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Stateless Money: The Example of Somalia

May 26, 2011
in Blog

It is a common belief that money and the financial markets are inherently unstable; or that a financial crisis is an easy outcome in the case of a random event (sometimes referred as sunspots). A central bank, along with proper regulation, is what is needed to guarantee the stability of the market. It is true that, by looking back in time one will eventually find historical examples of money markets without a central bank or strong regulations. However, it may be argued that whatever merits such historical cases may present for laissez-faire banking, the world today is under a very different situation. Complex financial instruments (like derivatives, derivatives of derivatives, SIV, etc.) and the use of fiat money rather than commodity money could be arguments in favor of regulation. Such complicated and delicate matters should not be left unsupervised.

Hayek argued in favor of currency competition in The Denationalisation of Money (1976), where he put forward the proposal to let banks issue fiat money privately. This, however, was not very well received by everyone. Milton Friedman, for example, thought that Hayek’s proposal will not result in competitive currencies, but only in one currency due to network effects. Friedman’s argument seems to have some resemblance with the cases of free banking. In such cases the commodity money is one (i.e. gold), or maybe two at most (i.e. gold and silver), but there are hardly cases of multiple commodities money competing with each other. What one can find is competition in the issuance of money substitutes, like banknotes. But the quantity of different monies in the narrow sense is still small. Fiat money is not a money substitute, but money proper in itself, and the same reason that led the market to have one or two commodity monies could led the market to have only a few fiat monies.

On this matter, the case of stateless Somalia offers an interesting case that was studied by Will Luther (GMU).  After the state collapsed in 1991, the Somalis had the liberty to shift to another currency or adopt new ones along the Somali shilling; for example the currency used by trade partners. As Luther tells us, this didn’t happened and the Somalis continued to use the Somali shilling even when having the possibility to adopt other alternatives. Even if the Somali shilling eventually started to depreciate, there was no shift into another currency.

Probably the case of Somalia is not a perfect historical lab experiment. The lack of a strong economy and financial markets may play an important role in increasing the transaction costs of shifting to currency competition. Maybe trade with partners is not frequently enough to easily adopt another currency, etc. Nonetheless, independently of whether Friedman’s or Hayek’s hypothesis on the number of competing currencies is right, the case of Somalia offers an important lesson: Even in an economy as underdeveloped as the one in Somalia money is possible not only without a monopolist central bank, but also without a formal government in place. If Somalia could go back (or should we say forward?) to work with fiat currency under the absence of a central bank, then for developed economies the possibility of alternative monetary institutions should be considered as a feasible alternative. The pursue of sound money and healthy monetary institutions requires to have an open mind on what the study of free markets in money can bring to the table.

Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.

Image by nattavut / FreeDigitalPhotos.net.