the US to become rich beyond its wildest dreams.

[Nick Rowe]

Max: "If people are confident in the government's power then they will want to hoard the government's money, and the government will never get a chance to demonstrate its power to make its currency "scarce" in your sense."

If people are confident in the power of Malibu Barbie they will hoard old Malibu Barbies, even if they don't want to play with them.

The whole point of the "paper money has value because of taxes" argument was to try to get away from the assumption that hoarding creates scarcity and bubble arguments that rest on confidence. Let me assume confidence and I don't need taxes to explain why paper money has value. People accept money in exchange for valuable goods because they are confident that others in turn will accept it from them. And there is a stock demand for money because the greater the stock of money an individual holds, the easier it is for that individual to do his shopping. That stock demand, plus a limited stock supply, determine the value of money. Easy.

"As for old currencies having value...are you aware of any case where the paper money of a defunct government has retained value?"

The old Iraqi Dinar? Also, Bitcoin (if it lasts), which doesn't really have a government.

Gregor: Yep, but. It's the ketchup theory. At some point in the future, when the economy recovers, and confidence returns, people won't want to hold all those dollars. And the US would have to buy them back, and/or pay higher interest, to get people to willingly hold them. Otherwise there's inflation. And the ketchup problem is we keep on hitting the bottle harder and harder trying to get some ketchup to come out, and we are afraid it will eventually all come out in a rush.

[Max]

Gregor, the people who say that QE doesn't work don't say that fiscal operations don't work.

[RebelEconomist]

Actually, this could get interesting. One can imagine a standoff in which people are reluctant to hold, say the new drachma, and an industry develops that brings together taxpayers and government suppliers such that the government can only buy things when taxpayers need new drachma. The result might be seasonal variations in the value of the new drachma, which might even be strong at times. And the government would deserve all the trouble they get as far as I am concerned - deliberate, surprise devaluation is theft.

[Max]

"The whole point of the "paper money has value because of taxes" argument was to try to get away from the assumption that hoarding creates scarcity and bubble arguments that rest on confidence."

To some extent it is a bubble since confidence in the government's power reinforces the government's power. But if you take the government's power as a given, then why shouldn't everyone believe it and act accordingly? Only in the odd case where the government is powerful but nobody believes it, does the government have to demonstrate its full power.

Yes, bitcoin is an interesting case. Even if it uniquely fulfills a real need (not true of old government paper!), it won't necessarily retain value, because you can have a "hyper transfer" to a different bitcoin type money.

[Gregor Bush]

Nick,

Yes, but. We can see market expectations of inflation in real time. They can tell us how hard we can hit the bottle before all the ketchup comes pouring out. The ketchup theory sounds like Richard Koo's argument regarding Japan which to me sounds like: "Japan is in deflation becasue demand is weak becasue private balance sheets are weak. But if the BoJ tries to do anything about it, we'll wind up with a hyperinflation."

If the Fed monetized $1 of debt, nothing would happen. If they monetized all $13 trillion, we'd have a hyperinflation. there must be some amount that will cause people to expect inflation to be 1% higher than they currently do. We can look at market recactions for clues as to what that amount is. Bettet ywt, we could skip to Sumners NGDP futures market.

Max,
I think what I described was monetary policy not fiscal policy. If the Treasury buys up all of the world's assets with cash that it obtained from selling bonds, that's fiscal policy. If the Fed buys up all of the world's assets with newly printed money, that's monetary policy.

[Nick Rowe]

Max: Yes, I find the analogy between government and money interesting. Stephen Harper is not especially physically strong, AFAIK. He has power because people believe he has power. Paper money has positive value because people believe it has positive value. The whole of society is one big self-fulfilling equilibria set of beliefs. That such equilibria can exist, and persist, even though there exists a second equilibrium in which Stephen Harper is just a guy, and Her Majesty Queen Elizabeth is the real power, and in which paper dollars have zero value, is no more puzzling in the case of money than anywhere else.

But yes, for the sake of this post I take the government's power to tax as given exogenously. The government has the power to make people pay taxes in loonies. Don't explain that. Just assume. But is that sufficient to make paper Loonies valuable? No.

But OK, I think I see your point? You are saying that it is the government's power to demand more in taxes than it spends that creates value of paper money? Even though it never need exercise that power in equilibrium. Like the threat of punishment is sufficient to deter crime, so nobody ever gets punished in equilibrium?

Interesting new twist on an old theory. But I don't believe it. I think it founders on the individual/aggregate distinction. No (small) individual can make money valuable. But I might need to think more about that new version.

We are waay off-topic though.

[Nick Rowe]

Max: OK, perhaps not waaaaay off-topic.

Gregor: "Yes, but. We can see market expectations of inflation in real time. They can tell us how hard we can hit the bottle before all the ketchup comes pouring out."

We (OK, the US) have already hit the bottle harder than would be necessary if expectations adjusted to the new, good, equilibrium. If people now expected recovery, and moderate inflation, the existing stock of base money would be too large for equilibrium. Market expectations may not be a monotonic function of what the central bank does. It may look S-shaped. Tipping points and stuff. A better analogy would be like pressurising the ketchup bottle to get the ketchup out, when there's a skin of dried ketchup on top.

Switching to a different way of doing monetary policy, or providing some different focal point for expectations, a la Scott Sumners, could create a more well-behaved function. A bit like the pole.

[Max]

Gregor, debt monetization as most people understand it (changing an interest bearing bond for non interest bearing money) is impossible, at least if the central bank ever wants a non-zero interest rate. It has to pay interest on the money it creates, no different from paying interest on bonds.

[scepticus]

I'm not sure why a central bank would particularly want a non-zero interest rate. I don't think a non-zero interest rate is compatible with deposit insurance over the long run. Various economists and commentators have made this key point.

If a CB had to choose between deposit insurance and a non-zero interest rate, I would imagine they'd pick the former. And they have!

If the only way to have a zirp equilibrium is a peak debt situation, then so be it.

[Gregor Bush]

Nic

"Switching to a different way of doing monetary policy, or providing some different focal point for expectations, a la Scott Sumners, could create a more well-behaved function. A bit like the pole."

I agree. I thought the NK consensus (Woodford, Svensson, Eggertson, Mankiw, Bernanke) prior to the crisis was to adopt a price LEVEL target when short-rates hit zero. But policymakers won't even try that relatively modest step (even with one of the principal academics as the most powerful practitioner!). The vast majority of economists just cannot conceive of monetary policy as anything other than setting interest rates. Your observation that interest rate setting is a social construction of monetary was quite profound.

Max,
Sorry I don't see it.

The central buys the bond with newly printed money at the current market price. Nothing about that transaction implies that market interest rates have to be zero.

Governments throughout history have monetized debt. France paid a greater share of the cost of WWI through currency issuance (a higher price level) than it did through taxes.

[John]

Nick,

I don't think your discussion with Max is way off topic at all. At the heart of your post as far as I see it is the question "how do you monetize an economy?" Or in this case re-monetize an economy by replacing one currency with another?

Answer this question: You have a bunch of people on an island in the middle of nowhere. Trade is conducted on the island through barter. A colonizing force (from Europe or something) lands on the island and introduces two stocks of what the colonizers call "money" (one stock is made up of red slips of paper while the other stock is made up of blue slips of paper). At the same time the colonizers impose a head tax on the population payable only in the red paper, which the population can earn by doing work for the colonizers. If the head tax is not paid the colonizers threaten violent force. The blue slips, by contrast, are distributed to the population sort of haphazardly, and the population doesn't know what to do with them. The economy is now "monetized", but what is the medium of exchange, red slips of paper or blue?

-JFL

[Jacques René Giguère]

JFL: As to the introduction of ObamaBucks,go to my comment re Chinese peasants in the Money-Value-Taxes thread.

Nick: modern central banking as in let's use the power of a CB to make things right, after underatanding that something weird is happenning and it's not a drought.
BoE and BdF were private businesses run by people totally unschooled in economics and ( fortunately) not graduate of an MBA program. They operated by "we'll do whatever is needed and whatever works works." Only later did they officialized their thinking, wrote rules and regulations, got mixed up with the Treasury view and caused the Great Depression (I mean the 1919-1931 British one, the "Economic consequences of Mr.Churchill" one.)

Rebel: OK, NewDrachmas would not be a reserve currency. But would you refuse to use them to buy cheaper olives and ouzo? Would greek shippers refuse to have their idled ships chartered? Murdering your own country's economy is par for Finance Ministers and post-modern Central Bankers. Not for business owners (I am excluding the executive commitee of any Chamber of Commerce or editorial writers as obviously they have never engaged sccessfully in business.)

[K]

Rah, rah, Gregor! The ketchup bottle is an invention of the bond vigilantes, the stick to go with the confidence fairy carrot. If there were any chance of it being true TIPS spreads would be trading significantly above realized inflation. They aren't.

I think the belief in the ketchup bottle stems from a basic misunderstanding of the process of the reversal of QE. Imagine that first inflation expectations rise (which presumably would be observed as a rise in TIPS prices, but likely also a rise in treasury yields). Then the Fed reacts by selling bonds, which is the part where bond vigilante types get confused. Depending on your view of QE, the sale of bonds is either a tightening of monetary policy, or a non-event. Therefore the outlook for the future natural rate will (if anything) *decline* as will bond yields.  To the extent that QE was a form of *easing*, reversal of QE is a form of *tightening*, and tightening causes yields to *drop*. Think of it this way if you want: taking money out of circulation lessens the need for future rate hikes. Since treasury bond yields are expectations of the path of the future short rate this leads to *lower* yields.

To repeat: when the Fed unexpectedly sells bonds, bond prices go *up*. This is *very* hard for the bond vigilantes to get their heads around, since they see it only in terms of supply of bonds, but suddenly forget the supply of money.

There is a further assumption that I think you'd have to make to believe in the Full Ketchup: as rates suddenly rise, this won't act to contain inflation. Instead, like Kocherlakota, a true bond vigilante believes that rising rates will, *in and of themselves*, cause inflation expectations to rise. Suddenly black will be white, up will be down, the world as we know it will come to and end (and the BVs will be raptured!).

Nick: This wasn't directed at you! I know you are definitely not a believer in the Full Ketchup :-)

[K]

All of which is to say: the Fed could reverse all of QE in one fell swoop next month if they felt like it. The banks would happily buy up $2T of treasuries at some minimal yield with zero capital costs and funding costs at the short rate (i.e. zero). This act of tightening *alone* would insure a vastly longer period spent at the ZIRB, and a huge rally in treasuries guaranteeing this to be a highly profitable trade for the banks.

[Nick Rowe]

Max/Gregor/scepticus: people are willing to hold some money, even if money does not pay interest (or pays a lower rate of interest), and even if that money is losing its value rapidly, because holding some money is so damn convenient for doing the shopping. Bonds aren't as convenient for doing the shopping, so you have to pay a higher (real) rate of interest to get people to hold bonds. There's a downward-sloping demand curve for holding an average stock of money. But there's a limit. To how much they will hold. go past those limits and you get inflation. Right now, times are abnormal, and those limits are abnormally wide. They won't always be.

K: sure, Open Market Purchases of bonds for money by the central bank can easily be reversed. But the governments sales of bonds for real goods cannot easily be reversed (except in some special cases). You have to raise taxes and/or cut spending to cut the debt. And that hurts, on all sorts of micro and generational distributional grounds.

And the biggest conundrum is: monetary policy (and fiscal policy) have their biggest effects on AD when people think they won't be reversed. So at the same time we are trying to reassure the hawks that they can easily be reversed, but we want people to fear they won't be.

[Nick Rowe]

John: "At the same time the colonizers impose a head tax on the population payable only in the red paper, which the population can earn by doing work for the colonizers."

I think us Brits did something like this in Kenya. (But don't trust my history).

If they say: "10 bits of red paper per hour of labour", they have essentially introduced a convertible currency. It's convertible at a fixed price into labour. Just the same as if it is convertible into gold. In effect, you can pay your taxes in labour (corvee), or buy back your labour at 10 bits per hour. There is no problem in explaining why convertible paper money has value. It's convertible into something valuable at a fixed exchange rate. The more interesting case is where paper currency is *initially* convertible when first introduced, but then convertibility is withdrawn later. Which is modern history. Von Mises Regression Theory of Money then slots right in, though I interpret mises story slightly differently.

I'm getting lost in the comments. Sorry.

[Nick Rowe]

Gregor: "But policymakers won't even try that relatively modest step (even with one of the principal academics as the most powerful practitioner!). The vast majority of economists just cannot conceive of monetary policy as anything other than setting interest rates."

Yep. But maybe, just maybe, a new currency would help people conceive of monetary policy differently?? "We used to manage the old dollar by setting interest rates. The New Dollar, however, will have its value determined in a Sumnerian NGDP futures market...."

[scepticus]

"Bonds aren't as convenient for doing the shopping, so you have to pay a higher (real) rate of interest to get people to hold bonds. "

I think that's at least partly wrong, since they (bonds) are more convenient for saving compared to cash or bank deposits. If you have a very large sum to deposit, say a few tens of million, cash is a very bad deal and bank deposits are not insured above a few tens or hundreds of K. Given that the average dollar remains immobile most of the year that suggests to me that saving convenience wins in aggregate over shopping convenience.

Further, I can quite easily sell all my bonds tomorrow - they are totally liquid. If they are all short duration I likely won't be in any danger of major loss due to changing inflation expectations. In any case, the danger of loss is compensated by the fact I can earn a multi-year duration interest rate but still sell out whenever I like.

[Nick Rowe]

scepticus: if bonds are always better than cash, why do people hold cash? On average, I hold about $100 currency in my wallet, and a couple of thousand in my chequing account. Why?

[K]

Nick: I first saw the ketchup bottle metaphor in The Economist last year (maybe it's much older). There, and most places I see it, it refers to debt monetization by the cb, particularly via QE. So if we can all agree to kill that version of it, we are making huge progress.

As far as your version goes, I don't follow. As government debt rises, the natural real rate falls due to crowding out/raised expectations of future taxation. Inflation is independently determined by the monetary authority. So in general, government borrowing grinds down the natural rate by crowding out real investment. So there's no ketchup here, and none in QE either. So where's the ketchup?

And we dont need to reassure anybody that QE can be reversed since our ability to reverse it doesn't depend on their beliefs. It depends on the ability of leveraged players to arbitrage bond yields vs the short rate. The BVs are irrelevant since they are bidding way below the market or shorting treasuries and getting killed. So all they can do is talk but nobody's listening.

[Nick Rowe]

K: in standard models, an increase in government deficits and/or debt *increases* the natural rate of interest, and that's why it crowds out private investment. There's an increased (stock or flow) demand for loanable funds, so the equilibrium rate of interest rises.

[Min]

Nick the Greek: "I've also been struck how the disconnect between the "printers" -- countries with their own money -- and the "non-printers" -- is widening further. Greek, Italian, Spanish etc, government bond yields up, and UK and US bond yields down over the weekend."

Interesting, isn't it? Especially since the US politicians have been acting as though the US doesn't have its own money! ;) And I guess the UK politicians are, too.

[Min]

Joe: "Have you ever read the literature of free banking? They argue for privatizing the currency. Here's a link from Bill Woolsey... http://monetaryfreedom-billwoolsey.blogspot.com/2009/12/how-to-privatize-currency-in-three-easy.html

"Theoretically, they argue, such a system would maintain full monetary equilibrium because market forces would automatically cause the money supply to go up when money demand goes up."

And how did that work out in the US in 1837? (I am referring to the depression of 1837-1843, OC.)
My impression is that private banks cannot take on the risk to pump up the money supply when it has precipitously dropped. Nor do they, as a group, rein in lending during booms and bubbles, do they?

[Georgioz]

Nick: But OK, I think I see your point? You are saying that it is the government's power to demand more in taxes than it spends that creates value of paper money? Even though it never need exercise that power in equilibrium. Like the threat of punishment is sufficient to deter crime, so nobody ever gets punished in equilibrium?

This is basically how I see the position of MMT on subject (I'm no expert so take this with grain of salt). Let's assume for a moment that currency is used only for government purchases and paying taxes and that there is some other form of payment between private actors. Let's assume that government prints more money then it gathers in taxes. That ultimately means that economy as measured in government currency experiences inflation. If taking into account your water example, that also means that at some margin (spending exceeding the revenue) there is perfectly inelastic supply of money, meaning that government is actually unable to buy anything no matter how much it pays nominally(read hyperinflation). At this point there are only two ways how government can reverse this process - cut spending or increase taxes. Any of these actions necessary lead to fiscal surplus, which is the only way for government to destroy money, which directly translates into destruction of net private wealth as measured in government currency. If government can credibly promise such reaction then such threat itself could be enough to force people into hoarding the currency.

[Nick Rowe]

Geogioz. We are on the same page. I think we understand each other. (The only change I would make is that when you say "hyperinflation" I would say "the government's money has zero value in equilibrium". But that's probably what you meant).

Here's my response. I'm not 100% sure it's right.

If we thought of the private sector as a collective, I think your answer would be logically correct. *Assuming the government's threat is credible*. The private sector would say to itself "we had better buy this money from the government at a positive price, or else the government will make good on its threat to tax us more money than it issued, and we will be screwed because we won't be able to pay our taxes".

But what if each individual is individually rational? Is there a Nash Equilibrium where the stock of money increases over time, and also has positive value? Suppose there were, and that the rate of return on holding money were less than the rate of return on other assets. Each individual's rational choice would be to buy government money at the exact instant before he has to pay his taxes, then immediately hand it over to the government. Assume (just so I can get my head around it) that different individuals pay taxes at different dates spread out perfectly evenly throughout the year. The total demand to hold that stock of money would then be vanishingly small. Which contradicts the initial assumption of a positive growing stock of money with positive value.

Intuitively, each individual says "Sure, if none of us holds the government's money it will have zero value, and that will trigger the collective punishment of taxes greater than money issue. But I'm just a little guy. My holdings of money won't make any difference to its value, so my actions don't affect whether the threat will be carried out."

I don't think there is a Nash equilibrium to this game. If nobody holds money the threat will be triggered, which means it is rational for each individual to hold money. But if everybody holds money the threat will not be triggered, which means it is irrational for each individual to hold money.

Dunno.

(Plus, I don't think the threat is credible anyway. They know the government only prints money because it can't raise taxes enough to pay for its spending.)

[K]

Nick: The natural rate is the equilibrium rate of T-Bills.  T-Bills earn the risk free rate. People may *demand* extra return over the risk-free rate on long bonds, stocks, and any other risky assets. But there's no risk premium on the risk-free rate. The only determinant of T-Bill rates is what the CB considers to be neutral for inflation. And investors demanding extra risk premium on risky assets (due to excess supply of government bonds or whatever) puts *downward* pressure on inflation and therefore *downward* pressure on the natural rate. I.e. it's pushing the ketchup back in the bottle.

[Georgioz]

Nick: But then your argument can be used for any money. If people are not liquidity constrained and they may freely exchange all their assets into the most liquid one (money) at any time to purchase goods (or pay taxes), why should they ever hold any money be it private or government ones? If you ever find reason for people to hold private money, just imagine that government will require them to pay taxes at the moment of closing any contract. You may imagine it as a transaction tax, VAT or whatever. Then you have a system where people will want to hold government issued money as much as they want to hold whatever is used as currency in private exchange.

[Nick Rowe]

Georgioz: OK, but then if people are liquidity constrained, and they need to shop at Canadian Tire, then I could make the same argument that people will use Canadian Tire money, since that's what Canadian Tire accepts.

(I don't know if you are Canadian or not, but in case you aren't, Canadian Tire is a big chain of stores and it does issue a scrip which it accepts in exchange for goods).

[Min]

Nick Rowe: "Intuitively, each individual says "Sure, if none of us holds the government's money it will have zero value, and that will trigger the collective punishment of taxes greater than money issue. But I'm just a little guy. My holdings of money won't make any difference to its value, so my actions don't affect whether the threat will be carried out."

I thought you said that each individual is rational. That is not rational thinking.

Nick Rowe: "I don't think there is a Nash equilibrium to this game. If nobody holds money the threat will be triggered, which means it is rational for each individual to hold money. But if everybody holds money the threat will not be triggered, which means it is irrational for each individual to hold money."

The last clause does not follow.

[K]

Nick:
Which is to say that by invoking "loanable funds" I think you are
confusing the yield on long bonds with the natural rate.

[Yes, I mostly just wrote that to get back on the "recent comments" list. :-)]

[Nick Rowe]

K: Just as well, I have too many arguments going on!

If you like, and I find it useful to do this, you can define a natural rate of interest for each type of bond, or share, or real asset, including risk. Yes, a change in risk will change some or all of those natural rates.

This was the thing you said I was objecting to:

"As far as your version goes, I don't follow. As government debt rises, the natural real rate falls due to crowding out/raised expectations of future taxation."

Raised expectations of future taxation should shift the IS left, and reduce the natural rate, if consumption depends on expected future disposable income. OK. But if government debt rises, and people don't want to hold all that government debt, that should shift the IS right, and raise the natural rate. (Under Ricardian equivalence, the two effects exactly cancel, so the IS doesn't shift, and the natural rate stays the same.)

I'm probably losing the thread of your argument.