Milton Friedman and the case against currency monopoly.

• Author: Selgin, George
• Position: Report

A longstanding tradition in economics, dating back at least to Adam Smith, looks askance at statutory monopolies, condemning almost all of them as unnecessary barriers to economic progress. Thanks largely to this tradition most of the monopolies present in Smith's day are no longer tolerated. The few exceptions are found mainly in less developed countries, where they remain a cause of impoverishment. Needless to say, economists have also generally opposed the monopolization by fiat of undertakings that were already at least somewhat competitive in Smith's day.

But there is one set of notable exceptions to the last claim: government monopolies of paper money. During the late 18th and the 19th century such money consisted almost entirely of redeemable notes issued by commercial banks; and while complete legal freedom of entry into the paper currency business was rare, so were outright monopolies. In some countries, moreover, the paper-money industry "playing field" was more or less level, with numerous banks sharing similar privileges.

During the late 19th and early "20th centuries, however, competitive note issue gave way almost everywhere to monopoly as governments awarded exclusive note-issue privileges to flavored banks. Although significant numbers of economists opposed this development during its early stages (see Smith 1990; White 1995: 63-88), others either flavored it or were indifferent. As monopoly became the norm, the opposition ceased--or did so until the mid 1970s, when Friedrich Hayek succeeded in reopening it, if only on a very small scale.

Milton Friedman's views on the matter of currency monopoly offer a particularly interesting case study. Despite having been an unflinching champion of classical liberalism and free markets, he at first (Friedman 1960: 4-9) shared the common view concerning the necessity of official currency monopolies. But Friedman came to revisit and revise his original opinions in light of the renewed interest in the question Hayek's work helped to stimulate. Although Friedman ultimately concluded (Friedman and Schwartz 1986: 52) that there is, after all, "no reason currently to prohibit banks or other groups from issuing hand-to-hand currency," his opposition to official paper currency monopolies remained lukewarm. In effect, he took a stand resembling Walter Bagehot's of over a century before: although Bagehot thought competitive note issue a better and more "natural" arrangement, he considered it futile to oppose the Bank of England's monopoly, which was by then already firmly established. "You might as well, or better, try to alter the English monarchy and substitute a republic," he wrote, "as to alter the present constitution of the English money market" (Bagehot [1873] 1999: 330). (1)

I plan to argue that the case for abolishing official paper currency monopolies is in fact much stronger than Friedman believed it to be even in his later writings. By way of doing so I hope to convince at least some economists, and followers of Milton Friedman's work in particular, to take up the cudgels for competitive note issue.

Friedman's Early Views on Currency Monopoly

Friedman's early views concerning the necessity of state involvement in monetary affairs occur in his 1959 Millar lecture, "The Background of Monetary Policy" (Friedman 1960: 1-23). Although Friedman claimed at the time that he was "by no means certain" that monetary and banking arrangements ought not to "be left to the market, subject only to the general rules applying to all other economic activity," he believed that there were several "good reasons" for the general, historical failure of even relatively liberal governments to take this approach (1960: 4). As summarized later by Friedman and Anna Schwartz (1986: 40), those good reasons were:

[1] the resource cost of a pure commodity currency...; [2] the peculiar difficulty of enforcing contracts involving promises to pay that serve as a medium of exchange mid of preventing fraud in respect to them; [3] the technical monopoly of a pure fiduciary currency which makes essential the setting of some external limit on its amount; and finally [4] the pervasive character of money, which means that the issuance of money has important effects on parties other than those directly involved. Of the four reasons, only the second and the fourth, concerning the risk of fraud and the presence of externalities, supply grounds for official monopolies of paper currency. (2) "The very performance of its central function," Friedman observes (1960: 6),

requires money to be generally acceptable and to pass from hand to hand. As a result, individuals may be led to enter into contracts with persons far removed in space and acquaintance, and a long period may elapse between the issue of a promise and the demand for its fulfillment. In fraud as in other activities, opportunities for profit are not likely to go unexploited. A fiduciary currency ... is therefore likely to be overissued from time to time and convertibility is likely to become impossible. Historically, this is what happened under the so-called "free banking" era in the United States and under similar circumstances in other countries. Moreover, the pervasive character of the monetary nexus means that the failure of an issuer ... has important effects on persons other than either the issuer or those who entered into a contract with him in the first instance or those who hold his promises. One failure triggers others, and may give rise to widespread effects. The best solution, Friedman concludes (1960: 7), is to do away with convertible currency "altogether, replacing it with a "purely fiduciary" (i.e., fiat) outside currency issued by a public authority.

Friedman's Reconsideration Reconsidered

Just over a quarter-century after stating his original arguments against monetary laissez-faire, Friedman reconsidered those arguments in light of subsequently published research. The resulting paper, co-written with Anna Schwartz, revisits "all four of Friedman's proposed "good reasons" for intervention in money. In particular, it re-engages what Friedman and Schwartz term the "free-banking" question, which they frame as follows: "Given a well-defined outside money ... can and should strict laissez-faire be the role for banking--broadly defined to include the issuance of inside money in the form of currency as well as deposits?" (Friedman and Schwartz 1986: 41).

According to Friedman and Schwartz, the free-banking question encompasses three "sub-issues," namely, whether a public lender of last resort is necessary or desirable, whether regulatory restrictions on lending and investing by private financial institutions are necessary or desirable, and whether hand-to-hand currency ought to be a government monopoly. My immediate concern here is with the last of these sub-issues only. However, as I hope to make clear later on, it and the second sub-issue are not strictly independent, for in monopolizing the supply of hand-to-hand currency...