In a recent post I criticized the “free lunch” view of printing money. However I did acknowledge that there was a sort of free lunch aspect to having a monetary system, but only to the tune of a bit over 1% of federal revenues. A commenter correctly pointed out that someone must pay for any revenue received by the government.

Let’s explore this issue by comparing currency to state lotteries, which are often claimed to be a sort of “voluntary tax,” and hence not harmful. Readers of this blog surely understand the fallacy of that claim; the government keeps at least 1/2 of the total money bet, and that’s a tax of betting. But there is something different about lotteries, even when compared to other products for which the tax is falsely claimed to be “voluntary,” such as cigarettes. Lottery consumers applaud when states create lotteries, whereas smokers are unhappy when the state imposes cigarette taxes.

The explanation is simple; a new lottery does two things simultaneously, it legalizes gambling and it taxes gambling. Revealed preference tells us the lottery buyers gain more from legalization than they lose from the tax, whereas in the case of cigarettes the product was already legal. If they legalize and tax marijuana, that would be a good analogy for the lottery.

Now let’s consider currency, and assume we start from a state of nature with no private currency provided by free banks. In that case even a libertarian would probably acknowledge that fiat money is a useful thing to have around, even if it loses a bit of value through inflation. So the combined decision to create a currency and deliver seignorage revenue to the government may be a plus for currency holders in the same way a lottery benefits gamblers.

But of course this begs the question of whether a free banking alternative is plausible, as private lotteries clearly are. I think free banks are feasible, but I’m a bit of an agnostic on the question of the efficiency of free banking. That may be surprising, as I want to privatize just about everything the government does, except the most very essential core functions (and I’m not an expert on what those are, good (Chicago/GMU) microeconomists can better answer that question.) So why am I agnostic about free banking?

Currency is different from other goods in one important respect; its value largely flows from its fixed nominal price. If currency were interest-bearing zero coupon bonds with market prices than changed minute by minute, then it would be very complicated to use in transactions. You’d have to calculate the value of a bill with a $20 maturity value every time it was spent. This market failure, if it is one, is so rare it doesn’t even appear in textbooks (along with the conventional market failures like externalities, monopoly and public goods.)

So I’m going to assume currency must have a fixed nominal value. That fact by itself doesn’t rule out free banking—they’d have an incentive to produce the sort of currency consumers want. Indeed I believe (and will later argue) that the private sector might do a better job than the government in meeting consumer taste in money.

But there is another problem. Because we assume the price of currency is fixed, that means free bankers could not use price competition to compete for customers. Free banking advocates will respond that if non-price competition is better, then it’s efficient for free banks to provide non-price competition. I’m not so sure. I worry that this might be an example of the “toaster problem,” which does not refer to bread getting caught in the toaster.

Younger readers may not recall that when banks were not allowed to pay interest on checking accounts (prior to 1980), they engaged in non-price competition, such as offering free toasters to depositors. Economists of all ideologies argued that this was inefficient, and that price competition was better. I worry this could occur under currency competition, even though the reason for the lack of price competition would be technical, not legal. I think it’s actually possible that a monopoly currency issuer could be more efficient, by avoiding wasteful price competition. Most debates stop there, with the anti-libertarians claiming QED, the government is better than free banking in currency issuance.

But in 1995 I did a paper (JMCB) that went one step further. Markets really are more efficient than government. So why not allow markets to at least play some role in the process? Why not auction off the rights to issue the following five denominations, to five different companies:

Up to 99 cents.


$1.10 to $10

$11 to $90


Companies would then have an incentive to maximize seignorage after winning the license. They would have an incentive to adopt optimal denominations. Thus they might drop the penny, saving hundreds of millions. They might replace the dollar bill with a dollar coin, which would save manufacturing costs. They might follow the post office and put the picture of pop stars on the bills. Perhaps a hip hop star could go on the $100. Or maybe money would become beautiful, as it once was.

Younger readers will notice that my obsession with old-fashioned currency makes me a bit of a dinosaur. We are rapidly moving toward an electronic money regime, which will eliminate all my arguments against free banking. Price competition would immediately become efficient. And yet, while I agree that we are rapidly approaching an all electronic regime, while we are doing so paper currency use is actually increasing rapidly, even as a share of GDP. It will be highly controversial when the Feds ban paper money. And (ironically, given how libertarians hate fiat money) it will be a loss for liberty. It’s all part of the Federal government’s “1984 project,” a panopticon state that the public is meekly acquiescing to.

BTW, some have argued that paying interest on currency is efficient via lotteries (another connection!), with one serial number winning each week. But this would cause massive time wastage, as the public kept checking serial numbers. Another issue is whether we want to make currency more convenient, as today it is mostly used for tax evasion, and hence the cost in foregone income tax revenue probably exceeds the gains in seignorage. And there are many other issues to consider. So the question of whether there is any sort of free lunch aspect to currency is surprisingly complex, and has links to seemingly unrelated issues like “voluntary” lottery taxes and the toaster problem.

PS. When interest on money does become feasible it should equal the fed funds rate, plus or minus the difference between actual NGDP and target NGDP. Then currency demand would fluctuate in such a way as to automatically stabilize NGDP. I am indebted to Robert Hall (JME, 1983) for that idea. Miles Kimball would love the idea.