Competitive devaluation through currency fragmentation We promised at the end of our previous post that we would qualify the economic case for the introduction of "free money" with some direct references to Willem Buiter, Citi chief economist and former BoE MPC member. So here follow some of his observations on all things "money" during a liquidity trap, as plucked from his papers on seigniorage, the nature of irredeemable fiat money, numerairology and the use of virtual currencies to break through the ZLB from the last decade or so. On the power of state seigniorage, for example, Buiter noted in 2007: Note that while the Central Bank does not, in its solvency constraint, view irredeemable base money as an effective liability, households do view base money as an asset in their solvency constraint. This asymmetry is the formal expression of the view that fiat money is an asset of the holder but not a liability of the issuer. Because base money does not have to be redeemed ever, it does not constitute an effective liability of the state. The increase in net private wealth is also in the most liquid form possible. When government fiat money is perceived as an asset by the private sector but not as a liability by the government, there can be no liquidity trap equilibrium if the long-run growth rate of the nominal money stock exceeds the nominal interest rate on money balances. The above applies to the power of state seigniorage, but it seems fair that in today's world the "asset for the private sector, but not a liability for the issuer" applies equally to virtual currencies as well. In some sense, if we get really abstract, it also applies to bank credit "money" for as long as the assets cannot be differentiated from state money and for as long as the conditions tied to those assets are met. If they fail to be met, such bank assets can turn into equity consuming liabilities very quickly. If they can't be properly segregated, this leads to a money entanglement problem which only the state can resolve by unconditionally turning bank liabilities back into "liability free" private sector assets once again. But of course, seen from this light, that means (as Buiter noted in 2003) that such assets - and by definition similarly constructed private assets if guaranteed by the state - represent a nation's net wealth or stock all along. The more money can circulate without inflationary consequences, the richer the nation can be judged to be. From Buiter: The next step is to show how the existence of irredeemable fiat base money implies that fiat base money is, in a precise but non-standard way, net wealth to the consolidated private and public sectors, and that this bestows on monetary policy a pure fiscal effect: in a representative agent model with rational expectations, changes in the stock of nominal base money can change real private consumption demand by changing the permanent income or comprehensive (financial plus human) wealth of the household sector, after consolidation of the private and government sectors" intertemporal budget constraints. In other words money represents the national endowment (with public debt a fiscal tool deployed to redistribute that endowment according to central priorities) which to all extents and purposes is "us," the collective power of our ingenuity and labour. Or as Buiter notes: The endowment is therefore rather like labour time or labour services. There is a market for current labour services but, in the absence of slavery, no market in ownership claims to future labour services. Buiter in part echoes our bank credit-money entanglement point by noting that the currency could still be unbundled from the numeraire without the need of a virtual unit, providing that the central bank stopped supplying currency on demand to the banking system, which would see bank money lose its fixed parity with bank reserves at the central bank. This is another way of saying that if the state guarantee was removed, bank credit money would begin to float freely be valued on its own market merits. This is a point which was noted by Frances Coppola recently as well. Consequently, if we were to go down the unbundling route, the introduction of a new parallel currency would work equally well whether it was introduced by the state or by the private market. As Buiter notes: Assume that instead of fiat paper or electronic currency, there is some exogenous supply of intrinsically worthless objects, say "pet rocks" like rai, the stone money of the Yap islands. These are large, doughnut-shaped carved disks, usually of calcite, that can be up to 4 meters in diameter, although most are much smaller. Money would disappear from the government budget constraint and from the government tax rule. The government solvency constraint (63) would be unaffected. Note that the pet rock money is a true "outside asset," an asset to the owner but not a liability of anyone else - "nature" was the issuer. Once the "pet rock" currency was in that case introduced, the government/central bank would instead of targeting interest rates begin to target the exchange rate between its own currency and the pet rock currency, as per any country that attempts to fix or peg its currency to that of another for the sake of economic gains. I.e. just like China has traditionally made its currency less attractive than the dollar by oversupplying it on purpose - in so doing stimulating its own economy - the central bank could ensure that its units were always oversupplied relative to the new pseudo currency, in a way that synthesised a negative real interest rate in the numeraire currency, stimulating the economy much in the same way. You can think of it as a currency war waged within domestic boundaries. In that context, a virtual unit with a fixed supply is never going to be able to competitively devalue as easily as the official currency. In the pet rock currency model, pinning down the initial value of the exchange rate between one unit of euro bonds and a unit of pet rocks, during a period when the interest rate on euro bonds goes negative after being positive in the previous period, would again require either a terminal boundary condition, or a fixing by the government. In the case of fiat euro currency, the authorities certainly have the ability to set the value of the exchange rate in any period, as they can issue any (non-negative) amount of currency. This is not true in the case of pet rocks whose aggregate supply is given and finite. Either way, the ultimate thing to understand is that if currency union in a deflation represses economies or economic zones which can't print their own currency, the surefire way to stimulate them is to allow them to issue their own parallel currencies instead. Since debts are still accountable in the old currency (which also remains the numeraire), new units remain anchored by the fact that exchange rates can't be allowed to get too weak. For this to have any easing effect whatsoever, however, it is also essential for the old currency to remain the unit of account. As Buiter explained in 2009, using the euro as an example in a world where a virtual Wim currency has been introduced: If the numéraire instead were to "follow the currency" and a wim price level Phillips curve, we would have achieved no more than a change in the unit of account for the euro currency economy, like the change from old French francs to new French francs in January 1960, with 100 old French francs - 1 new French franc. The zero lower bound would continue to exist in the new French franc economy as it had in the old French franc economy. As Buiter concludes, while authorities can encourage the use of a particular financial instrument as a unit of account, they can't dictate it. Ultimately the numeraire is determined by a collective but uncoordinated, decentralised social choice of the agents making up the economy, even in fiat money frameworks. That's why the key risk of the policy is if the numeraire follows the currency regardless.