Sovereign Currency

Discussion

What Is Sovereign Currency?

The Modern Monetary Theory point of view:

"In this blog we examine the concept of a sovereign currency.

Domestic Currency. We first introduce the concept of the money of account—the Australian dollar, the US dollar, the Japanese Yen, the British Pound, and the European Euro are all examples of a money of account. The first four of these monies of account are each associated with a single nation. By contrast, the Euro is a money of account adopted by a number of countries that have joined the European Monetary Union. Throughout history, the usual situation has been “one nation, one currency”, although there have been a number of exceptions to this rule, including the modern Euro. Most of the discussion that follows will be focused on the more common case in which a nation adopts its own money of account, and in which the government issues a currency denominated in that unit of account. When we address the exceptional cases, such as the European Monetary Union, we will carefully identify the differences that arise when a currency is divorced from the nation.

Note that most developing nations adopt their own domestic currency. However, some of these peg their currencies, hence, surrender a degree of domestic policy space, as will be discussed below. However, since they do issue their own currencies, the analysis here of the money of account does apply to them.

Note also, following the discussion at the end of Blog 4, we recognize that individual households and firms (and even governments) can use foreign currencies even within their domestic economy. For example, within Kazakhstan (and many other developing nations) some transactions can occur in US Dollars, while others take the form of Tenge. And individuals can accumulate net wealth denominated in Dollars or in Tenge. However, the accounting principles that apply to a money of account will still apply (separately) to each of these currencies.

One nation, one currency. The overwhelmingly dominant practice is for a nation to adopt its own unique money of account—the US Dollar (US$) in America; the Australian Dollar (A$) in Australia; the Kazakhstan Tenge. The government of the nation issues a currency (usually consisting of metal coins and paper notes of various denominations) denominated in its money of account. Spending by the government as well as tax liabilities, fees, and fines owed to the government are denominated in the same money of account. The court system assesses damages in civil cases using the same money of account.

For example, wages are counted in the nation’s money of account and in the event that an employer fails to pay wages due, the courts will enforce the labor contract and assess monetary damages on the employer to be paid to the employee.

A government might also use a foreign currency for some of its purchases, and might accept a foreign currency in payment. It might also borrow—issuing IOUs—in a foreign currency. Usually, this is done when the government is making purchases of imports or when it is trying to accumulate foreign currency reserves (for example when it pegs its currency). While important, this does not change the accounting of the domestic currency. That is, if the Kazakhstan government spends more Tenge than it collects in Tenge taxes, it runs a budget deficit in Tenge that exactly equals the nongovernment sector’s accumulation of Tenge through its budget surplus (assuming a balanced foreign sector it will be the domestic private sector that accumulates the Tenge).

We will argue that the government has much more leeway (called “domestic policy space”) when it spends and taxes in its own currency than when it spends or taxes in a foreign currency. For the Kazakhstan government to run a budget deficit in US Dollars, it would have to get hold of the extra Dollars by borrowing them. This is more difficult than simply spending by issuing Tenge to a domestic private sector that wants to accumulate some net saving in Tenge.

It is also important to note that in many nations there are private contracts that are written in foreign monies of account. For example, in some Latin American countries as well as some other developing nations around the world it is common to write some kinds of contracts in terms of the US Dollar. It is also common in many nations to use US currency in payment in private transactions. According to some estimates, the total value of US currency circulating outside America exceeds the value of US currency used at home. Thus, one or more foreign monies of account as well as foreign currencies might be used in addition to the domestic money of account and the domestic currency denominated in that unit.

Sometimes this is explicitly recognized by, and permitted by, the authorities while other times it is part of the underground economy that tries to avoid detection by using foreign currency. It might be surprising to learn that in the United States foreign currencies circulated alongside the US dollar well into the 19th century; indeed, the US Treasury even accepted payment of taxes in foreign currency until the middle of the 19th century.

However, such practices are now extremely rare in the developed nations that issue their own currencies (with the exception of the Euro nations—each of which uses the Euro that is effectively a “foreign” currency from the perspective of the individual nation). Still it is not uncommon in developing nations for foreign currencies to circulate alongside domestic currency, and sometimes their governments willingly accept foreign currencies. In some cases, sellers even prefer foreign currencies over domestic currencies.

This has implications for policy, as discussed later.

Sovereignty and the currency. The national currency is often referred to as a “sovereign currency”, that is, the currency issued by the sovereign government. The sovereign government retains for itself a variety of powers that are not given to private individuals or institutions. Here, we are only concerned with those powers associated with money.

The sovereign government, alone, has the power to determine which money of account it will recognize for official accounts (as discussed, it might choose to accept a foreign currency for some payments—but that is the sovereign’s prerogative). Further, modern sovereign governments, alone, are invested with the power to issue the currency denominated in its money of account.

If any entity other than the government tried to issue domestic currency (unless explicitly permitted to do so by government) it would be prosecuted as a counterfeiter, with severe penalties resulting.

Further, the sovereign government imposes tax liabilities (as well as fines and fees) in its money of account, and decides how these liabilities can be paid—that is, it decides what it will accept in payment so that taxpayers can fulfil their obligations.

Finally, the sovereign government also decides how it will make its own payments—what it will deliver to purchase goods or services, or to meet its own obligations (such as payments it must make to retirees). Most modern sovereign governments make payments in their own currency, and require tax payments in the same currency." (http://neweconomicperspectives.blogspot.com/2011/07/mmp-blog-6-what-is-sovereign-currency.html)

What (Should) Back(s) Up Sovereign Currency?

The Modern Monetary Theory point of view:

"What “backs up” domestic currency? There is, and historically has been, some confusion surrounding sovereign currency. For example, many policy makers and economists have had trouble understanding why the private sector would accept currency issued by government as it makes purchases.

Some have argued that it is necessary to “back up” a currency with a precious metal in order to ensure acceptance in payment. Historically, governments have sometimes maintained a reserve of gold or silver (or both) against domestic currency. It was thought that if the population could always return currency to the government to obtain precious metal instead, then currency would be accepted because it would be thought to be “as good as gold”. Sometimes the currency, itself, would contain precious metal—as in the case of gold coins. In the US, the Treasury did maintain gold reserves, in an amount equal to 25% of the value of the issued currency, through the 1960s (interestingly, American citizens were not allowed to trade currency for gold; only foreign holders of US currency could do so).

However, the US and most nations have long since abandoned this practice. And even with no gold backing, the US currency is still in high demand all over the world, so the view that currency needs precious metal backing is erroneous. We have moved on to what is called “fiat currency”—one that is not backed by reserves of precious metals. While some countries do explicitly back their currencies with reserves of a foreign currency (for example, a currency board arrangement in which the domestic currency is converted on demand at a specified exchange rate for US Dollars or some other currency), most governments issue a currency that is not “backed by” foreign currencies. In any case, we need to explain why a currency like the US Dollar can circulate without such “backing”.

Legal tender laws. One explanation that has been offered to explain acceptability of government “fiat” currency (that has no explicit promise to convert to gold or foreign currency) is legal tender laws. Historically, sovereign governments have enacted legislation requiring their currencies to be accepted in domestic payments. Indeed, paper currency issued in the US proclaims “this note is legal tender for all debts, public and private”; Canadian notes say “this note is legal tender”; and Australian paper currency reads “This Australian note is legal tender throughout Australia and its territories.” By contrast, the paper currency of the UK simply says “I promise to pay the bearer on demand the sum of five pounds” (in the case of the five pound note). And the Euro paper currency makes no promises and has no legal tender laws requiring its use.

Further, throughout history there are many examples of governments that passed legal tender laws, but still could not create a demand for their currencies—which were not accepted in private payments, and sometimes even rejected in payment to government. (In some cases, the penalty for refusing to accept a king’s coin included the burning of a red hot coin into the forehead of the recalcitrant—indicating that without such extraordinary compulsion, the population refused to accept the sovereign’s currency.) Hence, there are currencies that readily circulate without any legal tender laws (such as the Euro) as well as currencies that were shunned even with legal tender laws. Further, as we know, the US Dollar circulates in a large number of countries in which it is not legal tender (and even in countries where its use is discouraged and perhaps even outlawed by the authorities). We conclude that legal tender laws, alone, cannot explain this.

If “modern money” is mostly not backed by foreign currency, and if it is accepted even without legal tender laws mandating its use, why is it accepted? It seems to be quite a puzzle. The typical answer provided in textbooks is that you will accept your national currency because you know others will accept it. In other words, it is accepted because it is accepted. The typical explanation thus relies on an “infinite regress”: John accepts it because he thinks Mary will accept it, and she accepts it because she thinks Walmart will probably take it. What a thin reed on which to hang monetary theory!" (http://neweconomicperspectives.blogspot.com/2011/07/mmp-blog-7-what-backs-up-currency-and.html)

...