When money ceases to be an IOU

Despite its odd denomination, the above is a genuine banknote. Ne Win, Burma's military dictator from 1962 to 1988 and the man pictured in the note, was convinced that his lucky number was nine. So he had notes issued in multiples of nine, including the forty-five and ninety kyat notes (which also each add up to nine 4+5=9, 0+9=9). But I'll get to this story later.

This is a continuation of a post I wrote earlier describing how central banknotes aren't mere bits of intrinsically useless paper. The standard view among economists is that banknotes are bubble assets. Because they are intrinsically valueless, the fact that paper notes earn a positive value can only be explained by the fact that the market expects them to have value in the future, much in the way that a ponzi scheme or chain letter is perpetuated. This view goes back to Paul Samuelson (pdf), who described how a "grand consensus" might be arrived at whereby society could contrive to have "oblongs of paper" pass at a positive value from generation to generation. The creation of such a bubble would allow for an efficient allocation of resources. As long as each generation could fool itself into thinking that the next would accept these worthless bits of paper, the scheme could continue indefinitely.

However, if real life banknotes were in fact pure Samuelsonian bubbles, then no one would bother participating in central bank redenominations. If a central bank were to announce a 10:1 redenomination, why take in your $1000 note to be redeemed for a $100 note? After all, your existing $1000 note will buy you more stuff than a prospective $100. That we do take part in redenominations is due to the fact that the central bank is threatening to do something to its legacy note issue—it is threatening to cease honouring them as its liability, or IOU, an act sufficient to drive that notes' value to zero. This quality of a banknote as a liability or IOU means that a note is not a Samuelsonian asset.

That central banks offer legacy note conversion at all is another sign of the IOU-nature of bank notes. It explains why we don't see revolutions during redenominations and demonetizations. Those suddenly left holding old paper would riot on the streets upon the sudden displacement of their notes by a new currency. We don't see riots due to redenominations or demonetizations because banknotes aren't Samuelsonian—central bank paper carries an implicit IOU whereby the central banker will typically repurchase the legacy notes that they've issued at a fixed rate rather than letting those notes flap around in the wind.

For instance, when the European central banks ceased their issuance of domestic banknotes they didn't strand them. Rather, they offered a window in which individuals would convert legacy notes into euros. This window varied in size by country. In the case of the Banca d'Italia, for instance, lira could be converted into euros until February 2012, a ten-year window. De Nederlandsche Bank continues to offer to convert old Dutch guilders into euro, and will do so until 2032, while the Bundesbank, Banca D'Espana, and the National Bank of Belgium guarantee to perpetually redeem deutsche marks, pesetas, and francs respectively with euros. Here is a full list:

As a convertibility window narrows toward zero, a central bank's paper loses its IOU nature and approaches the ideal of Samuelsonian money. For instance, when Saddam Hussein decided to cancel the old "Swiss Dinar", he did so by offering note holders a tiny six-day exchange period, a mere crack compared to the massive windows left open by European central banks. Saddam narrowed this aperture even further by deviously shutting down the Iraqi border during the exchange period, preventing the large population of merchants in Jordan and elsewhere from crossing over into Iraq to swap their Swiss dinars for new dinars.

The Burmese kyat, pictured above, is another example of a note that approaches bubble money. In September 1987, Ne Win demonetized the largest denominations of kyat: the twenty-five, thirty-five, and seventy-five kyat notes, issuing in their place the aforementioned forty-five and ninety notes.

As dictator, Ne Win didn't seem to see any problem in burdening the Burmese population with these awkwardly-denominated notes. The legacy notes being replaced that September were already in odd denominations (25, 35, and 75), the hallmark of a redenomination in 1985 that replaced more conventional denominations of twenty, fifty, and one-hundred kyat notes. It seems that the seventy-five note was issued to mark Ne Win's 75th birthday, and the thirty-five replaced the fifty because it was, according to Ne Win's numerologist, the luckier of the two numbers.

To make matters worse, the legacy issue of kyat notes could not be converted into new forty-five and ninety kyat notes, effectively removing the IOU embedded in kyat notes and rendering a large part of the nation's stock of notes worthless. Here is an account of a Burmese individual at the time:

Then on September 5, without alerting even his cabinet, Ne Win passed a sealed envelope to the Information Minister. Inside were instructions to broadcast the enclosed announcement at 11:00 a.m.

I listened to the 1:00 p.m. news on the car radio outside the art exhibition. When the announcer said government employees would receive 450 kyats as emergency funding, I knew our kyat notes in denominations of 75, 35, and 25 had all been instantly devalued. At home that afternoon my family members gathered to pool our currency. Ko Gyi had received cash payment from a client on Thursday, all in 75-kyat notes, and I had not yet opened my two most recent pay envelopes, one containing my salary, the other my bonus, also dispensed in 75-kyat notes. My brother and I together had only 25 kyats in 10- and 5-kyat notes. Our other cash was useless.

Still hoping from compensation after the demonetization announcement in 1987, some people hoped to make a quick profit. Expecting a grace period, they started collecting 75 kyats by paying 50, then collecting 30 kyats for the same amount, then 20, until finally, when no follow up news came from the government, they realized they had lost everything. Two thirds of the total currency in circulation became useless paper, and ordinary citizens lost their entire savings. Even the beggars suffered. - No Time for Dreams: Living in Burma Under Military Rule, by San San Tin

Ne Win had contrived to create Sameulsonian money. Rather than greeting Ne Win's contrivance with open arms, popular uprisings began in 1988, eventually leading to Ne Win's resignation. Aung San Suu Kyi would emerge as an opposition leader in these uprisings.

North Korean won are a more recent example of notes devolving into mere "oblongs" of paper. In November 2009, the North Korean government announced a 100:1 redenomination. Nothing unusual here, except that North Koreans were given a seven-day window to convert existing Korean won into new notes. This window, already narrow, was further constricted by a ₩100,000 limit on the amount that could be converted. Given the then prevailing black market exchange rate of ₩3,000 to the dollar, the amount of legacy won that could be converted into new won was limited to around $30. Tragically, any North Korean who had won-denominated savings larger than that amount lost much of what they had.

Public anger forced the government to increase the limit to ₩150,000, but widespread uprisings as in the case of Burma never followed. The perception that future surprise redenominations might rob existing note holders has not promoted the stability of the won. Indeed, the inflation rate in North Korea is one of the highest in the world. Circulation of US dollars and Chinese yuan increased dramatically as a result of the redenomination, since no one fooled once wants to be fooled twice. (A shift to the use of the dollar also occurred in Burma as a result of Ne Win`s 1987 redenomination, as this interesting article points out.)

Though Samuelsonian money is an elegant idea, the reality is ugly. Only the most sinister dictators have tried to perpetuate it. The contrived currencies that have had Samuelsonian characteristics—Burmese kyat, North Korean won, and Saddam dinars—have been among the world's worst currencies. Widely accepted and long-lasting bank notes like dollars and euros are not bubble-like. Their issuers threat these as IOUs, much like a stock or a bond. If they fail to take these commitments seriously, say in the case of redenominations, their currencies will quickly be out-competed by currencies issued by banks that do.