Over the weekend I had a conversation with a brilliant mathematician and ueber-libertarian, which turned (as conversations with brilliant ueber-libertarians usually do) to the subject of free currency.
In brief, many libertarians want to be rid of our current “monetary authoritarianism,” i.e. the government’s monopolistic control, via the Treasury and Federal Reserve, of the currency and money supply. (Technically the government doesn’t fully control—just influences—the money supply, as banks and individuals can reduce the money supply by choosing to hold more reserves and cash.) They would prefer, instead, ‘free currency,’ i.e., a system in which private banks and institutions could issue their own bills, which would not be backed by the full faith and credit and power of the federal government, but, rather, by the credibility of the private issuing institutions themselves.
Now, this idea isn’t actually as crazy as laypeople initially assume. To understand why, we need to think about the fundamental nature of money. U.S. paper dollars have no value in themselves, i.e., for consumption, but are useful only as a store of value, which value is a function of our shared faith in the issuer of dollars, the federal government. Another way to think about this is that currency is a super- or infinitely-liquid asset. But there are other highly liquid assets issued by private institutions, which function so much like money that they are said to circulate in the ‘money market.’ These include short-term corporate bonds. Their value depends on and varies with the faith bondholders have that the issuing corporation is solvent, willing and able to redeem the obligation. Thanks to financial innovation and some oversight, the markets for these bonds are actually extremely efficient and reliable, and chances are much of the ‘money’ you have in your bank account or mutual fund is actually ownership of these bonds. But you don’t need to worry about it disappearing, because highly sophisticated analysts aggressively police the credibility of bond issuers, and bond issuers have a huge incentive to deserve it. (And, paper currency itself, of course, historically traces to checks issued by private banks which promised to redeem them with gold.)
The last way to think about this is that, in fact, today we do have competing currencies – that is, the different currencies of different countries (or, since the advent of the Euro, different ‘monetary unions.’) Right now, a Eurozone employer pays his employee in Euros, and an American employer pays his employees in dollars; but each employee can travel to the other’s country and buy the other’s employer’s goods, because each can buy the other’s currency at a value set by the foreign exchange market. Efficient forex markets set the exchange rate of each currency such that the two bundles of currency that trade for the same value can buy the value of the same bundle of goods in either country. (I.e. If 2 dollars and 1 euros both buy one gallon of oil in the U.S. and the Eurozone respectively, but you could ‘buy’ 1 euro for only 1 dollar, then financial intermediaries would have an incentive to sell their dollars in exchange for euros, to buy up oil at a cheap ‘dollar’ price, and resell it in the U.S. for 50 cents plus profit; this process will itself drive up the ‘price’ of euros, continuing until it takes 2 dollars to purchase 1 euro.) And, because we have efficient forex markets, you can travel anywhere in the world with a Visa card and an American bank account and get the local currency from an ATM without getting ripped off.
Now, suppose we let corporations and banks move from just issuing money-like ‘commercial paper,’ and let them issue their own currencies, and relieved the Treasury of that duty. In principle, these banks would simply function much like sovereign nations’ central banks function today. Employer A pays employee A with Bank A’s currency, while Employer B pays Employee B with Bank B’s currency; and then a currency exchange market, with many traders who aggressively seek arbitrage opportunities, discovers the efficient exchange rates among the currencies. Given modern information technology, in a free-currency world, you could have a bank account that stored purely private moneys, and you could still walk into any store and swipe your bank card, secure in the faith that, if your own bank is credible, and the currency markets are as efficient as traders have an incentive to make them, you won’t get ripped off — just as today, you can swipe your Visa card at foreign shops without much worry.
Now, one obvious difference between banks and governments is that governments have armies, and this is a major source of governments’ credibility – i.e., when they face a solvency crisis, they can simply confiscate assets via taxation. Private institutions don’t have that power, and so have less ability to maintain widespread faith in the currency (which is also, incidentally, why corporate bonds sell at a risk premium above Treasuries, even when the issuing corporations are more intelligent and conscientious than the U.S. government). But for free-currency advocates, this is precisely the advantage of getting rid of ‘monetary authoritarianism.’ Today, we all must use and accept U.S. dollars, regardless of the bad behavior, inflationary policies, etc., of the U.S. government, because we are forced to. But in a free-currency world, we would choose which banks’ currencies we wanted to use, according to the banks’ reliability, our aversion to inflation, etc. If we are committed to long-term savings, and averse to the risks of financial markets, we could simply choose a bank that reliably promises never to let its currency inflate, and store its currency under mattresses, protecting our savings against inflation, without bearing the risks of a mutual fund. And as dynamic currency markets developed, currency traders would have an incentive to monitor the credibility of issuing banks, so they could short-sell the currencies of banks that are alienating customers or risking their solvency – and this itself would debase those bank’s currency value, giving every bank a huge incentive to be good and reliable. And governments would have to work harder to live within their means, because they would lose the ‘stealth taxation’ that comes from printing more money and inflating the currency.
So I really mean that the idea is not as crazy as it sounds. Indeed, the currency libertarians have a point that most all of our economic interactions in life are mediated by markets, and so the presumption of proof must be on those who advocate a government monopoly on this one particular asset – money.
So allow me to presume to make that proof. I have four basic, preliminary objections to free currency:
First, money may be a natural monopoly. It is, curiously enough, sort of like Facebook: The value of currency to any individual currency-holder comes from the value that others place on that currency. The more people use a particular currency, the more sought after that currency should become, the more people will use that currency, and so forth. Which means that free currency markets should exhibit ‘snowball effects/virtuous cycles,’ etc, leading to monopoly. Even if Bank B has a slightly better currency policy, if Bank A’s currency dominates the market, I will stick with Bank A for security and it will be ‘locked in’ to its advantage. More than I fear a few extra basis points of inflation, I just want reliability – lack of hassle and certainty that it will be accepted. If money is a natural monopoly, we should expect it to be exploited. The natural response to this market failure is democratic accountability through government control.
Second, if I’m wrong, and money is not a natural monopoly, a free currency world is one in which there will be many different currencies vigorously competing for users. I think this competition has obvious theoretical virtues, but this complexity also has two kinds of dangers. Competing currencies could have the same broad effects as inflation. The main reason why high and unpredictable inflation saps economic growth is that it discourages the formation of economic contracts by creating uncertainty about the value of money in the future. In the same way, competing currencies could increase each market participant’s uncertainty and equivocation in small ways that, over the aggregate, clog the economy. Since it is very hard to predict the likely solvency of any private institution in, say, 30 years (in the same way that most everyone assumes the U.S. government will still be around then — and that if it’s not, their business ventures won’t be either), private currencies without recourse to the “full faith and credit” of the global superpower could discourage long-term contracts, hence long-term investments. Increasing complexity also gives the financially savvy more opportunities to take advantage of the financially naïve. Most of the population is doubtfully capable of understanding exchange rates, inflation, etc. A devious employer could contract with a naïve employee on a long-term basis, to pay him in a currency that has an announced policy of high inflation. Or he could promise to beat another employer’s offer of 100 Bank A notes per day, with an offer of 120 Bank B notes per day, secure in the assumption that the employee will not understand what it means that the exchange rate is 2 Bank B notes per Bank A note (or the employer could, even, make him work for 60 Bank B notes, by telling him that Bank B notes are worth twice as much—“See? 2 to 1.”).
Third, whether or not money is a natural monopoly, free currency would destroy the possibility of countercyclical monetary policy. Mainstream economics holds that, though artificially low interest rates set by the Fed do play a role, business cycles fundamentally derive from human psychology—i.e. virtuous cycles of increasing optimism and irrational exuberance, followed by vicious cycles of increasing pessimism, decreasing investment, decreasing output, decreasing income, decreasing demand, which increases pessimism even more, etc. Insofar as this is true, government has a counter-cyclical role to play in markets. When the business cycle turns down, higher inflation helps stop people from hording their money (see “the paradox of thrift”), to allow real wages to fall to a market-clearing, full-employment inducing level, and to fool people into thinking they’re making more than they are, to restore optimism. Private currency-issuers would not have, it seems to me, no incentive to provide counter-cyclical inflations. If anything, they might engage in competitive deflation – i.e., in times of economic distress, people flee to safety, and the bank that made the surest promise not to devalue its currency by issuing any more would attract the highest demand.
Finally, it’s not broke, let’s not fix it: Since the late 70s, inflation has been stable and low in the United States, and the value of low inflation has been broadly accepted by economists and central bankers throughout the world. The Federal Reserve appears to be the least incompetent component of the Federal Government (libertarians in particular should appreciate that monetary activism is the surest way to preempt ineffective fiscal stimulus). We are at no risk of hyper-inflation. The United States enjoys substantial economic advantages from the faith foreigners place in our currency, backed by our government’s full faith and credit. Free currency is a fun thought experiment—one that helps illuminate the underlying nature of money and markets—but a serious effort to implement it almost surely wouldn’t be worth the costs.