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.

Kaldor on Endogenous Money

I recently re-read Nicholas Kaldor's article "The New Monetarism" from 1970.  This contained an early statement of the principle that money should be seen as endogenous, in response to Friedman and his followers, who appealed to the idea of an exogenous money supply.  Kaldor writes "The explanation ... for all the empirical findings on the 'stable money function' is that the 'money supply' is 'endogenous' not 'exogenous'."

Two points strike me from this paper:

The first point is that, for Kaldor, the question over the exogeneity or endogeneity of money is all about the causal relationship between money and nominal GDP.  The new monetarists that were the subject of the article (we'd probably call them old monetarists now) argued that there was a strong causal direction from changes in the money supply to changes in nominal GDP, with the latter manifesting itself purely as changes in the price level in the long run.

Endogenous money in this context is a rejection of that causal direction.  Money being endogenous means that it is changes in nominal GDP that cause changes in money or, alternatively, that changes in both are caused by some other factor.  This is interesting because nowadays it seems to be quite common to use the term endogenous money to simply talk about the idea that 'loans create deposits', even in the context of models where the deposits so created have a strong casual link  to nominal GDP.  This appears to me to be almost the opposite of what endogenous money was originally about.

Secondly, Kaldor's analysis is based on seeing money for its function and what it does, rather than identifying a money supply with a particular asset class.  As long as policy works to accommodate the demand for money, we might expect to see a perpetuation in the use of a particular medium - bank deposits, say - as the primary way of conducting exchange.  But we would be wrong to conclude that bank deposits and money are one and the same.  That they appear the same is only because it is convenient for them to function that way and because it has been allowed to happen.  But any stress on that relationship will simply mean that bank deposits will no longer function as money in the same way[1].  The practice of settling accounts will adapt, so that we may need to revise our view of what money is.  Money cannot be captured in the concept of a "money supply".

UPDATE:  Since posting this I noticed that John Cochrane has just done a post on Greece, including a comment on the use there of the rolling of post-dated cheques to deal with business to business payments.  Cochrane writes "Money is created when needed, apparently."  I'm not sure whether the apparently is intended to be ironic.

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[1] There's an interesting comparison to be made here with the Lucas Critique.

Banks and Liquidity Preference

Consider a simple economy with three sectors: households, firms and government.  There are two assets: government bills and loans to firms.  Firms can hold bills, but we'll assume their holdings are generally zero.  All loans to firms are made by households.  The national balance sheet looks like this.

	Households	Firms	Government
Loans	L	- L
Bills	B		- B

(To avoid needing to include money as a separate asset class, we'll assume here that the bills are used as the medium of exchange.  This could be through direct physical exchange.  Alternatively, all bills could be held in individual accounts in a central registry with households and firms making payments by instructing the registry to transfer ownership interests.)

For simplicity, we will assume that firms wish to invest as much as they can and are limited only by the amount that households are prepared to lend.  Household behaviour can then be split into two decisions that are strictly independent. 

First, they make a decision that determines the total addition to their holdings of financial assets.  It is usual to think of this as being a decision about how much they spend on consumption, given their income expectation and other factors.  The accumulation of financial assets - saving - is the residual.

Secondly, they make a decision which determines the split between making additional loans and acquiring additional bills.  It will be useful to think of this as being a decision about the amount of additional loans they want to make.  We can imagine that bills are riskless and households have no limits on how many they hold, but that loans to firms carry default risk and households wish to manage their exposure.

It is crucial to recognise that these are two separate decisions.  Households can decide to spend less on consumption, without changing their decision about how much to lend to firms.  Likewise, they can decide to lend more to firms, without changing their decision about how much to consume.  Putting this latter point another way, a household decision to save more is not a pre-condition of an increase in loans to firms.

Each decision affects expenditure independently.  We have assumed that firms will spend all they can borrow, so the decision to lend affects expenditure directly.  As we have noted, this is not dependent on a decision by households to consume less.  So although, for the economy as a whole, investment must equal income less consumption, both investment and consumption are separately determined, making income the thing that needs to adjust.

If we were instead to assume that there was just one decision and the amount to be loaned to firms had to be exactly equal to the amount saved, then we would have the sort of situation conjured up by loanable funds imagery.  We could imagine that the amount to be loaned was determined by the amount households decided to save.  This might be the case in a simple barter model where saving could only be undertaken by retaining real goods

How do banks fit into this picture?  The answer is all to do with the lending decision and not the saving decision.  If the amount to be loaned to firms is still decided entirely by households, then banks are mere conduits - what people often mean when they question whether banks are just intermediaries.  On the other hand, if part or all of that decision falls to banks, then they immediately become an active part of the process.

We can illustrate this by adding banks into our balance sheet in two different ways.  In the first (shown below), banks hold the loans and households hold deposits at the bank instead. 

	Households	Firms	Banks	Government
Deposits	D		- D
Loans		- L	L
Bills	B			-  B

We need to make two further assumptions here.

a) that households decide between bills and deposits in the same way that they did between bills and loans; and

b) that banks accept any amounts deposited, which they then automatically lend out.

In this case, we can see that the lending decision still rests entirely with households, notwithstanding that banks are making the actual loans.  This is a true banks-as-simple-intermediaries model.

Alternatively, we might add in banks as shown below:

	Households	Firms	Banks	Government
Deposits	D		- D
Loans		- L	L
Bills			B	- B

In this scenario, a decision by households to increase holdings of deposits is the same as a decision to save.  There is no way for households to do one and not the other.  Rather than making two separate decisions, households now only get to make one.  The split between loans and bills - essentially the decision to lend - is in the hands of banks.  So, now, bank behaviour is crucial.

In reality, we are somewhere between these  two situations.  Bank decisions on lending are important, but household decisions matter too.  A major factor in the financial crisis was non-banks (households, here) trying to switch from bank debt (deposits) to government securities (bills).

Once we start to consider separate objectives for households and banks, we need to start bringing interest rates into the picture (or rather interest rate differentials).

We can see here the critical importance of portfolio decisions and how they are made.  This basic idea is really what liquidity preference is about in Keynesian and post-Keynesian economics.  Liquidity preference is perhaps an unfortunate term because, although liquidity is an important element, we need to look at aspects of portfolio preference that go beyond that.