About five years ago I published a book, Free Banking
and Monetary Reform, that proposed a radical reform of our monetary
system. Competing banks, I argued, should be free to supply any monetary
instrument, including currency or banknotes, while the government would
perform the limited but vital function of establishing a currency unit
(e.g., the dollar) in terms of which privately supplied monetary
instruments could be defined. And to ensure optimal stability of the
purchasing power of the currency unit, I proposed a mechanism of
indirect convertibility tied to a price (or, preferably, a wage) index.
I have been disappointed but not surprised to detect no
groundswell of popular support either for free banking or for any of my
specific proposals. I do not believe that this lack of enthusiasm
betrays any shortcomings with free banking or my proposals. What the
indifference to free banking reflects is rather a salutary, "if it ain't
broke, don't fix it" sort of conservatism. As long as inflation remains
low and the banking system is not collapsing, practical people will not
undertake the effort required to effect a reform of this magnitude. The
potential benefit from such a reform is not big enough to outweigh the
perceived risk in trading the monetary system we know for one we
don't.'1 I have therefore concluded that my proposals for
free banking are less relevant for the United States and other developed
countries with stable monetary systems than for less developed and
former Eastern Bloc countries now lacking the monetary stability
necessary for economic development. Without secure monetary
institutions, these countries have far less to lose than do advanced
countries by experimenting with free banking. Nor, for reasons that will
become apparent, can less developed countries simply copy the monetary
systems of the advanced ones. Free banking is, therefore, ideally suited
for overcoming the systemic problems that now frustrate the attempts of
less developed countries to achieve monetary stability.
To understand why free banking is so well suited to the
circumstances of less developed and former Eastern Bloc countries, we
must first consider how money and banking can contribute to economic
development. The role of money is familiar and obvious - it is a medium
of exchange. Money facilitates exchange by allowing us to trade without
having to identify, as we do in barter transactions, a double
coincidence of wants. Reducing barriers to trade promotes economic
progress by allowing resources to be shifted from less to more valued
uses. Such shifts create new opportunities and new demands for
resources, triggering an upward spiral of output and wealth.
It is worth observing that the capacity of money to
perform this extraordinarily valuable social function poses something of
a puzzle. The existence of an instrument that serves only as a medium of
exchange, providing no real services, seems to contradict the usual
assumption of economists that self-interest motivates economic
decisions. Why do people accept money, which (despite its social
utility) has no direct use for them individually, in exchange for real
commodities or services that do have direct use for them? The
acceptability of money is sometimes attributed to an implicit
understanding among people to act in the common good rather than pursue
selfish goals or to a command by the sovereign imposed through
legal-tender laws. But neither recognition of the common interest in
having a medium of exchange nor laws commanding that an instrument be
accepted as legal tender could make people use as money an instrument
that they would not have otherwise, in their narrow self-interest,
chosen so to use.
Self-Interest and Exchange
How then does self-interest cause anyone to accept a
money that has no use except to be exchanged for something else? Whether
it is in my self-interest to accept money in exchange for real goods and
services depends critically on whether I expect other people to accept
money in exchange for real goods and services. If I expect other people
to refuse money that I offer in exchange for their goods and services,
then my self-interest is to refuse money in exchange, too. But if I
expect other people to accept money that I offer in exchange for their
goods and services, then my self-interest may dictate accepting money in
exchange for the goods and services that I supply, because doing so may
allow me more easily to sell what I want to sell and more easily to buy
what I want to buy than if I try to barter. The less confident I am that
it will retain its value, the less willing I shall be to accept it in
exchange. So whether money is acceptable is a matter of degree, not a
simple yes or no question.2
It is, at any rate, clear that money cannot function
well as a medium of exchange unless people are confident that it will be
acceptable at roughly its current value in the future. Whatever
undermines people's confidence or trust in the future value of money
threatens its capacity to serve as a medium of exchange. The delicate
web of mutually supporting expectations that allows a medium of exchange
to function can easily unravel or collapse if the trust underlying those
expectations is eroded - or betrayed.
In primitive conditions, the medium-of-exchange role of
money can be performed without the aid of banks. Money could circulate
hand-to-hand, either in the form of precious metals, coins, or currency
(convertible or fiat) issued by the state. However, the transfer of
deposits within or between banks through checks (and now electronically)
is an exceptionally efficient way to convey money in trade. To engage in
monetary exchange through banks, people must hold deposits with them. By
holding bank deposits instead of some other form of money or wealth,
people lend banks capital which the banks then lend to borrowers (who
typically borrow to finance investment, not consumption). Thus, by
providing a convenient way for the public to hold money and execute
transactions, banks channel the savings represented by the public's
deposits to investors. As intermediaries between ultimate savers and
ultimate borrowers, banks increase the return to savers from savings and
reduce the cost to borrowers of borrowing, promoting economic
development within the areas they serve.
Creating and Maintaining Confidence
Having considered how money and banking promote
economic development, we can now ask which institutions will support a
stable system of money and banking. Since money cannot function well as
a medium of exchange unless people have confidence in its future value,
the fundamental task of monetary institutions is to create and maintain
that confidence. How can such confidence be created and maintained? The
answer for a private supplier of money, i.e., a competitive bank, is
very different from the answer for a state that supplies money. And it
is on that difference that I am going to rest the case for free banking
as the solution for chronic monetary instability in less developed and
former Eastern Bloc countries.
Why does it matter whether money is supplied privately
or by the state? When a private bank creates money, it does so by
issuing a special type of IOU against itself. The IOU allows the owner
of the IOU or anyone he assigns to demand its instant redemption in
terms of a fixed amount of a specified asset. For example, when Citibank
creates a demand deposit, it is promising to redeem that deposit in
terms of an equivalent amount of U.S. currency to the depositor or to
anyone to whom the depositor writes a check up to the amount of the
deposit.3
A bank's contractual obligation to redeem its IOUs on
demand does not automatically create the confidence in their future
value required for them to function as money. If the bank is widely
expected to default on its IOUs, those IOUs, regardless of the bank's
net worth or financial soundness, will not function as money, because
IOUs that people do not expect to be honored will be unacceptable in
exchange. For a bank to create confidence that it will continue
redeeming its IOUs, it must convince people that it would lose more by
defaulting than it would gain. Whether people will trust banks with a
substantial net worth to honor their contractual obligations depends in
large part on the legal consequences of default for the bank. If the
legal system under which banks operate strictly enforces contractual
obligations and penalizes default, default will appear unlikely.
One might question whether, if they were not legally
required to make their moneys convertible into an asset whose supply or
value they could not control (e.g., currency or gold), private banks
would voluntarily obligate themselves to redeem their IOUs on demand in
terms of such an asset. But no private bank has ever issued irredeemable
money without a state edict declaring the money legal tender and
acceptable for discharging tax liabilities. Moreover, the theoretical
argument denying that a private bank can issue irredeemable money is
compelling. The magic a bank performs by creating money is to impart a
value to something whose only use consists in being valuable. The bank
performs this conjurer's trick by legally committing itself to redeem
instantly its IOUs in terms of another asset whose value it cannot
control. That credible promise allows the bank's IOU to take on a value
identical to that of the redemption asset. But without the promise,
people, recognizing the potential profit from issuing valuable IOUs and
redeeming them for nothing, would never place a value on such IOUs any
higher than their expected final redemption value, namely, zero.
Inconvertible bank IOUs must be worthless. 4
Inside and Outside Money
It may be helpful to distinguish here between inside
and outside money. The money private banks supply is called inside money
because it represents a debt the bank creates against itself. Outside
money can be a physical commodity (e.g., gold) that has become
acceptable as a medium of exchange, or a fiat currency issued by the
state that has become acceptable as a medium of exchange. Like gold,
outside money is an asset without being anyone's liability. Private
banks cannot create outside money; they can only create inside money
which, to make acceptable, they promise to convert on demand into some
outside money.
A sovereign may choose to issue inside money by
committing itself, like a private bank, to convert its money on demand
into some asset whose supply and value are beyond its control, or to
issue outside money in the form of fiat currency. Should it do the
former, its IOUs are apt to be less acceptable than those of a private
issuer for one very powerful reason: while the default by a private bank
on its obligation to redeem its IOUs triggers immediate insolvency,
al-lowing creditors to seize its assets, a sov-ereign is immune from
such sanctions when it defaults. Indeed, a sovereign's default, isn't
even called a default, but a devaluation. People would therefore have
much better reason to expect a sovereign to default on its obligations
than to expect a private bank to do so.
Should the sovereign seek to issue an inconvertible
fiat currency, it faces credibil-ity problems of a different sort.
Sovereigns have, indeed, successfully issued fiat cur-rencies in
numerous instances, so fiat cur-rencies can maintain their value for
long periods of time. However, there have been more unsuccessful than
successful fiat cur-rencies. So it certainly is not the case that a
sovereign, just by declaring a fiat currency legal tender, can ensure
its acceptability in exchange.
A sovereign wishing to issue a fiat cur-rency must
overcome two problems. First, how can it create a demand to hold the
currency it is issuing? Why should anyone sacrifice any real goods or
services just to hold pieces of paper that have no use other than to be
exchanged for something else? For the pieces of paper to be used as
money, people must want them enough to sacrifice something else of value
for them. To assume that such pieces of paper have value because they
are money begs the question why people accept them as money in the first
place.
Second, a positive demand to hold an asset clearly does
not ensure its acceptance as money. As I explained above, for an asset
to be accepted as money, people must share expectations about the
stability of its future value. So even if the sovereign can create a
demand for fiat currency, how does it create sufficient consensus among
the public about the currency's future value for people to use it as
money?
Creating Demand for Fiat Money
Let us consider first how the State can make its
currency more valuable than the paper it's written on. A legal-tender
law that requires fiat currency to be accepted in the discharge of debts
doesn't, by itself, impart any value to the fiat currency. It simply
provides a way for some people to discharge debts that they previously
incurred but does not compel anyone to accept legal tender in exchange
for real goods and services. So why would anyone prospectively supply
something of value in exchange for fiat currency? If what the State
declares legal tender is not acceptable, people can avoid accepting debt
instruments that could be discharged by the proffer of legal tender.
A more powerful way to create a demand to hold fiat
money is for the sovereign to require its currency to be used in
discharg-ing tax liabilities. If the public owes the sovereign enough at
certain times of the year (e.g., April 15), then the demand to hold
currency may be sufficient (even during periods of zero or negative net
tax liability) to give the currency positive value through-out the year.
But though feasible, such a strategy may still be
impractical, which raises our second problem. Even if government tax
certifi-cates have a positive value, what would create a sufficient
consensus about the ex-pected future value of these tax certificates for
them to serve as money? Without such consensus, a positive value will
not enable them to serve as money. Indeed, there are few if any
historical instances in which a fiat currency was successfully
introduced with-out its first having been made convertible into another
money. Thus, although requir-ing taxes to be paid using a fiat currency
seems to be necessary to prop up its value after convertibility has been
suspended, acceptability as payment for taxes may not suffice to enable
a sovereign to create a new fiat currency. 5
To sum up: A private issuer of inside money has more
credibility than a sovereign issuer of inside money, because people
generally understand that a sovereign has less to lose than a private
bank by reneging on a convertibility commitment. A default-ing bank
forfeits its assets to its creditors while a devaluing sovereign
forfeits only its reputation. On the other hand, a private bank cannot
issue outside money, while a sovereign can. But a sovereign's capacity
to issue a flat currency without first making it convertible into some
other money or asset may be quite limited. Even if requiring its
currency to be used in paying taxes gives the currency a positive value,
the currency may still not be an acceptable money. Unless the currency,
upon introduction, is made convertible into an accepted medium of
exchange, the consensus about its future value required for a fiat
currency to serve as money may be lacking.
My argument thus far has two basic implications for
less developed and former Eastern Bloc countries. First, such countries
cannot create stable monetary systems based on inconvertible fiat
currencies, because their political regimes lack the credibility to
impose stable monetary institutions by fiat. Lacking a widely accepted
money about whose future value expectations are secure, such regimes
cannot create an acceptable money out of thin air, because they cannot
impose a consensus about the future value of a fiat currency.
Creating a new fiat currency inevitably creates a
hyperinflationary environment, because with no public confidence in the
future value of the currency, the public will be willing to hold very
little of it. This does not mean that the demand for money of any kind
is small. The demand for a stable money in which people had confidence
would be much greater than the demand for a new fiat money. An attempt
to force more than this small amount into circulation, say, to finance
the government deficit, causes rapid inflation. And the inevitable
attempt to overreach the limits of that revenue source by printing even
more money triggers a vicious inflationary cycle that causes a complete
monetary breakdown.
All Moneys Are Not Equal
Conventional monetary models make two unwarranted
assumptions that lead to disastrously misguided policies for developing
countries. First, they assume that all money is alike, so that there is
a given demand for money, which any instrument so designated can
satisfy. Second, they assume that total output is independent of the
amount of money. But not all moneys are equal and an inferior money in
which people have no confidence cannot perform the services that a
superior money could. Moreover, money serves as working capital for
households and businesses adding to their productivity, while monetary
stability provides a kind of intangible infrastructural capital that
adds to the productivity of all economic agents independent of the
amount of money they hold individually. Policies aimed at achieving
monetary stability in developing countries by restricting the quantity
of the available fiat money treat a minor symptom but ignore the
fundamental problem, which is that distrust of the available money makes
it useless and deprives the economy of desperately needed monetary
services.
Thus, the second implication is that in such
circumstances the only feasible way to create a consensus about the
future value of a currency is to make it convertible into another money,
e.g., the dollar, about whose future value expectations are secure. But
governmental commitments to establish and maintain convertibility, as
the recent Mexican fiasco has shown yet again, are obviously not
credible, because a sovereign that defaults on such a commitment faces
no effective sanction. Devaluations are a dime a dozen.
Nevertheless, given sufficient reserves, and given some
institutional constraints on money creation and on government borrowing,
governments can maintain a fixed exchange rate for a period of time.
With sufficient resolve, they may do so indefinitely. However, such pegs
are extremely fragile. Once an economic or political shock occurs, the
expectation of a future devaluation becomes almost irresistible even for
a developed country.
One way a government could increase confidence in its
commitment to maintain convertibility is to create a currency board
whose sole function would be to issue domestic currency in exchange for
an equivalent amount of some foreign currency in terms of which the
domestic currency would be defined. Such a system, if maintained,
converts the domestic currency into a denomination of the foreign
currency in terms of which it is defined. However, even a currency board
cannot prevent a government from devaluing if that is what the
government decides to do.
It is now clear why free banking is so well suited for
less-developed and former Eastern Bloc countries. By making the
commitment to maintain convertibility one which holders of money can
enforce through legal means against private banks instead of one that
can be abrogated by the sovereign at will, free banking avoids the
barrier that sovereign irresponsibility places in the way of creating
monetary confidence. 6
Under free banking, private banks would be allowed to
issue currency (banknotes) and create deposits denominated in units of
their own choosing. Thus, if the public wished to use dollars, free
banks would be willing to create money denominated in dollars. However,
since there would be legal problems in issuing banknotes denominated in
dollars, free banks would instead define new denominations (say, the
crown) in terms of dollars (one crown equals one dollar), so that prices
could be quoted interchangeably in either dollars or crowns. Because it
would allow private banks to supply the hand-to-hand currency needs of
the public, free banking would be preferable to simple dollarization
which would require a country to import the dollars required for
hand-to-hand circulation by means of a costly export surplus.
By setting an appropriate tax rate on bank profits,
governments would, in the end, derive more tax revenue from the profits
of the competitive banks than they could have by issuing fiat currencies
and seeking to exploit their monopolistic control over those
cur-rencies. But even this gain would be dwarfed by the general increase
in tax rev-enue that would result from an economic boom triggered by the
provision of sound and stable money by a system of free competitive
banking.
Dr. Glasner, an economist with the Federal Trade
Commission, is the author of Free
Banking and Monetary Reform(Cambridge University Press, 1989) and
the editor of The Encyclopedia of Business Cycles, Panics, Crises, and
Depressions (Garland, forthcoming 1995). The views expressed in this
article do not necessarily reflect those of the Federal Trade
Commission or of individual Commissioners.
1. Yet, as I pointed out in my book, continuing
financial innovation and technological progress toward a cash-less
economy will, like it or not, gradually lead us over the long term at
least part of the way toward free banking even with no deliberate
redesign of our basic monetary institutions. The same point has been
emphasized by Sir Samuel Britten in two recent columns in the Financial
Times, June 9, 1994 and June 16, 1994.
2. A money can survive even if there is some expected
depreciation in its value, but the more depreciation is expected the
less useful and the less acceptable money becomes. Because of the
positive feedback effects between your willingness to accept money and
my willingness to accept money (now referred to as a network
externality), monetary collapse can come very suddenly in response to a
seemingly small change in expected depreciation.
3. The legal restrictions requiring U.S. banks to hold
reserves of currency or otherwise restricting their behavior are, for
purposes of this discussion, irrelevant. What matters is that in
creating deposits, banks are offering an IOU that they are contractually
obligated to redeem in terms of an asset (U.S. currency) whose supply or
value they cannot control. If banks were legally allowed, as they once
were and as they would be under free banking, to create banknotes
circulating from hand to hand as currency, the legal status of banknotes
could be similarly characterized, except that the bank's obligation to
redeem would be to the bearer of the banknote not to the original holder
of the deposit.
4. 1 have explained this point more fully in my
article, "The Real Bills Doctrine in the Light of the Law of Reflux,"
History of Political Economy, Winter 1992, pp. 885-86.
5. On the role of prior convertibility in establishing
a fiat currency, see G. Selgin, "On Ensuring the Acceptability of a New
Fiat Money," Journal of Money, Credit and Banking, November 1994, pp.
808-26.
6. The government might still profit from devaluation
by reducing the real value of debt denominated in terms of the domestic
currency, but it is not clear that the government so circumstanced would
have anything to gain by denominating debt in terms of its domestic
currency rather than the foreign standard currency since denominating in
terms of the foreign standard currency would enable it to borrow at a
reduced interest rate.
Reprinted with permission from The
Freeman, a publication of the Foundation for Economic Education, Inc.,
July 1995, Vol. 45, No. 7.
Yourname@libertyhaven.com
