[An updated version of this article can be found at Competing Money Supplies in the 2nd edition.]
What would be the consequences of applying the principle of laissez-faire 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. Most recently, trends in banking deregulation and important pockets of dissatisfaction with the performance of central banks (such as the Federal Reserve System in the United States) have made the question of competing money supplies topical again. Some leading economists have become sympathetic to laissez-faire in money, including Nobel Laureates Friedrich A. Hayek and Milton Friedman, as well as Eugene Fama of the University of Chicago, Neil Wallace of the University of Minnesota, 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 checking accounts (also known as checkable deposits) and traveler's checks. Second, each national currency (like the U.S. dollar) competes with others (like pounds sterling, deutsche marks, 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 like gold or silver as a "fiat" currency.)
Much more competition in money has existed in the past. Under "free banking" systems, private banks competitively issued their own paper currency notes, called "bank notes," 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 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.
A significant number of economists would like to abolish 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 the suppliers of money to be more responsive to the demands of money users. Many economists (most notably, monetarists) would like to restrict the discretion given to central banks, and the small but growing number of free-banking advocates would like to abolish central banks entirely. Most mainstream economists argue, on the other hand, that a return to free banking would bring more instability to the financial system.
Proponents of free banking have traditionally pointed to the relatively unrestricted monetary systems of Scotland (1716-1844), New England (1820-60), and Canada (1817-1914) as models. Other episodes of the competitive provision of bank notes took place in Sweden, Switzerland, France, Ireland, Spain, parts of China, and Australia. In total there have been more than sixty episodes of competitive note issue 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 bank notes redeemable on demand for gold. In a system based on a frozen quantity of fiat dollars, as recently proposed by Milton Friedman and a few other economists, bank deposits and bank notes would be redeemable for paper dollars, as deposits are today.
Requiring private banks to redeem their deposits and bank notes for a fixed amount of gold or a fixed amount of paper currency issued by the government would rule out worries about "floating exchange rates" between rival banks. Citibank's ten-dollar notes, for example, would be redeemable for ten dollars in basic money, and so would notes issued by Chase Manhattan. What's more, competition among banks would compel all banks in the system to accept one another's bank notes at face value. Citibank, for example, would exchange one of its ten-dollar bank notes for ten dollars in Chase notes or Chase deposits. The reason is that by accepting each other's notes at par, both Citibank and Chase would make their own money more useful and, therefore, more widely accepted. This is not just abstract theorizing. The same competitive considerations have led banks to form mutual par-acceptance networks for automatic teller machine cards, so that customers of one bank can get cash at another bank's machines.
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). Bank notes and token coins serve the need for currency. Since bank notes do not bear interest, the competition among banks for a note-holding clientele is a nonprice competition.
Each bank in a free banking system is constrained to limit the quantity of its liabilities (the bank notes 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 bank notes) even if there were no central bank setting minimum reserve requirements.
Most economists (and most everyone else) believe that a free banking system, especially one without government guarantees of deposits or bank notes, would be plagued by overissuance of bank notes, fraud, and suspensions of redeemability, all of which would give rise to runs on banks 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 assets could support. In other words, redeemability restrained the system as a whole. Fraudulent and unsound bankers did not find it easy to get their notes into circulation. Rather, banks 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 those banks was redeposited in sounder ones. In the view of free banking proponents, the few historical episodes of contagious bank runs occurred in banking systems whose ill-advised legal restrictions 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 do not have any 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 is supposed to maintain monetary equilibrium at a stable price level. Instead of redeeming their notes for gold, silver, or government-issued paper money, banks would have to redeem notes and checking-account deposits for a standard "bundle" of diverse commodities. Instead of a one-dollar or one-gram-of-gold note, for example, Citibank would have a note that could be redeemed for one unit of the bundle. To avoid storage costs, people would redeem a one-bundle claim not for the actual goods comprising the bundle, but rather for financial assets (Treasury bonds, for example) equal to the current market value of one bundle. There would be no basic money, like 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 lacks 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 despite all the criticisms of current monetary systems, a return to the gold standard—or to any form of free banking—seems politically implausible today.
Even so, the move toward an economically integrated European Community has made the question of competing money supplies especially relevant. Proponents of a European "monetary union" want to establish a European central bank, perhaps modeled after the U.S. Federal Reserve System, that would issue a single European currency to replace the present national currencies. Advocates of currency competition, whose ranks have included former British prime minister Margaret Thatcher, are concerned that such a central bank could be very inflationary. With freedom to choose among competing national currencies, European citizens and firms can abandon high-inflation currencies like the Italian lira in favor of low-inflation currencies like the German deutsche mark. The threat that people will desert their currencies, thereby causing an embarrassing exchange-rate depreciation, imposes an anti-inflationary discipline on national central banks. No disciplinary pressure as strong would confront a pan-European central bank with a monopoly on supplying money.
Lawrence H. White is the F. A. Hayek Professor of Economic History at the University of Missouri, St. Louis.
Dowd, Kevin. The State and the Monetary System. 1989.
Goodhart, Charles. The Evolution of Central Banks. 1988.
Hayek, Friedrich A. Denationalisation of Money, 2d ed. 1978.
Selgin, George A. The Theory of Free Banking. 1988.
White, Lawrence H. "What Kinds of Monetary Institutions Would a Free Market Deliver?" Cato Journal 9 (Fall 1989): 367-91.
Related Material on Econlib:
"Constitution or Competition? Alternative Views on Monetary Reform," by Pamela J. Brown
The Rationale of Central Banking and the Free Banking Alternative by Vera C. Smith
The Natural Law of Money by William Brough
"Why Private Banks and Not Central Banks Should Issue Currency, Especially in Less Developed Countries," by Lawrence H. White and George Selgin