An advertisement in an English newspaper A offers a
one-million-dollar bill for saleat the remarkably reduced price of
£29.95 (about $50.00). However, this great deal comes with the words
"Not Legal Tender." Thereby the advertisement unwittingly presents the
essential problem of national currencies in a nutshell. Two magic words
are all it would take for the note to become spending money. Surely,
monetary policy cannot be that simple? In an age of government-issued
currencies, unfortunately it is.
Government control of national currencies has not been
stable or beneficial to say the least. In the last year, currency crises
hit the news frequently. The resulting lack of confidence in a nation's
currency means that international investments will seek more profitable
ventures where the fear of devaluation is not so acute. Devaluation
follows from governments' inflating their currencies through central
banks and fractional reserve banking; as money is "created," exchange
rates are affected and investors have to reconsider their projects.
Traders have long learned to avoid a great part of
exchange rate risk by employing currency futures and options. Even so,
an unanticipated currency movement can have a deleterious effect on a
company's profit forecasts and its investments and employment. The
ensuing effects on national economies can be disastrous; yet the cause
is not difficult to define. It lies with the uncritical acceptance of
legal tender rules. By maintaining those rules, national governments
permit their central banks to issue base money-effectively paper,
although soon it could be electronic cash-at their discretion. Any
central bank has the legal power to print a run of million-dollar bills,
define them as legal tender, and create new money out of thin air.
Rippling Effects
The repercussions of legal tender laws are quite
visible: by printing paper the central bank inflates the currency. Some
of that currency will seep into loan markets, affecting interest rates;
some wilt affect particular price ratios in markets, causing economic
dislocations; some will enter the foreign currency markets, reducing the
price of the national currency in terms of other currencies. Overall,
local prices will rise and the exchange rate will fall. The effects are
complicated by the actual paths that the new money takes, but the
overall qualitative result can be ascertained - resource allocation is
distorted and irrevocable damage done. It does not matter if the central
bank's inflation was anticipated beforehand-something that modern macro
theory attempts to argue-for no one is in a position to pursue the
transactions of every single new note printed. Therefore, no one is in a
position to establish the overall quantitative effects until afterwards,
at which point the damage has been done.
The inflationary policy can only be effective if
governments decree that the notes be deemed legal tender. Legal tender
imposes on traders the requirement to accept the note at its face value.
Therein lies the rub. If the government had to pay off a million-dollar
debt but could not stomach a rise in taxation, its central bank could
print the necessary legal tender bill, and the newly printed note could
discharge the government's debt. Such an action costs the government
nothing but the paper and ink the note is printed on, and traders cannot
discount the bill except through increasing their prices.
Legal tender thus provides national governments with a
covert method of raising funds without raising taxes. But once the money
seeps into the foreign currency markets to pay for increased imports or
to pay off debts, the currency must depreciate, for in the international
arena traders mark down the value of the currency against others.
It would be otherwise for national traders if legal
tender laws were abolished. Under a free tender scenario, traders would
use those currencies in national and international trade that prove to
be useful to them-that is, those that keep their value. Which currency
traders would choose is not something that can be determined by
legislation or a priori; the choice is fully in the hands of the
millions of traders in millions of markets.
If legal tender laws were abolished, traders would
discount government notes in local as well as international markets,
which would remove from government the possibility of earning revenue
from inflation (that is, paying off debts with legal-tender devalued
currency), The resulting effect is the reverse of Gresham's Law, in
which bad money drives out the good. Gresham's Law prevails when legal
tender rules apply; however, if traders were free to choose between
currencies, the good money would drive out the bad, a point noted by EA.
Hayek. Ample evidence of the Hayek-Gresham Law can be found in economic
history from early American currency history to pre-Revolutionary Russia
and to the more recent hyperinflations in which street traders clamor
for alternative currencies such as the dollar and deutschmark.
Money Can't Be Invented
Legal tender laws effectively have nationalized
currencies, making them the prerogative of the state. Economics teaches
that money cannot be invented or created by decree, that it is very much
the result of traders' decisions across many markets and over much time.
It is time to return currency to the market.
With free choice in currency, traders would converge on
the money that best suited their needs. In the last two decades
economists have conjectured what forms such money could take, from
electronic cash to redeemable currencies, some redeemable against a
basket of goods or even a basket of futures, or against gold and silver.
What is certain is that the choice is and should be the market's. No one
can predict the media that present businesses would find most useful -
most probably they will converge onto one medium or onto a few
universally accepted media, but the definite result would be an end to
the credit creation and inflationism of central banks and national
governments. Central banks would most certainly lose their powers, but
currencies would lose their chains.
At the time of the original publication, Alex Moseley
taught economics at the University of Evansville's British campus at
Harlaxton Manor.
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
February 1999, Vol. 49, No. 2.
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