Sunday, 12 July 2015

Value of State Currency When it's not Medium of Exchange

There's been some interesting posts speculating on how things might pan out if the Greek government were to switch from the euro to a new currency (drachma, say) for state finances.  For MMT theorists, the use by the state of such a currency, specifically for taxation, is the essential feature for establishing it as the basis for a medium of exchange.

An old post by Warren Mosler provides a simple outline of such a proposal (h/t Peter Cooper).   As I understand it this would work like this:

- All tax payments would be required to be made in drachma;

- All government expenditure payments would be made in drachma;

- Government contracts for goods and services would be re-denominated to drachma.

- Existing private contracts in euros (including existing bank loans and deposits) would remain in euros.

- The drachma would trade freely against the euro.

- Payments on existing euro denominated government debt would be suspended (this is necessary because the government is no longer raising euro revenue and is likely to undermine the value of the drachma if it attempts to use it to buy euro).

The idea here is to rely on the "taxes drive money" principle to ensure demand for the new drachmas. This would then allow the government to use them for domestic expenditure, removing the budget constraints it has in euro.

This idea raises some interesting questions.  The first question is what currency the private sector would use for quoting prices and making contracts.  Would they stick with euro, switch to drachma or use both?  When the drachma was originally replaced with the euro, this was of little consequence, since the exchange rate between the two was fixed.  When the exchange rate floats, it becomes an important question.

I'm inclined to agree with JP Koning that it would not be easy to shift private commerce onto the new currency.  I'm not sure that Mosler's steps alone would be sufficient, although maybe with some further measures that end could be achieved.  Here, however, I want to assume that the private sector chooses to stick with euro, because I wanted to think through the consequences.

The new drachma must carry some value, as it is needed to pay taxes.  Any taxpayer in Greece will need to acquire drachma at some point.  However, they do not need to hold drachma for any material period.  They can acquire the drachma on the same day that they pay the taxes.

When should a Greek taxpayer consider acquiring drachma?  If they wish to minimise their exposure to the drachma / euro exchange rate, then they need to buy drachma on the date when the tax liability is determined.  I am not at all familiar with Greek tax legislation in terms of calculation and timing of payments, but this probably involves a period of not more than a year on average between when the liability arises and when it is paid.  So, taxpayers may want to buy their drachma a year in advance, if they wish to avoid any exchange rate exposure.

On the other hand, if the drachma is perceived as weaker than the euro, then they may wish to defer that purchase until the tax is due, hoping to pick up the drachma cheaper.  Either way, the aggregate stock of drachma that the private sector wishes to hold would appear to be limited to taxes accrued but unpaid.

At the same time various private sector entities will be receiving government payments in drachmas.  Unless they have a tax payment due, they will be wanting to sell these for euro.  In some cases, people who are due to receive future government payments of known amounts of drachma might want to try and hedge their exposure to the exchange rate by forward selling these amounts.

So it would appear that the drachma / euro exchange rate would be directly determined by the supply and demand arising from government finances. 

It helps to consider some simple numbers.  Let's say that GDP is 100 euros and the exchange rate is one to one.  The tax rate is 20%, taxes are paid one year after they arise, and there are 20 drachmas is issue.  Each year the government spends 20 drachma, which is matched by 20 of drachma receipts from the previous year's tax, leaving issued drachma constant at 20.

What now happens if the government decides to try and boost activity by handing out 10 of drachma (in addition to its 20 of spending)?  At this point, the outstanding unpaid tax of 20 drachma is unchanged, so no-one would naturally want to hold the extra 10.  As people try to sell their additional drachma, the exchange rate against the euro falls.

When the exchange rate reaches 1.5 drachma to the euro, then annual GDP in drachma terms will work out as 150 drachma and the tax liability (at 20% of GDP) will be 30 drachma.  At this point, people may be willing to hold the full stock of 30 drachma and the decline in value will halt.  This is not exact though.  It depends a lot on expectations.  As described above, if people percieve the drachma as weak, they may decide not to match their liability exactly, but to wait and see if they can pick up the drachma more cheaply at a later date.  In which case the rate will fall even further.

It's useful here to consider the Quantity Theory, in the form MV = PY, for any money supply measure M, with P as the price level, Y as real output and V as the residual "velocity".

With P being fixed in the short term, an increase in M (brought about say by government expenditure) must correspond with changes in Y or V.  The question then becomes how much of each, and whether and to what extend this subsequently leads to changes in P.  (A monetarist would claim that P will eventually change so as to eliminate any temporary change in Y and V).

However, if P can change easily, then there is no traction to have any impact on V or Y.  In the scenario we are considering, all of P is captured by a single exchange rate that is freely traded.  This is very different from a situation made up of numerous individual prices and contracts.

In conclusion, I think it makes a big difference whether the euro or the drachma is used as the unit of account, for the setting of prices and the making of contracts.  The fact of price stickiness is what makes monetary economies behave as they do.  Unless the adoption by the Greek state of a new currency also entails the Greek economy switching to that currency, the power of fiscal policy to have real effects would be severely hampered.


  1. It's funny how the Neochartalists tell a story of people starting to work when the government imposes a tax liability on citizens. In reality, humans cannot do all the work for themselves and need others to do it for them. This "I work for you, you work for me" leads to a system of credits and debits. This system would have come long before governments came into existence. So it's not like people are non-social before governments announces "pay taxes".

    In this case there is some logic to it. Suppose in the case of Grexit, Greeks do not use the Drachma but have to pay taxes in Drachmas. This would lead to shortage of Drachmas and "price clearing" wouldn't work (price = exchange rate) and quantity adjustments need to happen: which is doing trade in Drachmas. But it might take time for people to realize this.

    However, this is all hypothetical. The main way in which Drachmas would be used if Grexit happens is the declaration by the State. Not because of some Mosler's Law.

    1. I think it's useful to understand the role taxes have in giving value to a currency. But I do feel that some Neochartalists go a bit far in seeming to think that that is the end of the matter. As to what came first, tbh I don't really care, but that's partly just me.

  2. Hi,

    I just saw this article. I just wrote an article explaining how the transition would work, and I doubt that Greece would move to "drachmas", rather "Greek euros", which I call EUR*(G). It would inherit the contractual relationships of the old drachma, which will partially act to fix the domestic price level. It will probably lose value versus the EUR (ex-Greece, which I denote EUR*(X), but the pass-through to the domestic currency should be less than 1:1, so long as the currency has at least some credibility.

    Meanwhile, capital controls will prevent Greeks from using EUR*(X) within their domestic operations. They will need to hold Greek euros for liquidity management purposes. Once the local currency finds its level, the capital controls could be lifted, and the two forms of "euro" could coexist, as you suggest here. (Although they would probably rename the Greek unit to the drachma first.)

    1. The steps you describe are the sort of measures I think would be needed to get the local currency (drachma, EUR(G), whatever) into broader use - I'm dubious that use for state finances would be enough in itself. Also, I think where are things are now that these sorts of measures would be necessary anyway due to the state of the greek banking sector.

    2. If you flipped your statement around - what if all levels of government stopped accepting its currency for tax payments? In a place like Canada, the currency could easily become worthless very quickly. (Since the euro is supranational, it is a different story.) That is consistent with the Chartalist story.

      Attempting to introduce a parallel currency within the euro area, without blocking the existing euros, is not really a test of neo-Chartalist arguments. The euro has a value which is driven by the tax demand of the other countries, so what Greece does will not affect the value of the euro to any major extent.

      But if you have an external currency entrenched in the banking system, it would take time for a new unit to displace the old, even with tax backing, as your article suggests. But at the same time, neo-Chartalists would argue that allowing the banking system to use an external currency is a policy error. The regulatory pressure to prevent the use of external currencies is a hidden assumption within new-Chartalism.

    3. As a follow up, within an "overdraft" style of banking system, where the central bank assets consist of advances to private banks, the private banking system is only solvent because it is borrowing from the central bank in EUR. Although people want to emphasise central bank "independence", it is still a subsidiary of the Treasury. If one wing of the government insists on using an external currency in its dealings with the private sector, we should not be too surprised that tax policy alone is enough to drive the use of a new unit of account. Obviously incoherent policies can lead to incoherent outcomes; it's hard to fault neo-Chartalist theory for this.

    4. Some interesting points, there. Here are some of my thoughts.

      1. I am not questioning here whether the parallel currency would have value - I think it would. In fact, my scenario could even be seen as super-chartalism, because I am not only saying that tax is what gives it value, but further that the values is strictly determined by the level of taxation and spending. This is currency purely as tax payment tokens, where supply is based on state spending and demand derives from taxation. There are no other reasons to hold the currency, so no other complicating factors in its valuation.

      2. The Mosler post I linked seems to suggest that the steps I described would be sufficient and that it would not be necessary to freeze out the old currency. This struck me as unlikely and was one of the reasons for doing this post. Like you, I think more is needed.

      3. I am less sure that if Canada started demanding taxes in euro, say, that this would leave C$ claims as worthless. There are many entities who are short C$ because they have borrowed in that currency. These entities all need to acquire C$ from somewhere to settle their debts and this leads to demand for C$ in the same way that there is demand to cover tax payments. In fact, the level of outstanding private debts is probably considerably larger than the outstanding accrued but unpaid tax. None of this is to suggest that I think the abandonment by the Canadian state of the C$ would have no effect.

      I'm not trying to provide a critique of neo-Chartalism here - just using an MMT idea to explore questions about the valuation of currency.

    5. I welcome this discussion; very worthwhile.

      My personal search is for some common reference point between future drachma and euro. An example would be 1000 euro = 1 gold oz. = 1500 drachma. Of course, that standard does not exist.

      What would happen if the Greek government announced an auction for purchase of gold? Assume that 10 million drachma would be offered for gold, no reserve. Someone may get 10 million drachma for one ounce of gold.

      You must start somewhere.

  3. Peru uses two currencies as do various other countries. Doesn't seem to be a problem.

    1. There's no reason why it should be a problem. My scenario where only euro is used was just the assumption I was making in order to explore questions about the value of a currency.

  4. In Greece, it seems like all the financial wealth is now in the hands of the private sector. The Greek government is completely broke, with no money at all. Even the tax income due government is pledged completely to creditors for some forth-coming time period.

    The Greek government is really in a financial pickle.

    If the Greek government confiscates privately held euros and converts to drachma, the effect on import-export will be horrendous. How many drachma are needed to buy a gallon of oil from anyplace? How many drachma to buy a ton of fertilizer?

    A much easier euro-drachma conversion may result from a government decision to pay for services partly in euros and partly in drachma. Perhaps fuel payment would be all in euros but pension payments would be half euro, half drachma.

    I think that the Greek government is still getting a small income stream in euros by the tax route. These euros can be recycled by the Greek government. Of course, if the recycled euros all went to pay debts held by creditors, all Greek held euros would eventually disappear.

    We may be discussing dual currencies for Greece more frequently if today's news is a forecast. The demands being placed upon Greece seem to be approaching 'backbreaking'.

    1. It may be that there is some policy option involving use by the state of two seperate currencies, but it does seem to throw yet another complexity into the mix.

    2. Spend in Drachmas, demand private debt be redenominated and settled in Drachmase but tax partly in Euros?