Strategic Regulation of Alternative Currencies

Strategic Regulation of Alternative Currencies Caitlin T. Ainsley∗ Abstract Recent technological advances in digital banking and currency have brought increased attention to the states’ tenuous monopoly control over domestic currencies. Histori- cally, instances in which either privately-issued or foreign “alternative” currencies have successfully entered circulated have often been viewed as state regulatory failures or signs of monetary incompetence. In this paper, I put forth a theory that challenges this understanding of currency regulation and highlights potential advantages for states to tacitly permit an alternative currency to circulate alongside their own. With a search- theoretic model of domestic exchange, I demonstrate how periodic non-regulation of alternative currencies can be part of a coherent state regulatory strategy. Using the intuition derived from the model, I then provide novel interpretations of two historical case studies, examining both the process of monetary consolidation in the British Pro- tectorate of Southern Nigeria as well as restrictions on local scrip currencies during the Great Depression in Austria. ∗Assistant Professor, Department of Political Science, University of Washington. cains- [email protected] Scholars of political economy and state-building have long recognized the importance of states’ monopoly control over national currencies. In addition to the straightforward returns from seigniorage, it is argued that state control over the medium of exchange facilitates the emergence of domestic markets, makes possible macroeconomic stabilization and nationwide taxation programs, and contributes to the formation of a national identity (Helleiner 2003). Unsurprisingly given the well-documented benefits states accrue from their control of national currency, laws restricting or outright prohibiting the use of alternative private and foreign currencies for domestic exchange are ubiquitous. While there is little variation in the illegal status of alternative currencies circulating in domestic markets, the degree to which such regulations and restrictions are enforced varies tremendously. In this article, I focus on this variation in the enforcement of alternative currency regulations and explore whether the periodic circulation of alternative currencies can be understood as part of a coherent regulatory strategy rather than an instance of regulatory failure. With a search theoretic model of exchange, I show that under certain conditions, states may tacitly permit alternative currencies to circulate in order to temporarily relieve pressure on their preferred national currencies. In contrast to the extant literature which largely views these periods as episodes of incompetent monetary regulation, I demonstrate why relaxing currency restrictions may increase the purchasing power of a state’s preferred currency and ultimately appreciate the value of the state currency vis-à-vis the alternative currency. I draw on two historical case studies to demonstrate how the theoretical model can con- tribute to our understanding of the process of currency regulation. In the first case study, I examine the process of monetary consolidation during Britain’s colonization in Southern Nigeria. Drawing on letters and reports from officers of the Protectorate of Southern Nige- ria as well as legislative proposals and historical pricing data, I use the implications of the model to provide a novel interpretation of the nearly half-century process of monetary consolidation. I demonstrate the colonial administrations’ regulatory strategy — which evolved from more passive manipulations of money supply to aggressive prohibitions and confiscation 1 efforts — is consistent with the expectations derived from the formal model. Rather than assuming the delayed regulations and restrictions reflect decades of regulatory failure, the model makes sense of the passive regulatory strategy that permitted alternative native currencies to circulate for nearly a half century before an outright ban and confiscation scheme was implemented. Next, I leverage the same model to explain a quite different regulatory approach taken by the Austrian government to restrict the use of alternative currencies during the Interwar Period. While Austria’s newly issued state currency – the Austrian Schilling – had stabilized in value by 1926, it experienced rapid deflation as Austrian officials remained committed to the monetary and fiscal reforms established as conditions for aid by the League of Nations. As the over-valued Schilling froze regional economies, local governments and communities began issuing local scrip currencies as alternative media of exchange in an effort to stimulate spending. In contrast to the experience in the British colonies, the state’s preferred currency in this case was of comparatively high value when it faced competition from an alternative currency. Thus, following the passive regulatory strategy observed in Britain’s colony would have only further incentivized the use of the local scrip currency by increasing their value. Instead, the Austrian government and its central bank were quick to issue an explicit ban on the use of such currencies and enforced this position aggressively in the national courts. The theoretical and empirical results presented here highlight the strategic incentives for states to periodically allow alternative currencies to circulate in domestic markets. Pe- riods of non-regulation have been under-examined in the extant literature, in many cases being left an unexplained puzzle or attributed to regulatory constraints, low state capacity, or incompetence. With the formalization of currency regulation strategies presented here, I demonstrate the empirically realistic conditions in which states have the incentives to tacitly allow alternative currencies to circulate periodically alongside their preferred national currencies. Incorporating periods of non-regulation as consistent with a state’s broader monetary regulatory strategy rather than treating them as accidental or off-path occurrences is an important contribution to our understanding of the state’s role in the issuance of currency 2 and management of domestic markets. While the empirical focus here is largely historical in nature, I turn in the conclusion to the implications for the ongoing debates over how states ought to regulate recent wave of alternative currencies including e-money and digital currencies. National Currencies, Competition, and Regulation Before turning to the theoretical model, it is worth briefly reviewing the extant literature on domestic currency politics and the role of the state in currency creation and regulation. National currencies — or those which are issued by federal governments and used for le- gal tender — are a relatively recent phenomena when one considers the history of money. Monetary nationalism and the “one nation, one currency” landscape only became the default monetary structure for most countries during the 20th century (Cohen 1998; Steil 2007). The extant research on the geography of money and national currencies attributes their recent emergence to the rise of the nation-state, arguing the “nation-state’s unprecedented capabil- ity to influence and directly regulate the money in use within the territory it governed” was a necessary precondition for national currencies (Helleiner 2003). Critical to this argument about the role of the nation-state is the recognition that establishing and preserving national currencies requires regulation and coercion by those in power to restrict the use of alternative currencies. That is, national currencies are not the result of natural market forces pushing domestic markets towards common, state-issued currencies that circulate within territorial boundaries, but rather a product of the political and economic interests of those in power. The benefits states accrue by establishing and controlling their own national currencies are substantial. Most obviously, a state realizes direct gains from issuing a national currency in the form of seigniorage. While seigniorage incentives play a central role in much of the ex- isting literature on monetary consolidation, scholars increasingly acknowledge the incentives 3 underlying national currencies are much broader than seigniorage alone.1 First, creating a national currency allows the state to establish or bolster national markets by altering transaction costs with foreign markets. By their construction along territorial boundaries, national currencies create an exchange rate risk that increases the transaction costs associated with cross-border exchange and advantages domestic producers, something Helleiner (2003) notes was particularly attractive when national currencies were being established during the 19th and early 20th centuries. Second, by virtue of giving the state control over the money supply, national currencies permitted the state to engage in macroeconomic stabilization by manipulating the supply of the national currency in circulation. Third, establishing a uni- form national currency facilitated the collection of taxes across large territories as well as fiscal expenditures. And fourth, national currencies are believed to strengthen and reinforce national identities. While it is clear there are substantial incentives for states to establish national currencies, this does not necessarily imply it is in the interest of individual market participants to adopt the national currency as the sole medium of exchange. Perhaps

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