A couple of months ago a friend my sent me an article from the Guardian about how “Nazi Germany flooded Europe with fake British banknotes in an attempt to destroy confidence in the currency. The forgeries were so good that even German spymasters paid their agents in Britain with fake notes..The fake notes were first circulated in neutral Portugal and Spain with the double objective of raising money for the Nazi cause and creating a lack of confidence in the British currency.”

The article made me think about the impact of counterfeiting and whether thinking about the effects of counterfeiting could teach us anything about monetary theory. It should be stressed that my argument will not be a defense of counterfeiting. Counterfeiting is obviously fraudulent and as such immoral.

Thinking about the impact of counterfeiting we need to make two assumptions. First, are the counterfeited notes (and coins for the matter) “good” or not. Second what is the policy objective of the central bank – does the central bank have a nominal target or not.

Lets start out analyzing the case where the quality of the the counterfeited notes is so good that nobody will be able to distinguish them from the real thing and where the central bank has a clear and credible nominal target – for example a inflation target or a NGDP level target. In this case the counterfeiter basically is able to expand the money supply in a similar fashion as the central bank. Hence, effectively the nazi German counterfeiters in this scenario would be able to increase inflation and the level of NGDP in the UK in the same way as the Bank of  England. However, if the BoE had been operating an inflation target then any increase in inflation (above the inflation target) due to an increase in the counterfeit money supply would have lead the BoE to reduce the official money supply. Furthermore, if the inflation target was credible an increase in inflation would be considered to be temporary by market participants and would lead to a drop in money velocity (this is the Chuck Norris effect).

Hence, under a credible inflation targeting regime an increase in the counterfeit money supply would automatically lead to a drop in the official money supply and/or a drop in money-velocity and as a consequence it would not lead to an increase in inflation. The same would go for any other nominal target.

In fact we can imagine a situation where the entire official UK money supply would have been replaced by “nazi notes” and the only thing the BoE was be doing was to provide a credible nominal anchor. This would in fact be complete monetary separation – between the different functions of money. On the one hand the Nazi counterfeiters would be supplying both the medium of exchange and a medium for store of value, while the BoE would be supplying a unit of account.

Therefore the paradoxical result is that as long as the central bank provides a credible nominal target the impact of counterfeiting will be limited in terms of the impact on the economy. There is, however, one crucial impact and that is the revenue from seigniorage from iss uing money would be captured by the counterfeiters rather than by the central bank. From a fiscal perspective this might or might not be important.

Could counterfeiting be useful?

This also leads us to what surely is a controversial conclusion that a central bank, which is faced with a situation where there is strong monetary deflation – for example in the US during the Great Depression – counterfeiting would actually be beneficial as it would increase the “effective” money supply and therefore help curb the deflationary pressures. In that regard it would be noted that this case only is relevant when the nominal target – for example a NGDP level target or lets say a 2% inflation target is not seen to be credible.

Therefore, if the nominal target is not credible and there is deflation we could argue that counterfeiting could be beneficial in terms of hitting the nominal target. Of course in a situation with high inflation and no credible nominal target counterfeiting surely would make the inflationary problems even worse. This would probably have been the case in the UK during WW2 – inflation was high and there was not a credible nominal target and as such had the nazi counterfeiting been “successful” then it surely would have had a serious a negative impact on the British economy in the form of potential hyperinflation.

Monetary separation could be desirable – at least in terms of thinking about money

The discussion above in my view illustrates that it is important in separating the different functions of money when we talk about monetary policy and the example with perfect counterfeiting under a credible nominal target shows that we can imagine a situation where the provision of the unit of accounting is produced by a (monopoly) central bank, but where production the medium of exchange and storage is privatized. This is at the core of what used to be know as New Monetary Economics (NME).

The best known NME style policy proposal is the little understood BFH system proposed by Leland Yeager and Robert Greenfield. What Yeager and Greenfield basically is suggesting is that the only task the central bank should provide is the provision media of accounting, while the other functions should be privatised – or should I say it should be left to “counterfeiters”.

While I am skeptical about the practically workings of the BFH system and certainly is not proposing to legalise counterfeiting one should acknowledge that the starting point for monetary policy most be to provide the medium account – or said in another way under a monopoly central bank the main task of the central bank is to provide a numéraire. NGDP level targeting of course is such numéraire.

A more radical solution could of course be to allow private issuance of money denominated in the official medium of account. This effectively would take away the need for a lender of last resort, but would not be a full Free Banking system as the central bank would still set the numéraire, which occasionally would necessitate that the central bank issued its own money or sucked up privated issued money to ensure the NGDP target (or any other nominal target). This is of course not completely different from what is already happening in the sense the private banks under the present system is able to create money – and one can argue that that is in fact what happened in the US during the Great Moderation.