Article originally published in GoldMoney Research, 9th January 2012.
Most students of economics today do not even know that monetary competition was the norm rather than the exception for large periods of human history. Even worse, almost none pay attention to this question at all. Tacit acceptance of legal tender laws and currency monopolies is the norm. This has resulted both in a true intellectual loss for those who are already or want to become economists, and in the absence of a public and academic debate on a true exception and even an anomaly of a market economy. In the following lines, I will try to contribute to this missing debate, even though quite modestly.
Following the definition espoused by the Austrian economist K. Menger, money is not a specific good but a property of the goods. In fact, different goods have been used as money according to their ability to (1) make transactions and (2) to be a proper store of value. For centuries, even millennia, the exercise of commerce served as a practical and unintended test to select the best money. First, it was those essential goods widely used and exchanged in a community – such as cattle, wheat, grains or salt. Then – because of the high transportation and storage costs, low durability and the lack of divisibility – those goods were substituted by precious metals for ordinary transactions, as metals were much easier to transport and store at a very low cost. Both gold and silver coins were efficient means both to settle payments and store wealth. They were goods that, in the words of Hayek, had “currency”, as they were very liquid and readily accepted as money across different communities and cultures.
Governments have regulated the content of gold or silver of the currencies, and they earn profits associated with their right to print (or mint) money (seigniorage). However, this does not mean that the state is the only one able to do it. With the massive use of paper money and the decline of gold coins, the state granted the monopoly of issue to a single (commercial) bank in exchange for easy and privileged credit; and it also established the legal tender clause of the paper notes issued by that bank. Thus arise central banks. Legal tender clauses mean the end of a free market in money. Within this framework, the state could easily increase its profit by expanding the notes in circulation with no difficulty at all.
There were many successful episodes of monetary competition during the 19th century (in Scotland, Sweden and Australia, among other countries). In this competitive market, banks accepted the notes of the competence, which were regularly taken to the issuer bank in exchange for reserve money (in most cases, gold). Thus, the banking practise in such a scenario created a sort of club of commercial banks which preserved the purchasing power of the money and public confidence in the payment system. Confidence in so-called “clearing houses” was essential. If a bank over-issued paper notes, the rest of the banks could redeem those notes quickly through a clearing house. Thus, the over-extended bank soon suffered the consequences in terms of a fall in its gold and silver reserves, which acted as a corrective to that bank’s unsound policy. However, the effectiveness of the money market adjustments just described relied on the timely running of those clearing houses, so that the imprudent bank could see the consequences of its policy.
In this hypothetical more open money market, competence will restrict the supply of money in the economy, as people will gravitate towards the currency that maintains its purchasing power on a long-term basis. As far as sustainable economic growth is concerned, this would be a blessing.