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Apr 1, 1977

Decontrolling Money

“It is certainly heartening that professor Hayek has become more Libertarian[, though] unfortunate that he seems somewhat less “Austrian.”

For the past thirty years Austrian economist Friedrich von Hayek has devoted the major part of his time to investigations of the political and philosophical foundations of the free society. In his 1960 treatise, The Constitution of Liberty, he had warned of the dangerous nature of inflationary monetary policies which “in the long run, must destroy the foundations of a free society.” But regardless of how disruptive government control of money had been, Hayek still believed that not only was a separation of money and the State “politically impracticable today but would probably be undesirable if it were possible.”

With his magnum opus, Law, Legislation and Liberty, almost completed, Professor Hayek is now once again returning to the problems of monetary theory and policy with which he began his career over fifty years ago. In early 1976, he published a short pamphlet on Choice in Currency in which he declared that government monopoly over money has become so harmful that the only “effective check against the abuse of money by government” would be “if people were free to refuse any money they distrusted and to prefer money in which they had confidence…let us deprive governments [or their monetary authorities] of all power to protect their money against competition.”

“When one studies the history of money,’ says Hayek, ‘one cannot help wondering why people have put up for so long with governments exercising a power regularly used to exploit and defraud them.”

Now, in a short book, Professor Hayek elaborates on how competitive currencies would work and how we could bring about a Denationalization of Money. “When one studies the history of money,” says Hayek, “one cannot help wondering why people have put up for so long with governments exercising a power over 2,000 years that was regularly used to exploit and defraud them.” Under various myths, such as the need for legal tender laws, the State has usurped a power that has enabled it to debase the medium of exchange for its own political coffers or to benefit other vested interests that have allied themselves with governmental activities. And when private traders and merchants have attempted to establish free market alternatives “absolutism soon suppressed all such efforts to create a non-governmental currency. Instead, it protected the rise of banks issuing notes in terms of the official government money.”

By competing currencies Professor Hayek does not mean merely a system of private and independent banks issuing gold and silver coins or paper notes representing fixed quantities of gold and silver. Rather, he contemplates a system of alternative currencies in which each issuing bank would promise and attempt to keep the value of its currency constant through an expansion or contraction of its money in circulation, as required. The criteria for what type of action would be called for in any particular situation, would be an index number of commodity prices representing a market basket “of widely traded products such as raw materials, agricultural foodstuffs and certain standardised semi-finished industrial products.” They have the advantage of being “traded on regular markets, their prices are promptly reported and, at least with raw materials, are particularly sensitive and would therefore make it possible by early action to forstall tendencies towards general price movements.” For when the index began to rise it would be a signal for that bank to withdraw its currency from circulation and when the index began to fall to increase the quantity of its currency outstanding. Not every region or bank would choose to use the same index of goods because different areas may find different commodities relevant to its production and consumption patterns. In fact, in some communities the use of different indexes may overlap, resulting in the competing currencies expanding and contracting independently of each other.


Why would a currency of stable value be desired by the public? Because, says Hayek, the requirements for economic calculation and the desire for less uncertainty involving contracts for deferred payments would probably make this the most preferred type of medium of exchange. And the possible utilization of alternative competing monies available on the market would act as a restraint on reckless monetary expansion on the party of any bank. For the expansionist bank would soon find its money depreciated in relation to other market currencies. Either the bank would have to return to a more conservative policy or face repudiation on the part of the public. “This is the process by which the unreliable currencies would gradually all be eliminated.”

How would these alternative private monies come into circulation in the first place? Hayek suggests that if he were in charge of a bank, “I would announce the issue of non-interest bearing certificates or notes, and the readiness to open current cheque accounts, in terms of a unit with a distinct registered trade mark name such as ‘ducat.’ The only legal obligation I would assume would be to redeem these notes and deposits on demand with, at the option of the holder, either 5 Swiss francs or 5 D-marks or 2 dollars per ducat. This redemption value would however be intended only as a floor below which the value of the unit could not fall because I would announce at the same time my intention to regulate the quantity of the ducats so as to keep their…purchasing power as nearly as possible constant.”

The advantage of using a money in exchange relationships is that it not only makes existing exchange activities run that much more smoothly, but, in fact, enables many other possible exchanges to come into existence that would not have under a system of barter. Indeed, as a society moves from a state of barter to one that uses several mediums of exchange to, finally, a situation in which only one or two monies are utilized, the intensity and complexity of division of labor and production increases. But, if this is true, it should also imply that as a monetary system disintegrates and a variety of mediums of exchange again start to appear, it should effect the ability of the economic system to function at its previous level of coordination. Since the demise of the Gold Standard, the Gold-Exchange Standard and, most recently, the Dollar Standard, world trade has had to function not with one or two monies, but more and more with as many monies as there are nation-states. Transfers of capital and resources becomes that much more difficult as the number of exchange rates fluctuating between national currencies increases. And to this extent efficient resource allocation is hindered.

It would seem, then, that what is required is not more and different monies, but less. But, Professor Hayek’s proposal would see the proliferation of currencies. Competing currencies using various indexes to determine their “stable” values, all having their exchange rates fluctuating between each other, cannot be considered a situation conducive to economic trade and stability. In fact, instead of only having national currencies to contend with, market participants would soon find themselves burdened with fluctuating monies in the states and provinces, cities and towns and even on the same city block.


Yet, even if we are willing to concede the possibility of continued efficient and complex trade patterns under competing currencies, as Professor Hayek suggests could occur through the use of hand calculators and constant up-dated reports on radio and in newspapers about what the exchange rates are between currencies at any one moment, we must still wonder about the process that would even result in the emergence of these competing mediums of exchange.

As Hayek points out, “During the Middle Ages…the superstition arose that it was the act of government that conferred the value upon the money…In the early years of this century the medieval doctrine was revived by the German Professor G. F. Knapp…” in his book The State Theory of Money. And, as Hayek continues, “It is probably impossible for pieces of paper or other tokens of a material itself of no significant market value to come to be gradually accepted and held as money unless they represent a claim on some valuable object…such as their convertibility into another kind of money.”

“Under various myths, such as the need for legal tender laws… the State has usurped a power that has enabled it to debase the medium of exchange for its own political coffers …or to benefit other vested interests that have allied themselves with governmental activities.”

Professor Hayek, it would seem, believes that competing currencies would have the ability to be accepted as money because they would, at least initially, be redeemable in stipulated quantities of already existing monies such as francs, marks or dollars. But what is making the dollar, or franc or pound in decreased demand on the part of market participants in the first place is the fact that these mediums of exchange are loosing their “moneyness.” They are monies that are diminishing in what Carl Menger called their “saleability” in exchange relationships. What market participants are then searching for is another commodity whose market value is not depreciating, or at least not expected to depreciate as rapidly or over as an extended period, as the exchange medium they had previously utilized. It seems, at the least, questionable whether individuals would show much willingness to accept a new money whose own present value is only represented by a promised intention to keep its future value stable according to a designated index number and whose redeemability is in initially fixed quantities of a money (or monies) from which individuals are trying to “flee.” It is because market participants no longer have confidence in existing currencies that there occurs the flight into “real goods” or into commodities that demonstrate that “saleability” in exchange relationships, e.g., gold, silver, etc.

But the greatest weakness of Professor Hayek’s proposal is the suggested goal of monetary manipulation on the part of the private banks so as to keep the value of their currencies stable. Though he admits that, “Strictly speaking, in a scientific sense, there is no such thing as a perfectly stable value of money—or of anything else,” and though he reminds the reader that he was one of the first to point out that the “additions to the quantity of money that in a growing economy are necessary to secure a stable price level may cause an excess of investment over savings,” he now believes it to be a “problem of minor practical significance.”

“He contemplates a system of alternative currencies in which each issuing bank would promise and attempt to keep the value of its currency constant through an expansion or contraction of its money in circulation, as required.”

Professor Hayek’s admission of the shortcomings as well as impossibility of stabilizing the value of money and his then proceeding to advocate such a program anyway, reminds one of the innumerable authors of Macroeconomic textbooks who warn the reader in the introduction of the pitfalls and dangers when talking about Price Levels and Aggregates, but then proceed to use and manipulate them throughout the rest of the book as if they were real entities.


For in fact the Price Level and Stable Money are purely statistical abstractions. There is only the exchange ratios between money on one side and any other good for which it might be traded on the other. And for any individual the only “value of money” that will matter pertains to the particular products or services he may purchase. And since hardly any two individuals purchase exactly the same goods, in strictness, the “purchasing power of money” is different for every market participant.

But even beyond the question of what a “stable value of money” would involve definitionally, the more important issue is that any attempt to stabilize a “general level of prices,” regardless of what market-basket of goods is used for indexing purposes, must result in serious destabilizing influences on productive activities throughout the economy.

In a market economy production decisions are never decided by the changes occurring in a “general price level” or in the “general” value of the monetary unit. Rather, it will be the movement of relative prices and profits that will act as guide for directing economic activities. And furthermore, it will only be a particular number of these relative prices that will act as signals to inform producers whether any specific line of production should be expanded or contracted or what combinations of resources to use in producing the product.

For instance, an increase in productivity will mean that a given volume of resources will now be able to produce a larger output. The price of the product will tend to fall. The consumer would now be in the position to purchase a given or increased quantity of the product at a lower price. How the decrease in price will influence the relative profitability of the firm or industry experiencing this greater productivity will depend on how responsive demand is to the change in price. If the proportional increase in quantity demanded of the product is greater than the proportional decrease in price (i.e., demand is elastic), the firm may not only find it still profitable to employ the same amount of economic resources as before the fall in price, but may even find it profitable to hire an increased amount of labor and capital. If, on the other hand, the change in quantity demanded is less than the proportional change in price (i.e., demand is inelastic), then it would probably be impossible for the firm to continue to employ the same volume of resources and cover the costs of production at the lower price. The new cost-price relationship, in this latter case, would act as a signal that a certain amount of the factors of production should be freed from their present occupation and be shifted to where they can more profitably be utilized. And it would only be by an appropriate movement of these various prices for the final product as well as for the factors of production that a successful transfer of resources to reflect ultimate consumer demand could be guaranteed.


Now, in a progressing economy there will develop a tendency for capital accumulation and productivity increases to result in a decrease in prices, with the price changes occurring in the various industries at different times and to different degrees. This process would reflect itself in a falling “price level” as measured by the chosen index of commodity prices.

If this “deflation” in the “price level” is considered appropriate grounds for an increase of the money in circulation, then certain destabilizing influences are set to work in the economy. The monetary expansion becomes reflected as higher money prices and profits in various sectors of the economy. Those industries and firms in which demand was found to be elastic under conditions of increased productivity will now be influenced by the higher money prices and profits in hiring a greater amount of labor and capital than would have seemed profitable if the price of its product had been allowed to fall. And if the industry or firm is one in which demand was found to be inelastic with increasing productivity, the higher money prices induced by the monetary expansion will influence the producers of this product to keep employed a greater amount of labor and capital than is warranted by the consumer demand preferences.

“…any attempt to stabilize a “general level of prices,” …must result in serious destabilizing influences on productive activities…throughout the economy.”

If in the face of continuing increases in productivity, the monetary expansion becomes a systematic one so as to preserve a “price level” and a “stable” value of money and if the monetary increases continue to enter the economy in a particular manner, then a lop-sided overproduction will begin to develop. The malinvestments and misdirections of resources induced by the monetary expansion will eventually materialize in the form of a depression when the factors of production spend their higher money incomes over time in a manner reflecting the true consumer demands for the alternative market products.

“Instead of only having national currencies to contend with, market participants would soon find themselves burdened with fluctuating monies in the states and provinces, cities and towns and even on the same city block.”

A system of competing currencies of the type Professor Hayek suggests will only tend to magnify these monetary disturbances. For if a single monetary authority within a national area can disturb the productive activities of an economy, a multitude of currencies each increasing and decreasing their monies in circulation as guided by their respective indexes, must intensify the number of faulty market price signals that producers will be influenced by in directing production.

The preceding critical remarks should not be taken as a criticism of all of Professor Hayek’s arguments in the book. Insightful analysis is sprinkled throughout the volume. For instance, Hayek discusses the “cash balance” approach to monetary phenomena which “enables us not merely to explain the ultimate effect of changes in ‘the’ quantity of money on ‘the’ general price level, but also to account for the process by which changes in the supplies of various kinds of money will successively affect different prices.” He then contrasts it with the more popular “velocity of circulation” approach which, through various statistical techniques, suggests “a simple connection between ‘the’ quantity of money and ‘the’ price level” which leads to “the erroneous belief that monetary changes affect only the general level of prices.” While the real harm of monetary increases “is due to the differential effect on different prices, which change successively in a very irregular order and to a very different degree, so that as a result the whole structure of relative prices becomes distorted and misguides production into wrong directions.”

Professor Hayek also declares that “we should have learned that monetary policy is much more likely to be a cause than a cure of depressions.” And that if money had been allowed to be part of the market process instead of the political process “free enterprise would have been both able to provide a money securing stability and that striving for individual gain would have driven private financial institutions to do so if they had been permitted.”

It is certainly heartening that professor Hayek has become more Libertarian in Denationalization of Money with his advocacy of placing monetary matters in the marketplace. Its unfortunate that he seems somewhat less “Austrian” when it comes to his analysis of how a free market money should operate.