The route to sound money

In a speech reproduced at the excellent Cobden Centre website, James Tyler argues for the introduction of a free money system (i.e. independent, private issuers of currency). This is part of the ongoing debate between sound-money advocates about the best way to achieve their agreed objective. Some believe that money must be backed by a commodity (typically gold) whose quantity is difficult to change rapidly (we might tag this the Misesian approach), others believe like James that competition between issuers will favour currencies whose value is debased most slowly and that private, competitive currency is therefore the way to achieve sound money (this might be called the Hayekian approach, though strictly we ought to call it the late-Hayekian approach, as Hayek had for a long time favoured the former solution, until he despaired that state-owned banks would ever adopt a sound-money approach).

James presents the Hayekian case in positive form - that competing currencies themselves would be beneficial. I am more Misesian than Hayekian, but I can see a case for the Hayekian approach. But that case is negative, not positive. In my opinion, the best argument for Hayek's approach is that it would fail, not that it would succeed. Let me explain.

Money is not a good like any other good. Neither is any other good, of course (I hasten to add before I fall into the mainstream economists' trap of over-generalization). Each good has its own characteristics, which makes it quite difficult to express the value of one good in terms of another. That is why barter is impractical, and highlights two of the key characteristics of money (part of whose function is to get round this problem). To serve its purpose well, it must be liquid and fungible. It also needs to be durable, portable, finely-divisible, and of consistent quantity (so that it retains its value as a reliable metric against which supplies of and demand for other goods can be judged). But for these purposes, the key point is that the more widely accepted a currency is, the more useful it is.

Let's imagine a world such as James advocates, where a number of currencies circulate simultaneously, including Tesco pounds issued by Tescos (but not usually worth a pound sterling once floated) and backed by a basket of Tescos goods. My wages must be specified in terms of a currency, and I will presumably be paid in that currency. Currently, I can easily use the currency in which I am paid to spend at any time in any shop in my home country. If, in this parallel universe, I am paid in Tesco pounds, will my wages be redeemable at Sainsburys? Or will I be obliged either to exchange my Tesco pounds for a currency accepted at Sainsburys or to do all my shopping only at shops that accept Tesco pounds? What does that do for the most important element bar none of a free-market system: competition?

What about the shop-owners? How many different currencies will they support? How will they display their prices in different currencies? Will they simply accept their losses as the exchange rates change and make goods on the shelf cheaper in one currency than another? Or will they re-price goods regularly? Or will they mark their prices in only one price and do the conversions to other accepted currencies only on the total at the till, leaving the shoppers to make the mental conversions as they shop?

As for the idea that Tescos pounds will be backed by a basket of goods, that Fisherism was disposed of by Mises years ago. Our tastes are not immutable, technology does not stand still, brands wax and wane, and some businesses and goods go out of production altogether. The goods that most closely constitute a representative sample of buyers' preferences will be different next year to this (accepting for the sake of argument that such a thing could ever usefully be defined). It is the same problem as for calculating price indices or equity-market indices. The constituents must change regularly if they are not to lose relevance, but the index itself loses its value as an anchor of value for comparison if the constituents are changed.

Besides, one of the principal purposes of a backing commodity for a paper or credit currency is that, should one lose faith in the currency (for instance if you fear it is being debased through issuance of unbacked paper or credit), one can ask for one's savings to be converted into the backing good in whose value you place more confidence. Hence the use of gold as the standard backing commodity. If we lose confidence in Tesco pounds, how exactly are we going to convert our savings into the basket of goods that is supposed to anchor its price? If we have any meaningful quantity of savings, we will have far more of a rather dull, de-personalised collection of goods than we can use or exchange with our friends (who anyway may well also be overloaded with these goods in these circumstances), some of which won't be to our tastes, and much of which will spoil before we can extract the value from them. A currency backed by a basket of consumer goods is pretty useless in providing security against precisely the risk that competing currencies are supposed to insulate us against.

In reality, the value of a liquid, fungible currency redeemable in as many venues as possible will greatly exceed the risk of devaluation of the small-to-negative amount of money typically held in a currenct account. Competitive pressures and network effects could be expected to consolidate the market for current-account currencies until the leading contender achieves a dominant position. It may be that, in the process of competition and consolidation, the winner that emerges is the one whose value is most reliable, and that we therefore end up with a dominant currency whose history predisposes it to maintenance of value. That, it seems to me, is the best that can be said for the concept of competing currencies, and probably what Hayek had in mind. He may well have expected that people would prefer a currency, such as one backed by gold, whose value was reliable, and that his idea would therefore lead us to the situation that he had preferred all his life, but had despaired of achieving by means of persuading politicians to legislate for restoring currencies to the gold standard.

And on that basis (the inevitable collapse of a market for competing currencies into a monopoly), I could live with the introduction of competing currencies, and am happy to have an amiable difference of opinion with proponents of the concept, remembering that the things about which we agree (the importance of sound money) are more important than our points of disagreement. But I do nevertheless disagree, however amiably. There are several considerations that, in my opinion, the competing-currencies crowd have ignored.

One is that we already have competing currencies that can serve the intended purpose. We have a couple of hundred of them worldwide, in fact. Where sound money is important is in savings - money whose value could be eaten away significantly by debasement. Unlike for current accounts, there is no insuperable obstacle to exchanging the money in which we are paid for another currency in which we will hold our savings, should we have more confidence in the value of the latter than the former. If we don't trust any central bank (perhaps because it is state-owned) and believe they will all devalue their currencies, we can buy gold or any other non-spoiling commodity or combination of commodities or any other good (Rembrandts or classic cars, for instance) that we believe will hold its value better than paper money. These goods may or may not be readily exchangeable as money (gold coins more so than classic cars, for instance), but even if not, they can be converted back to a more liquid currency should we decide we would now like to spend the money that has been invested in these value-retention goods. If the market for the goods is not sufficiently liquid to be able to convert them to more exchangeable goods in a suitable timescale, we probably ought to choose a different good as a repository of value.

More practically, there are significant risks of negative effects in the process of reducing competing currencies to a monopoly. One has already been mentioned: competition. Whilst there are many competing currencies, people may be constrained in the locations in which they can spend their money, which at least fragments the market, and can be manipulated by dominant retailers to create barriers to entry. In the worst case, the dominant currency that emerged as the monopoly currency might be something like the Tesco pound, which could leave us in a Robocop world where The Corporation is all-powerful, dominating the market for all goods, and governing as well as serving customers. In practice, if the sovereign currency is retained, it is very likely to crowd-out private competitors in the current-account market because of its ubiquity, but the risk of a Tescopoly on money is chilling even if the probability is small.

Another risk is that, even if the winner of the race for dominance is a sound currency that holds its value well, its issuers may move away from this position once the competitive pressures are removed. Network effects would tend to protect a currency's dominance once it had achieved that position, even if its issuers started to debase it, so long as they did not do so so aggressively that the network effects are outweighed by the value-retention of an upstart competitor (as has happened from time to time where the US dollar has replaced a sufficiently debased native currency). This is the same constraint faced by monetary authorities nowadays, in which case what exactly has been achieved, other than to reduce the possibility of democratic redress against debasement of the currency, and hand the benefits of money issuance from the state to a private organisation?

There can be no absolute assurance against debasement, whatever system is adopted. Private issuers would have as much incentive as state issuers to debase as much as they can get away with, and as much scope to do so once dominance were achieved. The threat of flight from a weak currency can be maintained under a public or private money system, if people have the will, for instance if enough people exchange their money for gold. Sound money (like so much else) ultimately rests on sufficient people having sufficient demand for a sound monetary regime, and the understanding and determination to apply the sanction of selling a debased currency. It also relies on the political will to allow people to exercise their judgments in this way. There is no getting away from the reality that the right policies depend on their being demanded by a populace with a good understanding of good economics and implemented by a government that follows sound principles and resists the pressures of those who hope to profit from manipulating policy in their favour. If so, why go through the rigmarole and associated risks of competing currencies, when 100% gold-backing could be implemented directly on the national currency, if the conditions for success (educated populace and responsible government) of either approach were present.