Progressive Libertarianism
Part 5: Money and Banking
Much as Gustave de Molinari challenged the conventional wisdom that security or policing is a natural monopoly that cannot work on a competitive basis, F. A. Hayek challenged the conventional wisdom that the issuance of currency ought to be done exclusively by government on a monopolistic basis. (This idea of competing currencies was further developed by George Selgin in The Theory of Free Banking: Money Supply Under Competitive Note Issue and by Steven Horwitz in Monetary Evolution, Free Banking, and Economic Order). Hayek writes:
“It has for so long been treated as a self-evident proposition that the supply of money cannot be left to competition that probably few could explain why. As we have seen, the explanation appears to be that it has always been assumed that there must be only 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.” — F. A. Hayek (Denationalisation of Money)
Government-issued currencies don’t have a good track record when it comes to stability. During the Great Depression and other economic recessions, central banks allowed the money supply to contract, resulting in a deflationary spiral and accompanying economic woes. At other times, government spending has resulted in excessive inflation or even hyperinflation. Most instances of hyperinflation resulted from war spending on the part of governments. This is the case with the hyperinflation of the American Continental, as well as with the post-WWI hyperinflation in the Weimar Republic and the post-WWII hyperinflation in Hungary. Yet some governments have even resorted to running the printing press hot in peace times, such as has happened in Argentina and Zimbabwe. Hayek and Selgin have argued that such government mismanagement of money is caused by a lack of competition.
The argument is that if we allowed private banks to issue their own currency and, thereby, compete with government-issued money, the banks would tend to keep the value of their currencies stable. F. A. Hayek, George Selgin, and Steven Horwitz posit that under a free banking system, the supply of bank-issued currency and deposits would adjust automatically to meet the demand for money. The banks would simply make adjustments in response to economic changes, so as to maintain the value of their currencies. When the money supply contracts, banks under a free banking system would naturally respond by issuing more money, thereby stabilizing the value of money and preventing an economic downturn. Alternatively, if the value of the currency started to drop, private banks under a free banking system would take measures to contract the money supply. Why? Because a policy of devaluing their currency would result in their customers switching to a more stable alternative medium of exchange issued by a competing bank. Any change in the value of a currency will negatively impact either debtors or creditors who have contracts denominated in that currency unit, so people would naturally choose more stable currencies to negotiate contracts in. This would create demand for stable currencies on the free market.
Under a free banking system, competition would drive private banks to regulate the supply of currency in a manner akin to how central banks are supposed to regulate the money supply under the status quo. Hayek writes:
“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 its outstanding circulation, it will on the whole have to confine its lending to relatively short-time contracts so that, by reducing or temporarily stopping new lending, current payments of outstanding loans would bring about a rapid reduction of its total issue….
“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 XIII, 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 circuation, 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 of exchange 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 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.” — F. A. Hayek (Denationalisation of Money)
By adjusting the money supply in response to changes in demand for money, private money-issuing banks under a free banking system would, in theory, stabilize the value of money relative to goods and services. This would have an effect similar to having a nominal GDP target at the central bank. Nominal GDP targeting is a way to ensure that the total spending in the economy grows at a steady and predictable rate, avoiding both high inflation and recessions. (Currently, no central bank adopts this specific policy; instead, they focus on targeting specific rates of inflation, currency exchange rates, unemployment levels, and other economic indicators.) Competition among banks in a free banking system would create an automatic stabilizing mechanism. Banks that issue too much currency would face redemption pressure, as people would likely want to withdraw their money and convert it to a more stable currency that is not being devalued. This would create a natural check on a private bank’s ability to issue money, aligning the supply of money with the actual demand for money.
In contrast to the free banking approach, under the existing system, central banks like the Federal Reserve manually adjust the money supply through various tools like open market operations, discount rates, and reserve requirements. A dialectical libertarian, recognizing that we aren’t likely to abandon central banking for free banking at any point in the near future, would recommend some sort of monetary policy that is analogous to what we should expect to occur under a regime of free banking or competing private currencies. On the one hand, we might prefer the market monetarist approach of having a nominal GDP target to the conventional approach of targeting inflation, as this would more closely resemble what might be expected to occur in a free banking system. Alternatively, we might support something like Claudia Sahm’s automatic direct stimulus proposal, which would automatically create and disburse funds directly to the people if key recession indicators were to go off, indicating a contraction of the money supply.
Insofar as the value of the currency is influenced by supply and demand, the issuer of currency must adjust the supply up and down relative to demand in order to stabilize the value. This means that in periods of deflation (rising demand for money), the issuer of currency needs to create more money in order to stabilize the price level. On the other hand, the onset of inflation indicates that the issuer needs to contract or shrink the money supply. In modern monetary systems, this can be done through interest rate policy, open market operations, or taxation. If we were to transition to a free banking system, where private banks were allowed to issue private currency and freely compete against the government’s money, the outsized role of the central bank in controlling the money supply would be minimized. The free banking system would limit the government’s ability to finance expenditures through money creation. The money supply under the control of the government bank would be much smaller, as a large part of the money in circulation would be private currencies.
Suddenly, with private banks issuing their own currencies, the government’s central bank would be subjected to the discipline of the market. In a free banking system, the government might find it more challenging to borrow money or engage in deficit spending. The central bank would be more limited in its ability to use monetary policy to allow increased government spending, so the government would need to rely more on market investors to fund deficits. If investors perceive the government’s fiscal policy to be unsustainable or inflationary, they might demand higher interest rates or shy away from buying government debt altogether. Competition in currency would also mean that the market, rather than the central bank, would set interest rates. This would take away the ability of the Federal Reserve to use artificially low interest rates (or easy credit) in order to inflate the money supply or stimulate the economy. As a result of these new constraints on monetary policy, there would be a strong incentive for the government to pursue a fiscally conservative approach to finance. The necessity of funding operations through taxation or market loans could make budget deficits both politically and economically more expensive. All these factors would likely push the government towards adopting a balanced-budget policy.
It should be noted that the theory of free banking isn’t entirely theoretical, as there are some historical precedents to consider. In his writings, George Selgin brings up historical examples, highlighting periods and regions where free banking systems were in operation. There were periods where free banking was quite successful in Scotland, Sweden, China, and Canada. He makes the case that these systems were relatively stable and resilient when compared to monopolistic money regimes in surrounding areas. If the reader is interested in the topic, I would highly recommend checking out Selgin’s works.
