Currency and the Role of Government

An irrelevant issue.

It is interesting, but totally irrelevant, that the ECONOMIST magazine (“On the Origin of Specie,” Aug 18th 2012) delves into a long-standing debate in economics.  That debate is the issue raised in the title of this blog: what is the role of government in the process of establishing a currency?  The government's role regarding currency has an impact upon whether the different roles of money can be retained by one commodity regardless of whether that commodity is a slip of paper or a physical good.

The ECONOMIST discussion is made irrelevant by the application of totally circular reasoning.  The article states: “The evidence suggests that only “informal” monies can spring up purely privately.” But, the article's definition of informal money seems to be that it is not endorsed by the government.  The net effect is that the article says nothing relevant to the discussion of the role of government in creating a viable currency.

In fact, the author goes on to point out that “informal money can exist on the grandest scale.”  It uses the example of the dollar’s position as the world’s reserve currency as an example of a currency being adopted informally.  By using that particular example, the article illustrates the irrelevance of their definition of formal money.  A government endorsement does nothing but meet their criteria for formal money.  That endorsement is totally irrelevant to whether something functions as a currency.  All of the functions of currency are totally unrelated to whether it is “formal” currency.  Such circular logic in order to reach the conclusion that government has a role in defining the currency is unfortunate.

Many of those who argue that currency requires, or is dependent upon, government will at the same time point out the advantages to the government of having a central role.  One of the advantages is the ability to capture seigniorage (the difference between the value of the currency and the cost of the inputs).  That, however, represents the introduction of inefficiency, a cost to using currency.  Further, there is no particular reason why only government could capture that seigniorage.

The historical evidence is that government is no more reliable as the benefactor of that seigniorage than private entities.  In fact, a number of the examples that are often used to illustrate the role of government in establishing a currency could equally well be used to illustrate governments’ tendency to abuse seigniorage.

The argument often also recognizes why governments get involved in the development of a currency.  It allows governments considerable efficiency in taxing economic activity confiscating resources produced by the private sector.  If those who argue that government has an essential role in defining the currency would look closely at history, they would realize that often the definition of the currency is dependent upon the definition of how one can pay taxes.  So, the argument that government has an essential role in establishing a currency is reduced to an argument that governments can define how they will take resources from the private economy.  That is true, but proves nothing.

Viewed from that perspective, it isn't surprising that often those who favor a major role for government in the regulation of society also believe that government has an inherent role in defining currency.  By contrast, those who would see the government's role reduced are inclined toward allowing the market to define the medium of exchange.  One of the great dangers to strong central government is that a substantial portion of the population will facilitate trade by barter and start holding their wealth in a form that is hard to tax.  That makes it much harder for the government to confiscate a portion of the increased value generated by trade.

The ECONOMIST article is interesting in that it points out that a currency can end up functioning both as an informal, some would say freely chosen, medium of exchange, while also existing as a formal, government-endorsed, medium of exchange.  The example often given is that a country's currency can also become a freely chosen international reserve currency.  That has been true throughout history and was true of gold, silver, the British pound and now the US dollar. 

What is dependent upon government involvement is how quickly a currency can cease to be a viable medium of exchange and store of wealth.  Governments change their method of taking resources much slower than the private sector can shift to a new currency.  That follows automatically from the fact that governments are always responding to the medium of exchange.  It also can leave the government collecting money that is less and less useful as a method of commandeering resources. 

One only needs to recognize that economists developed a number of “laws” to explain how currencies function when more than one medium of exchange was in existence.  If there was a formal mechanism for stating that this is the currency, the issue of how multiple mediums of exchange function would never have existed.

The issue of the government's role would be irrelevant.  There is, however, no reason to believe that “bad money drives good money out of circulation” could not equally apply to where money circulates.  One currency could be of no use other than to pay taxes, while another is used primarily for trade.  That separation in the roles of currency is exactly what happens and is described in connection with international reserve currencies.  In most countries the native currency will be a medium for paying taxes, while that function is totally missing in the international reserve currency function. 

More generally, alternative methods of facilitating barter can coexist quite comfortably alongside of formal money without the tax-paying role of money being undermined.  There have always been methods of exchange other than formal monetary transactions.   Similarly, it is not the money itself that produces in the future.  Money is just a method by which current resources are channeled into something that produces in the future. 

Economists often brush over the third role of money: “it must be a unit of account, a useful measuring-stick.”  They just assume that it follows from the first two.  Yet, in some respects it is the most telling.  If people start calculating their wealth using something other than the currency or start thinking of prices in terms other than the currency, the role of money is clearly in question.  That questioning will be the topic of the next posting.