Can currency be efficiently provided by competitive markets? A traditional laissez-faire view as, for example, has been expressed by Hayek based on ‘Bertrand competition’ argues that competition drives the price of money to its marginal cost. Therefore, if the marginal cost of producing currency is zero, competition drives nominal interest rates to zero and private provision of currency is efficient.
We show that there is a major flaw in this ‘Bertrand competition’ argument, when applied to fiat money: if suppliers of currency cannot commit to their future actions, then competition loses its bite. The reason for this is that, while currencies compete on their promised rates of return, once agents hold a particular currency there may be an incentive for the issuer to inflate the price of goods in terms of this currency, reducing, in this way, its outstanding liabilities. Current currency portfolios have been pre-specified, while there is full flexibility to choose tomorrow’s portfolios. Currencies compete for tomorrow’s portfolios. When choices are sequential, currencies are no longer perfect substitutes; in a sense, they are not substitutes at all. Does “Bertrand competition” still drive promised rates of return to the efficient level? Not if those promises are not credible, if issuers of currencies are not trusted.
Trust may solve the time inconsistency problem in the supply of money, since concern for the future circulation of money may deter currency issuers from creating inflation. Nevertheless, reputation concerns exist as long as currency suppliers expect sufficiently high future profits to refrain from capturing the short-term gains. Does competition, by driving down profits, enhance efficiency but also destroy the disciplinary properties of the ‘trust mechanism’? We show that there is no such trade-off. Without commitment, competition plays no role in sustaining efficient outcomes.
We analyze a model of currency competition where goods are supplied in perfectly competitive markets, and consumers can buy these goods by using any of a continuum of differentiated currencies. Each currency is supplied by a profit maximizing firm. Even though the currencies are imperfect substitutes, by making the degree of substitutability arbitrarily large we can characterize the limiting economy of perfect substitution among currencies. With commitment, currency competition achieves the efficient (Friedman rule) monetary equilibrium, as Hayek envisioned. It does this in a remarkable way: because the cost of providing money is very low, even a very large mark up is associated with a very low price charged for the use of money. In the limit, as the cost of producing money converges to zero, the equilibrium is efficient whatever the elasticity of substitution across competing currencies is.
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Money is an Experience Good: Competition and Trust in the Private Provision of Money
