Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Private Money and Counterfeiting

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Private Money and Counterfeiting

Article excerpt

Perhaps the most fundamental question in monetary economics pertains to the role of the government in providing money. A widely held view among economists is that the supply of media of exchange is an activity that should not be left-to the private sector. Indeed, even Milton Friedman, who in most respects has viewed the economic role of the government quite narrowly, argues in Friedman (1960) that the provision of money is fraught with peculiar market failures and that the government should have a monopoly in the supply and control of the stock of circulating currency.

Monetary systems that include the private provision of circulating media of exchange were not uncommon in the past. In the United States, most of the stock of currency in circulation prior to the Civil War consisted of notes issued by state-chartered banks. The U.S. pre-Civil War monetary system has been judged by some, but not all, as chaotic (Rolnick et al. 1997; Rolnick and Weber 1983, 1984), since it included thousands of note-issuing banks and the quality of these notes was difficult to distinguish. Counterfeiting was a problem, and there was sometimes poor information on a particular bank's chances of defaulting. However, the Suffolk Banking System in pre-Civil War New England is thought to have functioned quite efficiently (see Smith and Weber [1998]). In addition, the monetary system in place in Canada prior to 1935 featured private note issue by a small number of chartered banks, and this system also appears to have worked quite well (see Williamson [1999] and Champ, Smith, and Williamson [1996]).

Private money systems are not just of historical interest. In the United States, the government monopoly on the issue of circulating media of exchange resulted from the federal taxation after the Civil War of the notes issued by state-chartered banks, and from the elimination of the supply of government bonds qualifying as backing for notes issued by national banks. As argued by Schuler (2001), all serious federal impediments to private bank note issue in the United States were removed in 1976 and 1994 (also see Lacker [1996]). Thus, it would seem that private banks in the United States are currently free to issue circulating pieces of paper, though how U.S. regulators would respond to private note issue is uncertain. New transactions technologies also give financial institutions the capability to issue private electronic monies, such as stored-value cards, and several banks have conducted market trials of such products.

The purpose of this article is to study some of the benefits and costs of private money issue. The key benefit of privately issued money is that these private liabilities can intermediate productive assets, much as the deposit liabilities of private banks do. Economic efficiency is enhanced if private money is permitted, as this private money is backed by productive investment, which ultimately enhances production and welfare. If private money is banned, then circulating currency takes the form of barren, unbacked fiat money. However, one cost of having circulating private money is that it can be more easy to counterfeit than fiat money. If counterfeiting is not very difficult, then it can have negative ramifications for social welfare.

I explore these issues here using a search model of money. Early versions of these monetary search models were developed by Kiyotaki and Wright (1989, 1993), with later developments by Trejos and Wright (1995) and Shi (1995). Some of the ideas in this article are closely related to those in Williamson (1999) and Temzelides and Williamson (2001 b). In a monetary search model, economic agents typically find it difficult to get together to trade and make transactions, and there are limits on the flows of information. These are frictions which the use of money can help to overcome in the model-and in reality.

My first step will be to investigate the properties of the model when counterfeiting is not possible. …

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