BANKNOTES AND ECONOMIC GROWTHWilliam D. LastrapesProfessor of EconomicsTerry College of BusinessUniversity of GeorgiaAthens, GA [email protected] SelginProfessor of EconomicsTerry College of BusinessUniversity of GeorgiaAthens, GA [email protected] 29, 2007ABSTRACTModern paper currency contributes little to productive investment. This shortcoming is notinherent to paper money. It stems from the fact that currency today is monopolisticallysupplied by public monetary authorities that are poor intermediaries. Commercial bank-notes, in contrast, support efficient intermediation. The holding of private banknotes pro-motes economic growth just as the holding of private bank deposits does. We demonstratethis advantage in an endogenous growth model, and use the model to simulate, for a sam-ple of developing countries, steady-state growth rate gains from various degrees of banknotederegulation. The simulated gains are large compared to those from conventional forms offinancial liberalization.Keywords: Endogenous growth, economic development, financial repression, fiat money,currency.JEL Codes: E5, G2, O1, O4Historically local banks of issue have played an important role not only inhabituating the populace to the use of financial instruments and institutions, butalso in the development of small-scale local industry and agriculture. Conceivablythis can be done by means of deposit money, but in relatively primitive conditions... where laborers and entrepreneurs alike have but little sophistication in the useof modern financial instruments, there is much to be said for local banks of issue(Rondo Cameron 1967, p. 319).IntroductionPaper money forms a far from trivial part of the world’s money stock. As of 2004, in-ternational balances of paper money, excluding sums held by banks, were worth $3.2 tril-lion. A disproportionate share of this paper circulates among poor persons. The officialcurrency stocks of many less-developed countries exceed 10 percent of their GDP (Jeffersonand O’Connell 2004, Figures 1 and 2). Allowing for unrecorded holdings of foreign papercurrency would raise these values still further, and might increase them substantially insome cases.Modern research on money’s role in economic growth treats the presence of so muchpaper money as a cause for regret. Money, this research argues, promotes growth largely(though not solely) by serving as a vehicle for productive financial intermediation (Levine1997). This contribution is especially crucial in developing economies, where markets fornon-monetary financial assets are small or nonexistent (Fry 1995, pp. 4-5). But moneyholdings fuel efficient intermediation only when they serve as a basis for productive private-sector lending. In practice, this is taken to mean that money contributes most to economicgrowth when it consists, not of paper currency, but of the transferable deposit credits ofcommercial banks. Bank regulations are accordingly considered to be financially “repres-sive” when they amount to a “tax” on such deposits that reduces their attractiveness bothabsolutely and relative to paper money. (High required reserve ratios and deposit and loanrate ceilings are the most commonly-cited instances of such repressive regulations.) Thescope for financial development or “deepening” in poorer nations is in turn assumed to belimited by the imperfect substitutability of deposits for paper money.But is heavy reliance upon paper money necessarily a barrier to financial developmentand economic growth? Here we argue that it is not. Drawing on both theory and historicalexperience, we argue that the low productivity of paper money today rests, not upon anyinherent shortcoming of paper currency relative to deposits, but on the fact that the formermedium is today supplied almost exclusively by public monetary authorities which, for rea-sons to be considered below, happen to be inefficient intermediaries. We argue that privatepaper money, consisting of redeemable notes issued by commercial banks and backed bythe same general assets that presently back bank deposits, is no less capable of promotinggrowth than bank deposits themselves.1Our perspective suggests that the monopolization of paper currency by public author-ities itself constitutes an important, though generally unacknowledged, instance of repres-sive financial legislation. It follows that prospects for substantial financial development indeveloping countries might be considerably enhanced by extending the notion of financialliberalization to include reviving commercial banks’ ability to supply circulating banknotes.Banknotes, unlike bank deposits, are capable of supplanting a large share of current hold-ings of official paper money, with corresponding gains to private intermediation.Our argument begins with a brief review of the historical contribution of commercialbanknotes to economic development. We then discuss the difference between such notesand fiat paper money. Next we formally examine, using an endogenous growth model,banknotes’ potential contribution to economic growth. A calibration exercise based on ourmodel allows us to draw conclusions regarding the likely magnitude of the growth effects ofa banknote revival. We conclude by briefly considering some concerns raised by the possi-bility of a full-fledged banknote revival.1Although we refer throughout the paper to “commercial banks” and “banknotes,” theseterms can be understood to include other classes of private financial intermediaries, includingnon-governmental organizations (NGOs), and any circulating notes issued by them.– 2 –Commercial banknotesIs paper money inherently unproductive? Adam Smith, for one, didn’t think so. Al-though Smith understood that money “is the only part of the circulating capital of a so-ciety, of which the maintenance can occasion any diminution in their neat revenue” (1925,p. 272), he regarded not paper money but gold and silver coin as so much unproductivecapital or “dead stock.” Smith held paper money to be an especially efficient exchangemedium. He did so, not simply because paper currency can be produced at a lower costthan coin (although this is certainly true), but because in employing it a country may “con-vert a great part of [its] dead stock into active and productive stock; into stock which pro-duces something to the country” (ibid., p. 304). For Smith, paper money was itself a vehi-cle for productive