Will issuance of private currency help undermine government issued money?

J Fernández-Villaverde and D Sanches have a fairly technical paper looking at private players issuing their own currency along with central banks money. They summarise the findings:

 They say that Hayek’s idea of introducing private money will not lead to desired benefits.

Our analysis offers several valuable insights.

  • In general, a monetary equilibrium with private monies will not deliver price stability. When money is issued by a profit-maximising entrepreneur, that person will try to maximise the real value of seigniorage. There are many cost functions when minting money, so this maximisation does not imply that the entrepreneur delivers a stable currency. For example, if the cost function is strictly convex, entrepreneurs will always have an incentive to mint additional units of the currency. When Hayek conjectured that a system of private monies competing among themselves would provide a stable means of exchange, he was, in general, wrong. When money is issued by an automaton, there is no particular reason why the quantity of money will be compatible with price stability (except by coincidence). Bitcoin has already decided how many new units of currency will be issued in 2022, even though nobody knows what the demand for currency will be in that year.
  • Even when the cost function of minting money is such that we have an equilibrium with price stability, there is a continuum of equilibrium trajectories where the value of private monies monotonically converges to zero. The self-fulfilling inflationary episodes construed by Obstfeld and Rogoff (1983) and Lagos and Wright (2003) in economies with government-issued money are not an exclusive feature of public monies. Self-fulfilling inflationary episodes are, instead, the consequence of using intrinsically useless tokens (even if they are electronic and issued by private profit-maximising, long-lived entrepreneurs), whose valuation can change depending on expectations about the future.

But, as economists, we do not care about price stability per se. The goal of a well-behaved monetary system must be to achieve some efficiency goal. There is a third, and perhaps most important, result:

  • A purely private monetary system does not provide the socially optimum quantity of money even in the equilibrium with stable prices. Despite having entrepreneurs that take prices parametrically, competition cannot provide an optimal outcome because entrepreneurs do not internalise, by minting additional tokens, the pecuniary externalities they create in the market with trading frictions at the core of all essential models of money (Wallace 2001). These pecuniary externalities mean that, at a fundamental level, the market for currencies is very different from the market for goods such as wheat, and the forces that drive optimal outcomes under perfect competition in the market for wheat will fail in the market for money. The ‘price’ of money itself does not play a fully-allocative role: if one believes that money is used because there are frictions in transactions, one should not believe that the market can provide the right amount of money. (This argument slightly modifies the ideas in Friedman 1960.)

These three results cast serious doubts on Hayek’s proposal of currency competition. In most cases, a system of private monies will not deliver price stability and, even when it does, it will always be subject to self-fulfilling inflationary episodes, and it will supply a suboptimal amount of money. Currency competition works only sometimes, and partially.

But it will keep a check on government issued currency:

There is an important lesson here: the threat of competition from private monies imposes market discipline on any government that issues currency. If a central bank, for example, does not provide a sufficiently ‘good’ money, then it will have difficulties in implementing allocations. This may be the best feature of cryptocurrencies. In a world in which we can switch to Bitcoin or Ethereum, central banks need to provide, paraphrasing Adam Smith, a tolerable administration of money. Currency competition may have a large upside for human welfare after all.

The Free bankers will obviously disagree with the findings. There is a lot of history behind private vs government money..


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