This archived content originally appeared at, the predecessor site to, and does not carry the sponsorship of the Cato Institute.

Dollarization and competing currencies

The Austrian Economics Center blog has a post by Finbar Feehan-Fitzgerald on "Hayek versus Friedman: Concurrent Currencies." (The center is located in Vienna, hence it is Austrian by geography as well as by school of thought. I came to the post via a link from Jonathan Finegold's blog, Economic Thought.)  As Feehan-Fitzgerald summarizes their disagreement, Hayek thought that the costs of switching currencies were small, hence competing units of account was a realistic possibility. Friedman thought the costs were large, hence a single unit of account should dominate and fend off rivals unless it becomes quite unstable.

Part of the difference between them, I suspect, was what they explicitly or implicitly counted in the costs of switching. A truly level playing field among currencies is rare. The government typically favors its own currency by making all of own domestic payments in that currency and not giving people the choice of payment in another unit; by requiring taxes to be paid in local currency; by requiring in the case of some countries that all private-sector salaries likewise be paid in local currency; and, often, by provisions of the tax code, other laws, exchange controls, and regulations on financial institutions. The result is to create a minimum level of demand for local currency that might not exist in the absence of those laws and regulations.  (In fact, I think it would make a good master's thesis to ferret out all of the laws and regulations that tilt the playing field in a particular country and to explain just how they do so.)

Where the playing field is so heavily tilted, a substantial depreciation of the local currency is usually necessary to induce a partial switch to a foreign currency–partial dollarization, so called whether or not the foreign currency is the U.S. dollar. In dollarized countries, local currency continues to circulate and be used as a medium of exchange for small retail payments, but yields to the foreign currency as a store of value and as a unit of account for large payments. Foreign-currency deposits, if legal, are preferred to local-currency deposits as stores of value. House and car prices are typically denominated in foreign currency, even if officially it is illegal.

Once dollarization occurs, it can persist even if the local currency becomes more stable, a phenomenon dubbed hysteresis. Hysteresis seems to support Friedman, but I think it really supports Hayek because under partial dollarization, the playing field almost always remains tilted toward the local currency. It isn't that switching back is hard, it's that distrust of the local currency lingers and people prefer some foreign currency as a hedge despite all the legal advantages to holding domestic currency.

There are plenty of examples of partial, unofficial dollarization. Some occur because of instability in the local currency. Others occur because of trade links: the U.S. dollar is widely accepted in Caribbean countries that have good local currencies because merchants catering to the tourist trade find it advantageous. The latter cases are to me another piece of evidence suggesting that the costs of switching currencies are low in the absence of legal restrictions, but in practice typically high because restrictions are common.

The hypothetical monetary system Hayek envisioned in in Denationalisation of Money has constant, vigorous competition among units of account even within small areas such as a single city. In contrast, I would expect one unit to dominate withing small areas, though perhaps multiple units having large world market shares, providing a possibility of switching if the local unit becomes bad. The computer age opens up new possibilities here that did not exist until recently, though. As we move to all-electronic payments, switching from one unit of account to another becomes as easy as pushing a button, even for retail buyers and investors. It is another case where Hayek looks less like a speculative theorist and more like a visionary as time passes.


  1. It's nice to see mention made of the government's role in basically creating "currency" as we know it by setting the rules of the game, and not incidentally creating the rules such that they favor the government's ability to maintain control.

    This distinction between a bank and a brokerage seems to be at the root of monetary issues. I doubt this is accidental. A broker would offer credit to traders without interest as a way to draw customers, whereas banks charge credit ostensibly for access to the supposedly limited supply of money, but fiat money is nothing more than a relative measure of the multiplicity of exchange rates of various goods and services against one another, and a man whose job it is to connect customers with clients (for a nominal fee) is going to be a much better custodian of such currencies than a person whose entire livelihood depends on there being a sense that "currency" is in some way limited.

    Governments have for a very long time seen the value of controlling whatever trade goods tend to circulate as the easiest form of currency, and now that the perfectly logical step has been made to separate money from any particular underlying commodity, we by all rights should be free from this control. But far from it, we are now instead bound by laws controlling the issue of conceptual credit.

    The tools of domination are many and varied, so it would seem.

  2. Isn't the risk associated with switching 'back' to a local currency at the root of hysteresis a cost of switching? So, when the risk is high so is the cost, therefore, in this hypothetical case, the cost of switching 'back' is high. However, when the risk is low (there is general trust in local monetary authorities, fr.ex.), the switch can happen quickly. Does that make sense?

    This actually helps Hayek's case, I think. If the costs of switching currency are variable then there are some cases where multiple currencies can and would prevail if it weren't for state imposed cost burdens while, in other cases, a single currency would prevail. There are plenty of goods that behave exactly like this. In certain segments of the cell phone market iPhone is absolutely dominant while in others there is an almost overwhelming variety of different phones. There isn't a natural trend toward monopoly in the cell phone market and Friedman's argument doesn't support there being one in the money market.

    1. Agree. Some switching costs are externally imposed, such as those associated with exchange controls or other legally enforced discrimination against foreign currency, and it was those I was mainly thinking of. The externally imposed costs of switching back into local currency is usually low. The more purely subjective costs may be higher, and, as you suggest, quite variable, depending on how people evaluate the possible future paths of domestic monetary policy and the chance that one path will lead off a cliff.

  3. The AEC blog post draws heavily from my Economic Affairs article titled "Friedman Versus Hayek on Private Outside Monies: New Evidence for the Debate" which is available at:

    You might also find my new paper on bitcoin of interest, as I employ Dowd and Greenaway's model to discuss the central problem mentioned in the earlier paper. It is titled "Crypto-Currencies, Network Effects, and Switching Costs" and is available at:

  4. Kurt,

    Will Luther hits the nail on the head. Even with a perfectly level playing field legally, net work effects, which are at the heart and soul of what money is pose the large obstacle Friedman had in mind. This refers not only to the usefulness of money resting on how widely it is accepted by other as a means of payment but also on its wide spread if not universal use as the unit of account (for contracts, invoicing, pricing). This aspect was not fully appreciated by Hayek. Jerry O'Driscoll and I debated Hayek on this point in the 1976 Mount Pelerin Society meeting in St Andrew just after his competitive money articles had been published.

    1. As transaction costs diminish, though, network effects–at least, some network effects–should weaken. If I can hold Swiss francs rather than a much less reliable currency and only pay a very small transaction fee to exchange currencies, that weakens the network effect for the less reliable currency. We are not all the way there yet, but I think that's the implication of the continued spread of electronic payments and cheap communications.

  5. There is always a point at which the instability of ones currency leads to adopting another and the lower the switching cost and network effect impediments (two very different things) the quicker that will happen, so I agree with you up to a point (and so would Friedman). But I wonder if you have the store of value aspects in mind (which can be satisfied by many things) rather than the unit of account and means of payment aspects for which network effects are critical. A country has not dollarized if goods are not widely priced in and payments widely accepted in the foreign currency. A currency has to be pretty bad before crossing that threshold.

  6. Mathieu,

    I think Feehan-Fitzgerald has it right. Though the final Friedman quote in your blog is a bit hard to follow, I think Friedman is still making a networking cost argument. If a bank accepts deposits denominated in currency X, not the national currency, it needs to back it with assets also denominated in X (assuming the bank is not an exchange rate gambler). The bank could extend loans in X, but only if the borrower was willing to accept it and the risks involved if the borrowing's income is not denominated in X. These are all networking costs challenges to introducing a new of competing currency, which Friedman (and I) think are high. This doesn't not mean of courage that a currency cannot get so bad that people with not bare that cost (as in Zimbabwe a few years ago with it officially dollarized), just that it needs to be pretty bad.

  7. I'm not saying these costs are low, in fact my point is that Hayek didn't think these costs were low either. I think Hayek thought of his plan for the denationalization of money as one that would take off during a hyperinflation crisis, when those costs are low relative to the ongoing use of national currencies.

  8. Mathieu,

    Then Hayek and Friedman would agree on that. It has been a very long time since I read Hayek's proposals (or discussed them with him) but they evolved some. In his first proposal I think he was only talking about competing government monies. It was a not very controversial idea (at that time it might have been more controversial among main stream economists) that if legal restrictions on contracting and settling in other currencies were removed so that it was easier (but not easy) to use other currencies this would bring some (maybe only a little or maybe more than a little) competitive pressure on governments to manage their own currency better.

Comments are closed.