Bringing back the Somali shilling

Somalia has long played host to one of the world's strangest monetary phenomenon, a paper currency without a central bank. I explored the idea of Somalia's "orphaned currency" more fully four years ago, but if you're in a rush what follows is the tl;dr version. Despite the fact that both the Central Bank of Somalia and the national government ceased to exist when a civil war broke out in 1991, Somali shilling banknotes continued to be used as money by Somalis. Over the years, Somalis also accepted a steady stream of counterfeits that circulated in concert with the old official currency, a state of affairs that William Luther explores in some detail here.

The story is worth revisiting because apparently Somalia's newly restored central bank is on the verge of re-entering the game of printing banknotes after a quarter century absence. With the help of the IMF, the Central Bank of Somalia (CBS) plans to issue new 1000 shilling banknotes, the introduction of higher denomination notes coming later down the road.

Old legitimate 1000 shilling notes and newer counterfeit 1000 notes are worth about 4 U.S. cents each. Both types of shillings are fungible—or, put differently, they are accepted interchangeably in trade, despite the fact that it is easy to tell fakes apart from genuine notes. This is an odd thing for non-Somalis to get our heads around since for most of us, an obvious counterfeit is pretty much worthless. The exchange rate between dollars and Somali shillings is a floating one that is determined by the cost of printing new fake 1000 notes. For instance, if a would-be counterfeiter can find a currency printer, say in Switzerland, that will produce a decent knock off and ship it to Somalia for 2.5 U.S. cents each (which includes the cost of paper and ink), then notes will flood into Somalia until their purchasing power falls from 4 to 2.5 U.S. cents... at which point counterfeiting is no longer profitable and the price level stabilizes.

Below is the long-term price of Somali shillings, which I've snipped from Luther's paper. You can see how the purchasing power of a 1000 shilling note has fallen to what Luther calculates to be the cost of producing a new banknote, around 4 cents. His chart goes up to 2013, but if you look at the IMF's most recent report on Somalia (see Figure 3) you'll see that the exchange rate hasn't moved much.

From Luther

So with a new official banknotes on the way, what will happen to the old legacy notes and counterfeits? According to the IMF mission chief Mohammed Elhage, the IMF is in the midst of trying to determine at what price it will convert old notes for new official ones. So rather than repudiating counterfeits, the normal route taken by central bankers, the CBS will buy them up and cancel them. It will have to offer a decent price too, say like 5 or 6 U.S. cents for each 1000 note. If it makes a stink bid, say 3 U.S. cents, Somalis may simply ignore the appeal to bring in their old currency and keep using the old stuff. Because the buyback decision validates the work of counterfeiters, it just seems wrong. However, keep in mind that for the last twenty-five years it has been counterfeiters who have been willing to take on the risk of providing Somalis with a very real service, the provision of a working paper medium of exchange.

There is another good reason for buying up old legacy notes and counterfeits and cancelling them. If the CBS lets the old notes stay in circulation, then Somalia's ragtag multi-currency system will only get more confusing, with old legacy and counterfeit notes circulating concurrently with new shillings and U.S. dollars. With the new issue of shillings having a different purchasing power than the old ones, yet another floating exchange rate will be added to the mix. Who needs that sort of confusion? Better for the CBS to absorb the cost of buying up fakes in order to promote a more homogeneous currency.

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As I pointed out in my old post, there's an old and nagging question in monetary economics that has never been satisfactorily answered: why is fiat money valuable? Somalia serves as a great laboratory to investigate this question because its situation is so unique. One famous answer to the riddle of fiat money is that governments use force to ensure that fiat money is valued. But this can't be the case in Somalia: it hasn't had a government since 1991, yet shillings continue to be accepted.

A second answer is that once money is valued—say because it a central bank has been pegged to an existing store of value like gold—then once the central bank disappears and the anchor is lost, those orphaned notes will continue to have value by dint of pure inertia and custom. This theory certainly seems to fit Somalia's experience.

The last theory is that when a central bank is destroyed, the money it issues will quickly become worthless... unless citizens expect a future central bank to emerge and reclaim the orphaned currency as its own. If so, it makes sense to keep using the currency since it isn't actually orphaned—it's on the way to being adopted. If the expectation is that this future central bank will also adopt counterfeit notes, it makes sense for people to accept all knock-offs as well. So we can tell a story that shillings, both real and fake, never fell to zero because enough Somalis had a hunch that a future body would reclaim them, a hunch that is on the verge of being realized as a newly-christened CBS seems set to buy old and fake shillings back. Were Somalis really this good at predicting the future? I don't know, but like the second theory, the last one seems to explain the data.
 

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Personally, I think introducing a new paper currency is a bad idea. For some time now Somalia has been partially dollarized economy. U.S. dollar banknotes are the most popular paper currency, with old shillings being used in small payments and in the countryside. Mobile payments are extremely popular, but they are usually denominated in U.S. dollars, not shillings, and tend to be prevalent in cities where network coverage is best.

There are several problems with dual-currency systems like Somalia's. First, they impose a small but steady stream of currency conversion costs on the population, both the actual cost of shifting one's wealth from one to the other as well as the mental gymnastics involved in converting prices in one's head. Secondly, there are fairness issues. Civil servants are usually paid in the domestic currency and those in rural parts deal in the stuff. Urban private sector workers tend to earn dollars. In developing nations, dollars are usually more stable than domestic currency. As a result prices of houses, cars, and rent are often set in dollars. The class of folks who are paid in dollars make out better than the class that is earning shillings. Dollar earners never have to leave the much stabler dollar loop while those earning domestic currency suffer from constant slippage due to conversion costs and chronic inflation.

Now the IMF might argue that new shillings will completely expel dollars, thus forcing everyone into the same shilling loop and removing any monetary inequalities. But that's hog wash. The literature on dollarization teaches us that once the dollar begins to be used by a country—usually because the domestic currency has suffered from high inflation—it is very hard to remove it. Long after the local currency has been successfully stabilized, dollarization continues, an effect referred to by economists as hysteresis. Bring back the shilling and the dollar will stick around.

While bringing back new shillings doesn't make much sense, some sort of currency reform is probably worthwhile. While cities seem to be already well-served by dollars and mobile money, the rural population still relies on old and deteriorating shilling notes. Instead of foisting new shillings on these people, why not replace them with locally-minted small denomination dollar coins? I call this the Panama solution. For those who don't know, Panama is a dollarized nation. Due to the high costs of shipping in coins form the U.S., Panama mints its own dollar-denominated small change, paper money printed by the Federal Reserve taking care of the rest of the nation's physical money requirements. 

By adopting the Panama model all Somalis would get to deal in U.S. dollars, thus removing any monetary class divisions. Gone too would be the headache of constantly converting between shillings and dollars, since with U.S. coinage there would only be dollars. And poor Somalians living in rural areas without phone coverage would finally get clean and homogenous small denomination cash.

Admittedly, there's far less for a central banker to do if he/she issues a narrow range of small denomination U.S. denominated coins, say 1¢, 5¢, and 25¢, rather than a full range of banknotes. It's certainly not sexy. But it would be cost effective. Coins, after all, last much longer than notes. This durability means that coins are a cheaper circulating medium for a central bank to maintain than paper. There is also the national ego that must be satisfied. What nation doesn't have its own currency? The worst reason to adopt a new shilling is because some concept of nationhood requires it—Panama has been using the dollar for decades, and this hasn't prevented it from becoming one of Central America's most successful nations.

Orphaned currency, the odd case of Somali shillings

A few weeks ago, David Beckworth egged me on to write about Somalian currency. I can't resist—it's a fascinating subject. The material I'm drawing on comes from Luther & White (2011), Luther (2012), Symes (2005), and Mubarak (2003)

Orphaned banknotes

When Somalia collapsed into civil war in January 1991, the doors of the Central Bank of Somalia were blown apart, its safes were blasted, and all cash and valuables were looted.* But something odd happened—Somali shilling banknotes continued to circulate among Somalians. To this day orphaned paper shillings are used in small transactions, despite the absence of any sort of central monetary authority.

The strange case of circulating Somali shillings forces us to ask some fundamental questions about money. If the Federal Reserve and all other branches of the US government were to be suddenly swallowed up into the sea, would Fed banknotes, like Somali shillings, continue to be used? What forces conspire to keep coloured squares of paper in circulation when their original issuer has long since expired?

According to Luther & White (2011), the shillings' continued circulation within the context of a collapsed state casts doubt on the universality of the chartal theory of money. According to chartal theory, the requirement that people pay taxes with government-issued bits of paper is what drives the positive value of these bits. Since a world with no state is a world with no taxes, the continued use of shillings means that something other than tax acceptance must be driving their positive value. [As an aside, I'd note that the ongoing circulation of bitcoin also contradicts the taxes-only theory of chartal money. After all, bitcoin isn't used to pay taxes, it's used to avoid taxes].

Luther & White give what seems to me to be a very Misesian explanation for the shilling's continued positive value: the "inertia of historical acceptance". According to Ludwig von Mises's regression theorem, outlined in Theory of Money and Credit (1912), people's expectations about the value of bits of paper may "regress" into the past. An intrinsically useless bit of paper is valued today because it had a positive value yesterday, and it had a positive value yesterday because it did the day before, all the way back to day 1 when that useless bit of paper was anchored to some commodity.

This process is described as a coordination game in Luther & White. Though the central bank had collapsed in January 1991, a Somalian trader might choose to still accept shillings the day after the collapse because he had accepted them the day before and he knew that others had accepted them too. In a self conscious manner, the trader would also know that other traders knew that he had accepted them. Expectations about expectations about expectations, a Keynesian beauty contest of sorts, was sufficient to drive the use of shillings beyond the day of the central bank's demise.

Counterfeit notes and contingent redemption

Let's add some more texture to our example. Not only did old shillings continue to circulate, but several new issues of counterfeit notes joined them. These counterfeit 1000 and 500 shilling banknotes were created by warlords and businessmen subsequent to the country's collapse. Although the counterfeit notes had the same design as the pre-1991 legacy notes, small differences allowed for differentiation. According to Luther (2012), of the five known forged issues, four have the date 1996 printed on them, long after the central bank ceased to exist. The counterfeits dated 1996 are signed by central bank governor Ali Abdi Amalow who, having been appointed in 1990, had never held office long enough to have his signature affixed to genuine Somali notes. Even without these imperfections, fake banknotes would have been instantly recognizable to anyone—they would have been crisp and clean relative to the limp and dirty legacy issue.

Despite being easily differentiable, Somalians willingly accepted counterfeit 1000 and 500 shilling notes. Not only did they accept them, they considered them to be fungible with real 1000s and 500s. In other words, the market refused to place a discount on the fakes.

Mubarak (2003) offers a few reasons for the acceptance of counterfeits. Any reticence the public may have had concerning the legitimacy of counterfeit note was overcome by A) coercion on the part of issuing warlord; B) a financial inducement to accept new notes including an initial 5% discount to the price of legacy notes, and C) the claim that new notes were liabilities of the Central Bank of Somalia. According to Mubarak the latter instilled a "general public belief that the forged... banknotes must eventually be upheld and honoured when effective national government comes to power."

This last detail is interesting because it might explain not only why counterfeits were accepted, but also why legacy Somali banknotes continued to circulate after the Somali state collapsed. Upon the eventual reconstitution of the Somalian state, a new central bank would most likely be created. This newly recapitalized Central Bank of Somalia would hold a stock of assets funded, say, by the IMF.  The central bank might take upon itself the original central bank's note liability No longer orphans, old banknotes could now be convertible into deposits held at the new central bank and, insofar as the central bank targeted inflation via open market operations, these deposits would in turn be convertible into genuine backing assets.

Thus the promise of redemption by a not-yet existing central bank may have been enough to give present shillings, both genuine and counterfeit, a positive value.

This means that any changes in the purchasing power of shillings might be due not only  to variations in the quantity of outstanding Somali media-of-exchange. Reassessments of the probability of a central bank both being created and honouring the previous note issue would also affect their purchasing power. For instance, should the Transitional Federal Government, a government in-waiting of sorts, succeed in consolidating its position in Somalia by winning a key battle, the odds of redeemability would increase, as would the value of shillings.

Historically orphaned currencies

This tension between fiat-paper-as-redeemabale-financial-asset and fiat-paper-as-medium-of-exchange is an old one. It was at the centre of one of the greatest monetary debates of the 19th and early 20th century, a dustup that involved luminaries like Irving Fisher, Knut Wicksell, Laurence Laughlin, Benjamin Anderson, Ralph Hawtrey, and Ludwig von Mises. The discussion centered on the irredeemability of US Greenbacks.**

Greenbacks, which had been issued in 1861 to pay for the Union Government's expenses, were initially 100% redeemable in specie. The redemption clause was suspended later that year and subsequent issues of greenbacks didn't even claim to be convertible into gold. Greenbacks quickly fell to a large discount relative to the metal. By August 1864 the discount had hit its widest point as the paper traded at 38 cents on the gold dollar.***

As with Somali shillings, economists were curious about these seemingly-orphaned liabilities. Why were greenbacks still accepted? What governed their value? Wicksell, Mises, and Hawtrey held that if there is a demand for the medium-of-exchange as such, this demand would be sufficient to give value to whatever instrument was established by custom as the medium-of-exchange. Thus the continued acceptance of greenbacks at positive values was mostly due their already-favorable marketability.

Countering this panel of illustrious economists was J. Laurence Laughlin. Though Laughlin doesn't attract the same brand recognition as do these other long-dead economists, in his day he was considered to be America's leading monetary economist. In his book The Principles of Money (1903), Laughlin outlined the view that greenbacks should be treated like non-dividend paying common stock. Just as a stock might have some positive value now due to potential dividends several years down the road, the continued positive valuation of greenbacks was due entirely to the possibility of their future redemption.

To illustrate his point, Laughlin drew attention to the market's reaction upon the success of the Union Goverment in the Battles of Gettysberg and Vicksburg. After these battles the greenback's discount to gold dramatically narrowed, presumably because these victories were perceived by the market as increasing the probability of future redemption of greenbacks in specie. Laughlin also mentions the passage of the Redemption Act of 1875, in which the government declared its intention to redeem all greenbacks come January 1, 1879. Though still trading at a discount to gold, greenbacks began to steadily appreciate towards par as this date approached, just like a t-bill approaching maturity. Thus Laughlin's redemption theory held up nicely to the evidence.

While Wicksell described Laughlin's theory as "perverse and fantastic," it was hard for Mises, Hawtrey, or Wicksell to deny that the expectation of future redemption didn't have at least some effect on greenback's value. In his book the Value of Money (1917), Benjamin Anderson struck a middle ground between all parties. Anderson held that Laughlin was right to treat greenbacks like any other asset whose value was dependent on eventual redeemability. But Anderson also thought that Mises and the rest were correct to put an emphasis on greenback's unique monetary function. Anderson combined these views by illustrating how greenback's "money-use" would be captured by the market as an extra bit of ascribed value on top of redemption value, or a liquidity premium.

Just to make things more complicated: New Somali Shillings

Back to the Somali shilling. The last feature of the Somalian monetary economy that I find interesting is the presence of yet another media of exchange — the "New Somali Shilling".**** Just prior to the January 1991 collapse, Somalia had been experiencing accelerating inflation. The Somali government drew up plans to replace existing shillings with the New Somali shillings. Each New Shilling was to be worth 100 old shillings, and notes were to be printed in 20 and 50 shilling denominations

 According to Symes (2006), the first shipment of New Shillings arrived in Somalia several months after the collapse of the state. Ali Mahdi Muhammed, a factional leader in Mogadishu, seized several billion of these official New Shillings and spent them into the economy in November 1991. While New Shillings did gain acceptance, their use was limited to a small area in North Mogadishu—the area controlled by Ali Mahdi Muhammed. Nor were they fungible with the legacy notes. 500 worth of New Shillings, for instance, was not worth 500 worth of old shillings. Nor did New Shillings circulate at the pre-1991 intended value of 100 old shillings to one New Shilling. At the time of Mubarak's article, a New shilling was worth only a third of an old shilling.

This challenges Luther & White's theory that Somalians accepted shillings because of their previous experience with them. Why did Somalians accept New Shillings at all if they were not accustomed to doing so? Why not refuse and continue to trade in legacy shillings? Legacy shillings circulated in Mogadishu at the time, so traders would have presumably had a choice. Why take a bet on an untested currency?

New Shillings also challenge the Laughlin-esque theory that redemption underpins the positive value of fiat paper. If Somalians universally valued shillings because of their future redeemability, why would they not place a higher value on New Shillings relative to old? After all, according to its stated plan, the Central Bank of Somalia was willing to convert 100 old shillings into 1 New Shilling. If it was believed that a newly chartered central bank would take on the liability of Somalia's counterfeit notes, wouldn't that same central bank uphold a commitment to value New Shillings at a far higher rate than old ones? Why then do New Shillings trade a third the price of old shillings rather than at a multiple of 100?

As much as I dislike to leave more questions than answers, that's about all I can do for the time being. One major data point is yet to come. What actually happens to legacy and counterfeit notes when a new central bank begins to operate? The Central Bank of Somalia's website says this:

Towards fully assuming its functional and institutional responsibilities, the Bank has completed the reconstruction of its Headquarters in Mogadishu while the branch in Baidoa has been established and is already functioning with personnel in place.

Perhaps we don't have long to wait.
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*Abduraham in Luther (2012)
**Debate also surrounded the irredeemability of Austrian gulder banknotes. The Revolution of May 1848 resulted in the withdrawal of the convertibility of Austrian gulden banknotes into silver. The discount on gulder notes relative to silver averaged around 15% for the first 10 years and then dipped to an average of 28% from 1859 to 1865. Laughlin pointed out that by the 1860s speculation began to grow that Austria would switch from the silver standard to a gold standard. If the banknotes, still irredeemable, were to be honoured, it became increasingly evident that redemption would be in gold, not silver. At the same time, large silver discoveries were driving down the value of silver relative to gold. As a result of these forces, the market value of notes rose back to par with silver. As the market became progressively more confident that the notes would be redeemed, and redemption would be in much more valuable gold, gulder notes eventually exceeded their stated silver value. Laughlin's theory seemed to be borne out by the facts--the value of orphaned notes was dictated by their future potential redeemability.
*** From A History of the Greenbacks (1903), by Wesley Clair Mitchell
**** Mubarak refers to this instrument as the Na' Shilling.

Can a central bank eliminate its highest value banknote?

Singapore's $10,000 bill, worth around US$7500, shares title to world's largest value banknote with Brunei's $10,000

Peter Sands has adeptly made the case for eliminating high denomination banknotes. The rough idea is that if all central banks were to eliminate their highest value banknotes, then criminals would have to fall back on smaller denominations or more volatile media of exchange like gold. Since both of these options are more cumbersome than large denomination notes, storage and handling expenses will grow. This means the costs of running a criminal enterprise increases as does the odds of being apprehended.

Elimination of cash is a polarizing topic. For now I'm going to sidestep that debate because I think there's a more interesting topic to chew on: might a central bank be unsuccessful in its attempt to withdraw its own high denomination notes? Put differently, what happens if everyone just ignores a central banker's demands to retire the biggest bill?

Take the most popular high denomination banknote in the world, the US$100 bill. According to the Federal Reserve, there are 10.8 billion of these in circulation, or around $1 trillion in nominal value terms. Popular not only with criminals, the $100 bill circulates in many dollarized or semi-dollarized nations as a legitimate means of exchange in the absence of decent local alternatives. Say that the Federal Reserves wants to hobble criminals by cancelling all 10.8 billion notes. It announces that everyone holding $100s has until January 1, 2018 to trade them in for two $50s (or five $20s). After that date any $100 notes that remain in circulation will no longer be considered money. Specifically, they will cease to be recognized by the Fed as a liability.

Will this demonetization work? Consider what happens if everyone simply ignores the proclamation and continues to use $100s in trade. Say that by the January 1, 2018 expiry date, only $300 billion of the $1 trillion in $100 bills in circulation have been tendered leaving the remaining $700 billion (or 7 billion individual notes) in peoples' pockets.

So much for hurting criminals by removing the $100, right? We'd say that the central bank's demonetization campaign has failed. But not so fast.

Even though 7 billion $100 bills remain in circulation, the nature of $100 bill will have changed. Prior to January 1, 2018, the Fed maintained a peg between the $100 bill and all other denomination ($50, $20, $10, $5, and $1). This peg was enforced by the Fed's promise to convert any quantity of $100 bills into lower denominated notes and vice versa. After the expiry date, the Fed will no longer include the $100 in these pegging arrangements.

In addition to maintaining a fixed rate between the various denomination, the Fed also promises to peg the value of a dollar to a slowly-declining bundle of consumer goods (put differently, it set a 3% 2% inflation target). It does so by injecting an appropriate quantity of new currency into the economy via open market purchases or withdrawing sufficient currency by selling assets. When the Fed demonetizes the $100 note, it ceases to include the $100 in its consumer goods peg. This means it will no longer dedicate any of its assets to protecting the purchasing power of the $100 bill.

Given this new setup, as demand for $100 bills varies their value will float relative to both Fed dollars and the slowly declining consumer good bundle. Like bitcoin, which also has a fixed supply, fluctuations in the purchasing power of the $100 could be quite volatile. One day the $100 might be worth $110, the next it could be worth just $90. So even if the Fed has failed in withdrawing the $100, it will still have succeeded in imposing purchasing power volatility on criminals and other users of the $100. Volatile assets make for unpleasant and costly media of exchange and criminals will not be happy with these change.

By forswearing the $100, the Fed also ceases to act as a guardian of the quality of its issue of $100 bills against counterfeiters. The abdication of this function is especially important given that the marginal cost of printing a decent knock off of the $100 is probably just a few cents. Absent the threat of imprisonment, entrepreneurs will swarm to duplicate the $100, spending counterfeits into circulation and steadily reducing the purchasing power of the $100. After a few years of constant counterfeiting the $100 bill won't be worth much more than a few cents or so; the marginal cost of paper, ink, and printing. This hyperinflation will bring the nominal value of the original 7 billion in notes to just $700 million, down from $1 trillion.

Highest denomination note in various counties, sorted by US$ equivalent

Incidentally, we know this is a likely situation because of what has happened in Somalia. When Somalia's central bank was dismantled in the early 1990s, Somali shillings continued to circulate (see my blog post here). Over the next few years, warlords issued their own counterfeits which eventually drove the value of the shilling down to the cost of paper and transportation. William Luther has described this process here.

Along the way to hitting a terminal value of just a few cents, the $100 will lose any advantage it had previously enjoyed in terms of storage costs and handling. The moment a $100 falls to $49, the Fed's own $50 note becomes a cheaper note for criminals to use. And as the hyperinflation continues and the $100 falls to $19, the Fed's own $20 note will become preferred. The upshot is this: even if the Fed's January 1, 2018 expiry date fails to attract any $100s for redemption, competitive counterfeiting means that the $100 will inevitably cease to be used as the criminal economy's preferred medium of exchange.

Since criminals are rational and can anticipate that this sort of hyperinflation will ensue, they are more likely to tender their notes for cancellation prior to the original January 1, 2018 deadline. Better to get full restitution rather than lose all one's wealth.

Could criminals somehow police against hyperinflation by rejecting counterfeits? Militating against this would be the constant degradation of the note issue's quality due to normal passage of paper from hand to hand. In normal times, the Fed works behind the scenes to keep its note issue up to snuff, replacing worn out specimens with fresh new greenbacks. Once the Fed abdicates this role, $100 bills will quickly start to deteriorate. Picking the counterfeits out from a stack of bills will become more difficult, only making the job of counterfeiting easier.

In the face of this deterioration the mass of $100 bills may begin to fragment and lose fungibility. Fungibility is the idea that all members of a population are perfect substitutes. Well-preserved $100s that are easily identifiable as non-counterfeits may pass at a higher value than a slightly worn out $100, with well-worn and less identifiable $100 bills trading at an even larger discount. Without fungibility, it becomes far more difficult for a medium of exchange to do its job. Where a transaction with fungible $100 notes might be consummated in a few moments, it may take hours to grade a small stack of heterogeneous bills. The costs arising from non-fungibility may be so high that criminals will prefer to use relatively bulky $50 bills which, though possessing higher storage costs, will not be plagued by the requirement that each note be closely analyzed for quality.

So in the end, even if criminals ignore a central bank's deadline to tender notes for cancellation, they will eventually cease using the highest denomination notes through a more roundabout route. A central bank's renouncement of both its role as enforcer of the largest denomination's peg to other notes as well as its commitment to tend to that note's quality will set off forces that drive the purchasing power of those notes down to the cost of paper and ink, at which point they will be as good as demonetized.

Having settled whether a central bank can demonetize its highest value note, should it? That's an entirely different post. Or we can hash it out in the comments.

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PS. An alternative story to a Somali-style hyperinflation is an Iraqi-style deflation. See Tony Yates on Twitter. I've written about the odd case of the Iraqi Swiss dinar here. How likely is an Iraqi scenario? Criminals would have to assume that a future monetary authority, maybe even the Fed itself, reverts its decision and undertakes to adopt orphan $100 bills as a liability at a price consistent with their previous purchasing power. This would give $100 bills a fixed value in the present.

PPS. On the topic of altering the relationship between high denomination notes and other notes, see my posts on high value note embargoes. 

More fiatsplainin': let's play fiat-or-not

The (Great) Tower of Babel, 1563, Bruegel the Elder. "Therefore is the name of it called Babel; because the Lord did there confound the language of all the earth"

People bandy the term fiat currency around a lot, but what exactly does it mean? None of us wants to live in a Babel where people use fiat to indicate twenty different thing. So let's try to zero in on what most people mean by playing a game called fiat-or-not. I will describe a monetary system as it evolves away from a pure commodity arrangement and you will tell me when it has slipped into being a fiat system. (The technique I am using in this post cribs from a classic Nick Rowe post).

So let's start the game.

1) An economy in which gold coins circulate as the medium of exchange.

Fiat or not? I think we can all agree that there is nothing fiat at all here. (For simplicity's sake let's assume for the duration of this post that taxes can be paid with anything, and that there is no legal tender.)

2) A government-owned central bank begins to issue banknotes that are redeemable into a fixed amount of gold. Owners of banknotes need only line up at the central bank's redemption window to convert their $1 notes into 1 gram of the yellow metal. The central bank ensures that its vaults contain 100% gold backing for its notes.

Fiat or not? Some people associate fiat with the invention of paper money or IOUs, but in general I don't think very many of us would say that these banknotes qualify as fiat.

3) The central bank sells off a chunk of its gold and invests in safe bearer bonds. Its banknotes are no longer 100% backed by gold coins, but are backed 70% bonds/30% gold. The central bank continues to redeem notes on demand with gold at a rate of $1 to 1 gram.

Say the public suddenly wants to hold more coins. A lineup develops at the central bank's redemption window and eventually the central bank uses up its coin reserves as it meets redemption requests. To continue meeting additional requests, it need only sell some of the low-risk bonds from its vault and use the proceeds to buy additional gold coins.   

Fiat or not? Since low-risk bonds have now become part of the backing for the banknote issue, a few readers may choose step 3 banknotes as the entry point for fiat money. But this would be unconventional, since most note-issuing central banks in the 1800s were running this sort of 70%/30% system, and we usually call the monetary system that prevailed in the 1800s a gold standard, not a fiat standard.

4) The central bank announces that it  will undergo extensive renovations. As a result, its redemption window will have to be shut for two months. People can no longer redeem their $1 for 1 gram of gold on demand, but will have to wait until the renovations are over.

Fiat or not? Two months is a long time. But it could be that the central bank already closes its doors on the weekends anyways, banknotes being inconvertible for 48-hours. I doubt many of us would describe the weekend as a fiat currency episode. Should we think of the renovation closure as an extended weekend, or is it long enough that it generates fiat money?

5) Unfortunately the central bank chose an incompetent construction company. Renovations will take another two years!

To make up for the inconvenience of the redemption window being closed for such a long time, the central bank promises to send agents to the local gold market who will ensure that the market rate stays fixed at $1/gram. These agents will buy & sell whatever amount of gold is necessary to maintain the peg (by selling and buying banknotes).

Fiat or not? Thanks to the strategy of buying and selling in the local gold market, the $1/gram price holds just as well as it did in steps 2 and 3. So the public notices no difference in the purchasing power of the money in their wallets. On the other hand, two years without a redemption window at the central bank may be long enough for many readers to tick the fiat money box.    

6) The central bank is still undergoing renovations, but instead of dispatching agents to the market to buy and sell gold to enforce the peg, they go with bonds in hand.

If the market price for gold threatens to rise from $1/gram to $1.01/gram, because there is too much money chasing too few goods, the agents sell bonds and withdraw banknotes, thus reducing pressure on the exchange rate and bringing it back to $1/gram. And when the exchange rate threatens to fall below $1/gram to $0.99/gram, because there is too little money chasing goods, agents buy bonds with banknotes.

Fiat or not? Not only are notes not redeemable in gold, but now the central bank no longer operates directly in the gold market. With this step we are getting a bit closer to modern central bank money. The Federal Reserve, the Bank of Canada, and other major central banks all regulate the purchasing power of money by purchases and sales of bonds. The $1/gram peg still holds thanks to bond purchases and sales, so step 6 money does almost everything that step 2 and 3 money does.

7) With the renovation dragging on, the central bank decides that it doesn't need a redemption window after all. So what was initially a temporary suspension of convertibility becomes permanent. But the central bank continues to send agents to the market to buy or sell whatever quantity of bonds are necessary to maintain the $1/gram peg.

Fiat or not? You tell me. Perhaps permanent inconvertibility is the very definition of fiat. However, if steps 2-6 didn't qualify as fiat money, because gold stayed at $1/gram, why would step 7 be any different?

8) The central bank decides that, rather than fixing the market price of gold at $1/gram, it will set the market price of a typical consumer basket of goods and services (i.e. meat, car repairs, school, etc). 

This is a bit trickier to think about than the other steps. So for example, say that the central bank is currently setting the price of gold at $1/gram. And people can buy a consumer basket for $1000. But the price of that basket starts to rise to $1010, $1020, and then $1030. To stop this inflation, the central bank will announce its intention to reduce the price of gold to $0.99/gram. It does this by selling bonds and withdrawing money from the system, so that there is less money chasing goods. It keeps repeating gold price decreases/money withdrawals until it has successfully reigned in the inflation and brought the consumer price basket back to $1000. The net effect is that consumers are always guaranteed that the money in their pocket has constant purchasing power.

Fiat or not? This is pretty much the monetary system we have now in the U.S. and Canada where central banks target inflation. Well, there are a few small differences. Instead of temporarily setting the price of gold in order to regulate the value of a consumer price basket, the Fed and Bank of Canada temporarily set the price of a very short-term debt instrument to hit their target for the basket. And rather than shooting for constant consumer goods and services prices, these central banks prefer one that shrinks by 2% a year.

Given that step 8 describes something close to modern money, and it is common practice to refer to modern money as fiat, then it would only make sense that many readers raise their hands at this point. Complicating matters is that step 8 money isn't really that different from steps 2 to 7. After all, the central bank is establishing a fixed price for banknotes, the only difference being that the fix has been adjusted from gold to a basket of consumer goods and services. 

9) The central bank donates all of its assets to charity, closes its doors and shuts down for good. But it leaves all its banknotes outstanding. Money floats around the economy without a tether to reality. Or as Stephen Williamson says, money is a bubble.

Fiat or not? By this stage, everyone will probably have ticked the fiat money box. 

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Here is a collection of unconnected thoughts on the fiat-or-not game.

A) My guess it that readers will have chosen different stages as their preferred debut for fiat money. This is a bit tragic, since with no commonly-accepted definition for the term, most debates about fiat money have been and will continue to be meaningless.

B) We apply our definitions like cookie cutters to the real world. So if you chose step 7 (when banknotes became permanently irredeemable) as your flipping point, then 1971 would be a very important date in your scheme of the world since this is when the U.S. permanently removed gold convertibility.

But if you chose step 9 as your transition point to fiat, then the global monetary system is not currently on a fiat standard, since central banks have neither closed their doors nor donated their assets to charity. So 1971 really isn't an interesting date. I'm aware of only one country on a step 9 fiat standard: Somalia. Its central bank burned down yet Somali shilling banknotes continued to circulate. And ironically enough, if we choose to adopt a step 9 definition of fiat money, then bitcoin—which was designed to destroy central bank "fiat" money—is itself fiat, because it is unbacked, whereas most central bank money is not fiat.

What I've described is the Borges problem. Categories pre-digest the world for us. We get very different results depending on what definition we use and how we apply it to the world.

C) I think many readers associate fiat with hyperinflatable. For instance, here is Dror Golberg:

Was Canada ground zero for fiat money? This paper claims that fiat money was independently invented by French Canadians in 1685, copied by Massachusetts in 1690, adopted in Europe, and diffused to the rest of the world: https://t.co/bSXyYLYzwp pic.twitter.com/kWVWbi43hH

— JP Koning (@jp_koning) March 14, 2018

Readers who conflate fiat and hyperinflatable will probably have played the fiat-or-not game by gauging each step to see if it introduced (or removed) a set of features perceived to be conducive (inhibitory) to high inflation. They probably toggled the fiat button somewhere in the murk of temporary inconvertibility (step 4) and permanent inconvertibility (step 7). The thinking here is that convertibility into specie imposes a more imposing restriction on a central bank than a mere promise to hold gold's value at $1/gram by using open market operations (step 6). With the removal of convertibility, hyperinflatability is activated and thus money has become fiat.

There are certainly some good historical reasons for assuming that inconvertibility leads to hyperinflatability. Some of the most famous hyperinflations occurred after redemption was removed, including John Law's paper money scheme, the American Greenback episode, and the Wiemar inflation. But there is no inherent reason that these systems must lead to hyperinflation, or that step 1 (coin-based systems) and step 2 (fully convertible) systems aren't themselves hyperinflatable. In the case of coin-based systems, all that it takes is a rapid series of reductions in the silver content of coins to set off inflation, Henry VIII's consistent debasement of the English coinage being one example. And there is no reason that a fully convertible step 2 banknote system can't undergo a series of large devaluations leading to hyperinflation. 

D) Fiatness, fiatish? If we can't agree on what constitutes fiat-or-not, maybe we can agree that there might be a fiat scale, from pure fiat to not fiat at all, with most monetary systems existing somewhere in between. I am already on record advocating moneyness over money, so this fits with the general them of the blog. On the other hand, fiatness seems a bit of a cop-out.

E) We don't need gobbledygook like fiat. The term carries too much baggage. Let's select a more precise set of words, then apply them to the real world in order to understand what our monetary systems were like, how they are now, and where we are going. Until we settle on these words, let's avoid all conversations with the term fiat in them.

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P.S. I have a recent post about the desirability of coin debasements at the Sound Money Project and another post on money as a measuring stick at Bullionstar. 

Disowned currency: the odd case of Iraqi Swiss Dinars

A few months back I wrote about the odd case of the Somali shilling. Despite the fact that Somalia's central bank was looted in 1991 and ceased to function thereafter, orphaned Somali shillings continued to circulate, and do so to this day. Along these same lines, so-called "Swiss Dinars" circulated in northern Iraq between 1993 and 2004 despite having been demonetized and discredited by their issuer, the Central Bank of Iraq (CBI). Why did shillings and dinars continue to have value despite being orphaned from/disowned by their issuer? The bigger question at stake is this: what gives so-called fiat money its positive price?

The few bits of information I've found on the Swiss dinar come from a 2004 paper by Mervyn King, then governor of the Bank of England, a short article in the New York Times by Hal Varian, and a 2004 paper by Foote, Block, Crane, and Gray on the economic policy in Iraq. I've found a few odds and ends elsewhere from newspaper and numismatic websites.

The story, in short, goes like this. Having chased the Iraqi army out of Kuwait in 1991, President George Bush Sr. withdrew American troops from Iraq, leaving the Saddam regime untouched but crippled by a wide range of UN economic sanctions. Due to embargoes, the CBI could no longer source paper currency from De La Rue PLC, its UK-based supplier.¹ To help pay salaries and whatnot, Saddam began to print dinars locally, as well as sourcing bills from a Chinese based printer.²

Oddly, these new "Saddam" bills didn't circulate at par with the pre-war Iraq notes but traded at a discount. By May, 1992, the older notes were worth around 3 US cents whereas the newer ones traded at 1 cent.³ This is an odd thing to get one's head around. Canada, for instance, recently came out with plastic notes. The plastic notes circulate at par with paper notes, but if they were to trade at a discount, then we'd experience something akin to what Iraqis experienced in the early 1990s -- one issuer, one dinar, two different prices.

There seem to be a few theories for the dinar price discrepancy. The one that makes the most sense to me is that the poor quality of the post-war notes meant that they were easily counterfeited. The new notes were shoddy and lacked a watermark, the paper was thin, easily torn, and the ink ran.⁴ The pre-war notes, on the other hand, had been printed by De La Rue with modern technology. Traders may have discounted the newer notes for fear that they would be accepting fakes.

The pre-war notes printed by De La Rue were referred to as "Swiss Dinars". King claims that this name derives from the fact that De La Rue's printing plates were manufactured in Switzerland. Foote et al. float another theory that the Iraq dinar, historically a stable currency, was considered to be the Swiss franc of the Middle East.

In any case, the Saddam regime decided in 1993 to get rid of the dual price system by disowning the Swiss dinar. There may have been a few reasons for doing this. One can only imagine that the discount the market levied on post-war currency made the regime look weak. Since improving the quality of the post-war note issue was impossible, the only solution was to remove the Swiss issue. Secondly, this dual system would have limited the ability of the government to turn to monetary financing. The existence of the Swiss dinar along with a competitive alternative meant that there was a degree of market choice in currency use. The market could turn to Swiss dinars, which were fixed in supply, while avoiding post-war currency, which was printed in large quantities, thereby limiting the power of the CBI to print money to pay Saddam's bills. This system would have been akin to a partially dollarized system with the Swiss dinar taking the place of the dollar. Thirdly, the existence of multiple prices would have made transactions more complicated. Removing the Swiss dinar may have been a way to diminish the calculational burden placed on Iraqis by the existence of two sets of prices.

Saddam Hussein disowned the Swiss dinar in a manner calculated to maximize his return. On May 5, 1993, the regime announced that all Swiss dinars had to be turned into the CBI for an equivalent amount of post-war currency over a six day exchange period ending May 10, 1993. After these six days had passed, the CBI would cease to honour the Swiss dinars as their liability. The entire issue of Swiss dinars was comprised of 25 dinar notes, so these were to be exchanged for 25 new dinars. Since the market placed a large premium on Swiss dinars, the par exchange rate effectively overvalued post-war dinars and resulted in an immediate gain to the regime. After all, it allowed the CBI to repurchase far more Swiss dinars for a given amount of new Saddam dinars, and thereby increased CBI seigniorage profits.

The second part of Saddam's scheme was just as mercenary. A large percentage of Swiss dinar notes were owned by Jordanians who did business with Iraq, as well as Emiratis, Palestinians, and Kuwaitis.⁵ Swiss dinars also circulated in northern Iraq, effectively a Kurdish protectorate. Saddam closed the border over the entire six day exchange period in order to prevent foreigners and Kurds from repatriating their Swiss dinars. As a result, a huge portion of the float was stranded and never converted into new 'Saddam' dinars. By stranding so many Swiss dinars outside of Iraq, the CBI's liabilities were dramatically reduced, leaving its balance sheet unencumbered and ready for an orgy of monetary financing. By 1994, Iraqi inflation had hit 500% annually.⁶

A strange thing happened. Despite having been forsworn by the CBI, Swiss dinars did not become valueless. Along with US dollars, they continued to be used as a medium of exchange in northern Iraq. The fact that Swiss dinars were fixed in supply -- the Kurdish government did not attempt to print new notes -- helped sustain their price.⁷ Through the 1990s and early 2000s, the value of the Swiss dinar actually increased. While Swiss dinars were worth 2-3 times the price of Saddam dinars in 1993, they had appreciated to 300 Saddam dinars by 2003. See the chart from King, below.



The Swiss dinar also appreciated over that time period vis a vis the US dollar, as King's second chart shows.



Why would a disowned currency continue to be valued? One possibility is that the Kurds had a demand for currency as such, and whatever bits of colored paper already happened to circulate in northern Iraq would, perhaps by virtue of necessity and tradition, continue to be used despite their lack of credit. The problem with this explanation is that if peoples' demand for currency is so easily satisfied by unbacked coloured bits of paper, why didn't Kurdish businesses and consumers also create unbacked colored paper and spend these bits, earning large profits? A central authority might be able to preserve their monopoly by threatening businesses that issued competing brands of unbacked coloured paper, but no such central authority existed in northern Iraq. Something else seems to be working behind the scenes.

Another explanation for the continued positive valuation of Swiss dinars is that Kurds anticipated that their disowned dinars were likely to be reclaimed by a future central bank. For instance, if northern Iraq was ever to made sovereign, a new Kurdish central bank would likely adopt the Swiss dinar as their liability.

This reclamation of Swiss dinars is exactly what occurred, although not via an independent Kurdish state. As we all know, the US invaded Iraq in March 2003. On July 7, 2003, the head of the Coalition Provisional Authority, Paul Bremer, announced that an entirely new dinar was to be issued in October. Both post-war Saddam dinars and Swiss dinars would be exchangeable with these new dinars. Thus ended the decade-long disownership of Swiss dinars. Once again, these notes were the liability of a central bank.

Mervyn King gives a particularly detailed account of how this worked. Beginning in 2002, speculation concerning a US invasion of Iraq began to mount. Coinciding with war speculation was a sharp rise in the value of the Swiss dinar, which moved from 18 dinars to the dollar in May 2002 to 6 dinars a year later. According to King, the dinar's bull market was a function of expectations that a US invasion would bolster both the independence of the Kurdish state from Saddam, as well as the likelihood "that a new institution would be established governing monetary policy in Iraq as a whole that would retrospectively back the value of the Swiss dinar."

The Kurdish government, unhappy with the deflation and its effect on the economy, did their best to discredit Swiss dinars. They began to pay a larger proportion of government employees in dollars in order to underscore their support for that currency and tried to persuade currency speculators that the Swiss dinar would be worthless if Iraq united and a new central bank was formed.⁸

Foote et al point out the flipside of Swiss dinar appreciation -- the depreciation of Saddam dinars. Because these notes featured a smiling Saddam Hussein, fears that they would be disowned by the issuer once the Coalition took over caused them to weaken dramatically. That this fear would arise is not surprising given that Saddam had disowned Swiss dinars just ten years before. Whereas the Kurdish government tried to discredit Swiss dinars by paying government workers in dollars, the Coalition did the opposite and tried to alleviate fears concerning post-war Saddam dinars by choosing to pay government salaries with these notes. This decision signaled that there was a place for Saddam notes to play in a post-Saddam Iraq and caused their price to improve.

Interestingly, both interventions give a chartal flavour to the story. As the case of the Swiss dinar illustrates, government support is by no means necessary for a currency to have positive value. The appearance of monetary phenomena does not require the state as a prerequisite. But that doesn't mean that governments can't influence that value by choosing to modify their transactions behavior as a way to signal their support, or lack thereof, for a currency.

The final conversion price was set at a price that implied 150 Saddam dinars to 1 Swiss dinar. The conversion process began in October 2003 and ended by January 2004, officially ending Iraq's one-dinar-two-prices era, surely one of the odder periods in monetary history. Unfortunately, pinning down the exact reasons for the continued circulation of Swiss dinars despite being disowned is almost impossible to do. We've got theories, but confirmation is tough to come by. The difficulty of understanding monetary phenomena is a constant theme of this blog, as I hope my account of Somali shillings, Yap stones, and bitcoin all illustrate.

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1 King credits De La Rue as the printer of Iraq's currency^↩
2 From Joel's coins.^↩
3 These two articles describe the discount: New York Times, May 16, 1993 and Philadelphia Inquirer, May 19, 1993^↩
4 New York Times, May 16, 1993^↩
5 Philadelphia Inquirer, May 19, 1993^↩
6 According to Foote et al.^↩
7 Writes King: At no stage did the Kurdish groups lay claim to the Swiss dinar as their currency – they had no control over it – as shown by the interview given to Gulf News on 30 January 2003 by the Kurdistan Regional Government Prime Minister Barzani who said, “We don’t have our own currency”.^↩
8 New York Times, January 18, 2003^↩