Denationalisation of Money: The Argument Refined

INTRODUCTION TO THE THIRD EDITION

The central argument of this Hobart Paper by Professor Hayek is that price level stability can be achieved only by removing from national governments their monopoly of money creation. Although price level performance in the years before the Paper’s publication had been unsatisfactory worldwide (in Britain, for example, the cost of living had risen by just over 500 per cent during the previous quarter-century), the Paper had little apparent practical impact. Discussion continued to be of how to improve the performance of these government monopolies rather than of how to end them. If the idea of monetary competition was discussed at all, it was dismissed as ‘politically impossible’.

As Hayek observed, that objection should be irrelevant to an economist:

‘… the present political necessity ought to be no concern of the economic scientist. His task ought to be, as I will not cease repeating, to make politically possible what today may be politically impossible. To decide what can be done at the moment is the task of the politician, not of the economist…’ (Second edn., 1978, pp. 79-80)

Fortunately, Hayek was not alone in that belief. Other scholars have followed up his analysis, and have studied episodes where there has not been a government monopoly of money. Lawrence White (1984) studied the Scottish system of competitive money issue—a system admired by Adam Smith. Eugene White (1990) examined the period during the French Revolution when there was competition in the issuing of money. Hugh Rockoff (1990) examined competitive money issue in the United States. Of course, none of these episodes emerged as one of perfect monetary performance, and none is recent. But all turned out to be more stable than government monopoly of money has been; and their age is irrelevant, for the principle they illustrate is the timeless one that incentives influence conduct. Hayek’s analysis as set out in this Hobart Paper is acquiring empirical support.

At the same time, those who consider themselves practical men have started to think about what might be done to improve our monetary system. A few years ago the notion that a British Chancellor of the Exchequer would propose freeing the Bank of England from the authority of the Treasury would have seemed totally unbelievable. But Nigel Lawson has revealed that when Chancellor he made just such a proposal. This increased attention should be no surprise. In the years since Hayek’s Paper first appeared, price level performance has not improved. Between 1978 and 1990, the cost of living has risen in Britain by 230 per cent. That fall in the value of sterling has occurred despite the British economy undergoing a severe recession in an attempt to end inflation.

This failure is not unique to Britain. In Germany since 1978, prices have risen by 138 per cent; in Switzerland by 143 per cent; and in the USA by 190 per cent. All did better than Britain, but surely evidence enough that an independent central bank is, as Milton Friedman argued in 1962, no guarantee of satisfactory monetary performance. What then should and can be done?

The New Zealand Government has recently recognised that incentive is important, and has linked the pay of its senior central bankers to their success in delivering stable prices. In a forthcoming paper, Charles Goodhart (1991) urges the same for the Bank of England.

Is this effort to harness incentives to deliver the objective worthwhile? Is the objective of sufficient importance? And if so, can anything else be done? In this Paper, Hayek sets out with great lucidity why inflation is so important and so damaging. It does of course redistribute between borrowers and lenders. That is arbitrary. It is also inefficient, for it disrupts the working of the capital market. But the problems caused by inflation go beyond that; they affect the whole economy by making future prices harder to foresee and current price movements harder to interpret.

‘If the value of money is so regulated that an appropriate average of prices is kept constant … the unpredictability of particular future prices, inevitable in a functioning market economy, remains, [but] the fairly high long-run chances are that for people in general the effects of the unforeseen price changes will just about cancel out.’ (pp. 67-68)

Hayek contrasts this situation with one where there is inflation:

‘… the individual enterprise … could … not base its calculations and decisions on a known median from which individual movements of prices were as likely to diverge in the one direction as in the other. Successful calculations, or effective capital and cost accounting, would then become impossible.’ (p. 69)

And the problems are, he emphasises, additional to the

‘… temporary changes in the structure of relative prices [which inflation] also brings about, which will cause misdirections of production’, (p. 69)

The instabilities produced by these distortions and by the occasional efforts of governments to slow inflation are, Hayek argues, responsible for the recurring periods of mass unemployment which characterise capitalist economies. The benefits of stable money would not end with a stable price level.

How, then, to achieve monetary stability? Milton Friedman, and recently many others, have urged a monetary rule, embedded where possible in a ‘monetary constitution’, so that the growth of money is steady and predictable.1 There can be no doubt that such a rule would end the grosser failures of monetary management. But why do we need to regulate our suppliers of money? Here competition comes in. For regulation of an industry—by government, regulatory agency, or rule—can be defended only if the industry is not regulated by competition. In general, competition will deliver the best attainable outcome. Why not in money? That is the question addressed in this Paper; and the answer is that competition in the supply of money will produce that desired outcome, just as it does in other economic activities.

The republication of this Hobart Paper now is particularly timely. First, of course, because inflation has once more risen. But, secondly, because there is now an opportunity to have a substantial degree of competition in the supply of money. The countries of the EEC are committed to abolishing all exchange controls between each other. There are proposals to go further, to fix exchange rates and impose a common European currency. But if these latter proposals are resisted we will have competition between national currencies within Europe.2 By a very simple measure we will have harnessed the incentives of prestige and profit (for governments get revenue from money creation) to deliver stable money.

In just 12 years, the proposal in this Paper by Professor Hayek has moved from being ‘politically impossible’ to being within our grasp. We should seize it.

October 1990

GEOFFREY E. WOOD Professor of Economics, City University Business School

REFERENCES

Friedman, Milton (1962): ‘Should there be an Independent Monetary Authority?’, in Leland B. Yeager (ed.), In Search of a Monetary Constitution, Boston, Mass.: Harvard University Press.

Friedman, Milton, and Anna J. Schwartz (1986): ‘Has Government any Role in Money?’, Journal of Monetary Economics, January, pp. 37-62.

Goodhart, Charles A. E. (1991): ‘British Monetary Policy: March 1990’, in S. F. Frowen (ed.), Monetary Policy and Financial Innovations in Five Industrial Countries, London: Macmillan.

Her Majesty’s Treasury (1989): An Evolutionary Approach to Economic and Monetary Union, London: HM Treasury.

Rockoff, Hugh (1990): ‘Lessons from American Experience with Free Banking’, in Forrest H. Capie and Geoffrey E. Wood (eds.), Unregulated Banking: Chaos or Order?, London: Macmillan.

Vaubel, Roland (1979): Choice in European Monetary Union, Ninth Wincott Memorial Lecture, Occasional Paper 55, London: Institute of Economic Affairs.

White, Eugene (1990): ‘Banking in a Revolution’, in Capie and Wood (op. cit.).

White, Lawrence (1984): Free Banking in Britain, Cambridge: CUP.

Wood, Geoffrey E. (1989): ‘Banking and Monetary Control after 1992: A Central Bank for Europe?’, in Whose Europe?, IEA Readings No. 29, London: Institute of Economic Affairs.

 

3 It is worth remarking that in a recent paper (1986) co-authored with Anna Schwartz, Milton Friedman has moved close to the position here advanced by Professor Hayek.

4 The benefits of monetary competition in the particular context of the EEC were set out in Vaubel (1979), revived in Wood (1989), and were subsequently urged upon EEC Finance Ministers by Nigel Lawson in a paper (HM Treasury, 1989) he presented to a meeting of these Ministers when he was Chancellor.

• 1It is worth remarking that in a recent paper (1986) co-authored with Anna Schwartz, Milton Friedman has moved close to the position here advanced by Professor Hayek.
• 2The benefits of monetary competition in the particular context of the EEC were set out in Vaubel (1979), revived in Wood (1989), and were subsequently urged upon EEC Finance Ministers by Nigel Lawson in a paper (HM Treasury, 1989) he presented to a meeting of these Ministers when he was Chancellor.
• 3How, then, to achieve monetary stability? Milton Friedman, and recently many others, have urged a monetary rule, embedded where possible in a ‘monetary constitution’, so that the growth of money is steady and predictable. There can be no doubt that such a rule would end the grosser failures of monetary management. But why do we need to regulate our suppliers of money? Here competition comes in. For regulation of an industry—by government, regulatory agency, or rule—can be defended only if the industry is not regulated by competition. In general, competition will deliver the best attainable outcome. Why not in money? That is the question addressed in this Paper; and the answer is that competition in the supply of money will produce that desired outcome, just as it does in other economic activities.
• 4The republication of this Hobart Paper now is particularly timely. First, of course, because inflation has once more risen. But, secondly, because there is now an opportunity to have a substantial degree of competition in the supply of money. The countries of the EEC are committed to abolishing all exchange controls between each other. There are proposals to go further, to fix exchange rates and impose a common European currency. But if these latter proposals are resisted we will have competition between national currencies within Europe. By a very simple measure we will have harnessed the incentives of prestige and profit (for governments get revenue from money creation) to deliver stable money.