Friday, July 21, 2017

Dictionary money

Nick Rowe points out that if a central bank wants to control the economy's price level, it needn't issue any actual money—it can just edit the dictionary every morning, announcing the meaning of the word "dollar" or "yen" or "pound" to the public.

To a modern ear trained on a steady diet of central bank verbiage about interest rates, QE, and open market operations, the idea of conducting monetary policy by simply editing the meaning of a word seems odd. But I've got news for you: starting from Caesar's time and extending into the 1700s, the sort of dictionary money that Nick describes has been the dominant form of money in the West.

How has this system worked? People have historically advertised prices for wares using a word, or unit of account, the LSD unit being the most prevalent. In the case of Britain this meant pound/shilling/pence while in France it was livre/sous/denier, both of which come from the Latin librae/solidi/denarii. The monarch was responsible for declaring what these words meant. More specifically, the king or queen would post a sign in some central area saying something to the effect that a pound, or £, was worth, say, ten testoons, a type of silver coin. This definition was subject to change. The next day, for instance, an edict might be issued saying that a £ was now only worth nine testoons. Or, put differently, the £ now contained less silver. Just like that, prices had to rise 10% to account for the alteration made to the dictionary meaning of the word "pound."

Dictionary systems came to an end when the symbol for money was finally fused directly with the instrument itself. Remember, coins never used to have denominations, or units of account, on their face. Rather, they usually only had the monarch's head inscribed on them, maybe the name of the mint, and a few words about how awesome the monarch was. This lack of numbering was convenient. Since coins had no association with the unit of account, the quantity of coins (and thus silver) in the unit of account (i.e. the definition of the word) could be seamlessly changed by royal proclamation.

In the 1700s monarchs began to adopt the practice of inscribing the actual unit of account directly on the coin's face, i.e. coins began to be etched with 5¢ or £0.5.* Once this happened it became awkward to change the definition of the unit of account by editing the dictionary. Having permanently stamped the meaning of the word "dollar" or "pound" on millions of widely-circulating bits of stamped silver, changing that meaning by simply posting a sign on a popular street corner no longer did the trick. Every coin would have to be recalled and re-minted too!

Having long since put the definition of the word "dollar" or "yen" onto the actual instruments they issue, modern monetary authorities now have to do something to the instruments themselves if they want to conduct monetary policy. Maybe they issue a few more units of money or buy them back in order to alter their purchasing power. Maybe they jiggle the interest rate that those tokens throw off. Or they might raise or lower a currency's peg. Some sort of tangible action (or threat thereof) must be taken to change the economy-wide price level. Word updates won't do.

About the only place in the world that has dictionary money is Chile which, buffeted by high inflation, adopted a parallel unit of account called the Unidad de Fomento (UF) in the 1960s. (For more on the UF, see my old post here). Today, Chileans can choose to set prices in UF or in the Chilean peso. The latter is a conventional money, the word "peso" being defined as the 1 peso banknote issued by the nation's central bank. Unlike the peso, the UF lacks an underlying UF banknote. Rather, the Chilean government defines the word "Unidad de Fomento" to mean the number of Chilean pesos required to buy a fixed Chilean consumption basket. This definition changes every day and is posted here.

I think this is a pretty neat idea. As long as Chileans denominate their salary and other contracts using UFs rather than pesos, they are guaranteed to earn a steady stream of consumption, even if the Chilean peso hyperinflates.

These days inflation isn't really such a big deal, at least not in developed nations—central bankers seem to have mastered how to keep the purchasing power of the medium of exchange from getting out of hand. So adopting something like the UF might seem redundant. A dictionary money system is also unattractive because it imposes a calculational burden on citizens. People must be constantly doing conversions between an item's sticker price and whatever happens to be the medium of exchange necessary to complete the transaction. So if a book were to be priced at $5, you'd have to consult a government website to determine how many bitcoins, or dollar bills, or silver coins would be necessary to constitute a five dollar payment. The advantage of our current system is that because the word and the medium are unified, we don't have to do these conversions. A five dollar bill always suffices to cover a $5 sticker price. Simple.

On the other hand, dictionary money may have a role to play in our relatively recent deflationary age. Beginning with Japan back in the late 1990s, central bankers all over the world have been incapable of preventing deflation, or falling prices. Are their tools inadequate? Do they refuse to use these tools to their full extent? Do they not understand how to use them? With dictionary money, a central banker can't blame his or her tools for a miss, since all it takes to alter the price level is an update to the definition. A child could do it.

For instance, a nation like Japan could create dictionary money by removing the word "yen" on bills. It would do so by recalling all outstanding banknotes and replacing them with, say, Japanese pesos. Prices, however, would continue to be set in terms of the yen unit of account. Each morning the Bank of Japan would announce to the world how many Japanese pesos were in a yen. Say it starts with the yen being defined as ten pesos. To create some inflation, it would simply proclaim that the yen now contained just five pesos. Everyone with pesos in their pocket would suddenly be able to buy twice as much yen-denominated products as before. They would race out and spend. Shopkeepers who had previously been selling widgets for 1 yen, and getting ten Japanese pesos as payment, would quickly jack up prices to 2 yen in order to ensure that they still earn ten pesos per widget.

Voila, instant inflation.

* See Ernst Weber's "Pre-industrial Bimetallism: The Index Coin Hypothesis " [link]


  1. "In the 1700s monarchs began to adopt the practice of inscribing the actual unit of account directly on the coin's face"

    Any idea WHY monarchs started this practice?

    1. Weber's theory (link at bottom) is that early coinage degraded too quickly for the monarch to trust putting the unit of account on it. Technological advancements such as the ability to put designs on the rim and industrial presses made coins more durable and gave monarchs sufficient confidence.

  2. "Or they might raise or lower a currency's peg."

    Is this not the same thing as changing the definition? Please educate me. Thank you.

    1. It has the same final result. But it's not the same thing.

      For instance, say the UF is defined as 10 Chilean pesos, and the peso in turn is pegged to the US$ at a 1:1 rate.

      To deflate the price level by half, the Chilean monetary authorities can either redefine the UF as 20 pesos, or they can repeg the peso so that it is now worth US$2.

      Same result, but in the first they are just altering the word UF; in the second they are changing the nature of the underlying instrument, the peso. The first is effortless to achieve. The second is tougher; to double the value of the peso, they need ammunition like reserves. If they don't have enough, they won't be able to pull it off.

    2. Gene: to say the same thing a different way, a "pegged" exchange rate normally means the central bank has stocks of the two currencies, and offers to buy or sell one for the other at that announced exchange rate.

  3. Good post JP! I had no idea it was that prevalent.

  4. Interesting post and concept!

    This separating unit of account and unit of exchange is something I noticed is happening naturally in Bitcoin, at least for the time being. Speaking with a French artist who paints bitcoin related art work she was contemplating listing her prices in bitcoin with no peg or relation to another currency, as in a piece of art was priced at 1 btc, regardless of what btc traded against for the Euro/USD/GBP etc. Though she opted instead to allow the price in btc, to fluctuate with the price of euros (as do most vendors right now) which if I'm understanding this UF/peso concept correctly, would make the Euro the UF and btc to peso?

    I wonder what effects changing the peg would have on savings in the country (most likely in Peso) and would generally be better for those who can hold assets priced in UF instead of pesos themselves. Or if expansion of the peso supply would override the peg and cause UF prices to rise even when the peg remains the same.

    Then again I'm always a skeptic of monetary policy in general...

    1. "...which if I'm understanding this UF/peso concept correctly, would make the Euro the UF and btc to peso?"

      Yes, it's similar in that the unit of account has been split off from the medium of exchange, just like the UF.

      The difference is that the authorities control the content of a UF, whereas the bitcoin content of a euro is market determined.

      "I wonder what effects changing the peg would have on savings..."

      Well if the peso is pegged, and then it loses its peg, there will be consumer price inflation. The UF will be automatically adjusted to compensate for that inflation so that anyone setting prices (say a salary) in UF terms will get the same consumption basket before and after.

  5. Hey JP,

    Think this is another modern example of a unit of value not representing the underlying note .
    Latin American countries (like Brazil) often did this to curb runaway inflation. The benefits of doing so are not only ease of adjustment , like you mention, but they actually play a role in people's psychological perception of expected inflation. The policy was actually successful in this case.

    1. Great point, Tony. I really want to write about the Brazil example; hopefully later this summer I'll be able to take a crack at it.

  6. Really interesting post.. I guess it seems nice to be able to price things in UF because its tied to consumption.. But on the other hand UF can only exist because Pesos exist too right? Like if everything was priced in UF, it would be the same as any other currency.

    So it seems like the UF/Peso divide is a way of splitting up 1 economy into 2 economies? e.g I can buy/sell housing in UF, buy/sell food in Pesos. Since the govt. can create inflation/deflation in Pesos relative to UF, and wages are in UF, it is letting the govt. easily control how much spending money you have in the Peso economy. In this case seems like the Peso economy is for consumption and the UF economy is more for basics like wage & rent, so it can control consumption day to day..

    What happens at the intersection of the two currencies though? If i am running a business selling in Pesos and my main costs are wages, paid in UF, I would have to take on all the currency risk no? On the flip side as a consumer I am earning in UF and paying in Pesos, also taking on a currency risk. So basically everyone is standing in 2 economies, but the exchange rate between them is fixed by government rather than market... strange.

    1. "If i am running a business selling in Pesos and my main costs are wages, paid in UF, I would have to take on all the currency risk no?"

      That depends. Say there is some peso inflation and along within everyone else you increase your selling prices. But if you've denominated your wage costs in UF, then wages will increase by that same amount. So things balance out.

      You get some risk if you can't increase your selling prices as fast as the average business can increase them.

  7. Brilliant post, JP! It's really good to find out about something I never knew. Keep it up, I like what you're writing!
    Best regards.

  8. Interesting read, thanks!
    It appears to me that, theoretically, nowadays the central bank has two ways to manage the value of money: either by controlling prices (mostly done indirectly by setting interest rates and hoping for the complex monetary transmission process to do its thing), or by controlling supply.

    Dictionary money is basically a form of supply control. While it is an interesting angle, the effect on people's wealth is similar to price control. My wealth is W = V / P, the volume of money I hold divided by its price (the amount of goods I can buy). Inflation means higher prices, higher P hence lower W.
    But when supply is adjusted in the way you explain, then P may stay the same but V is lowered. The result is the same: lower W.

    I have been thinking about this in the context of cryptocurrency monetary policy. Interest rate setting is a no go (for now) to achieve price stability of cryptocurrency. Algorithmic supply management is theoretically possible (an algorithm managing supply based on measured prices of a basket of goods). The effect on people's wealth is, in the end, the same (abstracting from such hugely important details as distribution of wealth, debt, et cetera). But of course the question is what you gain with such monetary policy. The algorithm has successfully stabilised prices, but now everybody is stuck with wildly fluctuating wealth (due to algorithm-driven girations in V). So not very helpful. Anyway, nice to ponder all this.