Volume 2, Issue 1, November 2000

The Research Agenda: Payment Systems and Private Money, by Stephen Williamson

Introduction

Payments systems activity involves transactions using fiat objects (e.g., government-supplied currency), circulating physical objects (e.g. private bank notes), checks, debit cards, credit cards, and interbank electronic payments (through Fedwire and the CHIPS system in the U.S.). Payments systems and private money are worthy of study for several reasons. First, there has been rapid recent growth in alternatives to cash for transactions. Second, in the U.S. the restrictions prohibiting the issue of private money have been lifted. Third, given the recent advances in information technology, payments arrangements which were formerly not feasible now are. Fourth, with the advent of many efficient alternatives to outside money in making transactions, and a higher volume of payments carried out under the auspices of the central bank (for example, through Fedwire in the U.S.), there are important issues to address concerning how monetary policy should be conducted and how the payments system should be regulated. Some key questions we might like to address are the following:

• What are the efficiency properties of a private money system?
• Are there useful lessons from historical experience with private money systems (U.S. pre-Civil War, Canada pre-1935)?
• How should payments systems be designed with respect to clearing and settlement arrangements? What are the potential risk-sharing and incentive issues?
• Does monetary policy work differently in a private money system? Do we need a central bank?

A Model of Private Money and Settlement

In the model, there is random matching where "local" agents are met with higher frequency than "non-locals," and there are simple banking arrangements which permit the issue of circulating private monies (bank notes) and clearing arrangements across locations. In the paper, Temzelides and Williamson (2000b), we consider two cases. First, we suppose that there is full information, in which case the matching friction will determine discounts on non-local bank notes. Second, we consider an environment with private information concerning the assets backing a particular bank note, in which case matching frictions and informational frictions will determine the discounts on bank notes.

When there is no clearing of bank notes and full information, non-local notes either do not circulate locally, or they circulate at a discount. The discount arises because the value of holding a local note is higher than the value of holding a non-local note. The difference in values is due to the fact that non-local notes cannot be redeemed locally. Given that non-local notes are discounted, the redemption value of a local note may be sufficiently high that a local agent is not willing to exchange the note with a non-local agent at the going price.

When there is full information and a clearing arrangement for bank notes among banks, then essentially all bank notes are universally redeemable. This implies that non-local bank notes always circulate locally, and they will not trade at a discount. Welfare is higher, and there is more production and exchange. Thus, it is clear that note-clearing arrangements are a good thing when there is full information.

Now, private information about the quality of non-local bank notes changes the story considerably. Here, there are potentially good bank notes and bad ones, and there may be equilibria where only good notes circulate, where only bad ones do, or where both good and bad bank notes circulate. If the private information friction is not too severe, then we will obtain the same results as with full information, in that clearing arrangements are socially beneficial. However, with a sufficient private information friction, welfare-dominated equilibria may exist, i.e. there can be a coordination failure. Also, the clearing arrangement may increase the quantity of low-quality money in circulation relative to high-quality money, and clearing may not eliminate discounts.

These results have important implications for our interpretation of historical monetary regimes where private money was issued. For example, in the pre-Civil War United States, clearing arrangements for bank notes were unusual. Essentially the only successful clearing arrangement was the Suffolk system in New England. On the other hand, in Canada before 1935, all chartered banks issued notes in a system which appeared to have worked efficiently, with a nationwide clearing arrangement and all notes trading at par. The difference between the U.S. system and the Canadian one can be explained by the fact that private information frictions were much more severe in the U.S. than in Canada. The U.S. had many unit banks, while Canada had only a few banks with nationwide branching.

Payments and Settlement in a Deterministic Environment

In the model, there is a countable infinity of locations, with a producer/shopper household at each location. Each period, the producer stays at home and produces while the shopper goes to the next location to obtain goods. There is essentially a double-coincidence-of-wants problem. A given household does not produce every third period, and households are arranged in space such that each household will follow a three-cycle, where they consume in one period but do not produce, produce and consume in the next period, produce and do not consume in the following period, etc. In each period, two thirds of the population will be consuming and two thirds will produce. There are two key elements in the model: Barter is not possible, and privately-issued IOUs will not circulate.

The approach in this paper is to consider successively sophisticated payments arrangements, and to determine the general equilibrium implications of these arrangements. The first arrangement is one where there is no using fiat currency. Effectively, there are endogenous cash-in-advance constraints, whereby households acquire cash when they produce and spend it two periods hence. In an equilibrium with a fixed fiat money stock there will be price dispersion, and a competitive equilibrium will be suboptimal, for the usual reasons. That is, households economize too much on money balances and consumption will be too low.

Now, a second arrangement is one with a centralized clearinghouse. Here, households carry out exchange using IOUs, and these IOUs are settled on net through the clearinghouse at the end of each period. Settlement takes place using outside money. It is important to note that it is important that there be net settlement; with gross settlement the equilibrium allocation is identical to what it was with the previous arrangement. Here, there may be multiple equilibria, which can be ranked in terms of welfare, but each of these equilibria dominates the first arrangement in welfare terms. Thus, a centralized payments system improves welfare, and the velocity of money also increases. The equilibrium allocation is not Pareto optimal, however.

A Pareto optimal allocation can be achieved under a third arrangement, which we can interpret as banking with interbank lending. Here, there is not only within-period credit through the clearinghouse, but borrowing and lending across periods. In this case, in spite of the fact that goods cannot be transported across locations, an efficient allocation is achieved without outside money. Imposing settlement in this environment, where there is no risk, implies that the allocation will be inefficient.

A Random Matching Model with Private Information

• "Credit" is key to making incentives work in the payments system. Participants who receive a bad shock (can't produce) can generally still consume in the present, but their future liabilities to the system are higher than they would be otherwise.
• It is important for incentive reasons that credit and risk-sharing be internalized in the payments system.
• There are endogenous credit constraints.
• Idiosyncratic shocks are propagated through the chain of transactions.

Conclusions

References:

EconomicDynamics Interviews Stephen Parente on the barriers to development

EconomicDynamics: In your work with Ed Prescott, you show how barriers to the implementations of new technologies and production processes may explain the vast disparities of income levels across the world, disparities that standard growth theory cannot explain. Do you think your theory could also explain differences within OECD countries, for example why the United States have taken over the leader role from the United Kingdom, why France is not as rich as the United States, or why Ireland as recently gone through a growth spurt?

Stephen Parente: Without doubt! There is a lot of evidence of firms in Europe being far more constrained in their use of technology compared to firms in the United States. Ford Europe is not able to use just-in-time production processes, but Ford U.S.A. is. Martin Bailey working with the McKinsey Global Institute documents the greater regulations faced by European firms regarding the choice of technology and work practices in a number of industries such as airlines, telecommunications, retailing, and banking. So I think there is a lot of evidence that supports our theory for the current income differences within the OECD.

You brought up Ireland. Our theory predicts that a country that currently applies a small amount of the stock of available knowledge in the world to the production of goods and services can realize large increases in output if it reduces the constraints imposed on firms' technology and work practice choices. In 1985, Ireland's per capita income was roughly 45 percent of the U.S. level, and so there was a considerable amount of knowledge out there that Ireland failed to exploit. There were also a considerable amount of constrains on firms. Starting in 1986, these constraints were lowered as industries were deregulated, state enterprises privatized, and trade barriers lowered. Following the reduction of these barriers to technology adoption, Ireland underwent a growth spurt, just as our theory predicts.

ED: There is a large body of literature using models of leaders and imitators in innovations to explain North-South differences in output. Is your theory contradicting this?

SP: At a very general level, I see no contradiction between our theory and these North-South models. We purposely abstract from innovation (the North); in our work, the stock of ideas evolves exogenously over time. We are interested in understanding why some countries are so poor relative to the United States today, when there is a lot of proven, available technology they could adopt. We are not trying to account for why the United States is so much richer today than two hundred years ago. For the question we are interested, abstracting from innovation is reasonable. If we had some other question in mind, say one that involves the pattern of trade between rich and poor countries, we might use a North-South model.

At a very specific level, our theory does contradict those North-South models that predict the growth rate of the South is lower under free trade. Our theory is one of relative income levels, not relative growth rates. In our theory, international trade has a positive effect on an economy's relative income level, since an economy that is open has fewer barriers to technology adoption, ceteribus paribus.

ED: And does your theory contradict the arguments about protecting of infant industries in developing countries?

SP: Most definitely! Ed and I examined a number of industry studies, some contemporaneous and others covering the industrial revolution, in an attempt to understand why regulations were in place that prevented firms from using better technologies and work practices. These studies led us to the hypothesis that many of these constraints were erected by the state to protect the interests of specialized factor suppliers vested in current production processes. We put forth a model whereby groups with monopoly rights over the supply of factor inputs prevent the adoption of superior technology, and we showed that the effect of these rights on an economy's standard of living is large.

The policy implications of our theory are pretty strong. Governments should not give groups the incentive to organize and acquire monopoly rights. Temporary protection of an industry, whether it be an infant or a mature one, is far too likely to lead to permanent protection, as it provides factor suppliers the incentive to lobby the government to grant them monopoly rights.

ED: Your argument relies much on the existence of industry lobbies. Why would they arise more often and more powerfully in developing economies?

SP: That's a good question. Prescott and I showed how the existence of industry insider groups with monopoly rights over factor inputs to current production processes lead to the inefficient use of inferior technology, but we offered no theory of why societies differ in the prevalence of these groups. Understanding this is the next important question in this research agenda. It is a complicated issue, and I hope that our book will stimulate work in this area.

There probably is not a single reason for these differences. Clearly, political institutions matter. A number of researches, including Prescott and I, argue that market-preserving federalism, that is a political system with a hierarchy of governments with sufficient authority at the lower levels, is more conducive to economic development. Initial conditions might matter as well. I have a paper that emphasizes the concentration of land holdings two hundred years ago. The reason why this is important for the formation of industry insider groups is that landowners want to restrict the flow of workers out of agriculture so as to maintain a high rental price of land. If landowners have political power, which is more likely when land holdings are concentrated, they will have the state erect barriers to industry start-ups, the consequence of which is that few industries form. With fewer industries, workers in each industry have a greater incentive to organize and obtain monopoly rights because the demand for a particular industry's good is decreasing in the number of industrial goods. I have another paper, still in progress that examines the development experiences of Russia and China since market reforms. There is a large amount of evidence that suggests that monopoly rights are far more prevalent today in Russia compared to China. My own view on this is that these monopoly rights are something that carried over from central planning, which gave workers in industry rights to jobs. The challenge here is to understand why the state in Russia chose to preserve these rights whereas the state in China did not.

ED: You have applied your work to the formal and industrial sector of developing economies. But what about the the informal and/or agricultural sectors? In particular, the fact that the difference between industrial and agricultural productivity is much larger than in developed economies seems to contradict your theory.

SP: I don't think there is a contradiction here. The technology adoption model with Prescott has only one sector, so it has really nothing to say on these sectoral differences. However, given the success of this theory in accounting for international income differences and development miracles, one would obviously like to know if the model appropriately modified can account for the structural differences observed across countries, and over time within a given country. In a paper with Doug Gollin and Richard Rogerson, I took up this question. Since the Parente and Prescott technology adoption model aggregates up to the neoclassical growth model augmented with intangible capital and with cross-country differences in Total Factor Productivity due to differences in the size of the barriers to technology adoption, we analyzed an agricultural extension of the neoclassical growth model. We found that this model fails to account for key sectoral differences observed across countries, including the relative productivity difference you mentioned. This failure led us to consider the role of home production, something that Richard Rogerson, Randy Wright and I had explored within the one-sector growth model in an earlier paper. We found that the introduction of home production goes along way towards accounting for these sectoral differences. It doesn't go all the way so there is surely more work to be done here. But I am fairly confident that with a few additional modifications, the growth model can account for the structural differences observed across countries and across time within a given country.

References

The Review of Economic Dynamics: A New Editorial Team

In almost every respect, the journal will continue to operate as it has over the past few years. The difference is that submissions should now be sent to the following address:

Review of Economic Dynamics
Academic Press Editorial Office
525 "B" Street, Suite 1900
San Diego, CA 92101
E-mail: red@acad.com

Electronic submissions, are strongly encouraged. Please use truly portable PDF files (Scientific Word is especially problematic in this respect). The RED site has various tips for generating PDF files. Electronic submissions and inquiries about the status of papers in the review process should be sent to the review email address.

I also encourage you to renew your subscription to the Review through the Society membership. Many great papers are already scheduled for future issues and listed on the review web site.

Gary Hansen
Coordinating Editor
Review of Economic Dynamics

Society for Economic Dynamics: A Letter from the President

This is my first letter to you as President of the Society for Economic Dynamics. My first order of business is to thank Dale Mortensen for the superb job he did as President. During his tenure we were finally able to launch our own successful journal, the Review of Economic Dynamics, membership in the Society grew steadily, and the annual meetings improved in quality and the attractiveness of the locations.

The 2000 meeting of the SED was held in San Jose, Costa Rica. Alberto Trejos was the organizer and Per Krusell was the program chairman. Alberto and the host institution INCAE did a brilliant job. The hotel and the local arrangements were terrific and we thank Alberto for inviting us all to his beautiful country. The program organized by Per and Alberto was excellent, one of the most stimulating yet.

The 2001 meetings are going to be held in Stockholm on June 28 - July 1. The organizers are David Domeij, Martin Floden, Jonathan Heathcote, Paul Klein and Kjetil Storesletten. Ellen McGrattan is the Program Chair. Stockholm is one of the loveliest cities in Europe and June is the ideal time to visit. You won't want to miss it! The call for papers is below.

Another important bit of news is that Gary Hansen has taken over as Coordinating Editor of the Review of Economic Dynamics. I will continue as an editor, but Gary is the person in charge of RED. There are some new procedures for submitting manuscripts, and these can be found on the RED web site. If you have checked the Society/Review web pages at http://www.EconomicDynamics.org/ you will notice that they have been completely redesigned and re-organized. This is the contribution of our very talented designer and consultant Beata Skrzypacz, who worked with me to produce this new look.

Please join again in support of the advancement of Economic Dynamics. Information about how to pay your 2001 dues and your subscription to RED is available here.

I hope to see you all in Stockholm.

Sincerely,

Thomas F. Cooley, President
Society for Economic Dynamics

Society for Economic Dynamics: 2001 Meetings in Stockholm

The Society for Economic Dynamics solicits applications for papers in all areas of dynamic economics to be presented at this conference. Members and nonmembers are invited to participate. The deadline for submissions is February 1, 2001. Please use our standardized form available at http://www.minneapolisfed.org/ to submit an abstract, and include the name, affiliation, address and e-mail address of the author interested in presenting the paper. This form is required for all applicants. Submission of the paper is optional and should be done by mailing to:

SED Conference
c/o Carol Blunt
Research Department
Federal Reserve Bank of Minneapolis
90 Hennepin Avenue
Minneapolis, MN 55480-0291, USA

Fax transmissions will not be considered. For information concerning local arrangements, see the conference Web page at http://www.hhs.se/sed2001/.

CFP: Productivity Growth: A New Era?

Selected papers will be published in a planned special issue of the Review of Economic Dynamics (RED) edited by Boyan Jovanovic, and authors will receive a $5000 honorarium. Papers received will be considered submissions to both the conference and the special issue. They will be refereed and must meet the high academic standards of the RED.

Further details are available at the Conference page.

Review: Ljungqvist & Sargent's Recursive Macroeconomic Theory

The book covers the usual subjects in dynamic macroeconomics plus several problems that have emerged in the past decade, like incomplete market models or dynamic contract design, often by reviewing some important papers. The models are generally simplified in order to facilitate a compact (and sometimes necessarily terse) presentation. This should prove very useful for students as it gives a quick yet rigorous overview of the field. Also, for those who are intimidated by the original papers, the book offers sufficient background and intuition to make the reading of the original paper more fruitful. The authors always encourage to read the original works, refer to various extensions and give sometimes detailed indications on how to solve the complex problems.

Established researchers should find this book a good read, too. First, it helps to find a better understanding of the fields one does not follow as intensively as one's own. Second, it is a great source of inspiration as the book shows how the various theories are intertwined through a common way to approach problems. This reaches beyond the methodology: Microeconomic theory is now firmly integrated in macroeconomics, and dynamic general equilibrium is now an essential ingredient to any question in the field. This book, along with Stokey and Lucas (1989) and Judd (1998), constitute must-reads for any serious macroeconomist.

References:

EconomicDymamics Links: HoPEc: A Powerful Author Registration Tool

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