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Wednesday, July 15, 2009

Loonie Network Effects

Nick Rowe use California's IOUs and Canadian Tire money to illustrate possible outcomes when two currencies circulate side by side:

The State(s) Theory of Money: California and Canadian Tire, by Nick Rowe: I learn via [this] that there is a distinct chance that California will allow taxes to be paid in the new scrip it issued when it ran out of funds. I have no idea whether this will happen, or whether the Federal government will stop it. Let me just assume that it does happen, and that the Federal government does not stop it. I'm (almost) hoping that it does happen, and that the Fed doesn't stop it, because it would be such a fascinating experiment in monetary theory.

Assuming this experiment does go ahead, what are the chances that California scrip will circulate as a medium of exchange, and be generally acceptable, not just at banks, but in exchange for all or most goods and services?

Another way to ask this question: what's the difference between California and Canadian Tire?

For non-Canadian readers let me explain that Canadian Tire corporation is a large chain of stores selling a wide range of automotive supplies, hardware, sports and camping equipment, gasoline, etc., that has many outlets across Canada. And it issues Canadian Tire "Money". CT money consists of small paper notes, about the same size as US dollar bills, in denominations ranging from a few cents up to a couple of dollars. When you buy something at Canadian Tire, you get CT money with a face value of a couple of percent of the purchase price. Canadian Tire money is redeemable for merchandise, at par with Canadian dollars, at all Canadian Tire stores.

That last sentence is crucial. If the State of California accepts California scrip for payment of taxes, at par with US dollars, it is just like Canadian Tire. Sure, you have to pay taxes, and you don't have to shop at Canadian Tire, but most Canadians do shop at Canadian Tire, and do so more times a year than most Californians pay taxes (if we are talking about annual income taxes, at least). So the frequency with which Canadian Tire money can be redeemed at its issuer will exceed that of California scrip.

But Canadian Tire "Money" does not normally circulate as a generally accepted medium of exchange. In special circumstances, someone (other than Canadian Tire) might accept Canadian Tire money in payment for goods, but only as a favour if you have run out of "real" money, or at a discount. It is not generally used outside of Canadian Tire stores. People generally redeem it as soon as they next visit a Canadian Tire store (or just leave it stashed away until they remember to do so).

And we can understand why Canadian Tire money does not circulate as a medium of exchange. This is a case where, contrary to Gresham's Law, good money drives out bad. (Gresham's Law does not apply because there is no legal tender law saying that merchants have to accept Canadian Tire money at par, and only Canadian Tire does so).

We have known since Carl Menger that money, like language, has network effects. If the people with whom you interact are already speaking a particular language, or using a particular medium of exchange, that increases your incentive to adopt that same language or medium of exchange. Conventions can arise spontaneously, and have the force of custom. Canadian Tire money would have to be, not just as good as, but significantly better than the Loonie, in order to compete with the Loonie as a medium of exchange. It isn't. You can redeem Canadian Tire money at par in Canadian Tire stores, and below par elsewhere, so everybody just redeems it at Canadian Tire stores. It doesn't circulate.

So California scrip would end up like Canadian Tire money - being kept in the glove box until your next visit to the issuing store - except for one thing: California scrip pays 3.5% interest; Canadian Tire money pays none. In that one respect at least, California scrip is better than US dollars.

Suppose California scrip does end up circulating as a medium of exchange, being generally acceptable at par to US dollars. Is that possible? I don't think it is, because then Gresham's Law would kick in. If I hold both in my pocket, and merchants will accept both, at par, I would pay with US dollars, and hoard the California scrip, to collect the interest.

It's hard to model a stable equilibrium in which two different monies could circulate side-by-side. If one money gains any slight advantage over the other, and becomes more widely accepted, that makes people even more willing to use it, and less willing to use the other, until one money dominates. And that's what we normally see, except in "bilingual" border zones.

And I just find it hard to imagine that California scrip could ever displace the US dollar as the preferred medium of exchange, even in California. The 3.5% interest might offset any risk of default or depreciation, but the sheer force of custom should outweigh both.

    Posted by on Wednesday, July 15, 2009 at 12:31 AM in Economics, Financial System, Taxes | Permalink  Comments (7)


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