Last December, I was at the college Christmas Party. Somehow the conversation turned to privatization of currency.
Well, I know how. I shared my view that the reason for the crisis was that there was a shortage of low risk and liquid securities at a nominal yield of zero. In my view, the nominal yield on those securities needed to be negative in order to clear the markets for them.
The political scientist explained that if interest rates were negative, people will simply stuff "money" under the mattress. I explained, yes, that is exactly the problem. Our entire financial system is based upon currency that is low risk and perfectly liquid and has a zero nominal yield. If currency were privatized, then that would not be a problem.
The young physicist explained that private currency had already been tried and failed. He apparently had read something about private currencies in the Civil War. Along with that historical proof, he explained that privatized currency was unworkable because there would be no national standard of value. He asked, "What would a dollar mean?"
Clearly, my communications skills require some work. But I just can never see the problem. Why is it that everyone else seems to see tangible, zero nominal yield, hand-to-hand currency as essential to monetary order? In my view, privatizing hand-to-hand currency is simple.
The first step is to permit banks to issue hand-to-hand currency on the same terms as transactions accounts--checkable deposits. Most importantly, the Fed should accept hand-to-hand currency, whether paper notes or token coins, for deposit into reserve accounts on the same terms as checks. Just as a bank receiving checks drawn on another bank can deposit them into its reserve account, a bank should be able to deposit currency issued by another bank for deposit. Of course, the Fed should clear the currency exactly as checks are cleared--decreasing the balances in the reserve accounts of the banks which issued the currency.
Would anyone use private currency? I think the answer is yes. Would banks accept it for deposit? Yes, if retailers want to deposit it. Why? Because the banks want the business of the retailers and can, in turn, deposit private currency into their reserve balances at the Fed.
Of course, retailers would only need to deposit it if they accepted it in payment. Why would retailers accept it in payment? Because they want the business of their customers, and can deposit it in their own banks. The introduction of private currency simply requires that depositors be willing to withdraw private currency from their banks. Would they be willing to do so? Yes, because retailers will accept it in payment.
Why is this so obvious to me? I think it is because I think of private currency as being equivalent to checks rather than anything like the sort of fiat currencies that serve as base money. Retailers accept checks in payment. Banks accept checks from retailers. The Fed accepts checks from banks.
So far, I haven't explicitly mentioned that this proposal would have private currency redeemable on demand with Federal Reserve notes. However, the proposal was that the currency be issued on the same terms as transactions accounts, which are redeemable on demand with Federal Reserve notes. In my judgement, this characteristic is irrelevant for the workability of private currency. People will use private currency if retailers will accept it in payment. Retailers will accept it in payment if it will be accepted for deposit by banks. And banks will accept it for deposit if it is accepted for deposit by the Fed.
Clearly, if private currency clears through the Fed, it is redeemable. But the important redeemability is into reserve balances at the Fed. This is what would tie privately-issued currency into a payments system that is dominated by checks and electronic payments.
The first requirement for private currency to be issued is that banks must find it profitable. Nominal interest rates on earning assets must be high enough to cover the expense of initiating and maintaining a circulation of outstanding currency. While this should not be a problem normally, it could be a problem today.
The second requirement is that bank depositors must be motivated to withdraw private currency in place of Federal Reserve notes and coins. For example, issuing them from ATM machines. Whether banks can induce their customers to use private currency will have to be discovered. Of course, treating currency as lottery tickets, as suggested by Houston McCullogh, or continuing to pay interest on deposit balances for withdrawn currency until it clears would provide pecuniary motivations to use private currency.
If private currency circulates, then full privatization of currency requires that government currency be withdrawn from circulation. It really isn't difficult. The Fed must cease issuing it and give a future date after which it will no longer be accepted for deposit.
Of course, if government hand-to-hand currency no longer exists, bank liabilities, including checks and banknotes, cannot be redeemable in it. Contracts that promise such redemption must be void. Treating physical hand-to-hand currency as the ultimate legal tender for dollar denominated debts can no longer apply. Checks, electronic payments, or banknotes that are "good," that is, clear through the Fed, must instead settle debts.
It is possible that private currency could be introduced into circulation, but that when government currency is withdrawn, some kind of financial catastrophe would occur. However, the only plausible crisis would be a reduction in the demand for money, which would be inflationary. The necessary response would be a reduction in the quantity of money, presumably by the Fed contracting the quantity of the remaining monetary base--bank reserves.
And so, currency would be fully privatized.
What would the dollar mean? Dollar-denominated checks, electronic payments or banknotes, that are redeemable through the Fed. When sellers quote a price of $1, they would be expecting to receive a check, electronic payment, or banknote for one dollar. They would then deposit that and receive a balance of one dollar. And that would allow them to make payments, by check, electronic payment, or banknotes drawn on their own bank, of the amount of one dollar.
The Fed could control the quantity of bank reserves through open market operations, and that nominal quantity, along with the real demand for banks to hold them, either to meet reserve requirements or for prudential demand for adverse net clearings, would determine the price level. If the Fed preferred, it could manipulate the quantity of bank reserves to manipulate short term interest rates, including the overnight interbank interest rate. The existence of government issued hand-to-hand currency is in no way essential to the process.