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"Free issue" systems

As I mentioned in my previous post, Hong Kong had an unusual monetary system before returning to the currency board system in 1983. It was (retrospectively, perhaps) dubbed the "free issue" system and that seems as good a placeholder as any, though I welcome suggestions for a different name.

“Free issue” systems are those in which bank liabilities are not convertible into a commodity or foreign currency at a set rate, no party external to the commercial banking system such as a central bank issues a monetary base into which bank liabilities are convertible at a set rate (usually 1:1), and legal requirements compel people to use the local currency. The last characteristic sets them apart from all free banking systems, historical or imagined.

I have found only two historical cases of free issue systems: Hong Kong from 1974 to 1983 and Canada from 1914 to 1926 and again from 1929 to 1935. There are few discussions extant of free issue systems, and those I've seen are fragmentary. John Greenwood's book cited in my previous post is the only place I have seen a balance sheet treatment.

Here is how the Hong Kong system worked. Until 1972, the pound sterling was the anchor currency for the Hong Kong dollar at HK$16 = £1. Hong Kong’s three note-issuing banks were in effect agents of Hong Kong’s currency board, which was called the Exchange Fund. To issue notes, the banks had to give the Exchange Fund specified sterling assets, such as British Treasury bills, equal to the notes they wanted to issue. (If the banks took notes out of circulation, the Exchange Fund gave them back sterling assets of equal value.)

Hong Kong abandoned the pound sterling as the anchor currency during the upheaval that marked the breakup of the Bretton Woods monetary system. At first it switched to the U.S. dollar as the anchor, but the dollar too had problems, so in 1974 Hong Kong’s government floated the exchange rate. The Exchange Fund then began accepting Hong Kong dollar-denominated assets as backing for note issues alongside foreign assets. It converted much but not all of the Hong Kong dollar assets it received into foreign currency.

You can see the potential problem. The note-issuing banks could not influence the creation of British Treasury bills, but they could influence the creation of Hong Kong dollar assets. Buy a security issued by, say, China Light & Power (the local electric company), take it to the Exchange Fund as backing for issuing notes, use the new notes to buy another China Light & Power security, take it to the Exchange Fund as backing for issuing more notes, etc. In principle the monetary base could have become infinitely large. In practice it did not, mainly I suspect because hardly anybody understood how the system worked. It was also in the interest of the note-issuing banks not to barbecue their mortgage loans and other Hong Kong dollar-denominated financial assets with a hyperinflation.

(My example above is hypothetical. Until 1992 the Exchange Fund did not publish a financial statement and the government of Hong Kong rarely made public any information about it. We have rudimentary retrospective balance sheet information, but it would be worthwhile for somebody in Hong Kong or visiting Hong Kong to sift through the archives and write a paper describing the details of how the Exchange Fund worked during the free issue period.)

An essential element of a free issue system is some kind of requirement that people use the local currency, such as a forced-tender law. In a competitive currency system, an individual issuer issuing a currency with a floating exchange rate may create hyperinflation in its own currency, but people have the freedom to use other currencies instead. Damage to the economy will therefore be limited because few people will want to use a hyperinflating currency.

ADDENDUM: A commenter brings up the case of New Zealand, contemporaneous with that of Canada. Both countries later established central banks at about the same time as well.

  • "An essential element of a free issue system is some kind of requirement that people use the local currency, such as a forced-tender law. In a competitive currency system, an individual issuer issuing a currency with a floating exchange rate may create hyperinflation in its own currency, but people have the freedom to use other currencies instead. Damage to the economy will therefore be limited because few people will want to use a hyperinflating currency."

    I get it. That's fascinating.

    As a Canadian, it's interesting to see that we've got the only other example you've found. To fill in the blanks, when we went off the gold standard in 1914, privately-issued bank notes we're no longer convertible into gold or Dominion notes. But they were given legal tender status. That fills in the necessary requirements you list to be a "free issue" system. (I get these facts from this pdf).

    I can see why you say this could be dangerous. Gresham's law might kick in. Since the $ was effectively defined in terms of multiple media, and all units had to be accepted at face value thanks to legal tender laws, then people might prefer to trade away "bad" notes while keeping the "good" ones. Or something like that. Tough to bend my mind around this problem since it's not something one runs into everyday, but it does seem to me that some sort of Gresham effect will kick in.

  • Michael

    I think you will find that New Zealand from 1914 to 1933 or 1934 was another example. New Zealand had been on the Gold Standard until the outbreak of WW1, when the convertibility requirement was suspended. Convertibility into gold was never re-established. For some years, a de facto convertibility into sterling at 1:1 existed, administered by the banks collectively, but that was never government-imposed, and rate deviated quite materially from parity at times, especially during the Great Depression. In 1934 the Reserve Bank of New Zealand was established. In January 1933, however, the government had agreed with the banks to depreciate the exchange rate against sterling, offering as quid pro quo an Indemnity Act which ensured that banks would not suffer a loss on any subsequent reversal, and agreeing to buy any surplus sterling at the newly depreciated exchange rate.

    Hawke's 1973 history of the Reserve Bank is the most easily accessible book, or this working paper also covers the ground briefly http://www.rbnz.govt.nz/monetary_policy/about_monetary_policy/4543102.pdf

    • Kurt Schuler

      Thanks. In the Hong Kong and Canadian cases, and maybe (if it qualifies) the New Zealand case also, each government could quickly have established a proto-central bank to control the monetary base had it wanted to–some administrative elements that could have done so were already in place–but having just come off of an "automatic" system, each seems to have assumed that the changed system would continue to work automatically even though the set exchange rate parity through which the automatic process worked was now gone.

  • Michael

    Tocker's 1924 Economic Journal analysis of the Australian and New Zealand systems may also be helpful

    http://www.jstor.org/stable/pdfplus/2223378.pdf?&acceptTC=true&jpdConfirm=true

    In the NZ case, the proto-central bank might well have been the largest commercial bank, the Bank of New Zealand, in which the government held a controllling shareholding (since an earlier crisis). I think your 'each seems to have assumed that the changed system would continue to work automatically' describes the NZ situation quite well – and so close was the identification of NZ bank notes with sterling that for a long time any prolonged or large deviation from parity would have undermined customer confidence in the system. Hence, the banks managed credit availability to ensure that sterling resources were adequate to maintain something very close to parity through until the Depression.

  • Mike Sproul

    "Buy a security issued by, say, China Light & Power (the local electric company), take it to the Exchange Fund as backing for issuing notes, use the new notes to buy another China Light & Power security, take it to the Exchange Fund as backing for issuing more notes, etc. In principle the monetary base could have become infinitely large."

    This assumes the correctness of the quantity theory of money, which is the very point in question. The new dollar note was backed by a dollar's worth of China Light and Power (CLP). Thus the dollar-issuer's assets rose in step with its issuance of dollars and the value of the dollar would be unaffected. As long as every new dollar issued is backed by an additional dollar's worth of CLP, there will be no inflation. (Lloyd Mints made the same mistake in his "Money's Worth" criticism of the real bills doctrine.)

    There is, however, a danger in backing a dollar with dollar-denominated securities. Let's say the bank lost some assets and so the dollar, having less backing, fell in value. This will cause the (dollar-denominated) backing securities to lose value, which causes the dollar to fall still more, thus leading to inflationary feedback.

    For example, a bank accepts 100 oz of silver on deposit and issues 100 paper receipts (dollars) in exchange, so $1=1 oz. The bank then prints another $200 and uses them to buy $200 worth of CLP. Let E=the value of the dollar (in ounces). Setting the bank's assets (100 oz + $200 of CLP worth E oz. each) equal to its liabilities ($300 worth E oz. each) yields

    100+200E=300E, or E=1 oz./$

    But then the bank is robbed of 30 oz (or 10% of its assets) The equation becomes

    70+200E=300E, or E=0.7 oz/$.

    Thus the 10% loss of assets resulted in 30% inflation, because of the action of inflationary feedback. The danger of backing a dollar with dollar-denominated securities is that it causes increased volatility of the dollar, but not necessarily inflation.

    • Kurt Schuler

      I fail to see how it is controversial that when the demand for real balances stays the same and the nominal quantity of money rises, the purchasing power of each unit will fall. The free issue system has no nominal anchor, and it in principle allows banks to create reserves at will. In practice Hong Kong did not suffer hyperinflation, but the Hong Kong dollar was on a bad downward spiral of the kind that, at a minimum, ends with the local currency having a secondary role while a more trusted foreign currency becomes the dominant money; some details are in the books I mentioned in the previous post.

  • Mike Sproul

    First, let's suppose there is an anchor, so that $1 is anchored to 1 oz of silver. It's clear that whether banks issue $100, backed by 100 oz worth of assets, or $300 backed by 300 oz worth of assets, $1 will be worth 1 oz, even if the demand for real balances has stayed the same. Now change the composition of the bank's assets a little so that some of its assets are denominated in dollars instead of ounces. Those "assets=liabilities" equations I posted above show that a simple change in denomination of assets does not change the fact that each dollar will still be worth 1 oz. If it ever happened that ALL of the bank's assets were denominated in the bank's own dollars, then the value of the dollar would be indeterminate, but all real banks have real assets (buildings, etc) and these provide a real anchor for the bank's money even if there is no other anchor.

    It's not a question of controversy. It's a question of the rules of logic. You can't demonstrate the truth or falsity of a proposition by assuming its truth or falsity to begin with. If you assume that the issuance of new money causes inflation, even if that new money is adequately backed by the issuer's assets, you have assumed the falsity of the real bills doctrine. You cannot proceed from that point to the conclusion that the real bills doctrine is false.

    • Kurt Schuler

      The assumption that the demand for real balances is unchanged is a standard way of showing what happens in the simplest terms. The reality at the end of the free issue system, by the way, was that the demand for real balances in Hong Kong dollars was collapsing. Again, see John Greenwood's book for an account.

      At some future point let's engage in one or two back-and-forth blog posts in which we try to clarify the underlying points of view, because it's not so easy to do in the comments, which are supposed to be shorter.

      • Mike Sproul

        I'll be lurking out here in blogland, ready to explain the real bills view whenever you're ready. Quick summary: The real bills doctrine (aka backing theory) says that inflation is caused by the quantity of money outrunning the issuer's assets. The quantity theory says inflation is caused by the quantity of money outrunning the production of goods (i.e., real GDP).

  • harrydavid1

    Fascinating. I, too, find that these systems are too much neglected, from what I could tell from studying the case of Canada. One issue I would like to learn more about is the political economy of monetary institutions in a free-issue system. Where the economics profession sees (saw) the system as laissez-faire and sees it as producing excessive money creation, it's understandable that they see the institution of a central bank as a potential solution — a way of subjecting the process to conscious control.

  • Justin Merrill

    Kurt,

    I thought of a way that the Hong Kong monetary authority could operate a free issue system without a spiral. You could turn the fund into a publicly traded open ended mutual fund and require that the banks use the shares of the fund (liabilities) to back the notes of issue. The fund would purchase a diversified set of interest bearing securities and pay dividends. The mechanism is that if the market value of the security is at a premium to the NAV, this signals an increase in money demand and the fund will grow their balance sheet and issue more shares. You could also use the options market on the security as a guide to monetary policy.

    This is the application of an idea for a Wicksellian pure credit money I've been thinking about for a digital currency. It responds automatically to demand without discretion or a nominal anchor.

    • Kurt Schuler

      Interesting. You should write it up as a short note, fleshed out with some detail.

      • Justin Merrill

        Sure, Kurt.

        I'm putting the finishing touches on a couple papers, then I'll start outlining this one. I think I'll call it "Monetary Equilibrium in a Theory of Finance."