OK, I admit it: I tend to be early. The idea of private money – often referred to as "competing currencies" – has always fascinated me. I persuaded Jim Michaels, the late, great editor of Forbes Magazine, to let me translate the little-known academic literature into journalese in this article, which he published under the title Do You Want To Be Paid In Rockefellers? In Wristons? Or How About A Hayek? almost (ahem!) exactly twenty years ago. (May 30, 1988). The Great Inflation of the 1970s was then still a live memory. For some years, my account was regularly assigned in college courses. Now, GOP Presidential candidate Ron Paul seems to have single-handedly revived the issue with his relentless criticisms of the Federal Reserve. (Click here for Google web search). I still think it's going to happen – just as there will eventually be an immigration cut-off.
The Federal Reserve System will be 75 years old in December. A small but growing band of academic economists proposes a special sort of birthday celebration: The Fed, they say, should be abolished.
Abolished? The sole bulwark we have against runaway inflation and fiscal irresponsibility?
Most people can’t imagine life without a currency-issuing central bank, although in fact the Fed is younger than one of its most relentless critics, Nobel laureate Milton Friedman, still going strong at 76 [R. I. P. 19122006] and hard at work at California’s Hoover Institution.
The Fed allegedly manages the country’s money supply in order to prevent such economic disturbances as inflation, deflation and depression. But it is a matter of record that, since the Fed arrived, economic disturbances have been more severe than previously – notably the Great Depression of 1929 and the Great Inflation of the Seventies. In the process, the purchasing power of the dollar has almost completely eroded. Even now, inflation is still gnawing away at around 4% a year, compared with a mere 3.3% when President Richard Nixon first imposed wage and price controls in 1971.
Central banking distresses some. They argue that, far from preventing these disturbances, central banking may exacerbate them. The Fed has been accused of being too tight in the 1930s and too loose in the 1970s and of innumerable lesser errors. After bitter debate, most economists have come to accept at least a part of this critique.
For years, Milton Friedman has advocated doing away with some of the Fed’s flexibility by forcing it to expand the money supply only at a fixed annual rate approximating the long-run growth of the economy. The Fed’s new critics, however, go further. They think the government should be out of the money business altogether. They argue that money could and should be provided competitively by the private sector – just like baked beans, business magazines or any other goods.
What? Money is money, isn’t it? How can you have different kinds of money in the same economy?
The idea of Citibank and Chase Manhattan issuing their own money may indeed seem mind-boggling. What would their currencies be called – Wristons and Rockefellers? But the truth is that there have been several episodes of private, competing monies in world economic history, including in the U.S. Recent research is suggesting they worked much better than had been thought.
Meanwhile, financial deregulations at home and floating exchanges rates abroad are creating an environment in which elements of a competitive system are already emerging – without the permission of professors or politicians. In his forthcoming book, Free Banking and Monetary Reform, former Manhattan Institute economist David Glasner calls this phenomenon “the competitive breakthrough” that might eventually lead to the complete privatization of money.
Government money monopolies were effectively universal by the early 20th century. Even free market economists, with few exceptions, took them for granted. But these monopolies became much easier to question after Friedrich A. Hayek, who received the Nobel Prize for Economics in 1974, published his Denationalization of Money in 1976 and expanded upon it in 1978.
Hayek announced that, on reflection, he no longer thought government money monopolies were either necessary or desirable, given their record of inflation. Instead, private institutions such as banks should be allowed to issue their own monies, denominated as they wished.
Conventional wisdom had assumed that a profit-seeking bank would immediately print too much money. But Hayek pointed out that this course would be self-defeating. If a bank over-issued its currency, causing it to depreciate, people wouldn’t want to accept or hold it, preferring that of more conservative banks. The offending bank’s currency would go to a discount and, in short order, the bank would have to curb its enthusiasm. Competition, Hayek said, would do a better job of compelling private institutions to maintain their money’s value than politics had with public institutions like the Fed.
Maybe – but let’s be practical. How would I buy my groceries? Suppose the prices were marked in Rockefellers and all I had were Wristons? Suppose I’m a New Yorker in San Francisco? San Franciscans might prefer BankAmericas. What good would my Wristons be? How could a merchant function if his customers kept coming in with different kinds of currencies? How could a businessman keep his books?
The answer to these interesting questions depends partly on which of the several different proposals for privatizing money is under discussion. Hayek’s version is particularly radical. In most historical episodes of private money, banks issued their own notes but denominated them in the national unit of account – the dollar, the pound. These notes usually exchanged at par and would be discounted only as a last resort in specific circumstances, such as overissue.
But more generally it is clear from the response of merchants in border zones like Tijuana or Toronto, and from inflation-racked countries like Israel or Argentina that are evolving a de facto U.S. dollar standard, the costs of handling parallel currencies can easily be exceeded by the benefits. Computers and hand-held calculators reduce the confusion, just as they have helped business to handle international floating exchange rates.
The fact is that free markets don’t produce chaos. Efficiency will probably dictate that just a few kinds of monies, perhaps only one, will become universally accepted – exactly as the international computer industry has spontaneously evolved standard operating systems.
To understand Hayek’s proposal and the whole competing currencies concept, you have to think about the nature of money. Most laymen, and some economists, assume that money is a collective convenience requiring government to organize, like national defense. But the historical evidence seems to be that in reality money developed all by itself. Merchants just agreed upon common stores of value and mediums of exchange because they found using them more efficient than barter – an example of what Hayek calls “spontaneous order.”
Coins are traditionally supposed to have been invented in the 7th century B.C. by the Lydians, whose King Croesus became a legend for his wealth. But significantly, David Glasner reports, the earliest surviving coins appear to have been privately issued. The Lydian royal minting monopoly was only later imposed – by another king for whom the Greeks invented the word “tyrant.”
Recent observations have tended to confirm the private origins of money. In one famous case, cigarettes spontaneously evolved as the medium of exchange in a World War II prisoner of war camp. In much of Europe after WWII, U.S. nylon stockings were a kind of sexual currency.
Whether or not governments were needed in the money business, however, they undeniably found getting into it an irresistible source of revenue and power, particularly in time of war or national emergency. Minting coins was easy and profitable. Most convenient of all for a spendthrift king, the coins could be debased – reissued with the same face value but a lesser amount of precious metal – or actually clipped of some of their gold and recirculated. Later, when money developed into a claim on some other asset rather than being intrinsically valuable in itself, governments discovered that they could simply overissue it.
Of course, all this would eventually result in too much money chasing too few goods and rising prices – a process still going on merrily today. But that’s in the long run. And in the meantime, monkeying about with money produced interesting spasms in the economy that could be very useful politically – for example, to influence elections.
Market forces can be damned but not destroyed. By the Middle Ages, even governments that monopolized money found themselves confronted with a burgeoning banking industry that was being summoned into existence by the growth of trade.
Banks not only accepted deposits of money from customers, on which they paid interest, but also made loans to other customers, on which they charged interest. A loan was made by a bookkeeping entry that created a deposit upon which this new debtor could draw. These new banks were able to incur multiple liabilities against the same hard cash, because bank IOUs were exchanged among the public in settlement of their own affairs and rarely presented for payment. In effect, the banks were creating money.
Governments tolerated this development largely because they needed to borrow money themselves, badly. For example, the Bank of England, the ancestor of all central banks, was first granted its charter in 1694 because it promised to buy William III’s government bonds and finance his wars when Parliament would not.
Similarly in the U.S., the 1863 National Bank Act compelled qualifying banks to hold specified amounts of federal debt, helping to pay for the Civil War.
So even a government’s monopoly over the issuance of currency gives it only indirect control over the entire money supply. In recent years in the U.S. this control has been exerted by a straitjacket of banking regulation – much of it dating from the New Deal and subsequently rotted away by inflation, and by the Fed’s ability to alter the reserves that banks are required to maintain with it, thus affecting the size of the base upon which they can build their pyramids of credit.
But now “financial innovation” is producing a proliferation of irritatingly hard-to-categorize “near monies” – for example, traveler’s checks, some of whose issuers are bound not by reserve regulations but only by their own self-interested prudence. Thus, in a sense, American Express is already issuing its own private money, although denominated in and convertible into Fed-produced dollars.
Hayek’s proposal is particularly radical because it combines a number of distinct ideas that are already quite radical enough:
- “Free banking” – banks ought to be able to issue currency and create deposits (conceptually the same thing), choose their own reserve ratios and generally operate entirely without regulation.
- Different denominations – privately issued currencies need not be all denominated in the same unit: Citibank’s Wristons and Chase Manhattan’s Rockefellers would be traded against each other in a currency market just as the different national currencies are today.
- Private fiat money – these private currencies need not necessarily be convertible into gold or any underlying commodity, but would trade entirely on the word of the issuing bank that it would not debauch its money.
Wouldn’t this create chaos? Is Hayek serious?
Idea number one, free banking, is very serious. New York University’s Lawrence H. White has recently attracted much attention with his book Free Banking in Britain, a documentation and formal analysis of the system’s smooth working over a 128-year period in Scotland. Scottish free banking was suppressed in 1844, not because it didn’t work, but in the course of legislation aimed at difficulties in the very different English banking system.
But didn’t this cause chaos in the U.S.? What about the wildcat banks?
That bit of history is far from settled. Free banking briefly flourished under state charters in the U.S. from 1837 to the Civil War. “Wildcat banks” were accused of locating out in the frontier forests, with the wildcats, so that their notes could not easily be presented for redemption. But recent studies suggest that these problems have been much exaggerated. And most of them, it is argued, were caused by interfering state governments and inadequate enforcement of laws against fraud.
In both Scotland and the U.S. the private money thus issued was denominated in the national monetary unit and was theoretically interchangeable and redeemable into gold. In the U.S., unlike in Scotland, national branch banking was not allowed, so notes issued by unknown faraway banks, as well as those that were suspect for other reasons, sometimes traded at a discount. This was not, however, an impossible inconvenience: Bill brokers sprang up to act as middlemen. It would be even less of a problem in these days of instant communications – and, above all, if nationwide branch banking were allowed.
Still, the wildcat banks left their clawmarks on the U.S. economics profession. Many economists concluded that private banks had a theoretical incentive to behave badly: They would produce money until its value had been driven down to its cost of production, which is essentially zero. This would cause a price explosion – severe inflation.
David Glasner, however, rebuts this argument by pointing out that a bank can make profits only to the extent that the public will hold its money. Otherwise it will be driven into insolvency by adverse clearings with its competitors as the public converts out of its money and into their money. If people trust Wristons more than Rockefellers, Chase would have to either mend its ways or be driven out of business, and vice versa. Thus, for a bank like Chase Manhattan, the key question would be not the cost of physically creating Rockefellers but of keeping them in circulation. Chase’s “cost of production” would be the resources it expended in maintaining sufficient balances of whatever was necessary in order to convince its customers that their Rockefellers could be redeemed whenever they wanted.
But doesn’t bad money drive out good?
Everyone has heard of Gresham’s law, but practically no one understands it. Queen Elizabeth I’s financial adviser was talking about a situation where two monies exchange at a rate fixed by law – for example, if both are legal tender and must be accepted in discharge of debt. Under these circumstances, people will try to pass on the “bad” money – the money whose value is suspect, either because of debasement or overissue – and hoard the money that’s “good." But if the rate of exchange between the monies is free to fluctuate, it is the debauched currency that will depreciate and be driven out.
Nobody. A free banking system, its advocates insist, pointing to Scotland, is not inherently unstable. The celebrated 19th-century banking “panics” were relatively brief and self-correcting compared with the Great Depression, with the sound banks leading reserves to rescue unsound ones out of their own interest in preventing general collapse, as J.P. Morgan did in the panic of 1907. In Scotland, banks competed for the customers of failed banks by accepting their notes at par.
In fact, private money proponents think the Fed’s activities as a lender of last resort, and the New Deal’s deposit insurance programs, have actually made the U.S. banking system’s problems worse. They have encouraged bankers to take risks, knowing that the feds would bail them out, and thus in effect subsidized imprudent banking. Ask anyone in Texas.
The advocates of private monies are still arguing among themselves about other aspects of the scheme, including Hayek’s idea number two (different denominations) and idea number three (private fiat money). Lawrence H. White, for example, thinks that, as in Scotland, all monies should be denominated in the same unit, albeit visually distinguishable so that they could trade at a discount if necessary. And he predicts that the emerging successful money would probably turn out to be one offering convertibility into gold or silver.
But these disputes are not conducted with the usual academic acerbity. This is because all private-money advocates agree that such questions can really be settled only by allowing competition to begin. Then the free market, to employ a key Hayekian concept, will search out the best solution.
The privatization of money has important macroeconomic implications. It offers, according to its advocates, a way out of the current grand impasse of monetary policy.
For most of its existence, the Fed has focused on interest rates, the price of credit, assuming that the amount of money it was supplying to the economy was less important. But interest rates are affected by many factors, and the Fed often ended up supplying so much money that the resulting inflation could not be ignored.
But by the time the Fed finally admitted to the importance of the money supply, in the early 1980s, it turned out that the demand for money – its “velocity of circulation” – was jumping about unpredictably, too. Thus, judged by the usual measures, the Fed supplied massive quantities of money to the economy after 1982. But, contrary to what Friedman and like-minded monetarists predicted, it did not boil off into inflation. The velocity simply slowed.
So now the Fed appears to be flying blind, following neither a price rule nor a quantity rule, responding to ad hoc considerations such as the beliefs of the Fed chairman or whatever exchange rate influential politicians happen to feel would be convenient for the dollar.
Monetary policy would not be a problem if banks issued their own monies; it would cease to exist. Banks would automatically extend credit to the extent that they and their customers agree it is economically productive. If business conditions deteriorated, loans would be liquidated, liabilities written down to match, and the banks’ balance sheets would shrink. Thus the quantity of money demanded by the economy would be automatically supplied by the market, just as it now supplies the appropriate number of automobiles. (Imagine the mess if an outfit like the Fed were to control auto production, based on its best guesses of what demand ought to be.)
Occasionally, of course, banks and customers would make mistakes. But this should be no more disruptive than a mistake in any other business. Auto factories do overproduce. So do builders of office buildings. But the economy adjusts.
A much-loved answer to the mystery of monetary policy is to link the dollar in some way to gold. But gold standard advocates have always had a problem with gold’s moderate but real fluctuations in price, which would inflict involuntary deflations and inflations upon the economy. Competing currencies would tend to solve this problem. Joe Cobb, senior economist for the U.S. Congress’ Joint Economic committee, believes that a private money convertible into gold would eventually become dominant. “But with free banking, other types of money would come in at the margin if there were too little or too much gold-backed money,” Cobb says. Silver-backed, maybe, or oil-backed. These monies would either supplement the gold-backed currency (if the gold price had risen, causing deflation) or displace it (if the gold price had fallen, causing inflation).
Recently, the young economists in the private-money subculture have been electrified by hints that the leader of the monetarist school, Milton Friedman himself, is being converted. In 1986 Friedman coauthored a paper significantly softening his view that governments necessarily have a role in money. Even more significantly, he has abandoned his long-held position that the Fed should aim for a fixed rate of growth in the monetary aggregates. Now he argues that the monetary base – Fed deposits plus currency – should be frozen and complete free banking be allowed to pyramid upon this reserve base.
This looks like a revised monetary rule, but in fact it isn’t. Under Friedman’s new proposal the free market, rather than the Fed, would dictate the size of the money supply-based on the banks’ feel for the legitimate demand for money.
Friedman stoutly denies that his new proposal has anything to do with the volatile velocities of the 1980s, which he blames on Fed policy. Instead, he says he is now convinced that central bankers will never accept moderate restraint, so he proposes to eliminate their power. However, he agrees that under free banking the troublesome issue of velocity would be neatly bypassed.
The proponents of private money take Friedman’s shift as confirmation that their position is just the logical extension of market principles. “Once the question is put, there’s only one answer,” says the University of Sheffield’s Kevin Dowd, whose book The State and the Monetary System is being published by the Vancouver-based Fraser Institute.
Milton Friedman has an estimate of the chances of money being denationalized: “Zero.” But then, he recalls, for years economists were derided for arguing about the feasibility of floating exchange rates. Then suddenly the idea became reality. So, maybe the chances are better than zero.
The first victory of the competing currency school may well be negative. By stressing the fundamental flaws of central banking, they may help derail the diametrically opposed proposal: to develop one world currency centrally managed by the International Monetary Fund. This idea was the subject of a recent cover story in the Economist magazine, and a version of it has recently been advocated by Harvard economist and former Carter Administration official Richard Cooper. The single-currency proposal appalls the private-money people, since it would mean an immensely powerful world central bank, able to manipulate its money without the minimal discipline existing now because investors can flee into other currencies. The single-currency proposal, says Lawrence H. White, would be “suicide after prolonged self-torture.”
It’s even possible that competing currencies may come into existence on their own. Richard W. Rahn, chief economist of the U.S. Chamber of Commerce, has actually sketched out a proposal to launch a private currency convertible into commodities or government currencies under prevailing laws. He suggests using commodity futures markets to lower operating costs, and overseas tax havens to avoid the tax problems preventing wider use of the 1977 “gold clause” legislation that made contracts based on gold legally enforceable. “Private money is not just an abstract idea, but an idea whose time has come,” Rahn says. “It’s technologically and legally feasible.”
Meanwhile, a small network of economists attracted by competing currencies is quietly establishing itself. Books and articles are being published, sympathizers located (including outposts in Britain, France and Germany) and eminent authorities intrigued. “It’s an intellectually very respectable idea,” says Sir Alan Walters of Johns Hopkins University, a leading monetarist and formerly economic adviser to Prime Minister Margaret Thatcher. “I think free banking could work quite well.”
But seriously: Can a handful of thinkers change the world?
Strange things happen in the idea business. When Adam Smith (who did not regard money as necessarily a government function) wrote The Wealth of Nations in 1776, he commented that to expect free trade to be established in Britain was “as absurd as to expect that an Oceana or Utopia should be established in it.” But his ideas prevailed in spite of the odds against them, and some 90 years later not one British tariff was left.
January 29, 2008