Thursday, 23 March 2017


Friedman vs. Hayek on currency competition

August 22, 2014

In a recent post, co-blogger Jerry Jordan refers to the “new monetary scheme” offered by Friedrich Hayek in the mid-1970s. Hayek outlined his proposed reform in Choice in Currency (1976) and Denationalisation of Money (1976). Milton Friedman and others were quick to point out its shortcomings. I’ve written a bit more on the exchange between Friedman and Hayek elsewhere. The following excerpts convey the basic idea.

Hayek’s system of competitive note issue differs significantly from historical episodes of laissez faire banking in that issuers are not contractually obligated to redeem their notes for some underlying commodity. Rather, private banks provide the economy with outside money as the central bank does in most modern systems. The unbacked, irredeemable notes issued by private banks then trade against each other (and against commodities) at floating exchange rates on the open market.

According to Hayek, note issuers in such a system are dissuaded from manipulating the money supply in undesirable ways. […] Issuers who fail to stabilize the value of their notes are expected to lose market share.

Not so fast!

[…] stability of purchasing power is not the only consideration on which to base one’s decision to use a particular money. Money users are also concerned with its degree of acceptability among their trading partners—or, to use the modern terminology, the size and location of the money’s network—and the costs of switching. Therefore, a private issuer would have to regulate the value of its money [much better] for spontaneous switching from US dollars to result. Exactly how much better, Friedman could not be sure—but he expected it was a lot.

Although it might be sensible to prefer competition in currency, there are reasons to believe Hayek’s particular proposal would fail to function as intended. Network effects and switching costs dissuade users from switching to an alternative currency, undermining the check Hayek believed would limit the over-issuing of unredeemable outside monies. A more tenable proposal—with historical support—can be found in The Rationale of Central Banking and the Free Banking Alternative (1936) by Hayek’s student, Vera Smith. Modern supporters of currency competition tend to advocate systems along these lines.