By Rajiv Sethi, Professor of Economics, Barnard College, Columbia University. Cross posted from his blog

Among the many fascinating people currently affiliated with the Microsoft Research New York lab is Kati London, judged by MIT’s Technology Review Magazine (2010) to be among the “Top 35 Innovators Under 35.” Through her involvement with the start-up area/code, Kati has developed games that transform the individuals who play them and the communities in which they reside.

One such project is Macon Money, an initiative involving the Knight Foundation and the College Hill Alliance in Macon, Georgia. This simple experiment, amazingly enough, sheds light on some fundamental questions in monetary economics, helps explain why conventional monetary policy via asset purchases has recently been so ineffective in stimulating the economy, suggests alternative approaches that might be substantially more effective, and speaks to the feasibility of the Chicago Plan (originally advanced by Henry Simons and Irving Fisher, and recently endorsed by a couple of IMF economists) to abolish privately issued money.

So what exactly was the Macon Money project? It began with a grant of $65,000 by the Knight Foundation, which was used to back the issue of bonds. These bonds were (literally) sliced in two and the halves were given away through various channels to residents of Macon. If a pair of individuals holding halves of the same bond could find each other, they were able to exchange the (now complete) bond for Macon Money, which could then be used to make expenditures at a variety of local businesses. These business were happy to accept Macon Money because it could be redeemed at par for US currency.

The basic idea is described here:

The demographics of the participant population, the distribution of expenditures, and the strategies used by players to find their “other halves” are all described in an evaluation summary. The project had the twin goals of building social capital and stimulating economic development. Although few enduring ties were created among the players, participation did create a sense of excitement about Macon and greater optimism about its future. And participating businesses managed to find a new pool of repeat customers.

Macon money was a fiscal intervention (an injection of funds into the locality) accomplished using the device of privately issued money convertible at par. There was a temporary increase in the local money supply which was extinguished when businesses redeemed their notes. An interesting thought experiment is to imagine what would have happened if, instead of being convertible at par, businesses could only convert Macon Money into currency at a small discount.

Businesses that accept credit card payments are exactly in this situation, facing a haircut of 1-3 percent when they convert credit card payments into cash. Most businesses that participated in the original experiment would therefore likely continue to participate in the modified one. After all, businesses involved in Groupon campaigns accept a 75% haircut once Groupon takes its share of the discounted price.

But there is one critically important difference between Macon Money and a credit card payment: the former is negotiable while the latter is not. That is, instead of being redeemed at a small discount, Macon Money could be spent at par. If enough businesses were participating, it would make sense for each one to spend rather than redeem its receipts. The privately issued money would therefore remain in circulation.

What about a business that had no interest in spending its receipts on locally provided goods and services? Even in this case, there would be better alternatives to redeeming at a discount. For instance, if the discount were 3%, there would be room for the emergence of a local intermediary who offered cash at a more attractive 2% discount to the business, and then sold Macon Money at 1% below par to those who did wish to spend locally. Again, the privately issued money would remain in circulation.

As a result, the local money supply would have grown not just for a brief period, but indefinitely. The discount itself would allow for more money to be injected for any given amount of backing funds. And as long as convertibility was never in doubt, substantially more money could be issued than the funds earmarked to back it.

This simple thought experiment tells us something about policy. Macon Money provided an injection of liquidity that improved the balance sheets of those who managed to secure bonds. This allowed for an increase in aggregate expenditure, and given the slack in local productive capacity, also an increase in production.

It was expansionary monetary policy, but quite different from the kind of policy pursued by the Federal Reserve. The Fed expands the money supply by buying securities, which leads to a change in the composition of the asset side of individual balance sheets. Higher asset prices (and correspondingly lower interest rates) are supposed to stimulate demand through increased borrowing at more attractive rates. But in a balance sheet recession, distressed borrowers are unwilling to take on more debt and the stimulative effects of such a policy are accordingly muted. This is why calls for an alternative approach to monetary policy make analytical sense.

Furthermore, the fact that Macon Money was accepted only locally meant that it could not be used for imports from other locations. The monetary stimulus was therefore not subject to the kinds of demand leakages that would arise from the issue of generalized fiat money.

Finally, the project provided a very clear illustration of the difficulty of abolishing privately issued money. Unless one were to prevent all creditworthy institutions from issuing convertible liabilities, it would be virtually impossible to halt the use of such liabilities as media of exchange. Put differently, we are always going to have a shadow banking system. But what the Macon Money initiative shows is that the creative and judicious use of private money, backed by creditworthy foundations, can revitalize communities currently operating well below their productive potential. Whether this can be done in a scalable way, with some government involvement and oversight to prevent abuse, remains unclear. But surely the idea deserves a closer look?

—

Update. Another important feature of Macon Money is the fact that it cannot be used to pay down debt unless the creditors are themselves local. This means that even highly indebted households will either spend it, or pay down debt by selling their notes to someone who will. If increasing economic activity is the goal, this is vastly superior to disbursements of cash.

Joseph Cotterill asks (rhetorically) whether Macon Money is the anti-Bitcoin. Exactly right, and very well put.