Friedman versus hayek on private money: Review essay

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  • Journal of Monetary Economics 17 (1986) 433-439. North-Holland


    Review Essay*

    Stanley FISCHER MIT and NBER. Cambridge, MA 02139, USA

    Few areas of economic activity can,claim as long and unanimous a record of agreement,on the appropriateness of governmental intervention as the supply of money. - Benjamin Klein (1974, p. 423)

    1. Inlroduction

    Free market economists led by Friedrich von Hayek and the invisible hand - for Hayek was unaware of Kleins careful analysis - soon rose to the bait. In 1976, Hayek published a pamphlet The Denationalisation of Money arguing for the competitive issue of currency.

    The first half of the Salin volume is devoted to a chiefly -uncritical examina- tion of the remarkably vague Hayek proposal. After the editors introduction, it starts with an essay by Hayek summarizing his viewpoint, followed by a brief critical comment by Milton Friedman, and an evaluation of the currency competition proposal by Emil Maria Claassen. Subsequent sections on cur- rency competition include papers on the history of private note issue, on the history of monetary thought on free banking, and on the recent, now mori- bund, United States debate on the return to gold. The second half of the book is on monetary union, with emphasis on the European Monetary System.

    2. Theory

    Kleins null hypothesis was that government intervention in the monetary system was economically efficient. He concluded that individual monies would be convertible at a fixed rate of exchange into a dominant currency, but his analysis did not imply that the government should be the sole supplier of currency. Why not, he asked, allow competitive convertible private currencies like travelers checks to circulate? The tentative answer was that it would be easier to detect counterfeiting if there were only a single currency.

    *This is a review of Pascal Salin, cd., Currency Competition and Monetary Union (Martinus NijholT Publishers, 1984).

    0304-3923/86/$3.5001986, Elsevier Science Publishers B.V. (North-Holland)

  • 434 S. Fischer, Friedman vs. Hayek on private monqv

    Hayeks tract is messianic, not analytic. He starts from the view that the inflationary history of the last two and a half millenia of government control of money justify a new approach. The new approach is not adequately described. Hayek concedes to knowing little about how a competitive money system would work: he blames his ignorance on governments, whose monopolization of the monetary system has prevented the needed accumulation of competitive experience. However, he clearly envisages changes more far-reaching than travelers check type competition among currencies convertible into a domi- nant currency (p. 30). Private institutions are to be allowed to create their own brand-name currencies. He argues that competition would ensure that only the best currencies survive, and that such currencies would have stable real value, perhaps being explicitly indexed. He is silent on the essential issues: the unit of account, the costs of having multiple currencies, the issue of convertibility of currency into a dominant money or good (for example gold), and the question of whether currency suppliers would be able to issue fiduciary money.

    Early analysts argued that competition among private issuers of money would inevitably lead to a commodity currency: so long as the selling price of a unit of currency exceeded the marginal cost of production, suppliers would want to produce more. In the end, money would be worth more than the paper it was printed on by an amount equal to the cost of engraving.

    A modem analysis makes essentially the same point by recognizing that any profit-maximizing supplier of money, be it a government, corporation, or individual, faces the problem of dynamic inconsistency. Having once estab- lished a currency, the supplier may be tempted to produce inflationary surprises. Hayek explains why the problem would not arise (p. 30):

    The slightest suspicion that the issuer was abusing his position when issuing money would lead to a depreciation of its value and would at once drive him out of business. It would make him lose what might be an extremely profitable kind of business.

    This argument is totally inadequate. With this difficulty disposed of, Hayek is free to claim (p. 41) that his

    proposal would:

    . . . eliminate all the causes of the alternation of inflationary booms and periods of ,depression. and unemployment which have plagued mankind ever since deliberate attempts at a central control of money have been made. This is too difhcult and complex a matter to pursue further here.

    Hayeks essay is an editors dream of an opening chapter: it is provocative, interesting, and leaves the important issues unresolved. They are not resolved

  • S. Fischer, Friedman vs. Hayek on private money 435

    nor, except by Friedman, seriously addressed in the remainder of the book. Friedman supports Hayeks proposal for removing legal obstacles to monetary freedom, but is sceptical about the outcome. He questions Hayeks view that a stable real-valued currency would emerge by pointing to the failure of the private sector to issue indexed securities despite the absence of legal impedi- ments: a voluntary tabular standard has failed the market test (p. 45).

    Friedman accordingly sticks by the constant growth rate rule as the best monetary policy. In his remarkable introduction, Salin (p. 2) dismisses the monetary rule as inherently technocratic, not a rule of just conduct and not by its nature constitutional. By contrast: currency competition is a principle of freedom (p. 12).

    Given this advantage of currency competition, Salins analysis and rejection of arguments for government intervention in the monetary system are almost superfluous. He notes both that there is an inherent externality in the use of a money, and that the production process for money shows increasing returns. Perhaps, he concludes, there would be only one money in a competitive system. But potential competition would keep the sole money producer from abusing her position. It is dif%cult indeed to see why this should be so when there are substantial fixed costs of entry.

    Emil Maria Claassen expresses views similar to Salins both on the existence of a natural monopoly in money issue and on the undesirability of government having that monopoly. But his approach is less radical than that of Salin or Hayek, for he does not entirely rule out government regulation of money production. He argues also that there is a conflict between the monetary system that best promotes monetary stability - which has multiple competing currencies - and the system that best fosters monetary integration - which would have one currency.

    The first section of the volume accurately reflects the unsatisfactory state of current theory on the working of a competitive monetary system. T,he theory is inherently difficult. But it surely does not help for the proponents of a perhaps radical new system not to attempt to describe what they are talking about. At one extreme, competition may mean only allowing more banks to issue their own travellers checks. Not much good or harm would come from this. At the other extreme we may be abolishing the dollar and all financial regulatory institutions, and allowing the financial innovators who brought us Equity Funding, EMS, and the Continental Illinois Bank to enter the competi- tion of selling - what?

    Competition should do well at producing a standardized product when optimal firm size is small relative to the market. In the case of money the product is not well defined, and there are increasing returns to scale. I assume that a Hayek type system would not get off the ground without a government

    King (1983) reviews theory and some evidence on private money.

  • 436 S. Fischer, Friedman vs. Hayek on private monq~

    definition of money, as for instance a claim on a particular amount of gold or a claim on a specified number of dollar bills. Once that is done, much of the novelty in the Hayek proposal disappears. Given good supervision, ap- propriate capital requirements for banks, and perhaps reserve ratios or perfor- mance bonds, a system of that type could work well.

    No doubt it would ruin the fun for proponents of monetary reform to descend to detail, but the cause will not get anywhere until they try.

    3. Facts

    Perhaps the facts can provide guidance where theory has not. The Scottish and American experiences are the cases most quoted by proponents and opponents of free banking, respectively. Lawrence White (1984) describes the Scottish case of a virtually unregulated banking system with no central bank, free entry, and remarkable stability. He attributes much of the stability to the banks practice of accepting competitors notes, and then clearing them immediately through a note exchange. This feature was present also in the successful Suffolk Bank system in New England in the early nineteenth century.

    White notes in passing that shareholders in Scottish banks had unlimited liability. The losses of Ayr Bank, which collapsed in 1772, were borne entirely by its shareholders. Would unlimited liability be necessary for the success of free banking in the United States? It would certainly help the stability of the system, but might reduce the volume of banking activity excessively. It should also be noted in evaluating the stability of the Scottish system that the banks were operating under the gold standard; their product was thus well defined as a claim on gold. White also remarks on a tendency to increasing concentration of note issue over time, again suggesting economies of scale.

    The United States experience with wildcat banking undergoes continuing reappraisal. Rolnick and Weber (1983), whose thrust is that the failures of free banking have been exaggerated, nonetheless present evidence of substantial failure rates. Although one half of the free banks in the four states they examine failed, less than a third of those banks did not eventually redeem their notes at par. Of course, given the demand for liquidity, eventual redemption at par is not as good as not failing at ah. In a subsequent contribution, Rotick and Weber (1984) show that most free bank failures were not a result of wildcat banking (that is, banking where the sole purpose of opening a bank was to make off with the proceeds), but rather of falls in the value of the banks asset portfolios.

    Chapter II of the Salin volume contains five contributions on the history of currency competition. The major paper is by Vaubel, who usefully reviews the history of private note issue in Britain, the Continent, North America, and

  • S. Fischer, Friedman vs. Hayek on private monqv 437

    Asia. He confines himself to cases in which bank notes were convertible at a fixed rate into another asset. His table of types of currency competition (p. 60) suggests that the only example of indexed private note issue was in the German hyperinflation.

    Vaubel finds several periods(during hyperinilation) in which private notes were more stable in value than government notes. Further, although the number of issuers within a given system tended to decline over time, there was always more than one private supplier; Vaubel thus suggests that scale economies do not extend far enough to make money a natural monopoly. The failures of some competitive currency systems are ascribed variously to entry restrictions, government interference, insufficient liability, restrictions on bank size, insufficient protection against fraud, or inadequate disclosure legislation. Obviously the legal framework is crucial to the success of a competitive banking system - and despite the view found scattered throughout the book, the law will have to do more then keep the government out of the money business.

    4. History of thought and the U.S. gold standard

    Pedro Schwartzs paper - subtitled A Century of Myopia in England - examines the history of thought on central bank monopoly. He argues that English economists were blind, or at least short-sighted, in studying central banking mainly because English and Welsh experience with private note issue up to 1844 was unfavorable, and the Bank of England behaved well up to 1914. Schwartz ascribes the failure of private note issue in England and Wales to misguided regulation.

    Schwartzs review of English economic thought is tough on J.S. Mill who moved from support of free banking to a weak-kneed eclecticism. In 1857, Mill told the Select Committee on the Bank Acts that it was not a matter of great consequence whether there was one or many banks of issue (of notes). Schwartz criticizes this view for failing to recognize that note issue competition among banks would have ensured the survival of the gold standard, whereas a single central bank could - and did - ask for the suspension of payments. The Scottish example is the basis for his confidence that competition would have saved the gold standard. The hero of the article is Bagehot, who supported the Bank of Englands holding of the countrys gold reserve as only second best to each bank holding a reserve of its own. But Bagehot did not see any way of reversing the Banks monopoly of note issue and reserve holding after it had operated successfully for over twenty years since 1844. Schwartz concludes by showing that Keynes did not have things right.

    Lawrence Whites informative bibliographical note completes the section on the history of thought.

  • 438 S. Fischer, Friedman vs. Hayek on private money

    5. Monetary union

    The shorter half of the Salin volume - on monetary union - is less exotic than the first. Salin takes a sceptical view of the prospects for the European Monetary System, doubting that the European central banks would be suffi- ciently willing to agree on the inflation rate to make fixed exchange rates possible. He argues that recent research has shown that exchange rates are linked to only one phenomenon: differences in inflation rates (p. 208); the unvarnished monetary theory of the balance of payments plays a major role in Salins chapters on the EMS. In fairness, he was writing well before the dollar took off against the Deutschmark despite the similarity of the U.S. and German inflation rates.

    Niels Thygesen presents a more generous interpretation of the EMSs adjustable peg, arguing that the system has been reasonably successful. Thygesen asks in his article why proponents of monetary targets are so scornful of exchange rate targets (p. 227). Pieter Kortewegs answer is that often real exchange rates should change, and that maintaining the nominal rate constant only creates real disturbances somewhere else in the economy. Of course, the same comment applies to money stock targets.

    Hat-men Lehment presents a balanced weighing of the choice between flexible exchange rates and a common currency. He ranks managed floating lowest on the list, free flexibility next, and real currency union first. While recognizing that there is some way to go till governments are willing to subordinate domestic policies sufficiently, he nonetheless looks forward to currency unification among the U.S., Japan-the EEC, and Switzerland. Paul de Grauwe comments that monetary union will not precede political union, for which there is very little enthusiasm in Europe.

    The volume concludes with a brief chapter Towards a better European Monetary System by Salin, featuring a parallel indexed currency for Europe. The new currency, the europa, would consist of a basket of European currencies, with quantities of each currency in the basket adjusted to maintain its real value. The central banks of each country would be required to make good the losses suffered by the European institution issuing the europa. It is not specified whether the gains also accrue to the central banks of the member countries.

    6. Concluding cdinment

    Currency competition and free banking might increase the efficiency of the financial system, and bring some small triangle welfare gains. But the key question is whether their adoption would improve macroeconomic perfor- mance. Even though Salin argues (p. 281) that the best system is that which produces the least inflation, fluctuations in output are also expensive.

  • S. Fischer, Friedman vs. Hayek on private money 439

    Hayek states that the adoption of his proposal would end recessions. There is absolutely no reason to believe that. Nineteenth century history is evidence that free banking and currency issue, in the wrong legal and regulatory framework, can produce rather than reduce instability. The proponents of free banking and currency issue in this volume do not go much beyond a general belief in competition in justifying their views; they have certainly not explored the necessary legal and regulatory environment in any detail.

    There is no question that economists arguing from general principles underestimated the fluctuations in real exchange rates that would take place in a flexible rate system. A general belief in competition and dislike of inflation is not enough to justify jumping off the deep end into an uncharted new financial system.

    This is not to say that we live in the best of all possible financial worlds. It is for their stimulating insistence on this point, and demonstration of the need for further research, that we can be grateful to the authors in the Win volume.


    Hayek, Friedrich A., 1976, Denationalisation of money, Hobart paper, 2nd ed. 1978 (The Institute of Economic Affairs, London).

    King, Robert G.. 1983, On the economics of private money, Journal of Monetary Economics 12, 127-158.

    Klein, Benjamin, 1974, The competitive supply of money, Journal of Money, Credit and Banking 6,423-454.

    Rolnick, Arthur J. and Warren E. Weber, 1983, New evidence on the free banking era, American Economic Review 73, 1080-1091.

    Rolnick, Arthur J. and Warren E. Weber, 1984, The causes of free bank failures: A detailed examination, Journal of Monetary Economics 14.267-292.

    White, Lawrence H., 1984, Free banking in Britain (Cambridge University Press, Cambridge).