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One of the chief things which monetary theory ought to explain is the evolution of money. If we can reduce the main lines of that evolution to a logical pattern, we shall not only have thrown light upon history, we shall have deepened our understanding of money, even modern money, itself.
J. R. Hicks, A Theory of Economic History
Money – general purchasing power over goods – is surely among the most remarkable products of human civilization. Without it, the incredibly complex division of labor that provides us with the highest standard of living in human history would be unthinkable. I propose in this book to make the workings of the increasingly sophisticated and complex monetary system that is an integral part of our modern economy somewhat more comprehensible. That task can be made a bit less daunting if we follow J. R. Hicks's advice and begin by trying to understand the forces that determined the early evolution of money and banking. Once we understand those forces, we shall have gone a long way toward understanding more recent monetary developments.
From the earliest times, thinkers have been perplexed by this peculiar artifact of civilization. Although no one doubts the usefulness of money, why people began using money in the first instance is not at all obvious.
The power of the state to issue currency and control the monetary system is so entrenched, and the presumption among economists that money must be supplied monopolistically by a central authority is so widespread, that the notion that money could be supplied competitively has rarely been taken seriously. This book boldly challenges the conventional view that the state must play a dominant role in the monetary system. Part I explores the historical evidence and examines how a well-developed monetary system might have developed without any special role for the state. Part II offers a theory for a competitive supply of money and uses it to shed light on the development of monetary theory and the course of monetary history over the past two centuries. In Part III the author outlines new proposals for monetary reform that will protect the financial system against instability and will ensure macroeconomic stability.
Mr. Herbert Spencer … advanced the doctrine that, as we trust the grocer to furnish us with pounds of tea, and the baker to send us loaves of bread, so we might trust … enterprising firms … to supply us with sovereigns and shillings at their own profit. …
Though I must always deeply respect the opinions of so profound a thinker as Mr. Spencer, I hold that in this instance he has pushed a general principle into an exceptional case, where it quite fails. … In matters of currency, self-interest acts in the opposite direction to what it does in other affairs. …
There is nothing less fit to be left to the action of competition than the provision of the currency.
William Stanley Jevons, Money and the Mechanism of Exchange
Unlike physicists and chemists, economists cannot conduct decisive experiments to find out which of two or more competing theories best explains reality. So economists don't have any simple, straightforward rules to follow when choosing among rival theories. What determines their choices? A complex and subtle process in which advocates of rival theories try to offer their colleagues persuasive reasons to accept their theories. A persuasive reason for accepting a theory could be that the theory explains some well-known facts better than other theories do or that it casts light on some previously unknown facts that were unilluminated by the rival theories.
Either the quantity of money in circulation is a datum – and the theory of Keynes can be true – or the quantity of money is fixed by the size of the cash balances which the users of money desire to hold, and the Keynesian explanation of permanent underemployment equilibrium falls to pieces.
J. Rueff, “The Fallacies of Lord Keynes' General Theory”
Before his blistering attack on the Treaty of Versailles and the three leaders – Clemenceau, Lloyd-George, and Wilson – he held responsible for it, John Maynard Keynes's reputation as an expert on the arcane subject of the Indian currency, as the author of a philosophical work on probability theory, as an intimate of the Bloomsbury group, and as an effective and tireless civil servant at the Treasury was confined to a narrow circle of public officials and intellectuals. But so extraordinary was the impact of The Economic Consequences of the Peace (1919/1971) on American and European public opinion that from then on, Keynes could count on a large and attentive audience for almost anything he wrote. And after the German hyperinflation of the early 1920s seemed to confirm his warning that the Treaty of Versailles had imposed an unbearable burden on Germany, Keynes's reputation as an economic savant grew larger still.
It is an extraordinary truth that competing currencies have until quite recently never been seriously examined. There is no answer in the available literature to the question why a government monopoly of the provision of money is universally regarded as indispensable. … Nor can we find an answer to the question of what would happen if that monopoly were thrown open to the competition of private concerns supplying different currencies.
F. A. Hayek, Denationalization of Money
Since the second half of the nineteenth century, the conventional wisdom has been uniformly hostile to the idea of competition in the supply of money. Yet in the nineteenth century that hostility never suppressed the competition. That was because the hostility focused exclusively on competition in issuing banknotes but ignored it in creating deposits.
Why was that distinction made? Mainly because those who most mistrusted competition in the supply of money believed that deposits were not money. That notion was a legacy of the debate over the Bank Charter Act. Members of the Currency School, as we saw earlier, argued against competition in the supply of money and for a legal limit on the quantity of banknotes. They rationalized supporting a limit on banknotes but not on deposits by insisting that only the former, not the latter, were money.
Another plan is a convertible paper currency, the paper to be redeemable on demand, – not in any required weight or coin of gold, but in a required purchasing power thereof. Under such a plan, the paper money would be redeemed by as much gold as as would have the required purchasing power. Thus, the amount of gold obtainable for a paper dollar would vary inversely with its purchasing power per ounce as compared with commodities, the total purchasing power of the dollar always being the same. The fact that a paper dollar would always be redeemable in terms of purchasing power would theoretically keep the level of prices invariable.
Irving Fisher, The Purchasing Power of Money
The goal of monetary reform based on free banking poses a dilemma. On the one hand, the free market could provide us with a highly efficient, low-cost medium of exchange. But on the other hand, purely free-market moneys could not protect everyone from the costs of price-level uncertainty. Free-market moneys would minimize the costs of holding money, but they would not necessarily minimize the more general costs of price-level uncertainty. Those costs would still be borne by workers, employers, borrowers, lenders – indeed, by everyone who contemplates entering into commitments for the future exchange of values expressed in nominal terms.
The late multiplication of banking companies in both parts of the united kingdom, an event by which many people have been much alarmed, instead of diminishing, increases the security of the public. It obliges all of them to be more circumspect in their conduct, and, by not extending their currency beyond its due proportion to their cash, to guard themselves against those malicious runs, which the rivalship of so many competitors is ready to bring upon them. … This free competition too obliges all bankers to be more liberal in their dealings with their customers, lest their rivals should carry them away. In general, if any branch of trade, or any division of labour, be advantageous to the public, the freer and more general the competition, it will always be the more so.
Adam Smith, The Wealth of Nations
The conventional explanation for suppressing competition in the supply of money is that competition increases the supply and reduces the price of whatever competitors are supplying. For most goods this a great benefit. But unlike the physical services generated by, say, a refrigerator, which do not depend on how much, or how little, the refrigerator is worth, monetary services would vanish if money lost its value. Cheapening an ordinary good does not destroy the physical attributes that make it desirable.
What an extraordinary episode in the economic progress of man that age was which came to an end in August, 1914! … The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages. … He could secure forthwith, if he wished it, cheap and comfortable means of transit to any country or climate without passport or other formality, could despatch his servant to the neighboring office of a bank for such supply of the precious metals as might seem convenient, and could then proceed abroad to foreign quarters, without knowledge of their religion, language, or customs, bearing coined wealth upon his person, and would consider himself greatly aggrieved and much surprised at the least interference. But most important of all, he regarded this state of affairs as normal, certain, and permanent, except in the direction of further improvement, and any deviation from it as aberrant, scandalous, and avoidable.
What you should tell the governor of the Bank and the board is that they should inscribe these words in letters of gold in their meeting place: “What is the object of the Bank of France? To discount the credits of all French commercial houses at four percent.”
In describing the evolution of money and banking in the previous chapter, I deliberately slighted the role of the state. I wanted to show that money is not a mere creature of the state, so it was necessary to show how money and the institutions that supply it could have emerged without state intervention. But let there be no misunderstanding. Just because money could have evolved without a special role for the state does not mean that the state ought not to have a special role in monetary affairs. It simply means that we need to think about why the state has played such a dominant role in the supply of money. Once we answer that question, we then can ask what role the state ought to play in an efficiently operating monetary system. The latter question will occupy our attention in Part III. But for now, it is the former question that concerns us.