Money Without a State

William Luther

Advisor: Lawrence H White, PhD, Department of Economics

Committee Members: Peter J. Boettke, Omar al-Ubaydli

April 26, 2012, 03:00 PM to 12:00 PM


In three essays, I consider the monetary system of Somalia. The first chapter challenges the notion that positively valued fiat money cannot exist after the sovereign disappears. Economists commonly invoke sovereign powers to explain the acceptance of unbacked paper money at a positive value. The government accepts or compels taxes to be paid in the money (makes it publicly receivable) or compels creditors to accept it (grants and enforces legal tender status). Thus fiat money is thought to rely on enforcement of a literal fiat or decree. The case of Somalia defies such an account. Following the state’s collapse in 1991, unbacked paper Somali shillings continued to circulate at a positive value. I explain how historical acceptance, or “inertia,” can sustain the ongoing acceptance of unbacked money even in the absence of ongoing sovereign support. Although sovereign power might be necessary to launch a fiat standard, I conclude that it is not a necessary condition for its survival.

The second chapter contributes to work developed over the last few decades concerned with potential mechanisms to govern the supply of money in a desirable manner. Interestingly, a rough mechanism seems to have emerged naturally following the collapse of the Somali state in 1991. Without a functioning government to restrict the supply of notes in circulation, Somalis found it profitable to contract with foreign printers and import forged notes. Forgers were constrained since the average Somali would only accept denominations issued prior to 1991; larger denomination notes could not be issued profitably. Although the exchange value of the 1000 Somali shillings note fell from $US 0.30 in 1991 to US$ 0.03 in 2008, the purchasing power eventually stabilized, as the exchange value equaled the cost of producing additional notes. After reviewing the historical episode, I make explicit the mechanism by which the supply of money is governed and compare the actual experience of Somalia to that predicted by the model. I conclude that, following the initial adjustment period, the Somali system has performed reasonably well in terms of maintaining a stable purchasing power.

The third chapter aims at estimating the optimal denomination structure for Somalia in order to evaluate the actual notes in circulation. Two distinct approaches have been taken in the literature to consider the optimal denominations of coins and banknotes. One approach reduces the problem to determining the smallest set of denominations capable of handling a given range of transactions. Another approach argues the optimal denomination structure would minimize the number of coins and banknotes used in the average transaction. Both are ultimately concerned with the optimal spacing of denominations. In contrast, I estimate the optimal range of denominations for coins and banknotes conditional on real income and the monetary unit employed. I show that the surviving 1000 Somali shillings note is too small for conveniently making large transactions, but too large to make precise change in small transactions.