Competing Money Supplies
By Lawrence H. White
What would be the consequences of applying the principle of laissez-faire—that is, completely free markets—to money? While the idea may seem strange to most people, economists have debated the question of competing money supplies off and on since Adam Smith’s time. In recent years, trends in banking deregulation, developments in electronic payments, and episodes of dissatisfying performance by central banks (such as the Federal Reserve System in the United States) have made the question of competing money supplies topical again. Nobel laureate Friedrich A. Hayek rekindled the discussion of laissez-faire in money with his 1976 monograph Denationalisation of Money. Milton Friedman, in a 1986 article coauthored with Anna J. Schwartz, reconsidered the rationales he had previously accepted for governments to provide money. Other leading economists who have entertained the idea of laissez-faire in money include Gary Becker and Eugene Fama of the University of Chicago, Neil Wallace of Pennsylvania State University, and Leland B. Yeager of Auburn University.
Two sorts of monetary competition already exist today. First, private banks and financial firms compete in supplying different brands of checkable deposits and traveler’s checks. They also compete in providing credit cards that are close substitutes for paying ready money. In a few corners of the world (Scotland, Northern Ireland, and Hong Kong), private banks still issue paper currency notes. Second, each national currency (such as the U.S. dollar) competes with others (such as euros and yen) to be the currency in which international contracts and portfolio assets are denominated. (Economists refer to paper money that is not convertible into an underlying asset, such as gold or silver, as a “fiat” currency.)
Much more competition in money has existed in the past. Under “free banking” systems, private banks routinely issued their own paper currencies, or “banknotes,” that were redeemable for underlying “real,” or “basic,” monies like gold or silver. And competition among those basic monies pitted gold against silver and copper.
Today, virtually all national governments regulate and limit monetary competition. They maintain government monopolies over coinage and the issuance of paper currency and to varying degrees restrict deposit banks and other financial firms, nationalize the interbank settlement system, restrict or place special taxes on holdings of gold or of foreign-currency assets, and refuse to enforce contracts denominated in alternative currencies. In developing countries, government banks sometimes monopolize the provision of checking accounts as well.
Some economists recommend abolishing many or even all of these legal restrictions. They attribute significant inefficiency and instability in the financial system to the legal restrictions on private banks and to poor central-bank policy, and they view competition as a potential means for compelling money suppliers to be more responsive to the demands of money users. While many economists would like to restrict the discretion given to central banks, the small but growing number of free-banking advocates would like to abolish central banks entirely. Most mainstream economists, though, fear that a return to free banking would bring greater instability to the financial system.
Proponents of free banking have traditionally pointed to the relatively unrestricted monetary systems of Scotland (1716–1844), New England (1820–1860), and Canada (1817–1914) as models. Other episodes of the competitive provision of banknotes took place in Sweden, Switzerland, France, Ireland, Spain, parts of China, and Australia. In total, more than sixty episodes of competitive note issue are known, with varying amounts of legal restrictions. In all such episodes, the countries were on a gold or silver standard (except China, which used copper).
In a free banking system based on a gold standard, competing private banks would issue checking deposits and banknotes redeemable on demand for gold. In a system based on a frozen quantity of fiat dollars, as Milton Friedman and a few other economists have proposed, bank deposits and banknotes would be redeemable for government notes, as deposits are today.
Competition among banks would, history indicates, compel all banks in the system to redeem their deposits and banknotes for a common basic money, such as gold or a standard paper currency issued by the government. Banks in such a system are parts of a unified currency area; “exchange rates” among them are fixed rather than floating. Citibank’s ten-dollar notes, for example, would be redeemable for ten dollars in basic money, and so would notes issued by Chase Manhattan. To attract customers, Citibank would be glad to accept deposits in Chase notes or Chase deposits, which it would then return to Chase for redemption at the clearinghouse. Given negligible risk and redemption costs (both likely under modern conditions), Citibank would even accept Chase notes at par (without a discount or fee, just as banks accept one another’s checks today). Chase would do likewise. The reason is that by agreeing to accept each other’s notes and checks at par, both Citibank and Chase would make their own money more useful, and therefore more widely accepted. This is not just abstract theorizing. We see par acceptance emerging historically among note-issuing banks. Similar competitive considerations have led banks more recently to form mutual acceptance networks for automatic teller machine cards, allowing customers of Citibank to get cash at Chase machines. Chase charges a fee for withdrawing Federal Reserve notes today, to cover its borrowing costs of carrying an inventory of Federal Reserve notes. Chase would not need to charge a fee for withdrawing Chase notes, because it has no borrowing costs in carrying an inventory of its own unissued notes.
What forms of money do households and business firms ordinarily use in a free banking system? When bank-notes and checks issued by any bank in the system are accepted nearly everywhere, and when banks pay interest on deposits, the public seldom feels the need to handle basic money (gold or whatever is the asset for which bank money is redeemable). Banknotes and token coins serve the need for currency. Because banknotes do not bear interest, banks compete for customers—that is, note-holding clientele—through nonprice means.
Each bank in a free banking system is constrained to limit the quantity of its liabilities (the banknotes and deposits it has issued) to the quantity the public desires to hold. When one bank accepts another bank’s notes or checks, it returns them to the issuer through a cooperative interbank clearing system for redemption in basic money or in claims on the clearinghouse. An issuing bank knows that it would suffer adverse clearings and a costly loss of reserves if too many of its liabilities came into the hands of its rivals. So banks would have to carefully manage their reserve positions (the funds they use to redeem their banknotes) even if there were no central bank setting minimum reserve requirements.
Many economists (and almost everyone else) believe that a free banking system, especially one without government guarantees of deposits or banknotes, would be plagued by overissuance of banknotes, fraud, and suspensions of redeemability, all of which would give rise to runs on banks (see bank runs) and, as a result, periodic financial panics. That would happen, the thinking goes, because the inability of any one bank to meet a run would cause runs to spread contagiously until the entire system collapsed.
The evidence from free banking systems in Scotland, Canada, Sweden, and other historical episodes does not support that conclusion. When free banking has existed, the interbank clearing system swiftly disciplined individual banks that issued more notes than their clients wished to hold. In other words, redeemability restrained the system as a whole. Fraudulent bankers did not find it easy to get their notes into circulation; bankers whose condition went from trusted to suspect found their notes being returned for redemption. Banks thus found that sound management was key to building a clientele. Clearinghouse associations policed the solvency and liquidity of their members. Runs on individual banks were not contagious; money withdrawn from suspect banks was redeposited in sounder ones. Proponents of free banking point out that the few historical episodes of contagious bank runs occurred in banking systems (like that of the United States after the Civil War) whose ill-advised legal restrictions weakened and blurred the distinctiveness of individual banks, so that troubles at one bank undermined public confidence in the entire system.
Proponents of competing money supplies have suggested several different institutional frameworks under which a competitive system could operate. A few monetary theorists, beginning with Benjamin Klein of UCLA and Friedrich Hayek, have contemplated private competition in the supply of nonredeemable “fiat” monies. We lack historical experience with such a regime, but it is doubtful that it would survive. If banks did not have to redeem their notes, they would face a strong temptation to issue money without limit. It would be too profitable for an issuer to break any promise not to overissue and depreciate its money. In contrast, where banks must redeem their notes for something, the holder of bank-issued money has a “buy-back” guarantee against depreciation.
Robert Greenfield and Leland B. Yeager, drawing on earlier work by Fischer Black, Eugene Fama, and Robert Hall, have proposed another kind of laissez-faire payments system that they claim would maintain monetary equilibrium at a stable price level. Instead of redeeming their notes for gold, silver, or government-issued paper money, banks would redeem notes and deposits for a standard “bundle” of diverse commodities. Instead of a one-dollar or one-gram-of-gold note, for example, Citibank would issue a note that could be redeemed for something worth one unit of the bundle. To avoid storage costs, people would redeem a one-bundle claim not for the actual goods that form the bundle, but rather for financial assets (e.g., treasury bonds) equal to the current market value of one bundle. There would be no basic money, such as the gold coin of old or the dollar bill of today, serving both as the accounting unit and as the redemption medium for bank liabilities. This regime also has no historical precedent. Some critics have argued that it lacks the convenience of having a standard basic money as the medium of redemption and interbank settlement.
It is more likely that a deregulated and freely competitive payments system today would resemble free banking in the traditional sense. Bank money would be redeemable for a basic money produced outside the banks. To place all forms of money beyond government manipulation, the basic money could not continue to be government fiat paper unless its stock were permanently frozen (as Milton Friedman has suggested). The most plausible—and historically precedented—way to replace the government fiat dollar is to return to a private gold coin or silver coin monetary standard. But a return to the gold standard—or to any form of free banking—seems politically implausible anytime soon.
Even so, recent developments have emphasized the continuing relevance of the question of competing money supplies. In Latin America and Russia, the U.S. dollar competes with local currencies for use in local markets. Twelve countries have combined to form the European Central Bank and its currency, the euro, but the United Kingdom and Sweden have thus far declined to join. Advocates of currency competition, whose ranks have included former U.K. prime minister Margaret Thatcher, are skeptical that a transnational supplier of money, no longer in competition with their national monies, will provide a higher-quality product.