The Two Concepts of Money, and the Future of Europe

Leonardo Leiderman
Mario Bléjer, David Cheney, Jacob Frenkel, and Assaf Razin
Published Date:
June 1997
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C.A.E. Goodhart

I. On the Nature and Origins of Money

There has been a continuing debate between those who argue that a currency’s value is based essentially on the power of the issuing authority (“Cartalists”) and those who argue that the value depends primarily, or solely, on the intrinsic value of the backing of that currency (“Metallists”). An associated debate exists between those who have argued that money evolved as a private-sector, market-oriented response to overcoming the transactions costs inherent in barter—call them “Mengerians,” after Karl Menger (1892), who anticipated most of the more formal subsequent models by such economists as Brunner (1971), Alchian (1977) and, more recently, Kiyotaki and Wright (1989)—and those who argue that the state has played a central role in the evolution and establishment of money.

The “M” team has assembled the more illustrious collection of economists—not to mention the endorsement of Aristotle. The “C” team, in contrast, has arrayed a more motley and fringe group of economists, including Mireaux in France (1930), and (most) U.S. and U.K. post-Keynesians. Nevertheless, the C-team approach has also won the support of a sizable majority of those in other disciplines—including anthropologists, numismatists, and historians concerned with the origin of money. Whereas the M group has been strong on formal theory, it has been constitutionally weak on historical empiricism, with such few exceptions as Melitz (1974).

Thus, In view of the severe transactions costs of barter, many economists have constructed models showing how the private sector could evolve toward a monetary economy as a function of a search for cost minimization procedures within a private-sector system, in which government does not necessarily enter at all.

Precious metals, with their advantages—such as durability, divisability, and portability—first became generally used as a means of payment and medium of exchange. Yet in their raw state, it is difficult to identify and confirm their fineness and quality. The thrust of Alchian’s paper (1977), however, is that money arises as a result of the existence of a good with low identification costs. But the costs of identifying the quality of either unworked or fabricated precious metals for the ordinary person is probably considerably higher, for example, than the cost of identifying the value of items in everyday use—such as salt, corn, nails, or even perhaps cattle (most people in a rural agricultural community would, however, be able to assess the value of a cow)—and again greater than the value of an item acceptable by being needed for certain intra-societal functions (for example, religious or wergeld).

This may appear to be a straw man. Few people have argued that precious metals would be used as a medium-of-exchange currency, until the identification problem was largely resolved by the technical innovation of a mint process whereby the identification costs could be drastically reduced by stamping a quality guarantee upon a coin. Thus, the argument is that a combination of the innate characteristics of precious metals, plus the identification cost reduction permitted by minting, enabled the private sector to evolve toward a monetary system.

But to suggest that this all occurred purely within the private sector is historically flawed. Although, once the idea and technical process is discovered, minting would seem to be as capable of being accomplished by the private sector as any other metalworking process, in practice minting has, in the vast majority of cases, been a public-sector operation. In those cases where the mint has been privately run, the government has in most cases set both the standards of fineness and a rent, or seigniorage tax, that extracted most of the available profits.

Minting came under the government’s aegis for two associated reasons. First, a mint requires an inventory of precious metals, which attracts opportunistic theft and violence. Minting requires protection, and the protector (wielding the force necessary to maintain law and order in the economic system) will be able to extract most of the rent from the system. Second, the costs of identifying the true value (quality) of the metal included in the minted coin leads to time inconsistency. The mint operator is bound to claim that that quality will be maintained; in practice, the operator will be tempted to debase the currency in pursuit of a quick and immediately larger return. Olson (1997) describes how the development of a secure, dynastic regime reduces time inconsistency in the ruler.

Under the M-form theory, the collapse of stable government would have no relevance, or impact, on the quality of the currency (money) used. Under the C-form theory, the quality of money and the stability of the government are closely interlinked. History supports the C-form theory. The M-form theory has difficulty in accounting for the jump from a metallic-based currency to a fiat, paper-based currency. The C-form theory has no such difficulty.

I conclude that the inter-relationship between the governance structure of the economy, the form and usage of money (and also taxes in a three-way Interactive relationship), is essential. The attempt to model the evolution of money in a model without government (or taxation) may be intellectually rewarding but is historically and practically invalid.

II. The M-Form Spatial Theory, or Optimum Currency Areas

If the use of money can evolve through a search process of cost minimization, without any necessary intervention by a government, by analogous reasoning, the spatial domain for any one money can also evolve from such a similar cost-minimization search process. The optimum currency area analysis has, indeed, followed this approach; it has broadly compared the benefit, in terms of transaction cost minimization, of having a single currency over a wider area with the cost in terms of adjustment difficulty.

Under optimum currency area (OCA) theory, currency domains do not need to be coincident and coterminous with sovereign states. There is no reason why such a state should not have any number of currencies from zero to n, and an optimal currency area, in turn, should be able, in theory, to incorporate (parts of) any number of separate countries from one to n. Under the M-form OCA theory, currency areas and the boundaries of sovereign states should be divorced.

The reverse is, of course, true for the C-form theory. Since under this theory money is so intimately bound up with the stable existence and fiscal functions of government in any area, the sovereign government of that area should maintain its single currency within that area’s boundaries.

Which theory has the better predictive and explanatory power? Eichengreen (1996) writes,

“Michael Mussa is fond of describing how, each time he walks to the IMF cafeteria, down the corridor where the currency notes of the member states are arrayed, he rediscovers one of the most robust regularities of monetary economics: the one-to-one correspondence between countries and currencies. If monetary unification precedes political unification in Europe, it will be an unprecedented event.”

In practice, of course, virtually all empirical work on OCA, in contrast with the original theory (for example, of Mundell), has taken the coincidence of the nation state and its separate currency as the initial starting point, usually without noticing that this coincidence is explicable only under C-form theory. Such work goes on to discuss currency unification across several nation states—for example, in the European Union—or separation—for example, Quebec—without full appreciation, in most cases, that under C-form theory, the key factors must be the future political relationships between various levels of government and the monetary authority.

Perhaps the clearest indication of the comparative predictive and explanatory power of the C-form theory comes on the occasion of the break-up of existing federations into separate states, as in the recent case of the U.S.S.R., Czechoslovakia, Yugoslavia or Austro-Hungary after World War I, or, on the other hand, of the unification of smaller states into a larger federal state—as in the founding ofthe United States, Germany, or Australia. The C-form theory predicts that the fragmentation of sovereignty will lead to a fragmentation into separate currencies, while unification into an effective federal state will lead to unification of previously separate currencies. The M-form theory has nothing useful to offer on this. If the U.S.S.R. was an optimum currency area before its break-up, it should have been one afterward. Similarly, if Prussia and Bavaria had been OCAs before the unification of Germany, they should presumably have remained so afterward.

Two qualifications apply to the above argument. First, a sovereign government imposes laws and encourages behavior (for example, use of a single dominant language) that usually help make labor markets far more flexible within, than between, such countries. Second, the role of the unified federal fiscal system helps mitigate idiosyncratic shocks in the constituent member states. Note that neither qualification will apply under European economic and monetary union! What is remarkable, and virtually unique, about the proposed move to EMU and the euro is that it will be done without an accompanying federalization of governmental and fiscal functions.

III. Fiscal Limits Within EMU

Within nation states the domestic debt of the sovereign debtor—that is, central government bonds—always has the highest possible credit rating (AAA) because it has no credit risk, apart from political collapse. This is because the government has had the power to use its authority, through its central bank, in a pinch if necessary, to create money to pay off such nominal liabilities. This, of course, has the downside that the government may be tempted into imprudent fiscal and monetary policies that can, and do, create inflation and exchange rate risks. It is partly to reduce these latter risks that the single currency and the obligation of an independent European central bank to give priority to price stability have been promulgated.

All this is fair enough, but it leaves unanswered the question of how the national fiscal authorities will be affected once they lose the crutch of national money-creating powers. I contend that this divorce will significantly weaken their position. If so, the fiscal criteria of Maastricht and the Waigel pact obtain stronger backing, and might even need further tightening.

Apart from the participating nation states’ inability with EMU to vary (control is too strong a word) their revenue from seigniorage and their taxes on their banking systems, they will lose their former ability to use their money-creating powers to pay off their domestic currency debts, interest, and principal in legal tender, whatever the market conditions.

All this must change with the move to a single currency under EMU. The authorities lose their ability to inflate away the real value of their national debt; indeed, this is partly the purpose of the exercise. But what if there is a drop in demand in the bond market for national debt? Governments could previously have halted declining bond prices and rising interest rates by monetizing the debt. After EMU, they will no longer be able to do so. Moreover, a run on the bond market in such conditions becomes rapidly self-reinforcing, a vicious spiral. The higher interest rates worsen the fiscal outlook (unambiguously in the absence of seigniorage), which reduces bond demand. This, in turn, raises interest rates, which worsens the fiscal outlook. The possibility for a self-sustaining run in bond markets would seem even more serious than in the case of foreign exchange markets. EMU will abolish exchange rate disturbances and inflation differentials between members, and should thereby eliminate associated interest rate differentials. But will this be at the expense of greater bond market disturbances and interest rate differentials based on relative credit risk? How serious might these latter be?

Without associated central banks, national debt markets will assume the characteristics of those markets for public-sector debt wherein the borrower cannot itself directly create money. Two main categories of borrowers of this kind already exist, in the guise of the foreign currency debt of sovereign states and the debt market for subsidiary states, for example, the individual U.S. states. Liquidity risks in such cases tend to place more severe restrictions on the capacity of borrowers to raise debt, even more severely than solvency considerations. For example, sovereign states normally maintain much lower ratios of foreign currency to national currency debt.

At a recent discussion in which I participated, executives from a rating agency intimated that they expected the best guide to the credit rating of the national bonds of the participating countries would be the existing ratings of their current foreign currency debt. When I pointed out that the relevant ratios, of debt and debt-service-to-GDP, would, after EMU, become instantaneously far worse (than the current foreign currency debt ratios), there was no clear response. One suggestion was that, if not the European central bank, other countries might come to the aid of a member state facing adverse debt market conditions, perhaps to prevent exactly the same kind of contagion that eventually overwhelmed the exchange rate mechanism of the European Monetary System.

The main protection against liquidity crises is either to reassure the lender by collateralizing the debt, or to limit debt and debt service to a level that can easily be paid off by a feasible and relatively quick adjustment in cash flows. Despite some suggestions that sovereign foreign currency debt of states failing to meet interest payment commitments could be met by seizing and selling public-sector assets either within, or without, the physical boundaries of those states, this route does not appear promising. So, the main protection against liquidity crises must presumably be met by restricting debt and debt service to levels payable by a plausible and reasonably rapid change in cash flows, if pressed.

Eichengreen and von Hagen (1995) are absolutely correct in principle when they comment that the debt position of U.S. states and local governments needs to be much more constrained than that of member states participating in EMU. This is because the former have much less ability to improve their cash flow, at times of crisis, by raising taxes or reducing spending. This argument is correct, but Eichengreen and von Hagen go on to claim that,

“In Europe, the EU has only limited taxation and expenditure authority. The vast majority of taxation remains under the control of member states. This is certain to remain so for the foreseeable future. All this suggests that the rationale for the Excessive Deficits Procedure is weak,”

This does not follow, however, because what matters is the ratio between debt service requirements and the borrower’s ability to adjust its cash flow. Certainly the latter is lower in U.S. states, but so also is the former. The data on the debt service, outstanding debt, and operating primary surplus/deficit of U.S. states are vastly stronger than that for EU countries. The U.S. state with the lowest credit rating in 1994 (Louisiana, Baal) had a debt per capita of $895, debt service as a percent of revenues of 11 ½ percent, and an operating surplus of $311 per capita. By comparison, the figures for Germany and Italy were debt per capita of $9,026 and $21,020, respectively; debt service of 17.8 percent and 50.0 percent; and a deficit of $413 and $1,543! If Louisiana debt is rated only Baal, what should be the proper rating for member EU states?

Thus, the effective removal of central banks from participating member states within EMU may expose them to serious fragility and credit risk in their bond markets. Although this view has been adopted by a few C-form commentators, M-form theorists have not treated it seriously, nor, it would appear, has the market. Data from the swaps market, for example, suggest that the credit risk on Belgian government debt is being priced at 8–10 basis points (despite a debt service ratio of more than 45 percent of GDP!). Moreover, the main current feature in European debt markets is a convergence play, whereby bond yields are revised downward toward German bund yield levels dependent on their probability of entry in 1999. If my arguments are correct, the convergence play has been massively overdone, if not altogether wrong-headed.

The same argument suggests that a default (on its interest payments) of a member state within EMU is a real possibility, assuming the no-bail-out clause sticks. The main danger to the country involved, and to the EU, would then be a subsequent financial contagious collapse of some sizable part of the financial (banking) sector. Sensible, realistic capital asset ratios need to be imposed on bank holdings of participating member state bonds from January 1, 1999. But beyond this, the default of any participating member state would have an immediate and severe effect on the debt markets of several other member states, if these are feared to be in any similar position (similar to the “tequila effect”).

This represents a rationale for adopting, and adhering strictly to, the Waigel pact. The implications for demand management and unemployment within EMU in the next few years, therefore, look highly deflationary. This is partly a consequence of divorcing the fiscal and monetary authorities from each other’s embrace.


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