Commentary
Lawrence H. White
As published in Otmar Issing, Hayek, Currency Competition and European Monetary Union
(London: Institute of Economic Affairs, 2000): 39-47.
 

        I AGREE WITH PROFESSOR ISSING that the system of private fiat-type currencies Hayek imagined is probably not ‘a viable candidate for society searching for a stable monetary system.’  But I do not wholly agree with him about why this is so.  The problem with Hayek’s imagined system lies not in legally unrestricted competition among private currencies, as Professor Issing suggests, but only in the irredeemable character Hayek envisions for the currencies. Competition among private issuers in actual practice would be based -- and historically always has been based -- on a different contractual form, namely demandable debt.  Unlike the holder of fiat money, the holder of demandable debt has the option to redeem it.  Unlike private fiat money, redeemable private currency is viable and stable. Great merit thus remains in the fundamental message of Hayek’s Denationalisation of Money, which is that we should widen the options of money users by removing the legal barriers that restrict competition against central bank currency.
        Professor Issing correctly recognises this fundamental message early in his speech.  He notes that Hayek’s Denationalisation of Money (1978) was a “privatisation proposal” that “called for no less than the complete abolition of the government’s monopoly over the issue of fiat money, leaving the way open for comprehensive competition in its supply by the private sector” (p. 11).  Hayek envisioned “full competition between private issuers of currency.”  I am therefore baffled to find that Professor Issing later in the speech claiming that “What has happened with the introduction of the euro has indeed achieved the denationalisation of money, as advocated by Hayek, at least in the Euro-11 countries.”  The truth, of course, is that the European Central Bank project does nothing to privatise money.  Rather than abolish government monopoly in the supply of fiat money, it actually strengthens the monopoly because it eliminates potential competition among what were the currencies of the eleven member central banks, e.g. between the German mark and the French franc.  What has really happened, as Professor Issing elsewhere recognises, is the supranationalisation of money.  Supranationalisation is certainly not denationalisation as advocated by Hayek.
        Professor Issing understands the difference between fiat and redeemable currency.  He notes correctly that

Hayek’s proposal must be distinguished from free banking, which refers to a monetary system without a central bank, in which private banks would be allowed to issue currency and bank deposits without restriction. As practised in the 19th century, this version of free banking involved banknotes being redeemable in gold and silver coin (note 6).
I want to suggest that free banking in the sense of competition among redeemable currencies, on a common monetary standard, is the appropriate model for thinking about future private currencies, whether the redemption medium (or “outside money”) is gold or silver coin or something else.
        When we focus on a system involving redeemable currency and bank deposits, Professor Issing’s principal concerns about currency competition dissolve.  Under historical free banking, notes issued by reputable banks normally traded at par against one another, and all traded at par in terms of the (commodity) unit of account. The self-interest of issuers in a competitive system compels them to agree to mutual par acceptance and to pursue policies that maintain it. The problem of a “multiplicity of exchange rates” that Professor Issing worries about (rightly, with respect to parallel fiat currencies) does not obtain.  The same market imperative would insure that competing issuers maintain “inter-operability” among private electronic payment instruments.  There is no need for central bankers to impose technical standards.
        With redeemable rather than irredeemable monies, “free competition with respect to money” results in a stable and efficient outcome.  Redeemability is a “money-back guarantee” that overcomes the time-inconsistency problem --the temptation to make surprisingly large issues of money in order to gain greater profits --that is a genuine problem with irredeemable currency, public or private, in a world of imperfect foresight.[1]  Only in a world of perfect foresight would private fiat issuers not find it more profitable to expand more rapidly.  In such a perfect-foresight world, with perfect competition and negligible costs of issue, Professor Issing’s conclusion is correct: competition to pay a real return on currency would compel issuers to pursue negative inflation rather than the zero inflation Hayek predicts.  It is hard to imagine a model in which currency holders prefer a zero return to a positive return on holding currency.
        Professor Issing’s critique of laissez-faire in money focuses on the “unit of account”function of money.  He rightly reflects that the unit of account “is a basic convention of society, such as the language and the standards for measurement.”  To add an example, a silver standard means that there exists a social convention of posting prices and keeping accounts in units of silver. Pure private enterprise in money is inefficient, Professor Issing suggests, because “money used as a unit of account has characteristics of a public good.”  But how so?  A social convention is not per se a public good in the standard technical sense.  In the standard theory, a public good is something that (absent collective action) is continually underproduced because it involves an ongoing cost of production that is in no private party’s interest to bear. By contrast, once a convention (a unit of account, language, or measurement standard) has been established, no one needs to keep producing it.  A silver standard will not disappear if tax revenues are not spent to sustain it.  Like a language or a measurement standard, it is self-sustaining.
        Professor Issing’s real concern seems to be that the provision of a stable purchasing power of the money unit (rather than merely the provision of a unit as such) is a public good: “the commitment to maintaining price stability is like the standardisation of units of measurement.” By no means would I wish to deny the importance of a reliable unit of account for the co-ordination of a decentralized economy.  But price stability isn’t strictly a public good either.  Maintaining price stability means maintaining a stable purchasing power for units of outside money. As Professor Issing notes elsewhere, “outside money provides the unit of account for the whole system.”  Purchasing-power stability is accomplished by appropriately matching the quantity of outside money to the quantity demanded.  Stable purchasing power is thus a quality characteristic of outside money.
        Outside money itself is clearly a private good.  Accordingly improvements in its quality -- the primary benefits of maintaining a stable purchasing power of money -- do not shower down indiscriminately on everyone. They are enjoyed primarily by those who those who hold the money to which they are attached.
        Granted, some benefits of a more stable unit of account may also be enjoyed apart from money-holding as such by those who can keep more accurate accounts and make better calculations in such a unit.  As Professor Issing puts it, citing Leland Yeager,
Money with a stable purchasing power serves agents, who do not even use it as a medium of exchange or a store of value, as the universally acceptable unit of account (p. 24).
But it seems likely that those who enjoy the largest benefits from a better unit of account --those who have the greatest stake in accurate accounting and calculation -- will correspond fairly closely with those who hold the largest outside money balances.  If so, then the problem of free-riding on the unit of account is unlikely to be serious. In a competition among outside-money issuers, users would be willing to pay more to hold what they perceive as a higher-quality outside money (or would demand more, at any given price), thus rewarding its producers, who achieve higher revenues.  (Professor Issing elsewhere remarks on “the price people are willing to pay for the use of electronic means of payment;” an analogous notion applies here.)  The benefits of high-quality outside money are thus internalised, just as the benefits of providing high quality are internalised with respect to other goods, by the producer enjoying higher prices or larger sales.  As Professor Issing notes, such competition goes on to some extent among national fiat currencies today.  The relatively widespread use of the Deutsche Mark outside its domestic economy was the Bundesbank’s reward for keeping its purchasing power relatively stable.
        Hayek imagines that we can rely on such a competition to hold private fiat money issuers to stable purchasing power.  The reason that in fact we cannot is the time-consistency problem: as long as people will trade valuable goods and services for his money (in the belief that it will maintain a stable purchasing power), it pays a profit-maximising fiat issuer to print ever more of it (White 1999, ch. 12).  True, over-issue means the loss of the issuer’s reputation, but it can be shown that the one-shot profit from a surprisingly large issue generally exceeds the present value of the profit to be gained by staying in business.  Potential customers who rightly suspect this will refuse to hold private fiat money in the first place.  (Professor Issing points to this very problem when he asks, with respect to a new issuer who promises higher quality, “why should people be willing to believe the claims of any potential new entrant that its currency will, unlike that of the incumbent(s), turn out to be stable?”  For this reason private firms have historically persuaded customers to trust them not by mere promises of stability, but by offering them a money-back contractual guarantee:  at any time the customer may redeem the issuer’
s notes or deposits for outside money.
        There is a second major reason to doubt that Hayek’s scenario is viable: it envisions multiple units of account operating in parallel within the same economy. Professor Issing is quite right to worry that great inconvenience would occur if there were “as many numeraires as there are issuers.”  The advantages of using the same medium of exchange as one’s potential trading partners, long ago explained by Carl Menger (1892), drives a network of traders to converge to a common medium of exchange and associated unit of account.  (It is puzzling that Hayek, who edited Menger’s collected works, should have overlooked this point in the first edition of The Denationalisation of Money.  He recognised it in the second edition, but did not revise his imagined system fully enough to obviate the criticism based on it.)  Once an outside-money standard has emerged, the disadvantage of holding a non-par currency or bank account similarly drives money-users to patronize banks that keep their liabilities at par.
        These forces of convergence to a common standard are akin to other examples of “network effects,” for example those driving the convergence to a common language, or even to a common videocassette format.  Professor Issing worries, however, about (unspecified) “network externalities” (emphasis added) that “may inhibit free competition and may make it difficult, if not impossible, to dislodge an incumbent issuer” who misbehaved.  He appears to have in mind a situation in which money-users prefer to trade with others using the same unit of account, so that if the established unit of account is proprietary (as the private fiat standards imagined by Hayek would be), entry is inhibited.   (A proprietary standard, like the VHS videocassette format, means that intellectual property law prohibits new entrants from conforming to the standard unless they pay a licensing fee.)  But monetary standards have always been non-proprietary --no one has ever owned exclusive rights to the “pound of sterling silver” unit of account, for example. When the established monetary unit is non-proprietary, the introduction of a new proprietary unit of account is a non-starter and has never been historically observed.
        Professor Issing is thus right to stress the greater practical importance of competition in “inside” (redeemable bank-issued) money.  He tells us that national governments
have not suppressed competition in the supply of inside money, which has been supplied exclusively by the private sector. Until just recently, inside money consisted exclusively of bank deposits which were supplied competitively by banks (p. 23).
This statement unfortunately overlooks the fact that, in giving their central banks monopolies of note-issue, governments have suppressed, and continue to suppress, competition in the supply of inside currency or banknotes.  (Professor Issing often speaks as though “currency” were synonymous with outside money or high-powered money. Banknotes are currency but are inside money and low-powered money.)  Currency is still a significant component of the stock of transactions media (M1), and under competition in the nineteenth century the volume of privately issued banknotes exceeded that of checking deposits.
        In a world that admits private banknotes, or their modern electronic counterpart in the form of currency smart cards like Mondex, we need to amend Professor Issing’s statement that
notes and coin issued by the central bank and, in some cases, by the government are unique in the following sense: they are the only instrument that can mediate a transaction and settle it with finality at one and the same time which it does by virtue of its legal tender status (p. 23).
If a payer and recipient agree on payment in banknotes or card balances (issued not by the central bank but by a private commercial bank), then banknotes or card balances settle the transaction with finality.  (The recipient has no legal claim against the payer should the issuer go belly-up before he redeems them.)  They can do so without having legal tender status. In addition, as Professor Issing himself recognizes elsewhere (fn. 17), the standard transaction instrument and settlement medium in interbank transactions is not notes and coin, but transferable claims on the clearinghouse bank (in most countries today the central bank).  So long as claims on the central bank remain the interbank settlement medium, the unit of central bank liabilities will continue to be demanded and to have a positive value.  It will thus be able to serve as the unit of account even if competition from electronic retail payment media were to drive notes and coins out of circulation.
        Professor Issing rightly recognises that private competition is today moving the payments system toward greater efficiency.  He informs us that the ECB considers certain forms of regulation over private inside-money issuers essential for efficiency in the coming electronic payments system, but he provides no argument as to why we need any more than simple enforcement of the contractual arrangements made in a competitive marketplace.  Private clearinghouse institutions have historically provided adequate supervision and enforced the redeemability of issuer claims (Timberlake 1984).   Particularly baffling from an efficiency standpoint is the ECB demand that central banks be able to “impose reserve requirements on all issuers of electronic money.”  Reserve requirements are nothing but a tax on bank liabilities.  They impede rather than enhance the efficiency of the payments system.
        Professor Issing says he favours the gradual improvement of the payments system “by piece-meal engineering,” and rejects “some abrupt legislative change as sought by proponents of competing currencies and free banking, of which Hayek could, with some justification, be regarded as the high priest.”  To be consistent, Professor Issing must then have opposed the abrupt legislative changes by which European monetary union was imposed, of which Jacques Delors could be regarded as the high priest.  As he notes, the euro was introduced “in a ‘constructivist’ way,” i.e. in “top-down fashion by legislative decree.”  In an earlier era, a consistent Professor Issing would likewise have opposed the legislative changes that introduced central banks and fiat money in the first place.
        Hayek himself did not seek abrupt legislative change to overhaul the payments system. He did not even propose to privatise the central bank. He merely proposed to open the field of competition in any country to foreign currencies (in Choice in Currency, 1976) and then to private currencies (in Denationalisation of Money, 1978).  Central banks can thus remain in business if, without the benefit of special legal privileges, they can produce a competitive product.  I am frankly baffled as to how Professor Issing can suggest that Hayek’s proposal to widen freedom of contract, or “the so-called hard ECU proposal, “amount to dangerous experimentation, but the ECB project does not.
        Within the euro zone, Professor Issing tells us, “any attempt by the private sector to issue banknotes or coins is counterfeiting, a serious criminal offence.”  Does this mean that if the United Kingdom were to join the euro zone, the banks of Scotland and Northern Ireland would necessarily lose the note-issuing rights that they currently enjoy? Such a restriction could not be squared with the principle of subsidiarity, much less with the avoidance of abrupt legislative change to the payments system.
        Professor Issing assures us that “the euro is being managed by a central bank (the ECB) that is protected from political interference by a Treaty” and that its independence “enables it to pursue its mandated ultimate objective, that is price stability, without interference from government.” Indeed “monetary independence from political interference and price stability, has, to all intents and purposes, already been achieved.”  I believe that such statements are premature at best.  It certainly remains to be seen whether the paper safeguards of the Maastricht Treaty will prove durable and the objective of “price stability” will long remain uncompromised.  No tangible enforcement mechanism binds the ECB to its mandate, and nothing prevents the ECB governing council from deciding that the somewhat ambiguous phrase “price stability” means something other than its current interpretation, consumer price inflation of less than 2% over the medium term.  We should remember that when the Federal Reserve System began, its supporters claimed that the structure of the system rendered its operations independent from government (indeed, made it not even a central bank).  A generation later the claim could not be seriously maintained.

References
Dowd, Kevin, ed. 1992. The Experience of Free Banking.  London: Routledge.
Hayek, F. A.  1976. Choice in Currency.  London: Institute of Economic Affairs.
_________.  1978. The Denationalisation of Money, 2nd ed. London: Institute of Economic Affairs.
Menger, Carl. 1892. “On the Origin of Money.” Economic Journal 2 (June), 239-55.
Selgin, George A. 1988. The Theory of Free Banking.  Totowa, NJ:  Rowman and Littlefield.
Selgin, George A., and Lawrence H. White.  1994. “How Would the Invisible Hand Handle Money?” Journal of Economic Literature 32 (December),  1718-49.
Timberlake, Richard H.  1984.  "The Central Banking Role of Clearinghouse Associations."  Journal of Money, Credit, and Banking (February), 1-15.
White, Lawrence H.  1995. Free Banking in Britain, 2nd ed.  London:  Institute of Economic Affairs.
White, Lawrence H.  1999.  The Theory of Monetary Institutions.  Oxford:  Blackwell.

Notes
1. On the theory and experience of free banking see Selgin (1988), Dowd (1992), and White (1995).  On the contrast with Hayekian competing fiat monies see Selgin and White (1994).