Constitution or Competition? Alternative Views on Monetary Reform

Money, for practically as long as it has existed, has been employed to realize two fundamentally different sorts of goals: production or plunder. In a market economy, private individuals routinely use monetary institutions in a cooperative way to achieve voluntary exchanges of goods and services. Political authorities, by contrast, use monetary institutions in a non-​cooperative way to achieve involuntary transfers of wealth.

As a means for realizing cooperatively achieved ends, the use of money signals a great social advance over its predecessor, direct barter exchange. Carl Menger provided the classical invisible hand or spontaneous order explanation of the process of natural social evolution from barter to commodity money. The emergence of money was an unplanned or “spontaneous” event. No one person invented money; it gradually evolved as individuals, seeking to minimize the number of barter transactions necessary to obtain the commodities they wanted, learned that certain goods were more marketable than others and began to accumulate trading inventories for the exclusive purposes of exchange.

Money’s usefulness as a general medium of exchange is clear in contrast to the inconvenience of direct exchange: money eliminates the would-​be trader’s need to search among the sellers of the commodities he wants to acquire in order to find those few sellers who, in turn, want to acquire the particular commodity or service that he has to offer. The use of money thereby serves, in the words of Karl Brunner and Allan H. Meltzer, as a “substitute for investment in information and labor allocated to search.” Brian Loasby aptly comments: “Money, like the firm, is a means of handling the consequences of the excessive cost or sheer impossibility of abolishing ignorance.” It may be added that money, again like the firm, permits a far greater degree of specialization and division of labor because it reduces the need to search through markets. Without the institution of money, the modern economy could hardly have grown to its current level of complexity.

The use of money as a medium of exchange brings with it the widespread practice of quoting prices in a common currency unit. As a consequence, money becomes a tool of economic calculation —a “means of appraisal” in addition to its medium-​of-​exchange role as a “means of adjustment.” It facilitates the formation of economic plans as well as their execution.

The corrective feedback processes of a complex exchange system crucially depend upon these social functions that money performs. The informational and operational constraints that block both the individual decision-​maker and the whole economic order from better coordination of plans would be far more severe had not the institution of money spontaneously emerged. The emergence of money was itself an adaptive response to those obstacles.

The single most important book which has to date been written on the subject of money is Ludwig von Mises’ Theory of Money and Credit, first published in 1912. If the reader wanted to read just one work for general instruction, this would be the text to choose. It offers still today the most comprehensive and sophisticated system of theory on monetary phenomena. There are of course a number of other important works discussing the nature, evolution, and functions of money.

In its contrasting role as a means for realizing non-​cooperative ends, a government-​issued circulating currency provides political agencies with an instrument for redistributing wealth. Wealth transfers are achieved through the manipulation of money and credit production, specifically through the injection of new money. For its first spenders the new money represents fresh additional command over goods and services; but, as the monetary injection does nothing to increase the available supplies of goods and services, the first spenders’ command of these goods and services comes at the expense of other participants in the monetary economy. Such money-​facilitated government interventions may either transfer wealth from one group of private individuals to others within the private sector of the economy, or transfer wealth to the government itself from the private sector as a whole, depending on whether the initial recipients of the new money represent public or private agencies. Economists refer to the first type of transfer as the use of “monetary instruments” in pursuit of macroeconomic “policy targets,” and to the second as government revenue creation via an “inflation tax.”

Discussion of the currently competing theories of macro-​economic policy can be found in a number of textbooks. The books of Arthur Marget, The Theory of Prices (1942), and Axel Leijonhufvud, On Keynesian Economics and the Economics of Keynes (1968), provide valuable doctrine-​historical perspectives on macro-​economic theory. Of the many extensive analyses of the nature and implications of the revenue-​generating potential of a government fiat currency monopoly, two works co-​authored by H. Geoffrey Brennan and James M. Buchanan deserve special attention: “Money Creation and Taxation,” which appears in The Power to Tax: Analytical Foundations of a Fiscal Constitution (1980); and Monopoly in Money and Inflation: The Case for a Constitution to Discipline Government (1981).

One point is worth noting in passing. There seems to exist a unidirectional (‘one-​way street’) dependence between the feasibility of utilizing a currency’s universal acceptability for facilitating economic exchange and the feasibility of exploiting this property for political ends. In other words, it appears possible for money to serve the needs of market participants without at the same time necessarily having to serve the interests of political agencies; yet it seems impossible for money to serve the non-​cooperative currency controller without it already having been adopted for use by the cooperative social order. The relationship, in other words, is like that of host to parasite.

As S. Herbert Frankel has noted in his Money: Two Philosophies; The Conflict of Trust and Authority(1977), the cooperative and non-​cooperative uses of money do not simply coexist peacefully. There exists a “trade-​off” between the cultivation of a monetary order best suited to the purposes ofmicroeconomic adjustment (processes based on the ability of individuals to calculate and exchange effectively), and the manipulation of the monetary system to achieve macroeconomic adjustment. Government impairs monetary reliability (i.e., the reliability of money price signals for calculation and exchange) when it manipulates money and credit flows in pursuit of “full employment” levels of output. Frankel has described the situation as one of “conflict between money as a tool of state action and money as a symbol of social trust.”

Crucial to the economic usefulness of money is the predictability of its exchange-​value or purchasing power. The greater the general stability of monetary conditions of the economy, the more efficiently does resource allocation based upon subjective valuation and availability of economic goods take place.Unpredictability in the value of the money unit, on the contrary, is the quality of a money that proves most valuable for political purposes. Government may most profitably expand the number of money units in circulation when the inflationary consequences are unanticipated, especially by the economic sectors which are destined to experience the greatest loss of wealth due to the actions of the authorities. Where inflationary expectations of market participants underestimate the effects of politically expedient monetary disturbances on the system, the resulting changes in the distribution of wealth and income, and the unanticipated transfers of capital, are an indication that political goals are, by a crude process, being achieved at the expense of economic ends. Alternatively, if such monetary manipulations for political purposes are being unsuccessfully executed, this may indicate that individual agents in the market sector are successfully anticipating and, as a result, guarding themselves against movements in the currency’s purchasing power. In this event, economic activities requiring the use of money are then succeeding at the expense of political programs.

In sum, the economic role of money within the market order is that of a general means serving no oneparticular end but rather an ever-​changing set of private ends. In order for this role to be most efficiently filled, the value of the money unit must be stable, or, at least predictable. By serving “economic” interests, money serves social interests in general.

In its political role, however, currency serves as an instrument to advance special interests. Unlike the market function of money, the political function of money is not end-​independent, but endspecific. Whether the end consists of implementing full-​employment policy or creating revenue, monetary systems that have been set up to permit manipulation of the money stock for the benefit of special rather than general interests tend to systematically destabilize the market. The resulting disturbances are the consequence of the falsification of economic calculations caused by price distortions. The distortions, in turn, result from the unpredictable changes in, and consequent uncertainty about, the structure of relative prices affected by policy decisions.

Several important works by economists and accountants have discussed the negative consequences of monetary expansion undertaken for political ends, as those consequences fall on particular private groups or individuals. Others have considered the burden of such manipulations in terms of their disruption of the overall orderliness of a monetized exchange system. Axel Leijon-​hufvud has cogently summarized the way in which inflationary monetary policies interfere with microeconomic coordination:

The economics profession generally acknowledges that use of monetary policy for full-​employment purposes involves some sacrifice. There is little consensus, however, concerning the nature and significance of this “trade-​off.” The properties of the “Phillips curve” —the graphic representation of a supposed trade-​off between lower inflation and lower unemployment—have been the subject of extensive theoretical and empirical investigation. Economists of the Austrian School have recently been joined on one issue by those of the Monetarist School, and especially the “Rational Expectations” wing of the latter. Both groups advance the proposition that any increase in output or employment that is induced by monetary expansion must be temporary and self-​reversing. Such an increase results only from mistaken actions influenced by the false price signals generated by the monetary expansion. Unexpectedly rapid money growth may bring greater measured output and employment today, but it does not bring greater output or employment tomorrow, and is indeed likely to depress aggregate productivity in the long run due to its structurally disruptive impact. Unquestionably, it brings greater inflation of prices.

The contrary belief that discretionary money and credit management can achieve positive policy outcomes has been associated with Keynesian economic thought. The literature in support of discretionary policy is vast, as is the literature in opposition. The issue is still very much alive in the economic journals.

The questions of the feasibility of generating (short-​run) increases in employment and output through monetary expansion, and of the consequences of such a policy for the (long-​run) reliability of money and money price signals, are matters for an impartial wertfrei economic science to investigate. However, the question of the relative desirability of such various policy-​dependent outcomes, no matter what theoretical and empirical propositions one may accept, calls for a normative, value-​oriented appraisal. The non-​value-​free nature of such an appraisal might have been emphasized by placing between quotation marks the words “problem” and “mismanagement” in the subtitle above.

A preference for long-​term stability in the purchasing power of a community’s monetary unit—as opposed to policy-​induced changes of dubious duration in levels of aggregate resource utilization—is a major impetus behind recent arguments for reform of existing monetary arrangements. An even greater impetus to reform is a perception of the injustice inherent in a system that enables those in authority to systematically plunder the real wealth of the citizenry via an “inflation tax” —clearly a most insidious form of “taxation without representation.” Economists in the field of monetary political economy have concluded that an extremely serious problem of design exists in the present organization of the governmentally controlled money supply system. In their view the money-​using public’s demand for long-​term monetary stability is not being met. The task remaining for specialists in the field is therefore clear: to discover and develop a more appropriate means for realizing of the goal of monetary stability.

Let us now consider what these writers have proposed.

The oldest and certainly most familiar solution to the corrupting effects of state-​controlled paper money is a return to a gold standard. To many of us, the idea of reintroducing the use of specie (coined precious metals) and specie-​convertible bank liabilities as exchange media is practically synonymous with a return to stable money. The essential virtue of a monetary system based on “hard” currency is perhaps best expressed by one of the leading proponents of the gold standard, Hans F. Sennholz. He writes, in his Inflation or Gold Standard:

As anyone pursuing the question of monetary reform soon discovers, a mountain of literature—both popular and technical —has been published over the years on the nature and benefits of commodity money. Ludwig von Mises, in The Theory of Money and Credit, has deeply explored the distinctions among the three types of money: commodity money, credit money, and fiduciary, fiat, or “token” money. Of late, the leading advocates of the reinstitution of a gold standard have included Murray N. Rothbard, Henry Hazlitt, and Hans F. Sennholz.

Of related interest is the concept of a “commodity reserve” currency convertible not into coin but into a wide “basket” of standardized goods. Unlike a gold coin standard, a commodity reserve system would necessarily have to be the technical creation of a few expert advisers. This proposal has been discussed by Friedrich Hayek and Milton Friedman among others.

Although much has been written on the pros and cons of a return to gold as the solution to the chaos of politically controlled fiat money, this classic debate will not be considered in further detail here. Instead we turn to reform proposals not based on re-​establishment of convertibility for government-​issued currencies. In this context, two alternative means of preventing continued government mismanagement of currency production have been suggested: imposing legislated constraints on the behavior of the monetary authority or, more radically, abolishing the government’s monopoly in currency production. An extremely significant literature has grown up in recent years out of the debate between these two camps concerning the most appropriate structure for a purely token money system. The first group supposes continued government monopolization, while the second argues for a free market in the issue of private currency.

The by-​now-​mainstream response among monetary economists to the need for reform of the existing currency arrangements is the proposal that a “monetary constitution” be constructed and imposed upon those authorities who are vested with the responsibility for managing the nation’s money supply. Such a “constitution” would lay down binding rules defining in detail the money-​supply procedure to be followed. Fundamental to this program is a perpetuation of the existing market structure in currency production, namely government-​run or nationalized monopoly.

At present, the United States clearly lacks any explicit legal rule restricting the federal government’s money-​creation behavior. Indeed, it lacks even general constitutional limitation upon governmental efforts to “manage” the economic system overall. As Neil H. Jacoby notes, “It is a remarkable fact that the federal Constitution says practically nothing about the role of the President in guiding the national economy. Present institutions of control have evolved outside the Constitution and to a considerable extent outside of federal statutes.” Jacoby conjectures that the Founding Fathers neglected “problems of economic stabilization” due to the fact that [s]uch problems did not exist in the predominantly rural and agricultural society of about four million souls that was the United States in 1789.”

Existing statutes concerning the federal government’s control over the monetary system are so vague that they may be interpreted in almost any fashion. They are therefore of little help in legally constraining the monetary authorities. This ambiguity is apparent in the original Federal Reserve Act of 1913, which broadly directed the monetary authorities to regulate the nation’s currency so as to “accommodate commerce and business.” The Act was initially designed to guide the authorities within the context of the gold reserve standard that existed at the time. The elimination of the gold standard brought about by World War I, however, rendered the Act inadequate to constrain bureaucratic behavior.

With the end of the gold standard, money-​creation authorities in the United States and other nations became free to follow more “activist” macroeconomic policy measures. The Keynesian intellectual underpinnings of such monetary policies as they have evolved in the last half-​century have been dissected by “Public Choice” economists James M. Buchanan and Richard E. Wagner, and by Austrian economists F.A. Hayek and Murray N. Rothbard.

As already suggested, the various programs that monetary constitutionalists have proposed rest on two basic planks. First, they propose to maintain the existing government-​run monopoly of the currency industry. Secondly, they advocate that a binding money-​creation “rule” be imposed on the monopoly authority. As we shall see below, a number of different rules have found advocates.

Imposing a strictly defined and inflexible rule of monetary discipline, of whatever kind, is taken by monetary constitutionalists to represent “nothing more than the replacement of an undefined and potentially biased system of monetary policy by a defined system.” They share the belief, as expressed by Milton Friedman, that “the monetary structure needs a kind of monetary constitution, which takes the form of rules establishing and limiting the central bank as to the powers that it is given, its reserve requirements, and so on.” By defining the “rules of the game” of currency production, the monetary constitution will supposedly require that the government execute plans affecting the money supply “by law instead of by men.” It will remove the “extraordinary dependence on personalities, which fosters instability arising from accidental shifts in the particular people and the character of people who are in charge.” As a result, such a monetary constitution will greatly diminish the wide fluctuations in economic activity which in the past have allegedly resulted from “the granting of wide and important responsibilities that are neither limited by clearly defined rules for guiding policy nor subjected to test by external criteria of performance.”

Before discussing some of the specifics of the various monetary constitutionalists’ programs for institutional reform, it is interesting to note that there appear to exist two very different theoretical rationales behind the advocacy of these reforms.

Many proponents of a binding monetary rule argue for its necessity on the grounds that those in control of the currency production apparatus are faced with insurmountable limitations of knowledge. They argue that the authorities’ inability to forecast precisely the lagged responses of the economic system to their policy actions renders the achievement of monetary stability via discretionary “fine-​tuning” technically impossible. Given the present state of knowledge, then, some sort of inflexible and binding managerial “constitution” is perhaps the most reasonable procedure available. Most notable among those advancing this “informational limitations” argument are the Monetarist authors Phillip Cagan, Anna J. Schwartz, and Milton Friedman. Friedman expresses this position in the following way:

An alternative framework for analyzing the problematical behavior and consequences of an “unconstrained” government monopoly in currency production, though it leads to the same policy conclusions, has been developed and utilized by James M. Buchanan and other Public Choice theorists. These writers emphasize the monetary authorities’ motivational shortcomings, rather than their informational limitations. The authorities, according to this viewpoint, actually lack the properintentions to be allowed to exercise discretionary powers in the day-​to-​day management of the supply of currency. Buchanan and H. Geoffrey Brennan, for example, base the case for a rule constraining government’s currency-​creating activities on “government behavior in the ‘worst-​case’ setting,” a setting in which the “natural proclivities” of politicians and bureaucrats predominate. The “natural proclivities” of political functionaries involve, according to these theorists, the tendency to make decisions and take actions based upon a “narrowly-​defined self-​interest” which “run[s] counter to the basic desires of the citizenry.”

Richard E. Wagner argues in the same vein: “Existing monetary institutions create a link between politics and monetary control. The consequence of monetary monopoly combined with the pursuit of political self-​interest can be macroeconomic discoordination.” More specifically, given the government’s notorious and seemingly irresistible tendency to consistently overspend and contribute annually to an already enormous federal deficit, its monopoly over the production of currency “alters the constraints within which government conducts its activities, and alters them systematically by creating the bias toward monetary expansion.” As Gordon Tullock notes, monetary administrators are

In short, monetary systems granting monopoly privileges and permitting the wide use of discretion to those in power will most certainly function in a manner which maximizes the prospects for achieving political ends through monetary means. As a result, such systems tend to do “maximum, rather than minimum violence, to the logic of the market economy, sufficing to transform it from a harmonious to a self-​destructive system.” As Wagner has emphasized, “it is contrary to reason and to history to expect that a monopoly position will fail to be exploited for the benefit of those in a position to practice such an exploitation.”

Constitutionally constrained monetary systems are, as John Culbertson defines them, “token money systems with explicitly defined behavioral properties.” Various monetary rules differ according to the particular economic variable whose behavior is singled out for explicit control. There are basically two sorts of rules: (1) those that focus on the behavior of some monetary statistic, such as Milton Friedman’s well-​known proposal for a fixed annual growth rate in some measure of the stock of money; and (2) those that focus on the behavior of some non-​monetary statistic, such as proposals for stabilizing the price level or interest rates. In either case, the monetary authority is required to manipulate the monetary variable(s) under its immediate control—for the Federal Reserve System this is the sum of currency plus bank reserves—so as to keep the economic “target” variable on track.

Upon closer examination of proposals involving the first sort of rule, it becomes evident that their long-​run aim is usually identical to those rules which directly focus on maintaining a constant consumer price index. Friedman’s proposal, for example, calls for a three to five percent annual growth rate in a particular measure of the money stock. This growth-​rate interval is chosen, he acknowledges, “so that on average it could be expected to correspond with a roughly stable long-​run level of final product prices…A rate of 3% to 5% per year might be expected to correspond with [such a] price level.” Elsewhere Friedman argues that the “optimal” growth rate of the quantity of money would be that rate expected to correspond with a falling price level, specifically a price level falling at a percentage rate equal to the real rate of interest.

Friedman and others have extensively discussed the details of possible programs incorporating a constant-​money-​growth-​rate rule. E. S. Shaw has elaborated a version of the program specifying a 4% growth rate. In all cases, inflexibility inherent in such programs has come under criticism. Martin Bronfenbrenner claims greater efficiency on behalf of a “lag” rule, “according to which the growth rate of the money supply is adjusted to prior fluctuations in the growth rates of real national output and the velocity of the circulation of money.” He argues that such a rule “may be worthy of consideration as a compromise between the rigidity of the Friedman-​Shaw proposals and complete reliance on that combination of forecasting ability, political pressure, and administrative routine which passes as ‘judgment’ or ‘discretion.’” Other writers suggest that the rule adopted should be a “flexible” one, containing “override provisions” which permit it to be subjected to “frequent review” and “modification…as may be needed for maintenance of stability in the value of money.” Yet inflexibility also has its defenders. They contend that the monetary rule, once put into operation, should function so “mechanically” and serve its purpose so effectively, that “hereafter, we may hold to it unrationally—on faith—as a religion, if you please.”

Several authors have proposed and examined rules which constrain the monetary authorities by directing them specifically to maintain a constant price level rather than a constant money growth rate. Foremost among these authors are Jacob Viner, Henry Simons, Clark Warburton, and William H. Hutt. James M. Buchanan’s prescription for monetary management more broadly emphasizes predictability rather than simple constancy in the level of money prices.

The number of different monetary rules which could be devised is virtually infinite. Those which have been engineered to date suggest just a few of the many possibilities. Yet, despite disagreement among these theorists on the specific content of the constitutional constraint proposed, unanimity reigns concerning the necessity and importance of the constitutional construct itself. All would agree with Milton Friedman where he writes,

The passing years have witnessed numerous and detailed suggestions concerning the specific content of a constitution or rule that would define the appropriate procedure for money creation and control. The same cannot be said, however, of recommendations concerning the internal organization of the currency management apparatus. Although monetary constitutionalists concur on the necessity of concentrating the control of the currency industry in the hands of a single producer, there have been few detailed suggestions concerning this monopoly’s specific setup and day-​to-​day internal operation. Henry Simons, in his classic article, “Rules Versus Authorities in Monetary Policy,” proposed placing the money-​creation power presently “dispersed indefinitely, among governmental agencies and private institutions, not to mention Congress itself,” under the jurisdiction of the Treasury, which might then be “given freedom within wide limits to alter the form of the public debt—to shift from long term to short term borrowing or vice-​versa, to issue and retire debt obligations in a legal tender form.” In order to “eliminate…the private creation and destruction of money,” Milton Friedman suggests that the right to produce and control the supply of token units in circulation be granted exclusively to “the Central Bank” or “the Reserve System.” In general, though, the various authors offer no clear prescriptions concerning the possible internal structure or appropriate bureaucratic characteristics of the monopoly agency that they advocate. W. H. Hutt merely refers to “a monetary Authority,” without giving details on the possible nature of this agency, while H. Geoffrey Brennan and James Buchanan speak simply of “government,” in their recent book The Power to Tax. Lack of descriptive precision on this matter is not surprising, however, since the monetary constitutionalists believe that the content of rule constraining the privileged producer, rather than the set-​up of the producing agency, is crucial to the success of their proposals.

With constitutionally constrained monetary management, its advocates contend, the currency industry will no longer be a primary source of uncertainty and structural discoordination for the economy. Instead, the management will conduct its activities in such a way that monetary conditions become economically “neutral,” permitting the emergence of what John M. Culbertson refers to as a “zero-​feedback” monetary system. Such a system does not add to “the net positive feedback of the economic system” which tends to make it “prone to excessive self-​feeding movements” away from equilibrium. It does not create inflations and recessions in the name of stabilization policy. Instead it allows the “financial side of the economy” to operate as the “feedback-​control” or coordinating mechanism.

In sum, the legislation and enforcement of a monetary constitution, by appropriately restricting the actions of those with jurisdiction over the money production apparatus, will, it is believed, create a framework wherein the circulating medium behaves in harmony rather than in conflict with the exchange system.

For decades, programs for a rule-​restrained government monopoly had no serious rivals in the area of proposals for reform of the existing, politically dominated monetary system. In the literature of monetary policy, the constitutionalists’ suggestions were the only seriously proposed alternative to thestatus quo —the gold standard aside—that promised to insure stability in the circulating medium’s exchange-​value. Then, in 1976, F. A. Hayek published a short but professionally shocking book entitledDenationalisation of Money: An Analysis of the Theory and Practice of Concurrent Currencies. Hayek seriously proposed the exciting, challenging possibility of a spontaneous monetary order providing for its own token currency needs, without the involvement of government. The result was a major explosion of research into this new—free market—alternative to the state’s historically exclusive right to issue currency for the economy.

First presented by Hayek “as a sort of bitter joke,” the proposition that the free market might provide the best institutional vehicle for the production of monetary services has emerged as the single most important development in the area of monetary reform in recent years. This free market approach to money is not to be confused with the so-​called “Free Money” policies advocated earlier in this century by such inflationists as Silvio Gesell in The Natural Economic Order and Henry Meulen in Free Banking, an Outline of a Policy Individualism (1934). Those policies were designed to permit abundant rather than sound private monies. The program behind the “Free Money Movement” called for by Hayek requires, by contrast, nothing less than a radical switch from the government’s traditionally closed monopoly in the token currency industry to a regime of free trade in the production and choice of exchange media. Hayek would allow government to continue to produce currency only as one competitor among many: “What is so dangerous and ought to be done away with is not governments’ right to issue money but the exclusive right to do so and their power to force people to use it and accept it at a particular price.”

Proponents of free trade in currency predict that a program for monetary reform which placescompetitive rather than “constitutional” constraints on the individual money producer will prove to be far more effective in orienting managerial activities toward satisfying the needs of a currency-​consuming public. Given the success of the market system in other realms of production, Hayek argues that the appropriate control of monetary aggregates to meet the demands of transactors “will be done more effectively not if some legal rule forces government, but if it is in the self-​interest of the issuer which makes him do it, because he can keep his business only if he gives the people a stable money.” Raising the informational as well as the motivation problems of monetary central planning and nationalization, he adds that “the monopoly of government of issuing money has not only deprived us of good money but has also deprived us of the only process by which we can find out what would be good money.”

It would be difficult to overstate the seriousness and urgency with which Hayek advocates the denationalization of money as a means for reforming the existing system. He does not propose the end of the monetary monopoly merely as a temporary expedient, to tide us over until we are able to design a constitutional mechanism that will channel the government monopoly into more commendable modes of behavior; nor as a standby plan in case the present system collapses. His alternative of monetary self-​organization requires nothing less than the permanent removal of all barriers to entry and free competition in the currency and banking industries. And what is more, it promises nothing less than an end to the catastrophic effects of central-​bank-​caused business cycles:

Earlier discussions of the nature and consequences of a regime of free trade in the money and banking industries may be found in the works of several classical political economists. Adam Smith, for example, in his unsurpassed Inquiry into the Nature and Causes of the Wealth of Nations (1776), expressed support for Scotland’s policy of laissez faire towards the issue and circulation of private bank notes used in commercial exchange. Smith explained that substantial economies could be gained by employing redeemable paper currencies in place of gold and silver coin, as the displaced coin could then be exported in exchange for productive capital goods. Nevertheless, he was also aware of the potential dangers of such paper monies:

The insecurity for domestic banknote users was, in Smith’s words, mainly due to “the accidents to which they are exposed from the unskillfulness of the conductors (issuers) of this paper money.” Smith’s solution, not surprisingly, was free competition:

John Stuart Mill, in his Principles of Political Economy (1848), also offered arguments for relying—with some qualifications —upon private sector competition in the production of money and banking services. He noted:

The irrepressible Herbert Spencer, in Social Statics, also voiced his support for private enterprise in servicing the public’s credit and currency needs. Spencer wrote:

Scholarly analysis of the properties of a competitive system of privately issued “token” monies—moniesnot redeemable on demand for precious metals—appears to be confined to recent decades. One of the first major theoretical discussions of such a system is William P. Gramm’s “Laissez-​Faire and the Optimum Quantity of Money,” which appeared in 1974. Developing a model of the currency industry characterized by a “perfectly” competitive market structure, Gramm counters the claims made by monetary economists Harry Johnson, Paul Samuelson, as well as Boris Pesek and Thomas Saving. These scholars claim that competition in the production of nominal money balances wastes resources and results in a non-​optimal quantity of money, implying, therefore, that the currency industry is subject to “market failure.” In his excellent “Theory of Money and Income Consistent with Orthodox Value Theory,” also appearing in 1974, Earl Thompson also analyzes the efficiency and macroeconomic stability properties of a system in which “competitive money creators” or “bankers” supply the needs of currency-​using transactors. Thompson demonstrates the beneficial consequences that follow when we properly apply the standard assumptions of orthodox neoclassical value theory to a perfectly competitive production-​and-​exchange economy in which the provision of money is also subject to perfect competition. The result is an equilibrium quantity of real money balances which is: (1) determinate; (2) “Pareto optimal” (i.e., all resources go to their highest-​valued uses); and (3) consistent with Say’s Law of Markets (i.e., inconsistent with permanent, aggregate resource unemployment).

In November of 1974, another major work on the competing currencies question was published in theJournal of Money, Credit, and Banking. In his article “The Competitive Supply of Money,” Benjamin Klein dealt the final blow to those arguments against monetary competition. Klein refutes the criticism that such a system would necessarily generate a hyper-​inflation, leading to an infinitely high level of money prices. He demonstrates that we could expect such a result only when the “brand names” or “trademarks” of the various privately issued token monies are not protected from counterfeiting. He provides an excellent discussion of the process by which the competitive system would punish a money-​producing firm that attempted to cheat its customers by deceitfully manipulating the supply of its brand of money, and how, correspondingly, it would reward a firm that operated to preserve its customers’ trust. Klein concludes with a short historical discussion and a consideration of the pros and cons of competition, but he comes to no strong conclusions concerning the preferability of a competitive market structure over the existing closed government monopoly. In two later articles, Klein applies his theoretical apparatus to the questions of European monetary unification and the seignorage profits earned by currency issuers.

Shortly after Klein’s first article, Gordon Tullock’s “Competing Monies” appeared in the Journal of Money, Banking, and Credit (1975). This fascinating article, after suggesting some possible examples of historical precedents in the use of competing private token issues, offers an important theoretical analysis of the microeconomic process by which a depreciating currency might gradually be given up in favor of another more stable one. Tullock’s article triggered an interesting exchange between himself and Klein concerning the authenticity and frequency of historical instances of competing private monies.

F. A. Hayek’s 1976 pamphlet, Choice in Currency: A Way to Stop Inflation, represented the beginnings of the first major attempt toinvestigate seriously the practical possibilities of a system of competing paper issues. It was here that Hayek began to address the question, “Why should we not let people choose freely what money they want to use?” —and to answer it: “There is no reason whatever why people should not be free to make contracts, including ordinary purchases and sales, in any kind of money they choose, or why they should be obliged to sell against any particular kind of money.”

The program presented in Choice in Currency involves domestic competition among different national government monies, each of whose circulation is presently confined almost exclusively to its country of origin. But over a period of eight months, the program quickly evolved into a full-​blown scheme of competing private (as well as governmental) monies. The result of this development was Hayek’s pathbreaking Denationalisation of Money: An Analysis of the Theory and Practice of Concurrent Currencies. First published in 1976, this work was subsequently revised and extended. It provides the best existing account of, and the best case for, free competition in the production and control of privately issued token monies. Hayek’s analysis of the hypothetical working of a laissez-​faire monetary system may seem deceptively simple, due to its brief treatment of a novel idea. The analysis should be closely read and carefully considered by the interested reader, as it has been misunderstood by more than one writer in the area. The author comes to the firm conclusion that “the past instability of the market economy is the consequence of the exclusion of the most important regulator of the market mechanism, money, from itself being regulated by the market process.”

Since Hayek’s Denationalisation of Money was first published, several other authors have made significant contributions to the small but rapidly growing discipline of currency competition. These include Lance Girton and Don Roper, whose “Substitutable Monies and the Monetary Standard” (1979) gives a clear and concise statement of the “theory of multiple monies” and discusses some of the major issues connected with the choice-​in-​currencies question. Roland Vaubel’s “Free Currency Competition” (1977) is an excellent study offering an extremely thorough overview of the subject and its controversies. In addition, it provides some personal predictions concerning what Vaubel believes to be the most likely outcome of a competitively determined currency industry. Vaubel refers to two as-​yet-​unpublished works, Wolfram Engels’ “Note Issue as a Branch of Banking” and Wolfgang Stutzel’s “Who Should Issue Money? Private Instead of Public Institutions? Bankers Instead of Politicians!”, that further discuss and argue for a free market in money.

Among lay audiences concern with understanding the existing monetary mess has reached a high level of intensity in recent months. In order to satisfy this popular demand, a number of nontechnical introductory articles on the competing token monies alternative have recently appeared. Among these are pieces by economists Martin Bronfenbrenner, F. A. Hayek, Lawrence H. White, and Peter Lewin. In addition, a number of works have examined historical incidents of privately-​issued monies (token, fiduciary, and commodity), complementing research done on the purely theoretical level.

The hypothetical day-​to-​day operation of an established competitive token monetary system is in fact no more (or less) mysterious than is the working of the market process in any other production domain. Private issuers would compete in a number of dimensions to meet the community’s demands for monetary services: purchasing-​power behavior over time, convenience of use in exchange, convenience of use in accounting, and so on. Depending upon the preferences of currency consumers, the producer would adjust the existing supply of nominal units of his money so as to provide the appropriate degree of appreciation or constancy in his money’s value. The purchasing-​power control technique (or “rule”) employed in actual practice by any given firm is, under a competitive system, a matter to be determined exclusively by the subjective judgments of the monetary entrepreneur.

Because people’s exchange needs are different, preferences with respect to changes in the exchange-​value of currencies can be expected to vary over the population of money users. This would result in issuer specialization to meet the unique requirements of particular user interests. Similarly, tastes may differ with respect to the index of commodity prices devised to monitor deviations from the desired level or rate of change of the purchasing power of a money. On this point, Hayek explains: “Experience of the response of the public to competing offers would gradually show which combination of commodities constituted the most desired standard at any time and place.” In short, under competitive conditions, the monetary standard, the monetary rule, and the purchasing-​power behavior of money are all determined by expressed choice in the marketplace rather than by arbitrary political command.

Over time, those issuers who most effectively satisfy the demand for monetary services would profit and expand their market shares. Others who, for example, increase the value of their currencies when most money-​holders prefer stable tokens, or stabilize their monies when most users prefer appreciating tokens, would be driven out of business or be forced to maintain a more modest circulation due to reduced profits. Which sort of monies would actually prove most popular, only the competitive market process can tell. For instance, Roland Vaubel points out, while purchasing-​power appreciation tends to enhance a money’s desirability as an asset (or “store of value”), purchasing-​power constancy may enhance its desirability as an accounting device (or “standard of value”).

The case for competition appears the logically superior one. However, doubts and queries about the operation of the system have nevertheless been expressed. Critics have especially emphasized potential problems concerning the stability and emergence of efficient supplies of currency when competition is allowed to regulate its production.

The issue of stability centers on the question of the controlability of a currency’s value under a “perfectly” competitive scheme. This is sometimes framed, inversely, as the problem of “infinite” levels of money prices presumably resulting from a laissez-​faire regime. Boris Pesek, for example, expresses the belief that in the long run a competitive paper currency system would generate a situation in which “money is so ‘abundant’ as to sell for a zero price and be a free good,” producing a “regression into full-​time barter since free money is worthless money, incapable of performing its task of facilitating exchange of goods among persons.” Benjamin Klein, as noted earlier, has demonstrated that such a result depends on improperly specified or protected property rights in the currency industry, and would emerge in any market in which brand names could be counterfeited. In such a market, producers and consumers lack a signaling mechanism by which to identify the outputs of different firms in the industry, so that a low-​quality product cannot be identified and shunned in advance. Explains Klein:

Thus, in order to solve the paradox of infinite price levels, we need only introduce into a competitive currency model that was designed to prove the instability of free trade in money an assumption implicit in all standard analyses of competitive industry: the premise that products are distinguishable with respect to origin. (This is not inconsistent with another assumption of “perfect competition” models: that products are completely indistinguishable or identical with respect to their flow of services.) On making this assumption the proof is reversed, and we may deduce stability properties typically found in a perfectly competitive world. Criticisms of the stability properties of a free-​market monetary system in this case point up a potential problem concerning the appropriate legal structure necessary for a properly functioning competitive system, rather than a problem of the competitive market structureitself, given a well-​defined system of property rights.

The emergence of a competitive token monetary system from the existing domestic government monopoly raises two questions. First, there is the issue of how in theory a system of multiple monies could emerge; and second, there is the question of whether in practice such an evolution should be expected to take place once the requisite property rights structure has been established for the industry.

Posing the first question, Henry Hazlitt asks:

Indeed, new currencies would not appear or be accepted overnight. During the gradual process of establishing a private currency, the issued certificates would not immediately be greeted by money-​users as currency. At the outset they would be supplied to the public in the form of money substitutes. These money substitutes would be supplied under an explicit contract guaranteeing the bearer some minimum rate of exchange between these certificates and one or more commodities or pre-​existing currencies. Currency entrepreneurs would of course decide which commodities or monies to use in this process, and money-​users would then choose from among the alternatives offered.

Only later, after the issuing firm had fostered sufficient consumer confidence in its trademarked tokens by making the necessary investments in the firm’s “brand-​name capital,” would the issued notes begin to take on a monetary life of their own. The point marking this transformation is reached when currency-​users effectively acknowledge the new currency as “monetized” by no longer routinely demanding that it be converted into another more liquid asset. Instead transactors begin circulating the notes as an independent exchange medium in their daily business.

Empirical doubts about the second question—whether a competitive currency system would in fact spontaneously emerge under the right legal conditions—are almost without exception framed in terms of the economic concept of “transactions costs.” They are presented on the basis of a number of confusions, widespread within the economics profession, concerning the notions of “cost,” “choice,” and “competition.” Such confusions are all too familiar to Austrian economists.

Arguments that deny the likely emergence of concurrent privately issued monies under laissez faire typically run as follows. People employ goods “having currency” for a variety of reasons, the most important among these being the purpose of transacting economic exchanges. In its capacity as a medium of exchange, a monetized commodity, due to its quality of being highly marketable, provides the transactor with a device which allows him to economize on the time and resources required to complete his desired set of exchanges. Thus far the argument is unobjectionable. Confusion enters in the form of a non sequitur when the argument leaps to the conclusion that, to the individual agent, “money is more useful the larger its transactions domain.” On this basis Roland Vaubel argues that

This argument leads Vaubel to conclude: “Ultimately, currency competition destroys itself because the use of money is subject to very sizeable economies of scale. The money-​industry must be viewed as a ‘natural monopoly,’ which at some stage must be nationalized.” He adds that since it is “undisputed that lines of production that are subject to permanently declining cost must at some stage be nationalized (or, in an international context, be ‘unified’), the fact that currency competition will lead to currency union must be regarded as desirable.”

This argument labors under some rather common misconceptions. First, only individuals transact, and they do so only with one other individual or organization at a time, rather than with the entireeconomic order or “transactions domain.” Further, there are likely to be many sectors of the monetized system with which these actors have little or no interest in dealing. These submarginal transactions areas vary from person to person. It is not at all obvious, then, that a money will be “more useful” to any given agent, the more universal or extensive the domain within which the money (or monies) he uses circulates. Some degree of specialization and heterogeneity in the currency industry’s supply of services may in fact persist indefinitely because of persistence of differences in the needs and purposes of the various money-​using members of a community. In that case, several different issues may circulate side by side, each servicing the individuated demands of a separate subset or “neighborhood” of the “global” transactions domain. And, of course these currency areas may overlap.

The exact configuration of the resulting monetary mosaic is unpredictable under a competitive monetary arrangement since each currency consumer’s choice from among the array of currencies available to him is made according to purely subjective benefit-​cost calculations. Accordingly, the aggregate impact of consumers’ choices in determining a given currency’s domain will be revealed only after the execution of the particular plans that are based upon these calculations. Since their requirements may, for example, be highly localized geographically, it seems unreasonable to conclude a priori that a system of several concurrently circulating monies is “likely to be purely transitory, and that the only lasting—and again desirable—result will be currency union.”

A second problem with the prediction of a “spontaneous monopolization” of the currency industry concerns the misconception of the competitive process that underlies this forecast. Surely, no one can resist reaching the conclusion that “competition destroys itself” in any industry in which marginal costs of production are continuously falling; no one, that is, who has adopted the entrepreneurially staticnotion of “perfect competition” as a benchmark. In that conceptual framework, the criterion of a “competitive” industry refers to a specific magnitude or pattern (“many” firms or price equal to marginal and average costs), rather than to the end-​independent (and unceasing) process (rivalrous pursuit of profits) that characterizes the operation of the system. It naturally follows that any industry not obeying the perfectly competitive “pattern” must by definition exhibit “monopolistic tendencies.”

Once we recognize, however, that real-​life competition is a dynamic and unending discovery process, we no longer can meaningfully judge an actual industry’s competitiveness by comparing it with some final static state of “optimality,” “perfection,” or “equilibrium.” So long as the necessary legal framework is in force, the competitive process is at work whether one firm or many firms persist. In Brian Loasby’s words: “[T]he critical question is, not what should the pattern of resource allocation look like, but howis it to be achieved; and the perfectly competitive model, which has defined the terms of the argument, provides no recipe for achieving anything. Actual competition is a process, not a state; and perfect competition can exist only as the description of a state.

Vaubel goes on to offer one more criticism of the efficiency of competing currencies. He argues that because “a good like money[‘s]…precise purpose is to reduce transaction cost, information cost and risk (as compared with barter), a diverse plethora of private issuers in the industry is likely to be “particularly inconvenient” due to the “diseconomies of small scale.” He further argues that these effects “do not disappear if all banks of issue are led or forced to denominate their monies in the same standard of value.” The issue of whether several concurrently circulating exchange media would present an inconvenience to currency-​users depends, again, on the individual users’ subjective evaluations of the benefits and costs involved. The outcome cannot be conclusively determined a prioriby the theorist. What is more, it is of interest to note that economic historian Hugh Rockoff has offered evidence which suggests by analogy that the benefits of a multi-​issuer system may in fact outweigh the possible inconvenience in the estimations of consumers:

It should be mentioned that a few advocates of the gold standard have questioned the feasibility of privately circulated issues of explicitly “token” form. Their criticisms are clearly directed not against market-​oriented monetary reform per se (as the gold standard they advocate is itself a market-​controlled monetary system), but rather against a system of irredeemable and exclusively paper monies. According to these skeptics, the Hayekian paper regime could never exist. A purely fiduciary money is simply not possible in a world of free and rational agents; and it follows, they argue, that a system of competing paper issues is also impossible:

It is surprising how many basic confusions concerning the theories of subjective valuation, money, and the spontaneous order have been included in such a short passage. The implication that an established token issue’s acceptability is necessarily dependent upon its possessing a governmentally sanctioned “legal tender” status (“Remember they are not legal tender”) is false. In contrast to these would-​be Misesian writers, Mises himself notes:

If these writers mean to suggest that token money is exclusively a “creature of the State,” perhaps they should say so directly.

The bald assertion that a newly issued private money’s value “could not be insured” is also incorrect. More than one author has explained how and why such “value insurance” for new monies might hypothetically be made available to interested-​but-​wary potential customers. What is worse, the assertion represents a disconcertingly unannounced jump in logic. It leaps from a general and objective analytical discussion of the issues to a highly specific and essentially entrepreneurial judgment concerning the dimensions in which the market for insurance services could or could not operate in the future. An economist oversteps his bounds in going beyond purely scientific explanations of the operations of the competitive process in the currency industry into the realm of concrete predictions concerning the industry’s future organization (“supply-​side”) and qualitative (“demand-​side”) features. Such prediction is the concern of entrepreneurs. In these instances, criticism seems to reveal a basic misunderstanding of the literature concerning the Hayekian private paper money system in particular, and of the theory of the spontaneous order as a fluid discovery process in general.

The fact of the matter is that individuals do transact with and are willing to hold merely “token” currencies. Even more generally, we may note that presumably rational, valuing agents, when situated within the context of a social system, continuously engage in various “customary” activities or follow established “norms” or procedures that do not yield obvious and direct benefits to them. These modes of behavior have evolved to facilitate social intercourse, though frequently those practicing them may be incapable of articulating or rationalizing those functions explicitly. The question is, should we deny or ignore the actual existence of certain forms of money or various other “products of human action but not of human design” simply because their acceptability seems “difficult to believe”? Or should we recognize that such structures do indeed exist, although to date their occurrence remains to be satisfactorily explained? To the inquiring mind, the answer seems obvious.

Additional and more practical objections to a system of free-​market paper monies have been developed in the literature. A number of these have come (somewhat surprisingly) from the program’s chief proponent, F.A. Hayek.

Finally, one of the most important arguments against monetary competition is implicit in a leading defense of a constitutionally constrained monopoly. This argument, which has been frequently invoked by monetary constitutionalists of both the Monetarist and Public Choice camps, seems, again, to rest on some rather serious misconceptions: The use of money, it is argued, is directly analogous to the following of legal rules of conduct within a civilization. Further, both the law and money come under the category of highly social “multi-​purpose instruments.” Since the extra-​market constitutional mechanisms devised in the past appear to facilitate the successful functioning and development of thelegal order, it seems naturally to follow that the creation of such a mechanism for the monetary order would serve to enhance its operation and progress as well. The creators and practitioners of law are continuously guided in their deliberations by a metal-​legal framework of general principles that provides a point of reference for “producing” proper legislation. Similarly, might not the creators and practitioners (managers) of the currency system be disciplined in their day-​to-​day activities by a set of principles? A monetary constitution would thereby insure that the “proper” monetary services would be produced and made available to market participants.

Two rather basic errors mar this argument. The first is that an analogy per se demonstrates nothing. It may indeed be true the use of currency in economic interactions has characteristics similar to those of the adherence to legal rules in social interactions. But it does not follow that it is therefore necessary for efficiency that the production of money be carried out within an institutional framework analogous to that created for the production of laws—a closed, govermentally controlled, jurisdictional monopoly. If this conclusion really were thought to follow, moreover, it would prove too much. That is, it would be unclear why its proponents have not also endorsed the socialization of religion, say, or the development of a constitution mandating and defining an overall set of principles for the production and use of language in society. If the evolution of optimal “supplies” of languages and language areas is allowed to be determined by spontaneous order, why then should not optimal money supplies and currency areas be so determined as well?

The second and more serious problem with the above argument is that the specific analogy used is flawed. It overlooks a crucial difference between currency and rules: laws (written down explicitly or not) are prerequisites for market activity. Money, while it does facilitate such activity, is not a prerequisite. Money is a good with a distinct demand and supply. Being an economic commodity capable of providing specific services to its users, there is no apparent reason why its production cannot be regulated by the same rules which guide the creation of all goods—the body of laws protecting competitive activity.

When it is claimed that currency production must be supervised by its own “special” legal framework and protected from the competitive process by being manufactured only by government, whereas other goods may be produced competitively under the standard legal framework calling for free and equal exchange, a confusion between the notion of abstract rules and that of particular commands is apparent. Those advocating a monetary constitution propose not an abstract rule for the promotion of the general welfare of those who manage their affairs within the nexus of the monetized exchange system, but what is in essence a monetary command—a command being defined as a rule “for the performance of assigned, specific, tasks” —for centrally planned money production. They, in short, take a “constructivistic” approach to monetary matters. Indeed, money and law are both “multipurpose” tools facilitating social interchange. But whereas laws are procedural dictates, money is an economic good.

As Hayek has pointed out on numerous occasions, what generalized “principles of justice” or “rules of just conduct” are intended to generate is not a command society (which would be the result if these “rules” were defined according to the endspecific criterion implied by the monetary constitutionalists), but rather a competitive society. The proper role of constitutional laws or principles is that of arbitrarily defining the set-​up of the apparatus (government) by which the generalized rules of conduct of the liberal social order may be enforced. The French classical liberal Frederic Bastiat put the entire matter succinctly in The Law: “liberty means competition.” And, as Girton and Roper state clearly with respect to the monetary system of an open society in particular: “Competition in money issue providesa rule enforced by the market, and a monetary standard that is attractive compared to current monopoly paper money standards.”

By denying currency the status of a privately producible “good” capable of being regulated by the pressures of market competition (and instead elevating it to the status of a supramarket social tool which needs by its very nature to be supplied by a non-​market governmental agency), the monetary constitutionalists are in fact stepping out of realm of scientific conjecture and into the domain of entrepreneurial conjecture. In the case of each program for a monetary constitution or “rule,” the author has tacitly adopted the approach of the hypothetical currency producer-​entrepreneur seeking the best production method. But rather than admit this, and in the process acknowledge that the only objective test of the correctness of such conjectures is the profit-​and-​loss test of market competition, each author continues to use the rhetoric of scholarship in the development of a “scientific” argument for his own particular “brand” of currency and its production design. What we have here is a case of entrepreneurs in scientists’ clothing.

Economists have clearly articulated the need for reform of the existing monetary system. The available alternatives for change have in recent years also taken clear and unambiguous shape: either continued yet constrained monopoly or free-​market competition in the supply of currency. The case for competition rather than constitutional restriction seems at present to be far stronger. The essence of the argument for free currency competition has perhaps been best expressed by Brian Loasby, who writes: