Hayek and Free Banking

Hayek, free banking, currency competition, scotland

free banking, Hayek, Scotland, currency competitionI owe a heckuva lot to Friedrich Hayek.  Had it not been for him, I might never have heard of "free banking," meaning the genuine article rather than the phony antebellum U.S. version.  Certainly I would never have found myself writing about it.  Nor, perhaps, would any other modern economist.

It was two pamphlets that Hayek published in the 1970s — first, Choice in Currency (1976) and then Denationalisation of Money  (1978) — that caused the scales to fall off of my eyes and of those of  some other economists, thereby encouraging us to reconsider the merits of  private and competitive currency systems.  That reconsideration in turn led to a revival of interest in former free banking episodes, including those of Scotland and Canada, which monetary economists had previously neglected or overlooked.  In short, were it not for Hayek, there'd be no such thing as a Modern Free Banking School.

Yet Hayek himself was no free banker.  For starters, his own vision of "choice in currency" had little if anything in common with historical free banking arrangements.  In those arrangements, banks dealt in established, precious-metal monetary units,  like the British pound and the American dollar, receiving deposits of metallic money, or claims to such, and offering in place their own readily-redeemable liabilities, including circulating banknotes.  In Hayek's scheme, in contrast, competing firms issue irredeemable paper notes, with each brand representing a distinct monetary unit.  Far from resembling ordinary commercial banks, Hayek's "banks" resemble so many modern central banks in that they issue a sort of "fiat" money.  But they differ from actual central banks in enjoying neither monopoly privileges nor the power to compel anyone to accept their products.1

Competition, Hayek claimed, would force private issuers of irredeemable currencies to maintain those currencies' purchasing power, or else go out of business.  An overexpanding free bank, in contrast, is disciplined, not by an eventual loss of reputation, but by the more immediate prospect of running out of cash reserves.  Hayek's claims have always been controversial, even among persons (myself among them) who are inclined to favor competitive currency arrangements over monopolistic ones.  It isn't clear that a Hayekian money issuer would ever manage to get its paper accepted, or that it would resist the temptation to hyperinflate if it did.2

But Hayek didn't merely differ from free bankers in proposing a form of currency competition distinct from free banking.  He expressly opposed  free banking.  Asked, during a 1945 radio interview, whether he considered the Federal Reserve System a step along "the road to serfdom," he unhesitatingly replied, "No.  That the monetary system must be under central control has never, to my mind, been denied by any sensible person."   And although by the 1970s he had come to believe it both possible and desirable to have a currency stock consisting of the irredeemable paper of numerous private firms, he also continued to maintain that, so long as government authorities supplied a nation's standard money, private firms should not be able to issue circulating paper claims denominated and redeemable in that money.

The most explicit, later statement of Hayek's views on free banking occurs in a lecture he gave at a conference in New Orleans in 1977, just as Denationalisation of Money was in press:

We have indeed given government, and for fairly good reasons, the exclusive right to issue gold coins.  And after we had given the government that right, I think it was equally understandable that we also gave the government the control over any money or any claims, paper claims, for coins or money of that definition.  That people other than the government are not allowed to issue dollars if the government issues dollars is a perfectly reasonable arrangement, even if it has not turned out to be completely beneficial.  And I am not suggesting that other people should be entitled to issue dollars.  All the discussion in the past about free banking was really about the idea that not only the government  or government institutions but others should also be able to issue dollar notes.  That, of course, would not work.4

Actually, governments monopolized the coining of gold and other metals, not for any good reasons, but because doing so gave them the opportunity to manipulate precious-metal standards in pursuit of narrow fiscal ends.  But it is the last sentence of this quote that's most surprising, for what Hayek declares "unworkable" is an arrangement that worked quite successfully in many places, including Canada, where it survived well into Hayek's own lifetime.   Canada's banking and currency system had in fact been remarkably stable, altogether avoiding the crises by which the U.S. was afflicted in the decades leading to the Fed's establishment, and weathering the Great Depression far better than the U.S. system did despite having lacked a central bank until after that episode's nadir.5

That Hayek should have written as if he was quite unaware of the Canadian experience or, for that matter, of the still more famous Scottish free banking episode  is extremely puzzling.  It was Hayek, after all, who supervised, and signed off on, Vera Smith's 1935 doctoral dissertation on "The Rationale of Central Banking" (subsequently published by P.S. King & Son, and reprinted by LibertyPress) in which she discusses both the Canadian and the Scottish episodes, as well as some other free banking episodes, in unmistakably favorable terms.

Had Hayek forgotten his own PhD student's work, if not some of his own early research?  Had he simply changed his mind, reverting to conventional wisdom after a brief interval during which he had entertained a more favorable view of free banking?  Or had he never accepted Free Banking School arguments?

Larry White, who drew attention to Hayek's anti free-banking stance some years ago in a History of Political Economy article entitled, "Why Didn't Hayek Favor Laissez Faire in Banking?," favors the third hypothesis, tracing Hayek's position to his unwavering belief that a free banking system would manage the stock of bank money in a procyclical manner.  Whereas for Mises, who did favor free banking,6 a cyclical boom was most likely to be set off by a central bank, for Hayek it is the competitive commercial banks that are most likely to overissue.  Unlike Mises, Hayek subscribed to the popular view that banks might expand credit without limit so long as they expanded in unison, and that they would in fact be inclined to overexpand, while allowing their reserve ratios to decline, in response to cyclical increases in the demand for loans.

But Hayek was mistaken.  The popular view, according to which banks can expand credit all they like so long as they expand it in unison, incorrectly equates a bank's demand for reserves with its net demand for such — that is, with its need for reserves to cover expected or deterministic outflows. This overlooks banks' need for  "precautionary" reserves, or reserves that serve to protect against an undue risk of stochastic or random reserves losses.  Even a well-coordinated, industry-wide expansion of bank credit will involve some increase in banks' collective demand for precautionary reserves.  For that reason such a coordinated expansion isn't sustainable unless it's accompanied by an increase in the nominal quantity of bank reserves.  That is why, if one examines the record of so-called bank lending "manias," one finds that they typically involve, not a substantial decline in bank reserve ratios, but a substantial increase in the nominal quantity of bank reserves.

Whether Hayek was right to reject free banking or not, and tempting as it may be for fans of free banking to claim him as one of their own,  doing so would hardly be doing justice to that great economist.  We may credit him for inspiring us all; but we mustn't otherwise associate him with opinions that, rightly or wrongly, he flatly rejected.


Addendum (July 22, 2015): Over at Mises Wire, Joe Salerno points to some passages in my post that he considers misleading or wrong.  I've corrected one indisputable error — my suggestion that Vera Smith's book includes a discussion of Canadian free banking — by crossing-out the offending words.


[1] The modern cybercurrency market, consisting of Bitcoin and its many less well-known rivals ("altcoins") offers something close to a real-world counterpart of Hayek's scheme.

[2] For criticisms of Hayek's scheme, and others like it, see George Selgin and Lawrence H. White, "How Would the Invisible Hand Handle Money?," Journal of Economic Literature 32 (4) (December 1994), and Lawrence H. White, The Theory of Monetary Institutions, Part XII, "Competitive Supply of Fiat-Type Money" (New York: Blackwell, 1999).

[3] Hayek on Hayek: An Autobiographical Dialogue, ed. Stephen Kresge and Leif Wenar (Chicago: University of Chicago Press, 1994), p. 116; quoted in White, "Why Didn't Hayek Favor Laissez Faire in Banking?, p. 763 n12.

[4] F. A. Hayek, "Toward a Free Market Monetary System." Journal of Libertarian Studies 5 (1) (Fall 1979).  Whether Hayek, like Friedman before him, imagines that private banks' circulating paper dollars would be indistinguishable from the fiat dollars issued by the central authority, is unclear from this passage.  If so, he committed the crude error of equating free banking with counterfeiting.

[5] On Canada's decision, despite its monetary system's good record,  to establish a central bank in 1935, see Bordo and Redish.

[6] See Lawrence H. White, "Mises on Free Banking and Fractional Reserves," in John W. Robbins and Mark Spangler, eds., A Man of Principle: Essays in Honor of Hans F. Sennholz (Grove City: Grove City College Press).

  • Andrew_FL

    I'll be honest, even already knowing Hayek never favored free banking as we understand it, his choice of words in 1945 is still pretty shocking. No sensible person? Was Hayek unaware of Mises' position or was he really thoughtlessly insulting him?

  • Renato Andrielli

    I disagree that Bitcoin/altcoins provide a good model of Hayek's proposal, since they are not meant to be managed by a bank with real-world capital. Though it's possible that some rich guy (or a cartel) with vast reserves of bitcoin could act like a central bank to stabilize it's value.

    • George Selgin

      You are correct, Renato, to observe that with Bitcoin there is no deliberate management of supply; instead it is predetermined. That's actually an improvement on what Hayek envisioned. The similarity to which I referred had too do with the fact that both schemes involve irredeemable private "fiat" (that is, non–commodity) monies.

      • Renato Andrielli

        Having competition, private fiat currencies could be as redeemable as the market demanded. I am supposing that the issuing banks could make promises to insure the value of their moneys, and bind themselves legally to these promises.

        Rather than Bitcoin, imagine a "Fordcoin", issued by the car company, that could be used to buy cars, or would be (by legal promise) convertible into a certain amount of gold: less than the full car-value of the money, but still enough to serve as a guarantee.

        • Andrew_FL

          Sounds like I could make a profit on the business model of buying up Fordcoins with gold, buying cars from Ford, selling the cars for gold, and buying up more Fordcoins.

          • martinbrock

            You could also make a loss on this business model.

          • Andrew_FL

            Martin, I couldn't figure out why Renato thought Ford would be able to consistently offer less gold than car for their coins in terms of the current gold price of cars. Do you think they would be able to, or would the possibility I outlined above prohibit it?

          • martinbrock

            I'm not sure what he means by "full car-value of the money". If he means an amount of gold that people will exchange for the car, I see your point, but people don't exchange gold for the car. They may exchange the money for the car or they may exchange it for gold. Ford could offer gold for the money at a rate that doesn't cause most money holders to prefer gold to the car. This rate would be variable, of course.

          • Renato Andrielli

            I'm sorry, let me try to be more clear.

            Analogous examples: an Internet Service Provider contract that only guarantees 10% of the advertised internet speed, but in normal conditions will deliver 100%. Or (I don't know if this exists) pre-paid cell phone credit that can be redeemed back into dollars, at the phone company, but only at 10% face value.

            The NORFED Liberty Dollars had a "silver base" that was worth less than the face value of their money. But you could not get rich by forcing NORFED to convert your silver –> liberty dollars –> federal reserve dollars, and then buying a larger amount of silver.

        • George Selgin

          The thing is, Renato, that as soon as the currencies in question are made redeemable or convertible in real goods, they cease to qualify as "fiat" money in the sense in which I and others discussing Hayek's scheme define that term. It is the hallmark of his proposal–and, according to many, it's main shortcoming– that no convertibility commitment of any sort is involved.

          • JP Koning

            "Competition, Hayek claimed, would force private issuers of irredeemable currencies to maintain those currencies' purchasing power, or else go out of business."

            How did Hayek plan to maintain those currencies' purchasing power without convertibility? Presumably the bank kept some sort of stock of assets with which it could repurchase currency when it fell below the bank's stipulated rate?

          • George Selgin

            The Fed generally keeps assets on hand with which to "buy back" its dollars when that serves in maintaining the dollar's purchasing power at some desired level. So, JP, does the Fed not issue fiat money after all? And how about the Bank of England and Bank of China. They occasionally sell off some gold, that is, use gold to buy back their monetary "liabilities." So, have England and China actually been on gold standards all along?

            Sorry: those are rhetorical questions. But surely the distinction between exchanging one's money for other assets at a variable exchange rate and having a genuine fixed nominal redemption commitment is so fundamental that is should not be so easily fudged!

          • Andrew_FL

            George, based on my readings of Koning's blog, I believe he does indeed think pure fiat money does not in fact exist.

          • Mike Sproul

            "surely the distinction between exchanging one's money for other assets
            at a variable exchange rate and having a genuine fixed nominal
            redemption commitment is so fundamental that is should not be so easily

            But it is easily fudged! Convertibility can be instant or delayed, certain or uncertain, for real amounts or for nominal amounts, and people will value those moneys based on the issuers' assets and liabilities. Clearly, a currency can be backed without being convertible, but it cannot be convertible without being backed.

            Hayek failed to support free banking because he failed to see that the dollar is backed by the Fed's assets.

          • JP Koning

            "The Fed generally keeps assets on hand with which to "buy back" its dollars when that serves in maintaining the dollar's purchasing power at some desired level."

            My question was meant to draw out the distinction between bitcoin/altcoins, existing bank deposits, and Hayek's private money. Bitcoin/altcoins are not anyone's liability and weave to and fro around according to market whim. Hayek's private money would be the liability of some bank, the bank's assets being used to support its value relative to some target good/basket. So that while not convertible, the value of Hayek money would hold "as-if" it were convertible into the thing which is being targeted. It seems to me that Hayek's money is more similar to existing bank deposits than you are willing to grant and further away from cryptocoins, insofar as we consider their stability.

          • Renato Andrielli

            You are right in that I am blurring the distinction between fiat and credit money. Pure fiat implies no hard (legally binding) promises. If it's backed by freedom™, a pure fiat money could be constrained by the market to behave very well.

            But Hayek's ducats are NOT in this category: they are a "fiat with credit failsafe" hybrid.

            Quote from "Denationalisation of Money: The Argument Refined":

            "The only legal obligation I would assume would be to redeem these notes and deposits on demand with, at the option of the holder, either 5 Swiss francs or 5 D-marks or 2 dollars per ducat. This redemption value would however be intended only as a floor below which the value of the unit could not fall…"

            I also want to add that Hayek's ducats are not a prescription, but just an illustration of how he would try his hand in a competitive monetary market.

            This has always been how I see the Austrian proposal: a market free and flexible enough that it can try many kinds of money against each other, including full-reserve gold, no-limits-fractional-reserve credit, Leland Yeager's commodity basket standard, bimetallism, and whatever else the human mind can invent, as long as it works.

      • martinbrock

        Bitcoin is less an improvement over Hayek's vision than a particular instance of it. A predetermined cap on the supply is one of many possible policies that an issuer of irredeemable currency could offer, and the blockchain is one possible mechanism whereby an issuer guarantees the policy.

        A currency without this cap, but with other constraints on supply and other mechanisms for ensuring respect for these constraints, is conceivable. Hayek presumably didn't anticipate crypto-currencies, but he could have discussed other accounting systems effectively ensuring that an issuer pursues its advertised policy.

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  • RepubAnon

    In today's "I'll be gone, you'll be gone" financial markets, where big bonus checks from sales of risky paper to the gullible are routine, "free banking" is not an appealing idea.

    Bitcoin is a good example – look at the wild speculative swings in bitcoin values, and explain why anyone would want to use it as a medium of exchange for everyday purchases (unless they're trying to conceal things from the tax collectors, or the police). It's like buying something priced in a different country's currency – each purchase becomes both a sale of goods and also an exercise in currency speculation.

    Meanwhile, there would be the joy of trying to conduct transactions in a world where each bank had its own currency. What if your employer sets your salary in one currency, but your mortgage is payable in another? We see this in countries where loans are made in foreign currencies:

    While foreign currency loans offer some advantages to borrowers – such as lower interest rates and longer maturities compared to domestic currency loans – they also carry a significant exchange rate risk. A sharp depreciation of the domestic currency can prevent unhedged borrowers from being able to service their foreign currency loans. As a result, these loans could create a substantial systemic risk to the European banking sector. Banks could fail jointly as a result of their exposure to unhedged households and non-financial firms which default on their loans when the domestic currency depreciates sharply.
    (Source: Foreign-currency loans and systemic risk in Europe, voxeu.org, Pınar Yeşin 26 November 2013

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  • Renato Andrielli

    Hayek was clearly not comfortable with third parties issuing banknotes and checking accounts denominated in someone else's money. For example, the chapter on "parasitic currencies".

    This can be remedied by creating a new intellectual property right to protect private currencies. If Joe's bank wants to issue notes or checking accounts denominated in, or linked in some way to Hayek's ducats, he will need permission from Hayek's bank. In order to get that permission, he has to submit to Hayek's rules, which could be as draconian as those of any central bank.

    The US Dollar could be privatized tomorrow under such a system, together with the Federal Reserve System as owner of the currency, safely preserving its powers.

    If the legislation allows licenses in the style of the GPL, we can have "open-source" currencies and even anarchic (BSD license style) ones. This makes it possible for genuine free banking to exist alongside non-free banking, but the free banks would not have the right to issue notes/accounts denominated in non-free currencies, or to formally link their own currencies to it.

    • George Selgin

      True enough, Renato. But it must be understood that in Anglo-Saxon nations government coin monopolies were justified on public good grounds, while the right to issue banknotes denominated in official coin units was for centuries a right in common law. Considered against this background the idea of treating the standard unit as a "brand" belonging to the government, and not to be encroached upon by private firms except with express permission, appears retrograde.

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  • Benjamin Cole

    Well, as I do favor central banks (the power of a sovereign nation, I contend), I agree with Hayek's sentiments.

    Whether or not I agree, the world believes in central banking, and it does not look to change soon.

    So, for me, the question becomes clarity and accountability in central banking, and making sure central bankers serve the general public and larger economy.

    I think the Market Monetarists come closest to what can be done within current realities. I would favor an even more-robust policy towards growth, and much less hand-wringing about inflation anywhere under five percent.

    It is amazing to ponder that in 1992 Milton Friedman bashed the Fed for being too tight–when the CPI was at 3%, and that Fed had cut its rate from 10% to 3%. Four times in career Friedman said the Fed was too tight.

    One cannot fund a right-wing economist today who professes anything but a slavish devotion to tighter and tighter money. It has become some sort of religion.

    If the Fed had been growth-oriented in the 2000s, there would be little if any discussion of free banking, and probably no 2008 bust. The Fad's abject tight-money policies are reviving free banking and other ideas–understandably.

    But, the US military has lost three wars in a row (Vietnam, Afghanistan and Vietnam) after incredible outlays. Do we privatize the military?–or it that properly one of the powers of the sovereign?

    Great discussions and comments btw.

    • George Selgin

      Benjamin, I sometimes get the impression from your comments that some of them are directed, not at my own opinions, but at those of some "right wing" economist or other. I can assure you that I am not responsible for what the "right-wing" thinks about money, let alone what it thinks about defense, foreign policy, and all that. If I think 5%, or even 3%, inflation typically too high, it's my understanding of macro., however muddled, that's telling me so, not my politics.

      Concerning the fact that the "world believes in central banking, and it does not look to change soon," that is of course beyond dispute. However it is worth considering how, as late as 1913, it could have been said–indeed it was often said–that the U.S. emphatically did _not_ believe in central banking, and did not look likely to change its mind soon. A year later, the U.S. had a central bank, albeit a (thinly) disguised one.

      Beliefs, in short, can change faster than people often realize.

      • Andrew_FL

        My impression from reading Cole's comments, especially at Scott Sumner's blog, is that he's not so much a Market Monetarist as an unreconstructed inflationist ideologue. He's openly expressed nostalgia for the inflation rates of the 1970's.

        • George Selgin

          Hmmm. Benjamin, is that so? I lived through the 70s inflation, and nobody liked it a bit then!

          • Andrew_FL

            A few actual quotes:

            "print money to the moon." "I sometimes wonder if the old “commie threat” days were really good for
            Western democracies. Back then, leadership felt an obligation to improve
            economic performance and increase living standards for domestic
            populations." "Shoot for 7% NGDP growth for seven years, and wake me up after that. Pile on the QE. Print money until.the plates melt. When it is boom times in Fat City, then who will whimper about ination?" "When you hear lots of sniveling and whining about “labor shortages” then monetary policy might be expansive enough." "If the natural interest rate is -4%, then go to the mattresses, lock the
            Fed front doors, and run the money presses red hot for long, long time."

            Here's a great, long one:

            "The magic 2 percent ceiling on inflation.

            That is the divine number, unless it be 0 percent. Major central
            banks everywhere genuflect now to this exalted wisdom (except the
            People’s Bank of China, which will tolerate a 4 percent ceiling. How is
            their economy doing? Rip-roaring, why do you ask?)

            No one ever says where this sanctified 2 percent comes from.

            Let me pose a fact: Real per capita income rose by more than 30
            percent in the 1960s. In the 1950s, you might see a kid with rickets in
            the USA. By 1970, no.

            Structurally, the USA economy was a mess in the 1960s. The private
            labor force was 50 percent unionized, the top tax rate was 90 percent.
            The banks, Wall Street, phones, airlines, trucks, trains and cars were
            heavily regulated. Little foreign competition.

            The Fed stimulated, and got results anyway. Huge results. Real
            incomes up about one-third in one decade. The sense of better material
            well-being in the 1960s was nearly palpable. Fat City baby.

            So now what do we hear from economists about the 1960s?

            Only “waa-waa.”

            You see, inflation popped its head above 5 percent in 1969. Horrors. The decade was a failure.

            Give unto me such failures every decade.

            So now we will have a decade with inflation under 2 percent. Who is happy now?

            Central bankers and inflation-obsessed economists."

            Give unto me such failures every decade. Really.

            Quick tip how to turn oneself off to "market monetarism"; believe Mr. Cole is representative of what they want to do, then google "benjamin cole" "fat city".

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