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.

There won't be a drachma-induced recovery

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I catch both Lars Christensen and Brad DeLong making the claim that an introduction of the drachma will work wonders for Greece. Lars, for instance, says that:

However, Grexit will also remove the monetary straitjacket, which has had caused an enormous amount of economic hardship in Greece since 2008. The removal of this straitjacket will cause a significant easing of Greek monetary conditions, which in my view very likely will cause a sharp rise in nominal GDP in Greece in the coming years.

I hate to rain on the party, but even if a drachma is introduced and it collapses in value there won't necessarily be a drachma-induced recovery. Greece is currently in a straitjacket because its monetary standard -- the system for measuring and conveying economic value -- is a euro standard. Think of the euro as being akin to the metric system, a standard for measuring weights and distances, or dots per inch, a standard for measuring print resolution. An introduction of drachmas banknotes into circulation is simply not a sufficient condition to create the sort of effects that Brad and Lars want. To get their recovery, Brad and Lars need an all out monetary standard switch. But as long a Greek prices continue to be expressed in euros, drachmas will simply swim within the existing euro standard fish bowl. All sorts of mountains must be crossed before the penultimate switch of standards. This isn't "snap of the fingers" territory.

Drachma as another bitcoin

To better understand the destiny of a new drachma, its nice to have an example. Lucky for us, we can find one in the recent emergence of one of the world's newest currencies, bitcoin. Now Lars assumes that a collapse in the drachma will have all sorts of beneficial effects on the Greek economy. But does the world economy roar when bitcoin plunges? No, and here's why.

While merchants accept bitcoin as payment, they haven't accepted it as a standard. Sticker prices continue to be set in units like dollars, yen, pounds, etc., Bitcoin swims within the existing fiat standard. To accommodate those who want to pay in bitcoin, merchants will typically use the last-second bitcoin-to-dollar exchange rate (taken from foreign exchange markets) as the basis for the bitcoin price of their goods. Which means that as bitcoin plunges in value, the amount of bitcoin that retailers ask for their stuff is immediately adjusted upwards by a concomitant amount.

This is important because implicit in Brad and Lars's drachma recovery story is a certain degree of price stickiness. As the fundamental value of the standard unit plunges, sticker prices are slow to adjust upwards. Knowing that sticker prices will at some point start to catch up, people spend their currency now before it loses value, thus stoking an economic boom as merchants' inventories are drawn down. This sticky price effect is entirely lacking in bitcoin. Given a sickening collapse in bitcoin, those who own the stuff have no reason to spend it on before it loses value. After all, the amount of bitcoin that retailers require is adjusted every second, so prices in terms of bitcoin don't stay sticky. A bitcoin collapse therefore has no real effects on the world economy.

Applying this lesson to Greece, there's no guarantee that a decline in the drachma will boost the Greek economy. The appearance in circulation of drachma banknotes needn't mean that sticker prices will be set in drachmas. To determine how many drachmas Greeks must pay for an item, retailers may simply refer to its euro sticker prices and convert that amount into drachma by glancing at the last-second drachma-to-euro exchange rate. If so, then just as bitcoin prices are not sticky, neither will drachma prices. Without the requisite stickiness, a collapse in drachmas will not have the real effects that Lars and Brad want. Only a collapse in the euro, the monetary standard, will harness the sticky price effect the two implicitly invoke. But that effectively means Greece remains in its monetary straitjacket, despite having debuted a drachma.

Hurdles to switching

I've talked about the network externalities involved in switching standards before. Take an incumbent standard and a new standard. Even if the quality gap between the novel standard and the inferior incumbent is quite high, the costs of coordinating everyone onto the new standard may be too onerous for adoption to occur. Hysteresis, or lock in, is the result.

Switching to a drachma standard requires that a strong third party step in to overcome these network externalities. They need to punish, or credibly threaten to punish, those who refuse to comply. The Greek government, which has already demonstrated an inability to execute on basic tasks like tax collection, could very well lack the resources that are necessary to adequately perform the tasks of a third party.

Further militating against a drachma standard is its massive quality gap. A monetary standard should be as nuisance-free as possible. Merchants do not want to be adjusting their prices every day, and customers want to know that the blender they saw on a store's shelves on Tuesday will be worth the same amount when they go back on Wednesday. If sticker prices must be adjusted hourly, or even by the minute, the amount of time and mental space that people must allocate to calculation and measurement will displace other more meaningful activities. Like bitcoin, the drachma would probably be a one of the world's most volatile currencies; the incumbent euro one of its steadiest. So rather than improving on the euro standard, a drachma standard would represent a regression in quality.

Given that a strong government must spend a significant amount of resources getting its population to adopt a better standard, it's hard to imagine that a weak government will ever be able to foist an inferior standard on its population without facing a backlash. So contrary to Lars and Brad, there is no guarantee that issuing drachmas offers an ultimate salvation. In the end, there's probably very little difference between a Greece that introduces a drachma or one that doesn't, since either way the incumbent euro standard will likely stick around.


Note: This is very similar to my previous post on the topic. I've introduced the bitcoin analogy, which I think helps drive home the point, and also brought the quality gap to the forefront. 

Nick Rowe comments here.

Grexit: An Escape to More of the Same

The upcoming Greek election has renewed interest in the idea of Grexit. This option is often presented to the Greek public as desirable given that it would restore an independent monetary policy to the nation.

Beware, this is dangerous advice. The euro isn't a glove that you can take on and off, it's a Chinese finger trap; once in, it's tricky to get out. Even if Greece were to formally leave the euro, odds are that it would remain unofficially euroized, leaving it just as bereft of an independent monetary policy as before. The real trade off in a Grexit-or-not scenario is between formal membership in the euro with some say in monetary policy, no matter how small, or informal membership without any say whatsoever.

The optimists, say someone like Hans-Werner Sinn, advise the Greeks to leave the euro and adopt a new currency. The value of this new drachma would immediately collapse. As long as prices in Greece are somewhat sticky, Greek goods & services will become incredibly competitive on world markets, spawning an export/tourism-led recovery. By staying on the euro, however, Greece forfeits the exchange rate route to recovery. Instead, Greece's competitiveness can only be restored via a painful internal devaluation as wages and prices adjust downwards.

While the optimists tell a good story, they blithely assume a smooth switch from the euro to the drachma. Let's run through the many difficult steps involved in de-euroization on the way to an independent monetary policy. All euro bank deposits held at Greek banks must be forcibly converted into drachma deposits, and speedily enough that a bank run is preempted as Greeks desperately try to evade the corral by moving euros to Germany. At the same time, the Bank of Greece, the nation's central bank, needs to issue new drachma bank notes, the public being induced to use these drachmas as a medium of exchange.

Now even if Greece somehow pulls these two stunts off (I'm not convinced that it can), it still hasn't guaranteed itself an independent monetary policy. To do so, the drachma ₯ must also be adopted as the unit of account by the Greek public. Not only must financial markets like the Athens Stock Exchange begin to publish stock prices in drachmas, but supermarkets must be cajoled into expressing drachma sticker prices, employees and employers need to set labour contracts in terms of drachmas, and car dealership & real estate prices need to undergo drachma-fication.

Consider what happens if drachmas begin to ciruclate as a medium of exchange but the euro remains the Greek economy's preferred accounting unit. No matter how low the drachma exchange rate goes, there can be no drachma-induced improvement in competitiveness. After all, if olive oil producers accept payment in drachmas but continue to price their goods in euros, then a lower drachma will have no effect on Greek olive oil prices, the competitiveness of Greek oil vis-à-vis , say, Turkish oil, remaining unchanged. If a Greek computer programmer continues to price their services in euros, the number of drachmas required to hire him or her will have skyrocketed, but the programmer's euro price will have remained on par with a Finnish programmer's wage.

As long as a significant portion of Greek prices are expressed in euros, Greece's monetary policy will continue to be decided in Frankfurt, not Athens. Should the ECB decide to tighten by lowering interest rates, then Greek prices will endure a painful internal deflation, despite the fact that Greece itself has formally exited the Euro and floated a new drachma.

We know that a unit of account switch (not to mention successful introduction of drachma banknotes) will be hard for Greece to pull off by looking at dollarized countries in Latin America. To cope with high inflation in the 1960s and 70s, the Latin American public informally adopted the U.S. dollar as an alternative store of value, medium of exchange, and unit of account. Even after these nations' central banks had succeeded in stabilizing their own currencies, however, dollarization proved oddly persistent. This is referred to as hysteresis in the economics literature. Economists studying dollarization suggest that network externalities are the main reason for hysteresis. When a large number of people have adopted a certain standard there are significant costs involved in switching over to a competing standard. The presence of strong memories of past inflation may also explain dollar persistence.

In trying to de-euroize, Greece would find itself in the exact same shoes as Latin American countries trying to de-dollarize. Greeks have been using the euro for 15 years now to price goods; how likely are they to rapidly switch to drachmas, especially in light of the terrible performance of the drachma relative to other currencies through most of its history? Those few Latin American countries that have successfully overcome hysteresis required years, not weeks. If Greece leaves the euro now, it could take decades for it to gain its own monetary policy.

As an alternative illustration of the power of network externalities, consider the multi-year plans made by Slovakia (pdf, fig 2) prior to switching over to the euro, or the Czech Republic's timeline when it makes the changeover. Each step must be broadly communicated and telegraphed long ahead of time so as to ensure that all members of a nation are properly coordinated, thus ensuring the network effects engendered by the incumbent currency can be overcome. These euro changeover plans weren't adopted a few days before the switch, but often as much as a decade before.

In sum, I fail to understand how Greece can ever expect to enjoy the effects of a drachma-induced recovery if the odds of drachma-fication or so low, especially given the sudden nature of a Grexit. At least if it stays part of the euro, Greece has a say in how the ECB functions thanks to the Bank of Greece's position in the ECB Governing Council. And at least Greece's inflation rate and unemployment rate will be entered into the record as official data worth considering by ECB monetary policy makers. For just as the Federal Reserve doesn't consider Panamanian data when it sets monetary policy (Panama being a fully dollarized nation), neither would the ECB care about Greek data if Greece were to leave the euro, though still be euroized.

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Basil Halperin responds.