Wednesday, February 10, 2010

Dual Currencies Are Always A Bad Idea

Michael G. Arghyrou and John Tsoukalas advocate The Option of Last Resort for the solution of the current euro-area crisis: A Two-Currency EMU, on Economonitor of 7 February.

“The plan we propose involves the temporary implementation of a two-currency EMU, with both currencies run by the Frankfurt-based ECB. The core-EMU countries will continue to use the present currency, the strong euro. The periphery countries on the other hand, will adopt, for a certain period of time, another currency, the weak euro. Crucially, the bonds and external debt of the periphery countries will stay in strong-euro terms. Upon its introduction, the ECB will devalue the weak euro by a percentage enough to restore the competitiveness losses periphery countries have suffered over the last decade against their main trading partners, the core-EMU countries. This will give the periphery a competitiveness boost while it introduces extensive structural reforms. The ECB will implement monetary policy for the whole of the EMU with its primary objective being price stability for all its members, strong- and weak-euro countries. It will do so in much the same way it does now, the only difference being that the ECB will be setting two rather than one reference rates.”

A similar plan was advocated by Charles Goodhart and Dimitrios Tsomocos in the FT of 24 January: The Californian solution for the Club Med – except through the temporary introduction of a dual national currency, for Portugal by way of example, through an escudo IOU instead of a dual “weak-euro” throughout the euro-zone, just like the IOUs that California and Argentina’s districts used to cope with a fiscal crisis.

The Gresham-Copernicus-Oresme-Aristophanes Law

The trouble with any dual currency system – whether bi-metallic or bi-paper or mixed – is that either the rate of exchange between the two currencies is determined by the market, depending on what can or cannot be done with either currency and how, or their rate of exchange is managed by monetary authorities presumably at a rate other than would otherwise prevail in the market (or there would be no point in managing it). At a market-determined exchange rate, the introduction of a new currency simply increases the amount of liquidity in the system, without any other effect; nothing happens that could not have happened by expanding money supply in the old currency (as it can always be done with paper money). At any managed exchange rate different from the market rate, Sir Thomas Gresham (1519 – 1579), an English financier during the Tudor dynasty, rules: “Bad money [the currency overvalued with respect to the market rate] drives out good [the undervalued currency]”. The dual currency ceases to be dual. This law is one of the oldest economic discoveries: it was anticipated by Nicolaus Copernicus, even earlier by Nicole Oresme in the fourteenth century, and had been stated clearly by Aristophanes in his play The Frogs, around the end of the fifth century BC.

The chervonets precedent

In the past the introduction of an additional currency has been advocated, and at least once implemented, not to weaken a strong currency and restore competitiveness but to stabilize a rapidly depreciating currency suffering from hyper-inflation. Thus in 1922-24 Lenin introduced in the Soviet Union a new gold-backed convertible currency, called chervonets after Peter the Great‘s gold coinage, and circulating next to the overinflated rouble, or sovznak. Over time the sovznak was de-monetized and disappeared through hyperinflation, while the new currency and the government budget were stabilized.

In the case of the chervonetz-sovznak coexistence clearly the rate of conversion between the two currencies had to be floating and market-determined, for the new currency at an under-valued fixed rate would be displaced by Gresham‘s law, while an overvalued rate would be pointless and rouble-inflationary. But if the two currencies were exchanged freely in the market the old currency would gradually disappear through higher and accelerating rouble-inflation and hyperinflation, which is what I understand actually happened in 1922-24, leaving a single sound currency. The parallel currency implemented a slow motion currency-stabilisation through accelerating rouble inflation, instead of a single inflationary shock to reach immediate balance.

In 1988-89 George Soros, Wassily Leontief, Ed Hewett and Ivan Ivanov (Deputy Chairman of the State Foreign Economic Committee, GVK) launched their “Open Sector”project, with the participation of many Soviet, western and east-European economists (see Phil Hanson, "Foreign Advice", in M.Ellman and Kontorovich, The Destruction of the Soviet Economic System – An Insiders’ History, M.E. Sharpe, Armonk-New York, 1988, pp.238-255). It was a plan, initially surrounded by secrecy, for both wiping out monetary overhang and promoting foreign trade by introducing a new convertible currency inspired by the 1920s chervonets, paid to Soviet exporters and then circulating in parallel with domestic roubles. I took part in the project and went along for the ride, but never believed in it: what had happened with the chervonets would have happened with the parallel, convertible hard rouble: slow-motion stabilisation through rouble hyperinflation. Not a very effective or attractive measure, and it was shelved, like other radical plans, without being taken seriously into consideration.

No way to restore competitiveness

The introduction of the weak-euro or the IOU escudo would undoubtedly add liquidity that might reduce the danger of sovereign default, especially through the use of IOUs directly issued by sovereign debtors – at a price, i.e. the higher discount rate applicable to the IOUs. But seeing how the weaker new currency could restore competitiveness is rather nebulous.

The envisaged devaluation of the weak euro immediately after its introduction, “by a percentage enough to restore the competitiveness losses periphery countries have suffered over the last decade” presumes that the weak euro becomes legal tender in place of the old at par, and that traded goods prices quoted in weak-euro remain unchanged with respect to old euro prices. True, this happens to some extent with every devaluation, but here Gresham’s Law would demonetize the strong euro for all uses not specifically reserved to the old currency; producers and traders would be forced to re-consider their price policy in terms of the new weak-euro.

One inconsistency of this plan is worth stressing: “Crucially, the bonds and external debt of the periphery countries will stay in strong-euro terms.” But the weak-euro countries in order to benefit from greater competitiveness would have to price and invoice their goods in weak-euros, so how would they acquire the strong-euro they need to service their debts?

Easier euro-area enlargement?

Another claim made by Arghyrou&Tsoukalas for their two-currency EMU is totally bogus: “… our proposal will be beneficial for EMU’s enlargement: In the present circumstances, the young democracies of Central and Eastern Europe cannot realistically expect to join the EMU in the foreseeable future. A two-currency EMU will provide them a chance of joining the EMU at a reasonably close date, initially as members of the weak euro, thus maintaining internal popular support and the momentum of enlargement.”

Both the central parity with the Euro at which EMU candidates join ERM-II, and the final rate of exchange at which they replace their domestic currency with the euro, are negotiated by candidates with the EU monetary authorities. Joining a “weak-euro” or a “strong-euro” would happen at different parities, which could be tailored to the relative strength of weak and strong euro, without any competitive advantage for one or the other. This particular claim is nonsense.

National IOUs

The Goodhart-Tsomokos plan has some advantages over the weak/strong-euro scheme. For a start, the devaluation of the national IOU would be geared to the specific conditions of the country involved, rather than being a single-size for all “periphery countries”. Being a national scheme, it would not necessarily involve the ECB: “If the central bank does not want to do this, and under the Maastricht Treaty it could refuse, the Treasury could do this on its own.” And there is a mechanism for the national management of national IOUs and the euro: “… the government, whose taxes remain paid in euro, would be long in euro, whereas the Portuguese private sector would be long escudo, short euro. So, the government transfers its net long to the central bank and asks the central bank to manage the escudo/euro exchange rate, so that it is stabilised, say at a level that represents a 25 per cent internal devaluation, (the choice of number would need careful calculation).” “While managed, the exchange rate should not be pegged.”

But there are also serious additional difficulties with respect to the Arghyrou&Tsoukalas plan. “… escudo IOUs would be acceptable for all internal payments, except tax payments, between Portuguese residents, but not for any external payments between Portuguese residents and foreign residents. All public sector and private sector wage payments shift on to an escudo basis as do interest payments by a Portuguese resident to another resident. Portuguese residents’ deposits and borrowing with Portuguese banks shift to an escudo basis; others remain in euros.” “The escudo would be inconvertible, and non-residents would not be allowed to borrow it. After all, this would be but a humble state IOU, though written rather large and not a ‘proper’ currency; indeed its success would be evident in its disappearance within a defined horizon, say 4 years.”

Back to the drawing board

“It would be messy, and an unattractive dual currency mechanism.” Spot on, Charles. “But it could work; it has done so before now in other countries and circumstances.” You should remind us where and when (the chervonets/sovznak rate was floating and is not comparable to the managed IOU/euro regime). And you should explain how on earth, if external payments between Portuguese and foreign residents take place in euros, is Portugal’s external competitiveness going to be enhanced by the introduction of an inconvertible IOU escudo?


chilosi said...

All the messy proposals of a dual currency rightly bashed by Mario are roundabout and complicated ways to bring about a reduction in the euro wages of the highly indebted Eurozone countries, in order to re-establish their competitiveness. Why not then proceed directly, without childish games and too obvious attempts to deception, if only by reducing by decree what in Greece are apparently the over-inflated wages of public employees, and some additional effective containment and taxation of private wages and other incomes? Moreover the situation of crisis and excessive indebtedness is bound to come back again if the institutional and social causes of the disease (which dates back to the times preceding the Euro) are not cured. This reminds me of the situation of Italy from the seventies up to the beginning of the nineties, when recurring crises were cured through recurrent devaluations that did only bring about a temporary respite. Here the results of devaluation may be sought through direct attacking uncompetitive cost conditions and the institutions that are bound to reproduce them. But in order to implement some drastic measures some internal consensus is needed (and it seems that in Greece it is forming) and the specialized assistance of the IMF. The issue of avoiding shaming the EU is ridiculous: the EU has already been shamed by the prospect itself of a possible default of some of the Eurozone members and the ineffective handling of the stability and growth pact.

D. Mario Nuti said...

Why play games with fancy and dubious currency arrangements, rather than reduce wages outright? In order to try and exploit wage earners' money illusion, of course. But even that may have been superceded: 3 million workers represented by IgMetall have voluntarily accepted a wage freeze in Germany, in order to preserve jobs.

And, as you rightly point out, even if a devaluation of, say, 25 per cent were sufficient to restore international competitiveness - notwithstanding the drawbacks discussed in my post - there is no reason to believe that that competitiveness could be sustained without further devaluations.

Finally, I agree that the rejection of IMF involvement in a possible rescue operation is sheer insanity.

Dan said...

"At a market-determined exchange rate, the introduction of a new currency simply increases the amount of liquidity in the system, without any other effect; nothing happens that could not have happened by expanding money supply in the old currency (as it can always be done with paper money)."

True - but the point is that a Currency Union member cannot expand money supply in the old currency, and therefore its own Central Bank/Treasury has to monetise some other kind of paper in order to gain additional resources.

D. Mario Nuti said...

Sure. Indeed in my following post I have discussed how it could work. My objection is to the procedures envisaged by Arghyrou&Tsoukalas and Goodhart&Tsomocos. The first involve the ECB in managing the soft-euro and targeting price stability for it as if it was hard, in which case your objection does not apply: the new currency expands money supply just like it could be done (by the ECB) with the old currency. The second introduce an inconvertible currency that cannot be used to pay taxes, and still expect its devaluation to both improve competitiveness and raise additional government revenue.

See my following post for a reconciliation of what you and I are saying.

Antonio Lettieri said...

I am following, with interest and curiosity the quarrel on a possible solution to the financial crisis in Greece. I have also noted that different positions converge on a problem of substance, namely the competitiveness. And from here the need of a huge reduction of wages. Let me make two remarks concerning this perspective.
First, in a single market, the new countries of Central and Eastern Europe will always be able to rely, other things being equal, on labor costs still lower than in Greece. In other words, the problem of competitiveness can’t be solved only by addressing wages, since it is a problem that relates to many other features concerning the technology and the quality of the production of goods and services.
Second, that said, it is not ruled out a policy of wage restraint in a context of austerity that touches all incomes, along with taxation and public spending. This kind of policy was followed in Italy after the crisis of the 1992 within an overall framework we defined “Patto sociale” or “concertazione”, in other terms a revenue policy.
Having had the occasion to handle these issues, before as a union leader and then as advisor for European Affairs of the Labor ministry, I never found that the IMF had any interest toward a solution based on the political and social consensus..
The question I still ask myself is: The European Union and, inside, the EMU could envision different arrangements than those purely intended (alike IMF traditional approach) to impose a drastic deflation to countries with financial difficulties? If so, the conclusion to be drawn is that, albeit from different angles, Feldstein was right in the past as well as currently Krugman is right arguing that it was a initial mistake to set up the euro and that it has not a future.
To be clear, I have to say that I, personally, consider it useful to carry on the European Monetary Union But, at the same time, I consider suicide the way the European institutions are managing the financial crisis of Greece (and possibly others) in a framework - don't forget it - of a global crisis - which hits also big countries such as United States, where, in any case, wages have been curbed for three decades.

D. Mario Nuti said...

Thanks, Tonino. You are right on both counts: low wages must go with technology and quality improvements in order to compete with the even lower wages of central-eastern Europe; and austerity could/should affect not only wages but all incomes and fiscal policy (as in Italy’s “Patto Sociale” or “concertazione” in 1992).

Today the IMF cares much more about political and social consensus then it used to do, as well as about the national “ownership” of stabilization programmes, their sustainability, and their prudent speed. But even if the IMF was totally indifferent to political and social consensus it certainly would not boycott a serious stabilization programme that was built on such consensus, as long as the accounts added up. There are no external constraints on EU/EMU countries to build austerity on the foundations of social and political consensus.

And nothing bad and irreversible has happened – so far – since the birth of the euro: there is still time to improve the coordination of fiscal policy within EU and EMU, the coordination of aggregate EMU fiscal and monetary policy stances, and the determination of an effective and transparent crisis management regime for EU/EMU members. This - and not the retrospective jaundiced judgement of Feldstein and Krugman - is what will determine the euro's future.

mwnl said...

Perhaps Germany might reissue the d-mark and d-mark bonds without withdrawing from the euro.

dmarionuti said...

Sure, But at what exchange rate with the euro??? Presumably so that the NewDM/Euro exchange rate would keep appreciating??? And what for???

John Hyland said...

I have been proposing a dual currency system here in Ireland, i believe it is workable, I have given a short explanation in my manifesto on my election site ( runing for dublin central registered but also want incent a 'write-in' velvet revolution ballot for direct election as taoiseach (prime Minister) I believe a dual currency system is workable as an alternative to interest loads from borrowed external currencies,, also a good alternative to IMF bailout conditioning.
My manifestos (pdf download)is on I'd really appreciate your opinions on my proposal.Thanks,
John hyland Dublin Ireland

D. Mario Nuti said...

Thanks for publicising your dual currency scheme for Ireland on this Blog. There are things in your Manifesto that I agree with - like your criticism of the car-scrapping incentive scheme in a country that does not produce cars - and other things that I do not agree with - such as your policies on immigration. I will only comment on the dual currency proposal.

You propose the New Irish Punt to be issued at parity with the Euro and permanently pegged to the Euro, internally legal tender but convertible into Euro at a 12.5% penalty.

Thus imports would still be transacted and paid for in Euro (or other currencies convertible into Euro). So would exports, presumably, i.e. there is no increase in competitiveness from introducing the new currency, is there? It would make more sense for the New Irish Punt to be convertible at a rate that floats downwards, so as to restore competitiveness. Except that even in that case one should not take for granted an improvement in the external current account, depending on trade elasticities. Starting from a trade imbalance and without devaluation an improvement in the current account would require an "internal" devaluation, i.e. a large price and wage deflation, in which case the New Irish Punt (NIP) would not have additional effects.

Don't forget that Irish debt - Public AND Private - would continue to be denominated in Euro, not in the New Punts. The only advantage I can see is the ability to expand NIP money supply, with likely increase in NIP differential inflation with respect to Euro-area inflation and associated loss of competitiveness.

Therefore I think the New Irish Punt would be less likely to succeed than a New Currency issued at a devalued, floating rate of exchange with the Euro. Admittedly there could be unspoken assumptions that escape me and make an important difference.

Anonymous said...

Would a dual currency scenario not make sense if (1) Greece were to issue the new currency ("NC") with one 1 NC being considered 1 EURO at least by the Greek State; (2) the NC would be considered legal tender in Greece to pay taxes, buy assets from the Greek State (and, hence, could also be used in private transactions, e.g., by Greek citizens selling products to holders of the NCs); and (3) Greece were to launch a bond buy-back in exchange for a sufficient amount of NCs (to make it attractive enought to tender)? Would that not be a first helpful step in bringing down the debt + related interest payments? (Of course, it would reduce the amount of tax revenues measured in Euro, but for internal purposes, the Greek state could continue to use any NCs it receives as tax revenue. And, of course, it does not address the competitiveness issue, just the level of debt + related interest payments.)

D. Mario Nuti said...

If “(3) Greece were to launch a bond buy-back in exchange for a sufficient amount of NCs (to make it attractive enought to tender)” this would involve abandoning the 1:1 parity between NC and Euro, and it would necessarily involve default, with all the pluses and minuses of that option.

You could obtain the same result by negotiating partial cancellation of debt and interest with the bond-holders.

Unfortunately neither rating agencies nor the ECB – of all people – recognize the difference between disorderly default and negotiated default.

Anonymous said...

A system by which any Euro Zone country may introduce a supplementary national currency to alleviate pressure on the Euro.

First an assurance must be declared that the status of the Euro within the country will remain unchanged:

That the Euro will still be legal tender acceptable for full payment of all goods and services.
That there will never be any forced conversion of Euro accounts into any new currency.
That Euro obligations, public and private, must be met with Euros.

With these assurances in place the intention can be announced that a new supplementary national currency will be issued to compensate for the loss of Euros in circulation. The new currency is declared to be of equal value 1:1 (or a convenient ratio such as 10:1 or 100:1) to the Euro within the country and of no value outside of the country. The intention is that the new currency circulates serving a portion of the internal economy and thus reduces the need to circulate Euros. There is no intention to devalue the new currency, that is not how it works.

The new currency must be issued at no cost to the nation and in such a way that all have an equal interest in its acceptance. It is also important that there is very little reason for anyone to seek to exchange national currency for Euros in the market and this requires careful control over the amount and manner of issue.

This can be achieved safely if the new currency is issued only in sufficient quantity to offset the inevitable loss of Euros that we are all braced to accept. If we are facing the need for say a 15% reduction in current wages and salaries to keep the country solvent then all wages should be paid 85% in Euros and 15% in the new supplementary currency. Although this creates a bit more work for accountants, it involves no new intrusion on the public because wages and salaries are already fully monitored for taxation purposes. The government will have to offer employers new currency in exchange for Euros so they can meet their new currency obligations but as the new currency circulates employers will prefer to meet those obligations with the new currency in their revenue and keep the Euros for other purposes.

It can be safely assumed that earners of these wages and salaries will carefully devote the Euros (85% of what they were receiving) to meeting their existing Euro obligations and will seek to spend their new currency in the shops buying mostly small things (it is only 15% of their earnings). There is also no doubt that the public will have no problem holding shops to their legal obligation to accept the new currency.

So far so good, people get new currency in their wages and salaries and then spend it straight away on small things in the shops. The problem now is that the shops are receiving all of their income in the new currency. This leaves them nothing with which to pay their Euro obligations and they may not find it so easy at first to insist that their suppliers accept the new currency. This is both unfair and unworkable and will create a distressed market for Euros in exchange for the new currency, damaging its integrity and reputation.

A rebalancing mechanism must be provided by government as a service to retailers and other businesses to reconvert up to 85% of their revenue from new currency back to Euros so that their income matches those of earners. This does mean that 85% of the new currency issued will at first be returned to the government with the obligation to exchange them back to Euros leaving only 15% of 15% = 2.5% of earnings permanently in circulation and only reducing the Euro circulation by 2.5% of earnings. This is OK, some economic activity has been stimulated and a small amount of Euro dependency has been permanently eliminated. As the new currency becomes established shops and businesses will start to find it easier to spend their excess new currency rather than seek to convert it to Euros and this will increase its permanence in the economy and eventually approach the 10-15% reduction in Euro use that was intended.

D. Mario Nuti said...

Ingenious, though cumbersome.

"If we are facing the need for say a 15% reduction in current wages and salaries to keep the country solvent then all wages should be paid 85% in Euros and 15% in the new supplementary currency." But this would not cut wages by 15%, not for a 1:1 exchange rate between euro and the new parallel currency. No improvement in external competitiveness, therefore.

What would achieved with the new parallel currency, that could not be achieved by a 2.5% increase in domestic euro money supply?

Anonymous said...

Re. Supplementary national currencies for Euro countries.

If we could have a 2.5% increase of Euros in the domestic money supply at no cost then we would not be in crisis and the Euro would be serving us well.

That we cannot do this is understandable because Euros can be spent in other countries who would not be happy to see us creating money from nothing that is an entitlement to their wealth. This is the price of using a currency good for purchase in other countries as our day to day currency for internal trading. It is an expensive luxury, it is becoming unaffordable and it is not necessary.

If a new national currency reached 10-15% of the money circulating within a nation then it would still be well within the bounds of the proportion of money that continually circulates within the country and is never used to purchase foreign goods. It is wasteful to pay (borrow and return with interest) for this money to have foreign purchasing power when it is not used for this purpose.

Devaluing this supplementary currency would be meaningless and pointless because by its constitution and manner of issue it is not convertible. Nobody in their right mind will seek to convert the new currency into Euros at an unfavourable rate when they receive 85% of their income in Euros. Unfortunately, with everyone continuing to hold heavy Euro obligations, the only devaluation that can help us is devaluation of the Euro which is beyond the control of any nation.

This proposal is not about achieving competitiveness by currency manipulation it is about reducing Euro obligations without causing a damaging contraction of the internal economy. It is an alleviation of the immediate Euro credit crisis that demands a reduction in Euro debt. To the outside world the country simply runs on less Euros; that is it holds less entitlement to the wealth of other countries. It is no concern of any other country that this country is managing to avoid internal collapse by issuing its own internal supplementary currency. Of course not having your internal economy collapse will be a positive factor in achieving competitiveness.

The system could be described as cumbersome but it is not messy. Although more accounting is required and a new government agency will be needed to administer the authorised currency exchanges needed rebalance incomes, the aim of this agency is very clear, to prevent the distress caused by overexposure to the new currency. We should expect that the solution to such an intractable problem may require a bit of effort.

I have taken the liberty of sending another post with further important details of this proposal.

Anonymous said...

Re. Supplementary national currencies for Euro countries.

As a currency that is supplementary to the Euro the new currency must have clearly defined limitations but as national currency it must have the full trust of the nation.

Limitations that new currency must respect:

It is not the Euro and has no validity in other Euro countries.

It is not exchangeable for Euros. The government offers no exchange outside of its rebalancing mechanisms, discourages private exchange and attempts to prevent a distressed exchange market from developing by preventing the distress that provokes a demand for it,

It cannot be used to pay off existing Euro obligations.

It may be necessary to permit refusal of it as full payment for some categories of transaction which are heavily loaded with unbreakable chains of Euro obligations. This may include housing (because of existing chains of mortgage obligations) and more appropriately wholly imported goods.
Strengths that the new currency must have:

It is the property of the nation. It is not borrowed, it does not have to be paid back and no interest is being paid for its use.

It is issued as state backed credit in wages and salaries that can be fully converted on demand to new currency banknotes and coins. Initially most of this credit will be turned into notes and coins and immediately spent.

It is subject to stricter accounting than the Euro. Demand deposits may not be lent out and lending on time deposits must be subject to strict maturity matching. There must be no duplication of access to the new currency such as occurs with fractional reserve banking.

It declares its own value with respect to the Euro within the country where it is used and has no interest in how it is valued outside of the country where its use is not intended. There is a convenience in parity but should the Euro fluctuate, it is not necessary that the new currency should follow it, it may be better to set a new value ratio.

There is very little to lose and a lot to gain with this system. It is not hostile to the Euro, it simply relieves it of a burden that it is unwilling to bear whilst allowing a country to maintain the health of its internal economy. The new currency makes no claim on the wealth of other countries.

An issue rate of 10-15% of earnings is probably about right. Any more and people and businesses will not be able to meet their Euro obligations and any less may not have enough impact. This rate, although cautious and replete with rebalancing mechanisms that can reduce its permanent effect to 2.5% of income, will make the new currency highly visible within the country. Few Euro banknotes and coins will be seen and new currency banknotes will take their place as people rush to make all small purchases out of their new currency income. Euros payments will tend to be larger commitments that are paid by credit transfer.

This much will get us out of trouble for now and produce a more civilised environment within the Euro Zone that will be more conducive to proper debate about the future of the Euro.

Anonymous said...

Hope I will get a reply to this even though there have been no new comments for about 2 months....

But the last Anonymous' idea seems pretty interesting, but how would the supplemental currencies be phased out once a reduction in debt and increase in competitiveness have been achieved?

Would it be that these temporary currencies would be linked to pay increases such that any pay increase would involve a reduction in the proportion of the salary paid in the supplementary temporary currency? For example, if under the scenario we say a relief of debt burden and an increase in competitiveness and down the line a salary increase of 10% is due to increased productivity then would we see the salary proportions change to 95% Euros and 5% supplemental currency (so the 10% increase comes in the form of an increase in Euros with a decrease in supplementary currency units)? If that is the case then the temporary currency could be phased out eventually yes?

And reintroduced should there be another crisis?

I like the idea because barring a social compact between the government and citizens (of all stripes), citizens generally fear wage cuts because they don't always come with price cuts. So the cost of living increases and they perceive it as being "unfair" that [place stereotype here, e.g. greedy bankers, merchants, etc] get to charge people the same prices (and thus collect the same income) but that they [the ones who are accepting "more than their fair share"] who experience wage cuts have to make due with less income. Under Anon's system, merchants would be visibly affected and would also have to accept a 15% reduction in real payments (in terms of euros) through the rebalancing mechanisms.

D. Mario Nuti said...

Suppose ther introduction of the new currency actually worked. This implies that its devaluation would boost net exports, GDP and employment - thanks to the ensuing rise in national competitiveness - by more, over time, than it would raise the cost of servicing a national debt also inflated by devaluation. A VERY BIG IF, UNLIKELY TO BE SATISFIED.

If the new currency did not satisfy this condition, you would be stuck weith it for ever. But if it did, phasing it out would be no problem at all. The National Central Bank that issued the new currency would simply buy it back in the market using the euro that it would have accumulated out of a persistent trade surplus. Euro circulation would be gradually restored, replacing the new currency into disappearance.

The problem therefore is not how to phase it out, but whether you ever could.

John Morrison said...

I am the anonymous that posted the idea for an internal currency for Euro zone nations.

Nations that issue their own internal currency in the manner I describe will still be using Euros as their hard currency and therefore there is no need for the internal currency to have any international value. The internal currency never presents itself to the outside world, it is there to give the economy some monetary autonomy so that it depends less on borrowed Euros.

Competitiveness is not achieved by devaluing the internal currency, that would be pointless, it is achieved by reducing the Euros that the nation needs to consume. Workers become Euro competitive by being more humble in their use of Euros while the internal currency gives them access to what the nation itself can provide.

I think that rather than phase the internal currency out, each nation will find its appropriate level of use. Once it is seen to be working, no nation will want to eliminate it completely because it will be seen as a foundation of national economic security.

I have thought some more about the issue and have come up with a more concise way of expressing the essential rules and mechanisms which are necessary to ensure that it can flow as full payment for wide range of goods and services strongly related to the internal economy while all receive the same proportion of Euros and internal currency in their income. The same mechanism also avoids the distress that would make anyone want to convert internal currency into Euros at an unfavourable rate and this will keep the currency firmly off the markets.

Here it is:

The government introduces a new national currency, a modest supplementary currency to circulate alongside the Euro. Instead of making it legal tender, which is impractical with so many Euro obligations around, it decrees and enforces that:

Every wage or salary earner must receive say 10% of income as new national currency.
Every business entity whose national currency income exceeds 10% of its total income may redeem the amount over 10% with the government as Euros at a nominal loss of say 1%.
The government initially fixes and publishes the value of the new currency against the Euro for pricing purposes.
It is illegal to sell or buy goods with national currency at anything other than the published rate.
It is illegal to settle Euro obligations with the national currency.
It is illegal to exchange between national currency and Euros except with the government as part of its monetary control program.

Those are the rules. Here is the most concise description I have managed yet of how it works.

It starts with the wage and salary earners who, anxious to keep their Euros for standing Euro obligations, will want to spend their new national currency as full payment for uncommitted spending, that is shops, cinemas, zoos etc. They will be doing this constantly with 10% of their income, few will think it sensible to save it. Shops etc. will accept the national currency but they may ask the government to redeem 90% of it as Euros and accept the 1% loss of value in the exchange as the price of the extra business. Shops etc. will still be left with 10% of their income as national currency which they will have to spend purchasing from each other. Once you have businesses within the nation purchasing from each other, you have permanently circulating currency. Only 10% of the money issued, that is 1% of incomes, is coerced into permanent circulation in this way. That is good because coercion is dangerous and should be applied lightly. Permanent circulation will increase as businesses find opportunities to spend their excess national currency and avoid the 1% loss on redeeming it as Euros. Any permanent circulation of the national currency is a reduction in the nations Euro borrowing requirements and the foundation of monetary sovereignty.

D. Mario Nuti said...

Thank you for taking the trouble to explain your proposed scheme in such careful detail, John, and for revealing your identity.

Your parallel currency seems aimed at raising a relatively small amount of non-inflationary liquidity in a euro member-state. But as a purely internal circulation, without any impact on competitiveness or debt reduction, it seems rather limited in its capabilities and ambitions.

I am worried by your last sentence: "Any permanent circulation of the national currency is a reduction in the nations Euro borrowing requirements and the foundation of monetary sovereignty." You treat any reduction of the public's demand for money as a reduction in government borrowing requirement, but I do not see how they can be regarded as the same thing...

John Morrison said...

D. Mario

There is one part of the process about which I should have been more explicit. If the currency is issued as 10% of salaries then the government only has to pay 90% of its wage bill in Euros and private companies will initially have to convert 10% of their wage bill from Euros to the new currency with the government. The government retains 1 Euro for each equivalent value of national currency issued. Until the new currency find its natural circulation, the government must hold 90% of the Euros it has retained for possible redemption. The other 10% can be used to reduce debt. Permanent circulation of the currency reduces government debt because it is no longer asking to be redeemed as Euros.

The purpose is to allow Euro zone countries to develop a degree of monetary sovereignty; the power to independently provide some liquidity to their own economies that does not require external borrowing and that has no effect on the issue or value of the Euro. Accepting the status of the Euro and all obligations denominated in it has two advantages: woe betide any nation that doesn't and keeping the Euro as the strong currency relieves the internal currency of all international credibility burdens and vulnerabilities. It is a nations private currency.

The need of governments to borrow money for every action of their economy is not normal. It places nations in artificial debt and the anxiety to stay sweet with creditors causes governments to over-borrow when invited and then, when panic hits, to impose dismal austerity measures in a desperate attempt to be seen to be doing the right thing. It is destructive to democracy leaving no government able to act other than as bailiffs selling out their own people

Recent events have shouted this very loudly:
Greece explicitly threatened with withdrawal of its next operating loan.
The entire political class of Italy and Greece supplicating to direct rule by bankers.

To escape from this tyranny, Euro nations have got to move towards a position of being able to say when necessary “Have your Euros back we´ll use our own currency instead”. I am trying to find a gentle and measured way in which they they can do this.

diogo said...

I intuitively think John Morrison's ideas need to be considered as a way out of the euro crisis.
It seems like a "National Local exchange trading scheme", and might just do the trick (to some extent)

D. Mario Nuti said...

Exit from the euro most definitely cannot provide a solution for the euro crisis. Public debt is denominated in euro and other foreign currencies, and the introduction of a new national currency, associated with devaluation and inflation and higher interest rates, would raise the debt/GDP ratio and lead to accelerated default, not to a solution.

Moreover exit from the euro would involve the heavy cost of leaving the Union, as well as losing access to any assistance already pledged by European institutions. Thus there is no incentive to leave unilaterally, and there is no mechanism to force an existing member of the euro-area to leave.

The introduction of a new currency(or the re-introduction of an old one) could simply be forced upon a member after default, following the resulting banking crisis and generalised illiquidity of the entire economic system due to lack of euro in an amount sufficient to keep the economy running.

A necessity imposed by a crisis if this ended in disaster, therefore, not a solution of a crisis but a desperate and costly way of coping with the consequences of failure, though better than even costlier alternatives. Let's hope that German opposition to greater latitude in ECB powers to purchase government bonds might cease at last.

John Morrison said...

The solution I am suggesting is not about exiting the Euro although it would provide a gradual way of doing so if it was really necessary. It is about making the best use of the Euro. It has some complexities and costs: People will have to handle two currencies, a permanent monetary balancing mechanism is required needing a lot of manpower and notes and coins will have to be issued. It is however, as I have said before, not messy. The issue of this currency does not cause defaults or anyone to be left short on existing obligations.

A much better solution would be for the ECB to evaluate the internal circulation requirements of each nation and simply provide each nation with that amount of Euros, debt free. This will be entirely fair. If the evaluation is correct then those free Euros will, on aggregate, never leave the country and therefore will not be used to purchase the wealth of other nations. If nations require Euros above those issued debt free then they must borrow, or earn them, as now and that is also fair because on aggregate these Euro will be used to purchase the wealth of other nations.

The problem with the Euro is that is cannot be a super strong world currency and at the same time serve well as the currency of circulation within Euro zone nations. Clearly the Euro was founded on an ambition to attain a trusted reserve currency status because the constitution of the ECB explicitly repudiates responsibility to the needs of Euro nations in favour of maintaining the value of the Euro.
Its strength as a world currency owes a lot to this promise therefore I see no possibility that the ECB will issue debt free Euros for internal circulation as I have suggested. From the point of view of international holders of Euro reserves, the need for Europeans to use Euros to buy their daily bread is an irritation and the ECB is committed to protecting them from this irritation.

Only a joint act of sovereignty by all Euro zone nations can change the constitution and purpose of the ECB – currently they don't even know how to talk to each other and Europe is steered by leaderless and vision-less summits of the strongest. It is for this reason that I am suggesting dual currency as a way a nation can take unilateral but benign action to at least safeguard the workings of its own internal economy.

Jason Welch said...

I read an essay by F. A. Hayek, “Choice in Currency”, in which he contended that allowing the citizens of a country the choice between competing national currencies can afford them a lifeboat against inflation. I was wondering if I could get your comments on whether or not preemptively introducing a second and third currency with free floating exchange rates into the United States could protect US citizens from inflation.

The new currencies could be introduced on a 1 for 1 basis for a span of 5 years before the parities were allowed to float. The currencies volumes and reserve requirements but not their parities could be managed by different governmental bodies such as the Treasury, Congress or separate parts of a divided Federal Reserve. If the nation correlated currency strength to job performance of the managing entity this could establish a currency soundness race to the top.

In this scenario, we are not concerned with increasing liquidity, defaulting on national debt or restoring or establishing international market competitiveness. We are not attempting to permanently establish a strong and weak currency. We are fine with Gresham’s law driving out bad money or most likely establishing circulating and personal reserve currencies. We are concerned only in maintaining the buying power of one or more and ideally all of the currencies.

I was just wondering if this or a similar scenario is at all workable and if our objective of a currency inflation hedge could be established?

John Morrison said...

I think the important thing is that any nation must a currency that it issues itself and whose value is based on the labour performed in return for its issue and the goods and services of the nation that are an appropriate reward for that labour. Declaring it the nations own private currency liberates it from the pressures that might undermine this very clear criteria of its value. Of course you can only have a private currency if you use something else for foreign trade, like the Euro.

Having an international reserve currency as your internal currency has some problems. The US might anger China less if it were to separate its own economic problems from the value of the dollar by issuing a new internal currency.

I don't see a reason for more than two currencies if the government manages at least one currency well.

D. Mario Nuti said...

I received a signed comment that I think is worth sharing with others:

Professor Nuti, I read your thoughtful comments on dual currency schemes back in 2010. Things have changed since then. I very much value your expertise in perhaps the most important subject in the world at the moment. Please tell me why my formula will not work:

Life is sometimes tough. But it’s all relative. If kids complain about their bedroom, some camping out can put things in perspective. Greek citizens are complaining about the necessary cuts. I believe the austerity program involves some 20% cuts from government employees, mainly teachers. 20% is a lot to be sure - on top of tax increases. The challenge is to convince the population, especially the large government work force, that taking the tough medicine now is better than exiting from the EU.

The leaders know this, but the average person is unconvinced, or at least unwilling to take the medicine. Here is how you convince them AND have them take the medicine.

You meet with the big unions and suggest they give up a more reasonable 5% pay cut. They also have to accept new drachmas for 15% on the basis of 1 drachma = 1 euro. Thus, they are paid 80% in Euros and 15% in drachmas. This system will be in place for one year before the country reverts to one currency or the other. The population will be no worse off with drachmas than taking the austerity program as planned. They will, however, be educated over the year in exactly what it is like to live with drachmas. Some patriotic grocers and service providers may honor the initial 1:1 value for a brief period. But very soon, if not immediately, the populace will see what the drachmas will buy -- not much.

The 80% Euro bedroom will start to look much better after a little drachma camping such that they can imagine what a disaster going to 100% drachma would be. They will feel fortunate that their leaders did not abandon the house with the bedroom that is not all that uncomfortable after all.

Now I realize that there are many legal and technical hurdles to this plan. But desperate times requires desperate measures. At least this will calm the streets and perhaps for those willing to work for drachmas, may even spur some short term growth.

D. Mario Nuti said...

Thanks for your thoughtful comment. My reaction is that this is an expensive educational exercise. And it may be too late, there is no longer a chance of a Greek government until after the 17 June elections. The left-wing anti-troika party Syriza is likely to be the largest party also benefiting from the 50 seats majority premium. Austerity on its own (without European resources) will not work anyway. German dogmatic and obtuse insistence on austerity is wrecking the European single currency project. And the Greeks are unwilling to learn other than through their own repeated mistakes.

Ron Maimon said...

This post and the comments miss the point of a dual currency. People here are imagining that expanding the money supply is equivalent to keeping the old currency and reducing the wages of those already working. It's exactly the opposite. It's only equivalent in a fictional Chicago school world.

Reduction of wages of those already working removes their purchasing power. Prices of goods never adjust properly, and this action produces further layoffs, and destroys an economy. It doesn't work to expand the number of working people, nor does it bring factories to full capacity. Right now, people and industries are idle, because people don't have enough money.

The way a local currency works is that the government can produce more of it, so as to buy the products. It can give people the new currency to do infrastructure jobs, to get people working locally, producing locally, and buying locally, since their wages can purchase local goods easily and imported goods with more difficulty. This allows the local economy to recover, and then you are in a position to work out the negotiations with other Euro countries, with a strong economy that can export.

When people are unemployed and factories are idle, you need to drop money out of helicopters, in Bernanki's words. The dual currency is a way to supply the helicopters, that's all.