"The Denationalisation of Money - The Argument Refined"

Greg Ransom points to an article by Benjamin Powell attacking the very idea of the existence of the Federal Reserve. Powell refers to F. A. Hayek's paper "The Denationalisaton of Money" (spelled with an 's' here because that's how it appears in my copy).

What follows are excerpts which I manually transcribed for a Usenet article some years ago. The source of this material is given at the very bottom.

Read this. It's an idea to have most peoples' hair standing on end, because they've been trained to be stupid. Put your thinking caps on and work through it. Stop being stupid. The political implications are profound, not least because of their economic implications.

Go buy the book cited at the bottom, from my annotated copy of which this was taken.

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"Denationalisation of Money - The Argument Refined"

1 - The Practical Proposal

The concrete proposal for the near future, and the occasion for the elimination of a much more far-reaching scheme, is that:

The countries of the Common Market, preferably with the neutral countries of Europe (and possibly later the countries of North America), mutually bind themselves by formal treaty not to place any obstacles in the way of free dealing throughout their territories in one another's currencies (including gold coins) or of a similar free exercise of the banking business by any institution legally established in any of their territories.

This would mean in the first instance the abolition of any kind of exchange control or regulation of the movement of money between these countries, as well as the full freedom to use any of the currencies for contracts and accounting. Further, it would mean the opportunity for any bank located in these countries to open branches in any other on the same terms as established banks.

Free Trade in Money

The purpose of this scheme is to impose upon existing monetary and financial agencies a very much needed discipline by making it impossible for any of them, or for any length of time, to issue a kind of money substantially less reliable and useful than the money of any other. As soon as the public became familiar with the new possibilities, any deviations from the straight path of providing an honest money would at once lead to the rapid displacement of the offending currency by others. And the individual countries, being deprived of the various dodges by which they are now able to temporarily to conceal the facts of the actions by 'protecting' their currency, would be constrained to keep the value of their currencies tolerably stable.

Proposal more practical than Utopian European currency

This seems to me both preferable and more practical than the Utopian scheme of introducing a new European currency, which would immediately only have the effect of more deeply entrenching the source and root of all monetary evil, the government monopoly of the issue and control of money. It would also seem that, if the countries were not prepared to adopt the more limited proposal advanced here, they would be even less willing to accept a common European currency. The idea of depriving government altogether of its age-old prerogative of monopolising money is still too unfamiliar and even alarming to most people to have any chance of being adopted in the near future. But people might learn to see the advantages if, at first at least, the currencies of the governments were allowed to compete for the favor of the public.

The suggested extension of the free trade in money to free trade in banking is an absolutely essential of the scheme if it is to achieve what is intended. First, bank deposits subject to cheque, and thus a sort of privately issued money, are today of course a part, and in most countries much the largest part, of the aggregate amount of generally accepted media of exchange. Secondly, the expansion and contraction of the separate national superstructures of bank credit are at present the chief excuse for national management of the basic money.

On the effects of the adoption of the proposal all I will add at this point is that it is of course intended to prevent national monetary and financial authorities from doing many things politically impossible to avoid so long as they have the power to do them. These are without exception harmful and against the long-run interest of the country doing them but politically inevitable as a temporary escape from acute difficulties. They include measures by which governments can most easily and quickly remove the causes of discontent of particular groups of sections but bound in the long run to disorganise and ultimately destroy the market order.

Preventing government from concealing depreciation

The main advantage of the proposed scheme, in other words, is that it would prevent governments from 'protecting' the currencies they issue against the harmful consequences of their own measures, and therefore prevent them from further employing these harmful tools. They would become unable to conceal the depreciation of the money they issue, to prevent an outflow of money, capital, and other resources as a result of making their home use unfavorable, or to control prices - all measures which would, of course, tend to destroy the Common Market. The scheme would indeed seem to satisfy all the requirements of a common market better that a common currency without the need to establish a new international agency or to confer new powers on a supra-national authority.

2 - The Generalisation of the Underlying Principle

If the use of several concurrent currencies is to be seriously considered for immediate application in a limited area, it is evidently desirable to investigate the consequences of a general application of the principle on which this proposal is based. If we are to contemplate abolishing the exclusive use within each national territory of a single national currency issued by the government, and to admit on equal footing the currencies issued by other governments, the question arises at once whether it would not be equally desirable to do away altogether with the monopoly of government supplying money and to allow private enterprise to supply the public with other media of exchange it may prefer.

The questions this reform raises are at present much more theoretical than the practical proposal because the more far-reaching suggestion is clearly much too strange and alien to the general public to be considered for present application. The problems it raises are evidently also still much too understood even by the experts for anyone to make a confident prediction about the precise consequences of such a scheme. Yet it is clearly possible that there is no necessity or even advantage in the now unquestioned and universally accepted government prerogative of producing money. It may indeed prove to be harmful and its abolition a great gain, opening the way for very beneficial developments. Discussion therefore cannot begin soon enough. Though its realisation may be wholly impractical so long as the public is mentally unprepared for it and uncritically accepts the dogma of the necessary government prerogative, this should no longer be allowed to act as a bar to the intellectual exploration of the fascinating theoretical problems the scheme raises.

Competition in currency not discussed by economists

It is an extraordinary truth that competing currencies have until quite recently never been seriously examined.[1] There is no answer in the available literature to the question of why a government monopoly of the provision of money is universally regarded as indispensible, or whether the belief is simply derived from the unexplained postulate that there must be within any given territory one single kind of money in circulation - which, so long as only gold and silver were seriously considered as possible kinds of money, might have appeared a definite convenience. Nor can we find an answer to the question of what would happen if that monopoly were abolished and the provision of money were thrown open to the competition of private concerns supplying different currencies. Most people seem to imagine that any proposal for private agencies to be allowed to issue money means that they should be allowed to issue the same money as anybody else (in token money this would, of course, simply amount to forgery) rather that different kinds of money clearly distinguishable by different denominations among which the public could choose freely.

(Sections not excerpted here:
3 - The Origin of the Government Prerogative of Making Money
4 - The Persistent Abuse of the Government Prerogative
5 - The Mystique of Legal Tender
6 - The Confusion About Gresham's Law
7 - The Limited Experience with Parallel Currencies and Trade Coins)

8 - Putting Private Token Money into Circulation

I shall assume for the rest of this discussion that it will be possible to establish a number of institutions in various parts of the world which are free to issue notes in competition and similarly carry cheque accounts in the individual denominations. I shall call these institutions simply 'banks', or 'bank issues' when necessary to distinguish them from other banks that do not choose to issue notes. I shall further assume that the name or denomination a bank chooses for its issue will be protected like a brand name or trade mark against unauthorised use, and that there will be the same protection against forgery as against that of any other document. These banks will then be vying for the use of their issue by the public by making them as convenient to use as possible.

The private Swiss 'ducat'

Since readers will probably at once ask how such issues can come to be generally accepted as money, the best way to begin is probably to describe how I would proceed if I were in charge of, say, one of the major Swiss joint-stock banks. Assuming it to be legally possible (which I have not examined), I would announce the issue of non-interest bearing certificates or notes, and the readiness to open current cheque accounts, in terms of a unit with a distinct registered trade name such as 'ducat'. The only legal obligation I would assume would be to redeem these notes and deposits on demand with, at the option of the holder, either 5 Swiss francs or 5 D-marks or 2 dollars per ducat. This redemption value would, however, be intended only as a floor beneath which the value of the unit could not fall, because I would announce at the same time my intention to regulate the quantity of the ducats so as to keep their (precisely defined) purchasing power as nearly as possible constant. I would also explain to the public that I was fully aware I could hope to keep these ducats in circulation only if I fulfilled the expectation that their real value would be kept approximately constant. And I would announce that I proposed from time to time to state the precise commodity equivalent in terms of which I intended to keep the value of the ducat constant, but that I reserved the right, after announcement, to alter the composition of the commodity standard as experience and the revealed performances of the public suggested.

It would, however, clearly be necessary that, though it seems neither necessary nor desirable that the issuing bank legally commits itself to maintain the value of its unit, it should in its loan contracts specify that any loan could be repaid either at the nominal figure in its own currency, or by corresponding amounts of any other currency or currencies sufficient to buy in the market the commodity equivalent which at the time of making the loan it had used as its standard. Since the bank would have to issue its currency largely through lending, intending borrowers might well be deterred by the formal possibility of the bank arbitrarily raising the value of its currency, that they may well have to be explicitly reassured against such a possibility.

These certificates or notes, and the equivalent book credits, would be made available to the public by short-term loans or sale against other currencies. The units would presumably, because of the option they offered, sell from the outset at a premium above the value of any one of the currencies in which they were redeemable. And, as these governmental currencies continued to depreciate in real terms, this premium would increase. The real value at the price at which the ducats were first sold would serve as the standard the issuer would have to try to keep constant. If the existing currencies continued to depreciate (and the availability of a stable alternative might indeed accelerate the process) the demand for the stable currency would rapidly increase and competing enterprises offering similar but differently named units would soon emerge.

The sale (over the counter or at auction) would initially be the chief form of issue of the new currency. After a regular market had established itself, it would normally be issued only in the course of ordinary banking business, i.e. through short-term loans.

Constant but not fixed value

It might be expedient that the issuing institution should from the outset announce precisely the collection of commodities in terms of which it would aim to keep the value of the ducat constant. But it would be neither necessary or desirable that it tie itself legally to a particular standard. Experience of the response of the public to competing offers would gradually show which combination of commodities constituted the most desired standard at any given time and place. Changes in the importance of the commodities, the volume at which they were traded, and the relative stability or sensitivity of their prices (especially the degree to which they were determined to competitively or not) might suggest alterations to make the currency more popular. On the whole I would expect that, for reasons to be explained later on (section 13), a collection of raw material prices, such as has been suggested as the basis of a commodity reserve standard,[38] would seem most appropriate, both from the point of view of the issuing bank and from that of the effects of the stability of the economic process as a whole.

9 - Competition Between Banks Issuing Different Currencies

It has for so long now been treated as a self-evident proposition that the supply of money cannot be left to competition that probably few people could explain why. As we have seen, the explanation appears to be that it has always been assumed that there must be only be one uniform kind of currency in a country, and that competition meant that its amount was to be determined by several agencies issuing it independently. It is, however, clearly not practicable to allow tokens with the same name and readily exchangeable against each other to be issued competitively, since nobody would be in a position to control their quantity and therefore be responsible for their value. The question we have to consider is whether competition between the issuers of clearly distinguishable kinds of currency consisting of different units would not give us a better kind of money than we have ever had, far outweighing the inconvenience of encountering (but for most people not even having to handle) more than one kind.

In this condition the value of the currency issued by one bank would not necessarily be affected by the supplies of other currencies by different institutions (private or governmental). And it should be in the power of each issuer of a distinct currency to regulate its quantity so as to make it most acceptable to the public - and competition would force him to do so. Indeed, he would know that the penalty for failing to fulfill the expectations raised would be the prompt loss of the business. Successful entry into it would depend on establishing the credibility and trust that the bank was able and determined to carry out its declared intentions. It would seem that in this situation sheer desire for gain would produce a better money than government has ever produced.[41]

Effects of competition

It seems to me fairly certain that:

1 -- A money generally expected to preserve its purchasing power approximately constant would be in continuous demand so long as the people were free to use it.

2 -- With such a continuing demand depending on success in keeping the value of the currency constant one could trust the issuing banks to make every effort to achieve this better than would any monopolist who runs no risk by depreciating his money.

3 -- The issuing institution could achieve this result by regulating quantity of its issue.

4 -- Such a regulation of the quantity of each currency would constitute the best of all practicable methods for regulating the quantity of media of exchange for all practical purposes.

Clearly a number of competing issuers of different currencies would have to compete in the quality of the currencies they offered for loan or sale. Once the competing issuers had credibly demonstrated that they provided currencies more suitable to the needs of the public than government has ever provided, there would be no obstacle to their becoming generally accepted in preference to the government currencies - at least in countries in which government had removed all obstacles to their use. The appearance and increasing use of the new currencies would, of course, decrease the demand for the existing national ones and, unless their volume was rapidly reduced, would lead to their depreciation. This is the process by which the unreliable currencies would gradually all be eliminated. The condition required in order that this displacement of the government money should terminate before it had entirely disappeared would be that government reformed and saw to it that the issue of its currency was regulated on the same principles as those of the competing private institutions. It is not very likely that it would succeed, because to prevent an accelerating depreciation of its currency it would have to respond to the new currencies by a rapid contraction of its own issue.

(Not excerpted here:
10 - A Digression on the Definition of Money)

11 - The possibility of Controlling the Value of a Competitive Currency

The chief attraction the issuer of a competitive currency has to offer to his customers is the assurance that its value will be kept stable (or otherwise be made to behave in a predictable manner). We shall leave for section 12 the question of precisely what kind of stability the public will probably prefer. For the moment we shall concentrate on whether an issuing bank in competition with other issuers of similar currencies will have the power to control the quantity of its distinctive issue so as to determine the value it will command in the market.

The expected value of a currency will, of course, not be the only consideration that will lead the public to borrow or buy it. But the expected value will be the decisive factor determining how much of it the public will wish to hold, and the issuing bank will soon discover that the desire of the public to hold its currency will be the essential circumstance on which its value depends. At first it might perhaps seem obvious that the exclusive issuer of a currency, who as such has complete control over its supply, will be able to determine its price so long as there is anyone who wants it at that price. If, as we shall provisionally assume, the aim of the bank is to keep constant the aggregate price in terms of its currency of a particular collection of commodities it would, by regulating the amount of the currency in circulation, have to counteract any tendency of that aggregate price to rise or fall.

Control by selling/buying currency and (short-term) lending

The issuing bank will have two methods of altering the volume of its currency in circulation: it can sell or buy its currency against other currencies (or securities and possibly some commodities); and it can contract or expand its lending activities. In order to retain control over is outstanding circulation, it will on the whole have to confine its lending to relatively short-term contracts so that, by reducing or temporarily stopping new lending, current repayments of outstanding loans would bring about a rapid reduction of its total issue.

To assure the constancy of the value of its currency the main consideration would have to be never to increase it beyond the total the public is prepared to hold without increasing expenditure in it so as to drive up prices of commodities in terms of it; it must also never reduce its supply below the total the public is prepared to hold without reducing expenditure in it and driving prices down. In practice, many or even most of the commodities in terms of which the currency is to be kept stable would be currently traded and quoted chiefly in terms of some other competing currencies (especially if, as we suggest in section 13, it will be mainly prices of raw materials or wholesale prices of foodstuffs). The bank would therefore have to look to the effect of changes in its circulation, not so much directly on the prices of other commodities, but on the rates of exchange with the currencies against which they are chiefly traded. Though the task of ascertaining the appropriate rates of exchange (considering the given rates between the different currencies) would be complex, computers would help with almost instantaneous calculation, so the bank would know hour by hour whether to increase or decrease the amounts of its currency in circulation to be offered as loans or for sale. Quick and immediate action would have to be taken by buying or selling on the currency exchange, but a lasting effect would be achieved only by altering the lending policy.

Currency issuing policy

Perhaps I ought to spell out here in more detail how an issuing bank would have to proceed in order to keep the chosen value of its currency constant. The basis of the daily decisions on its lending policy (and it sales and purchases of currencies on the currency exchange) would have to be the result of a constant calculation provided by a computer into which the latest information about commodity prices and rates of exchange would be constantly fed as it arrived. The character of this calculation can be illustrated by the following abridged table (table 2).


The essential information would be the guide number at the lower right-hand corner, resulting from the quantities of the different commodities being so chosen that at the base date their aggregate price in Ducats was 1,000, or 1,000 was used as the base of an index number. This figure and its current changes wold serve as a signal telling all executive officers of the bank what to do. A 1,002 appearing on the screen would tell them to contract of tighten the controls, i.e. restrict loans by making them dearer or being more selective, and selling other currencies more freely; 977 would tell them that they could slightly relax and expand. (A special write-out of the computer in the chairman's office would currently inform him which of his officers did promptly respond to these instructions.) The effect of this contraction or expansion on commodity prices would be chiefly indirect through the rates of exchange with the currencies in which these commodities were chiefly traded, and direct only with regard to commodities traded chiefly in ducats.

The same signal would appear on the currency exchange and, if the bank was known for taking prompt and effective measures to correct any deviation, would lead to its efforts being assisted by more of its currency being demanded when it was expected to appreciate because its value was below normal (the guide number showing 1,002) and less being demanded when it was expected to depreciate (because the guide number had fallen to 997). It is difficult to see how such a policy consistently pursued would not result in the fluctuations of the value of the currency around the chosen commodity standard being reduced to a very small range indeed.

The crucial factor: demand for currency to hold

But, whether directly or indirectly via the price of other currencies, it would seem clear that, if an institution acts in the knowledge that the public preparedness to hold its currency, and therefore its business, depends on maintaining the currency value, it will be both able and compelled to assure this result by appropriate continuous adjustments of the quantity in circulation. The crucial point it must keep in mind will be that, to keep a large and growing amount of its currency in circulation, it will be not the demand for borrowing it but the willingness of the public to hold it that will be decisive. An incautious increase in the currency issue may therefore make the flow back to the bank grow faster than the public demand to hold it.

The Press, as pointed out, would closely watch the results of the efforts of each issuing bank, and daily quote how much the various currencies deviate from the self-set standards. From the point of view of the issuing banks it would probably be desirable to allow a small, previously announced, tolerance or standard of deviation in either direction. For in that event, so long as a bank demonstrated its power and resolution to bring rates of exchange (or commodity prices in terms of its currency) back to standard, speculation would come to its aid and relieve it of the necessity to take precipitate steps to assure absolute stability.

So long as the bank had succeeded in keeping the value of its currency at the desired level, it is difficult to see that it should for this purpose have to contract its circulation so rapidly as to be embarrassed. The usual cause of such developments in the past was circumstances which increased the demand for liquid 'cash', but the bank would have to reduce the aggregate amount outstanding only to adjust it to a shrunken total demand for both forms of its currency. It if had lent mainly on short term, the normal repayment of loans would have brought this result fairly rapidly. The whole matter appears to be very simple and straightforward so long as we assume that all the competing banks try to control their currencies with the aim of keeping their values in some sense constant.

Would competition disrupt the system?

What, however, would be the consequences if one competitor attempted to gain in this competition by offering other advantages such as a low rate of interest, or if it granted book credits or perhaps even issued notes (in other words, incurred debts payable on demand) in terms of the currency issued by another bank? Would either practice seriously interfere with the control the issuing banks can exercise over their own currency?

There will of course always be a strong temptation for any bank to try and expand the circulation of its currency by lending cheaper than competing banks; but it would soon discover that, insofar as the additional lending is not based on a corresponding increase of saving, such attempts would inevitably rebound and hurt the bank that over-issued. While people will no doubt be very eager to borrow a currency offered at a lower rate of interest, they will not want to hold a larger proportion of their liquid assets in a currency of the increased issue of which they would soon learn from various reports and symptoms.

It is true that, so long as the currencies are almost instantaneously exchangeable against one another at a known rate of exchange, the relative prices of commodities in terms of them will also remain the same. Even on the commodity markets the prices of those commodities (or, in regions where a high proportion of the demand is expressed in terms of the increased currency, prices of all currencies) will tend to rise compared to the other prices. But the decisive events will take place on the currency exchange. At the prevailing rates of exchange the currency that has increased in supply will constitute a larger proportion of the total of all currencies than people have habitually held. Above all, everybody indebted in the currencies for which a higher rate of interest has to be paid will try to borrow cheap in order to acquire currencies in which he can repay the more burdensome loans. And all the banks that have not reduced their lending rates will promptly return to the bank that loans more cheaply all of its currency they receive. The result must be the appearance on the currency exchange of an excess supply of the over-issued currency, which will bring about a fall in the rate at which it can be exchanged into the others. And it will be at this new rate that commodity prices normally quoted in other currencies will be translated into the offending currency; while, as a result of its over-issue, prices normally quoted in it will be immediately driven up. The fall in the market quotation and the rise of commodity prices in terms of the offending currency would soon induce habitual holders to shift to another currency. The consequent reduction in the demand for it would probably soon more than offset the temporary gain by lending it more cheaply. If the issuing bank nevertheless pursued cheap lending, a general flight from the currency would set in; and continued cheap lending would mean that larger and larger amounts would be dumped on the currency exchange. We can confidently conclude that it would not be possible for a bank to pull down the real value of other currencies by over-issue of its currency - certainly not if their issuers are prepared, so far as is necessary, to counter such an attempt by temporarily curtailing their issues.

Would parasitic currencies prevent control of currency value?

A more difficult question, the answer of which is perhaps not so clear, is how far the unavoidable appearance of what one may call parasitic currencies, i.e. the pyramiding of a superstructure of circulating credit through other banks carrying cheque accounts and perhaps even issuing notes in the denomination of the currency of the original owner, would interfere with the issuer's control over the value of his own currency. So long as such parasitic issues were clearly labeled as debts to be paid in the currency of the issuer it is difficult to see how this could or should be prevented at law.

Clearly not all banks would wish to issue, or probably could issue, a currency of their own. Those that did not would have no choice but to accept deposits and grant credits in terms of some other currency, and would prefer to do so in the best currency available. Nor would the original issuer wish altogether to prevent this, although he might dislike the issue of notes more than the mere running of accounts subject to cheque in terms of his currency. Note issued by a secondary issuer would, of course, have to show clearly that they were not the original ducats issued by the bank that owned the trade mark, but merely claims for ducats, since otherwise they would simply be a forgery. Yet I do not see how the ordinary legal protection of brand names or trade marks could prevent the issue of such claims in the form of notes, and very much doubt whether it would be desirable to prevent it by law, especially in view of the essential similarity between such notes and deposits subject to cheque which even the issuing banks would hardly wish to prevent.

What the original issuer of such a currency could do and would have to do is not to repeat the mistakes governments have made, as a result of which control of these secondary or parasitic issues has slipped from their hands. It must be clear that it would not be prepared to bail out secondary issuers by supplying the 'cash' (i.e. the original notes) they will need to redeem their obligations. We shall see later (section 16) how governments were led into this trap and allowed their monopoly of the issue of money to be watered down in the most undesirable manner. (They shared the responsibility for control of the total amount of the standard denomination, yielding to the constant pressure for cheap money that was supposed to be met by the rapid spread of banks which they assisted by securing their liquidity; and in the end nobody had full power over the total quantity of money.)

The answer to the most serious problem arising from the scheme seems to me that, thought private issuers will have to tolerate the appearance of parasitic circulations of deposits and notes of the same denomination, they ought not to assist but rather restrain it by making it clear in advance that they would not be prepared to provide the notes needed to redeem parasitic issues except against 'hard cash', i.e. by sale against some other reliable currency. By adhering strictly to this principle they would force the secondary issuer to practice something very close to '100 percent banking'. So far as there would still be limited fiduciary parasitic issues they would have to be kept in circulation by a policy which assured that their value was never questioned. Though this policy might limit the circulation and thus the profit of the original issuer, it should not seriously impair hi ability to keep the value of his currency a constant.

To achieve this the original issuer of a currency with a certain label would have to anticipate the effects of the over-issue of such a parasitic currency (or any other currency claiming to maintain a value equal to its own) and ruthlessly refuse to buy it at par even before the expected depreciation manifests itself in the rise of some commodity prices in terms of that other currency. The dealings of an issue bank in other currencies would therefore never be a purely mechanical affair (buying and selling at constant prices) guided only by the observed changes in the purchasing power of the other currencies; not could such a bank undertake to buy any other currency at a rate corresponding to its current buying power over he standard batch of commodities; but it would require a good deal of judgement effectively to defend the short-run stability of one's own currency, and the business would have to be guided in some measure by prediction of the future development of the value of other currencies.

12 - Which Sort of Currency Would the Public Select?

Since it is my thesis that the public would select from a number of competing private currencies a better money that governments provide, I must now examine the process and the criteria by which a selection would take place.

(End abridged excerpts for this post selected from: F. A.Hayek: originally published as 'Hobart Paper Special No.70', 2nd [Extended] Edition, Institute of Economic Affairs, 1978, re-printed in "Economic Freedom", F. A. Hayek, IEA, 1991. Ch. 2, "The Denationalisaton of Money", pp. 125-162, all emphases original. Transcription errors my sole responsibility.)