No. 698 May 23, 2012 Competition in Currency The Potential for Private Money by Thomas L. Hogan Executive Summary Privately issued money can benefit consum- This paper examines two ways in which ers in many ways, particularly in the areas of val- banks could potentially issue private money. ue stability and product variety. Decentralized First, U.S. banks could issue private notes re- currency production can benefit consumers by deemable for U.S. Federal Reserve notes. Con- reducing inflation and increasing economic sidering that banks issuing private notes in stability. Unlike a central bank, competing pri- Hong Kong, Scotland, and Northern Ireland vate banks must attract customers by providing earn hundreds of millions of dollars annually, innovative products, restricting the quantity it appears that U.S. banks may be missing an of notes issued, and limiting the riskiness of opportunity to earn billions of dollars in annu- their investing activities. Although the Federal al profits. Second, recent turmoil in the finan- Reserve currently has a de facto monopoly on cial sector has increased demand for a stable the provision of currency in the United States, alternative currency. Banks may be able to cap- this was not always the case. Throughout most ture significant portions of the domestic and of U.S. history, private banks issued their own international currency markets with a private, banknotes as currency. This practice continues commodity-based currency. Legislation clarify- today in a few countries and could be reinstitut- ing the rights of private banks to issue currency ed in the United States with minimal changes to could help clear the path toward a return to pri- the banking system. vate money. Thomas L. Hogan is assistant professor of economics at West Texas A&M University. The competitive Introduction maintain substantial power over the overall issue of private money supply through its standard means In the United States and most countries of open-market operations, reserve ratios, banknotes could around the world, money is produced and and targeting of the federal funds rate. improve price managed by the government’s central bank. Allowing competition in currency would stability in the This paper discusses two potential oppor- bring the United States one step closer to tunities for creating private money: private obtaining the full advantages of a decen- U.S. economy. banknotes and commodity-based currency. tralized system. For most of U.S. history, competing private Private banknotes could easily be intro- banks issued paper currency redeemable duced in the United States. In Hong Kong, for coins of gold and silver. A few countries Scotland, and Northern Ireland, private today maintain similar semiprivate sys- banks issue banknotes redeemable for the tems in which private banks issue their own national currency. Despite the availability of banknotes redeemable for government cur- central banknotes in these locales, consum- rency. Allowing such a system in the United ers transact almost exclusively in private States would benefit all consumers by im- currency.3 Private banks consequently earn proving price stability and allowing banks to hundreds of millions of dollars annually in compete for customers. Alternatively, banks the private currency market. For each unit of might issue money whose value is based on private currency withdrawn by a customer, a commodity such as gold or silver. In inter- the bank retains one unit of government national trade, the U.S. dollar is often used currency, which can be invested or loaned in transactions because of its relatively stable out to other customers. The bank earns rev- long-term value. The dollar is also the domi- enue on these investments and loans for as nant form of currency used in many less- long as its private notes remain in circula- developed countries, yet economists gener- tion. If U.S. banks were able to capture even ally agree that historically the international a small percentage of the domestic market gold standard provided a more stable sys- for banknotes, they likely could earn billions tem of international trade than the current of dollars in annual profits. system of national fiat currencies.1 If a com- The idea that American consumers might modity-based currency could replace the dol- enjoy using private banknotes is far from im- lar in these foreign markets, it could improve plausible. Imagine if dollar bills carried pic- economic stability and help facilitate inter- tures of local sports teams, or if Wells Fargo national trade. produced its own dollar bills embossed with The competitive issue of private bank- images of stage coaches and the Old West. notes could improve price stability in the Perhaps customers would debate the relative U.S. economy.2 Private banks have the in- merits of the LeBron James banknote versus centives and information necessary to pro- the Michael Jordan, or admire a special note vide the optimal quantity of money to en- commemorating Independence Day or ded- courage economic growth. In the past, the icated to American veterans. Consumers in competitive production of currency helped Hong Kong, Scotland, and Northern Ireland the U.S. economy achieve high levels of already enjoy these experiences, with private gross domestic product (GDP) growth and notes depicting heroes, sports figures, and low levels of price inflation. Creating a semi- famous historical events. Once banks estab- private monetary system, in which private lish reciprocal exchange agreements, private banknotes were redeemable for notes from banknotes in the United States would trade the Federal Reserve, would reduce the gov- at equal value with Federal Reserve notes as ernment’s involvement in monetary policy. they passed from person to person through- The Federal Reserve would have less influ- out the economy. Banks might even pay cus- ence on the supply of currency but would tomers to use their notes. For example, an 2 ATM might give customers a cash bonus for a commodity or basket of commodities. A withdrawing “B. of A. Bucks” issued by Bank commodity-based currency would likely be of America rather than regular U.S. dollars, most valuable for international transactions. or Citibank might pay interest on its private International traders rely on the stability notes akin to earning points on a credit card. of exchange rates among nations, which in Private note issue appears to be legal in turn rely on a vast array of variables that are the United States today. The regulations pro- affected by each country’s economic perfor- hibiting the issuance of private notes were re- mance. To avoid the risk of currency volatili- pealed almost two decades ago, yet no banks ty, a large percentage of trade is conducted in have chosen to enter this potential market. currencies with stable values, such as the U.S. This may be because there is still some ques- dollar and the Swiss franc. A new currency tion as to whether private currency would be based on a commodity such as gold, whose accepted by the Federal Reserve, or whether value is well established, might reduce cur- its producers would be subject to legal ac- rency risk in international transactions and tion. Private issuers might be prosecuted un- capture some portion of this large potential der gray areas of the law, or Congress might market. The value of such a currency would choose to resurrect the prohibitions on pri- rely not on the economies of the countries vate notes. A few small-scale local curren- but on the value of gold itself, which has re- The lack of cies have been issued with the Fed’s blessing. mained remarkably stable over time. participants These local currencies provide examples of Poor performance by the Federal Reserve in the private how a new private currency might be intro- has motivated some policymakers to call for duced, but since none compete directly with a return to a gold standard. Such a transi- banknote market Federal Reserve notes, they provide little tion would be difficult domestically since appears to be due clarification of the legal status of a large- it would alter the entire U.S. money supply. to the uncertain scale private currency, and do little to inform An easier option might be to simply end the a prediction of the Fed’s reaction thereto. Federal Reserve’s monopoly on paper cur- legal status of One might ask: if a system of privately is- rency by opening the market to competition. private note issue sued currency is profitable, why is it not al- If a currency redeemable for gold were intro- ready in place? To answer this question, we duced as an alternative to the U.S. dollar, it and the rigorous estimate the potential profit from the issue might become popular domestically and/or prosecution of of private banknotes in the United States, abroad. A commodity-based currency would currency-related and find that capturing even a small per- have a slower adoption rate than one based centage of this market could lead to billions on U.S. dollars (since the domestic market crimes. of dollars in annual profit. We then consider is currently based on dollars), but the long- alternative explanations for the lack of pri- term advantage of value stability could vate notes. Banks might be deterred from provide greater macroeconomic benefits in entering the market for private banknotes if terms of lower inflation and increased eco- they fear a shrinking demand for paper cur- nomic stability. rency or a lack of demand for private notes There are substantial benefits to allowing on the part of skeptical American consum- competition in currency. In the next section, ers. The most plausible explanation for the we outline the benefits of private note issue lack of participants in this would-be-profit- and the costs of government note issue.