Many of us dream of inheriting a lot of money from a distant relative. In this chapter, I shall explore such a dream. One day you receive a letter in the mail. It is the will and testament of your old uncle Joe, the one that you always quarreled with at family reunions. He was an ardent old-fashioned capitalist and did not have any patience for your ideas about the digital society, especially not for digital payments. Uncle Joe wanted to have the money in his hands, and stacks of it in a large safe at home.
In Joe’s will he has bequeathed you an island in the Caribbean. It is a small island, but it has a hotel and some other facilities and, according to Joe, a lot of problems. Since he has never been able to fix these, he now offers you the opportunity to try.
At least you have a good excuse to take some time off and go to the Caribbean. The closest airport is on the main island; from there you take a small passenger boat to the island. To your astonishment, the captain calls you “boss.” Apparently the ferry is a part of your inheritance.
The island is beautiful but small and has a fairly large hotel. On the beach, not far from the hotel, are a small restaurant and a bar. In a meeting with the hotel manager you find out what their problems are. The currency on the island is US dollars and guests pay with cash while on the island. There is no Internet connection, so digital payments are not an option. On several occasions in recent years, criminals arrived by boat and robbed the bar and restaurant at the beach; on one occasion the hotel was also attacked. In addition, the hotel manager suspects that some of the employees may be skimming parts of the proceedings in the restaurant and bar. The manager has tried to overcome these problems by increasing security, but that is expensive.
While cash use could be limited at the bar and restaurant by letting hotel guests charge expenses to their room, this would not work for the high number of day visitors, who are tourists staying on the main island. They come with the ferry, stay the whole day at the beach, and return by night.
At first you think that this is an excellent place to test out your ideas about a digital economy, but the lack of a reliable Internet connection is a drawback. However, after exploring the problem you find that you do not really need the networks and the terminals. In fact, you can solve the problem with traditional means.
Your Own Currency
Together with a good designer and a printer, you develop a new currency—Island dollars. These are offered in the same denominations as the US dollars, but you skip the coins, using one dollar as the lowest denomination. Each note has a beautiful island scene. In addition, the notes have most of the security features of modern bank notes. To show that you are really modern, the paper is replaced by polymer plastics, which also enables guests to keep the notes in their bathing clothes. Your prerogative is to sign the notes. Since the notes are meant to be used at the island only, you are not afraid that customers will not trust the currency. This is a means of exchange only, not a way of storing value.
In your new system the ferry captain will change US dollars into Island dollars. This can be done either by offering US dollars in cash or by the use of a credit card. Most tourists use their credit cards. This offers no problem since the Internet connection is very good around the harbor on the main island. To keep things simple, you offer a one-to-one exchange rate.
The Island dollars can now be used on the island, replacing the US dollars. Since the Island dollars can be used on the island only, there is no incentive for robbers. Your control of the exchange process has also stopped skimming at the bar and restaurant. There is always a risk of forgery, but in practice you demand a receipt for transferring Island dollars back into US dollars. That is, the customer needs some sort of proof that this is a repeal of an earlier transaction.
Tourists can convert their Island dollars back into US dollars when they return home on the ferry. However, many keep a few notes as a souvenir. This is especially the case since the idea of Island dollars received a lot of media attention. The banknotes are something one can show people at home, and many want to have the complete series. Others don’t bother to convert back and some want to keep them until next time. In fact, the advantage of offering your own currency in a series of beautiful banknotes is so great that you drop every idea of moving to a digital system.
Since the national currency in the country where your island is situated is blighted by a high inflation rate, dollars are often used as an alternative, but there are not that many dollars around. After a while you find that taxi drivers, bartenders, and a few shops in the mainland are accepting Island dollars from tourists who have forgotten to change back. You are also inclined to offer a part of salaries in Island dollars. While employees do not have the possibility of changing these into dollars, they can use them on the island and, to a limited extent, also on the mainland.
An advantage of Island dollars is that they are pegged to the US dollar, while the local currency may depreciate. However, you understand that the authorities may allow a small influx of Island dollars, but will not tolerate any alternative currency. Therefore, you are careful to only sell Island dollars to tourists who are on the way to the island. If not, you would also be back to the early robberies.
Seigniorage
This is your bonus. You established the new currency to eliminate robberies and skimming. Now you see that part of your income is from seigniorage. Each note a tourist takes home as a souvenir is a direct income to you. You sold the notes for their denomination value and were paid in US dollars. Each note that is used on the mainland is an interest-free loan for you. Of course, the day may come when the notes are presented at the island, but until then the loan that you received when you sold the note is interest-free. Your only costs are for printing the notes, which is marginal compared to their denomination—even for the smallest bills.
Your task is to balance the number of notes that you put into circulation. This is no problem for the currency conversion that takes place on the boat, as the Island dollars sold here are “backed” by US dollars. However, you have to make sure that the part of the salaries that you pay in Island dollars is limited in order to maintain the value of the currency. The employees accept this arrangement and you end up paying salaries in dollars and using your own currency for bonuses.
In many ways your Island dollars are similar to other currencies that are used in closed environments. Today these are usually virtual, such as the initial coin offerings (ICOs) that have become so popular today (we shall return to this in Chapter 11). But you see the advantages of keeping the currency physical. Even if broadband arrives at your island, you will be reluctant to give up the advantages of printing your own money. However, you will have lost your argument with Uncle Joe. We may wonder why many central banks want to maintain a cash-based economy in a digital world. Part of the answer is here—cash offers seigniorage.
Exchange Rate
An option that you may want to contemplate is changing the one-to-one exchange rate. Since you already control prices on the island, this does not make much sense, but by offering more Island dollars for one US dollar, you can reduce the value of the outstanding Island dollars. Tourists who return with Island dollars would then find that they are not worth as much as before. However, it will probably be smarter to retain the one-to-one exchange rate as this will maintain the trust in your currency.
However, let us assume that your Island dollars are used more and more on the mainland. This allows you to pay a larger part of salaries in Island dollars. Then, a change in exchange rate can be a way of increasing or lowering salaries with regard to US dollars, without changing the actual amounts that are paid. This is primitive psychology, but it works. Lowering the value of the domestic currency with regard to more international currencies will, in practice, reduce the buying power of a salary, especially for traveling abroad and buying foreign products. However, a lower buying power is a complicated issue, while an explicit reduction in salary is not. While we as employees accept the former, we should go on strike if the latter occurs.
For the case of the argument, assume that, in a period where it is difficult to attract customers, you set the exchange rate at 1.1, giving 1.1 Island dollars for every dollar. If you maintain prices, this will offer visitors a 10 percent discount. But it does not cost you as much to offer this rebate. The part of the salaries and expenses that you pay in Island dollars will be the same as it was before. Only the part that you pay in US dollars will be affected. In the long run, your employees and the suppliers that you pay in Island dollars may find that the value of the currency with regard to US dollars is lower than before, and may ask for a salary increase and higher prices. Hopefully, the tourist market will have improved by that time.
Countries that have their own currency will see similar effects. We mentioned Norway earlier. When the price of oil fell in 2014, the Norwegian krone became cheaper with regard to dollars, euros, and British pounds. This was a clear stimulant for Norwegian export industries and the tourist trade. Suddenly, all exports became cheaper and tourists stopped complaining about high Norwegian prices. The drawback was that imported goods became more expensive, but this is also an advantage for national producers. Switzerland is an opposite example. There, the value of the Swiss franc increased with regard to the euro, causing problems for the export industries.
Inflation
One year, a hurricane destroys part of the island. While buildings are insured and rebuilt, the tourist traffic drops dramatically and you are out of funds for a while. In order to be able to pay your employees and other expenses, you start printing Island dollars. This may work if you are very careful not to print too many. Otherwise, employees, suppliers, and others will find that they will have to pay more when using Island dollars. Your employees will demand to be paid in US dollars or a higher amount if they are paid in Island dollars. Again, this may require you to print even more money.
However, you know everything about inflation, and know exactly what happened in Germany after the First World War and the situation in Zimbabwe recently. Therefore, you maintain the volume of Island dollars at levels that you can control. In this respect you are performing the same tasks as central banks, to maintain the confidence in the local currency. You print more Island dollars when you are in need of funds and then, when the situation improves, you start to buy the Island dollars back. Of course, this may cost you a lot of US dollars, but just the offer to change Island dollars into US dollars (at an exchange rate set by you) will increase the confidence in the currency.
Conclusion
The idea of this chapter was to simplify the complicated topics of seigniorage, exchange rate, and inflation by putting you in charge, and limiting the scope to a small island. However, as we have seen, the same effects are apparent in large countries. We shall return to these issues in later chapters.