Tuesday, 28 March 2017


Do we need a distinct monetary constitution?

November 9, 2015

Having a monetary constitution is important. But do we need a distinct monetary constitution?

Steven Horwitz says no. Agreeing with James Buchanan that a monetary constitution is desirable, Horwitz argues that a general constitution that protects private property rights, provides for contract enforcement, and maintains the rule of law is also a monetary constitution, even though money is not specifically mentioned or enshrined.

The reason that a general ‘constitution of liberty’ is also a monetary constitution is because it sets the political meta-rules in which robust money and banking systems can evolve. We have a fair idea of what money and banking arrangements would look like, if they evolved within this particular overarching system of rules. Money would ultimately be some commodity, such as gold or silver. Banks would evolve out of money warehouses, eventually loaning out deposits to finance asset portfolios, while paying depositors interest for the privilege. It is at this point that banking, which necessarily is financial intermediation, is born. From here, banks would start issuing paper liabilities, redeemable in the underlying money commodity, which along with other bank liabilities would come to be used overwhelmingly in day-to-day commercial transactions. Commodity money itself would only rarely be used. Finally, practices would evolve that facilitated rival banks clearing their liabilities against each other; eventually this regular note-clearing arrangement evolves into a formal institution, the clearinghouse, which provides other valuable services to its member banks, such as facilitating emergency liquidity transfers, sharing information about potential fraud, and maintaining basic standards such as capital ratios. This is a form of endogenous regulation: banks submit because being a member of the clearinghouse in good standing is a valuable capital asset, signaling to the public that the bank can be trusted with the public’s deposits.

A constitution of liberty is thus sufficient for setting the overarching rules wherein free or laissez faire banking systems grow and flourish. Historically, free banking systems of the kind described above, despite being subject to only the ordinary and general law of property, contract, and torts, have been both effective and stable. They were effective in that they satisfied the public’s demand for liquidity while also performing valuable intermediation services, helping to channel scarce capital to its highest-valued uses, and thus were powerful forces for economic growth. They were stable in that they were not crisis-prone, and even when large and ‘systemically important’ institutions looked like they would fail, the system as a whole did not ground to a halt.

While there are many other laudable proposals for increasing economic stability, such as NGDP futures targeting, I believe free banking offers the best prospects for securing genuine institutional robustness for money and banking. If I and other advocates of free banking are right, it appears the best monetary constitution is not a monetary constitution at all per se, but a constitution that protects the natural rights to life, liberty, and property that are central to Enlightenment liberalism.