The fundamental issue arising in banking and monetary policy is whether governments can improve the monetary institutions of the unhampered market. All government intervention in this field boils down to schemes that increase the quantity of money beyond what it otherwise would be. The libertarian case for the abolishment of government intervention in money and banking rests on the insight that the latter serves only redistributive purposes.

Banking and monetary policy are concerned with modifications of the quantity of money and money titles. Although policymakers might ultimately seek to control interest rates, unemployment, or the stock market index, attempts to realize any of these goals through monetary policy presupposes the ability to modify the quantity of money. For example, to reduce short‐​term interest rates, policymakers must be in a position to produce additional quantities of money and offer them on the so‐​called money market; without controlling these factors, they could not exercise any downward pressure on rates at all. Hence, the crucial question is: Who should be allowed to produce or destroy money and which goals should be pursued?

Banking policy is concerned with analogous questions. Rather than dealing with the production of money, it deals with the production of money titles, which can be instantly redeemed into money—as opposed to credit titles or IOUs, which can be redeemed into money only at some future point of time. A bank, in the sense that is relevant for banking policy, is a firm that issues money titles, which include bank notes, checks, credit cards, Internet accounts, Smart Cards, and so on. The crucial questions in banking policy concern who should be allowed to issue these money titles, for which purposes, and in which quantities.

In a completely unhampered market, every individual would have the right to invest his labor and property in the production of money and to sell or give away his product as he sees fit. Thus, every money producer would be in a position to pursue his own monetary policy, just as each shoe manufacturer in selling his products pursues his own “foot fashion policy.” The two main questions of monetary policy are thus answered by the organizing principle of the market: private property. Each individual is a policymaker, making policy with his own property, and each individual pursues the goals that he would like to pursue.

Historically, different sorts of commodities (gold, silver, copper, shells, tobacco, cotton, etc.) have been used as money. Yet gold and silver have tended to drive out the other monies from the currency market because of their superior qualities for various monetary functions: They are homogenous, durable, easy to recognize, easy to shape, and so on. Their production is subject to the same laws that rule the production of other commodities. Hence, the “monetary policy” of mine owners and of each mint is strictly oriented toward consumer satisfaction, the quantities produced depending only on consumer demand.

Because paper currencies are the dominant type of money today, there has been some speculation about the possibility of a free market in paper or electronic money. However, there is no historical evidence to support this possibility; noncommodity monies have at all times and places been creatures of the state. In modern times, the state has introduced paper money by endowing a privileged noteissuing bank (the national Central Bank) with the authority to suspend the redemption of its notes. Although the historical record does not prove that a noncommodity money is incompatible with a free market, a number of economists have argued that, by its nature, money must ultimately be translatable into a commodity.

In a totally free market, every individual would possess the right to become a banker. Everybody could offer to store other people’s money and issue money titles, which in turn would document the fact that money had been deposited with him and could be redeemed at any time.

Conceivably, bankers also would propose investment schemes that bear a certain resemblance to the business of storing money and issuing money titles. For example, they could offer to issue IOUs for money invested in their bank and try to make these IOUs more attractive by promising to liquidate them on demand at face value. They might even issue them in forms that are virtually identical with the forms in which money titles appear: “bank notes,” “smart cards,” “credit cards,” and so on. This, in turn, might induce some market participants to accept these IOUs as payment in market exchanges, just as they occasionally accept mortgages or stock‐​market paper as payment.

Some economists think that such investment schemes have been realized in the past and call them fractional reserve banking. They also use the term bank notes to describe these IOUs. Still it is important to be aware of the essential differences that exist between these IOUs and money titles. Despite these resemblances in appearance and use, money titles entail claims to money, while the promise to redeem an IOU entails claims to the efforts of a banker. Although all money titles can be redeemed at any time, only a part of these IOUs can be liquidated as promised by the banker, only a limited number of receipt owners can obtain such liquidation at the same time, and so on.

Identical names and the identical outer appearance of both money titles and liquid IOUs are not a mere coincidence. Historically, in most cases, bankers issuing liquid IOUs took pains to hide the real differences distinguishing their product from genuine money titles. Insofar as such efforts are meant to deceive other market participants, fractional‐​reserve banking is a fraudulent scheme that violates the principles of the free market and merely serves to enrich some individuals (the bankers and their customers) at the expense of all others.

The great issue in monetary and banking policy is whether free‐​market banking and the free‐​market production of money can be improved by schemes relying on coercion. The history of monetary analysis and policy has been the history of debates on the insufficiencies of the unhampered market and on how to remedy them with statist monetary schemes. Virtually all these discussions have revolved around problems of alleged money shortages, and the essence of all institutions designed to overcome these problems is to produce more money than could possibly be produced on the unhampered market.

Mercantilist writers traditionally argued that more money meant higher prices and lower interest rates, and that these in turn invigorated commerce and industry. Moreover, it was much simpler to levy taxes in a monetary system than in a barter economy. Thus, the mercantilists urged that imports of gold and silver be stimulated through tariffs on foreign goods and export subsidies for domestic products, endorsed fractional‐​reserve banking to the benefit of the Crown, and supported special monopoly privileges for national or central banks.

They had a point: The kings profited from increased monetary circulation, which made looting their subjects far easier. However, the French physiocrats and the British classical economists were able to entirely destroy the intellectual underpinning of the mercantilist scheme. Tariffs and export subsidies, they pointed out, cannot permanently increase the domestic money supply, and the amount of money circulating in the economy has no positive impact on trade and industry considered as a whole. The great contribution of classical economics to the theory of monetary policy was to show that increasing the quantity of money could never increase the amount of services that money can render to the nation as a whole. A higher money supply merely leads to higher money prices, but it does not affect aggregate industry and aggregate real output. This principle is what classical economists had in mind when referring to money as a veil that is superimposed on the physical economy.

Later economists further refined this analysis by giving a more sophisticated account of the impact of money on the real economy. They showed that increases in the money supply brought about two forms of redistribution of income. On the one hand, increasing the money supply entailed that the purchasing power of each money unit is diluted. If this loss of purchasing power was not anticipated, the effect would be that borrowers would benefit at the expense of lenders. On the other hand, and independently of the market participants’ anticipations, new money first reaches some market participants before others, and these people can now buy more out of an unchanged supply of real goods. All others will buy less at higher prices as the less valued money circulates throughout the economy because spending the additional money units raises market prices. Hence, although variations in the quantity of money bring no overall improvement for the national economy, they benefit some persons, industries, and regions at the expense of the other market participants.

For more than 100 years, the idea that a community could promote its well‐​being by increasing the money supply beyond what would exist on the unhampered market was discredited among professional economists, although the influential J. S. Mill undermined this monetary orthodoxy by various concessions.

Then John Maynard Keynes almost single‐​handedly gave new life to the old mercantilist policies. The charismatic Keynes was the most famous economist of the best‐​known economics department of his time. In his writings, public speeches, and private conversations, he used his personal and institutional prestige to promote the idea that multiplying money could achieve more than simply redistributing income in favor of the government and the groups that control it.

Keynesianism has vastly increased government control over the economy. It has given modern states the justification to engage in social engineering on an unheard‐​of scale and to deeply transform social relations and the geographical allocation of resources. However, Keynes’s greatest legacy is that his ideas keep guiding present‐​day research in monetary economics. Today, virtually all publications in academic journals take it for granted that Keynes was right and monetary orthodoxy was wrong. Based on the tacit assumption that government can improve money and banking, thus increasing aggregate output, mainstream debates tend to turn around issues of interest for government policymakers. Such issues are, for example, the definition of various monetary aggregates, signaling through the behavior of central‐​bank officials, various insurance schemes for financial intermediaries, and indicators to predict the impact of monetary policy on prices, interest rates, production, and employment.

There are some free‐​market economists who discard monetary orthodoxy and try to make the case for a free market in money and banking on mercantilist‐​Keynesian premises. These economists argue that the supply of money has to be constantly adapted to match the needs of trade, to bring about monetary equilibrium, and so on. Yet they think that the institutions needed to ensure this permanent adaptation are most likely to emerge on the unhampered market.

It is difficult to predict which course the mainstream thinking in banking and monetary policy will take. For libertarian monetary economists who embrace Austrianism, there are ample and largely unexplored research opportunities dealing with the impact of a government‐​controlled money supply on the economy and on society at large and with the best ways to abolish government intervention in money and banking.

Further Readings

Anderson, Benjamin. The Value of Money. Reprint. Spring Mills, PA: Libertarian Press, 1999.

Hayek, Friedrich August. The Denationalisation of Money. 2nd ed. London: Institute for Economic Affairs, 1977.

Hazlitt, Henry. From Bretton Woods to World Inflation. Chicago: Regnery Gateway, 1984.

Mises, Ludwig von. Theory of Money and Credit. Indianapolis, IN: Liberty Fund, 1980.

Paul, Ron, and Lewis Lehrman. The Case for Gold. Washington, DC: Cato Institute, 1982.

Rothbard, Murray N. What Has Government Done to Our Money? 4th ed. Auburn, AL: Mises Institute, 1990.

Selgin, George. The Theory of Free Banking. Totowa, NJ: Rowman & Littlefield, 1988.

Sennholz, Hans. Money and Freedom. Spring Mills, PA: Libertarian Press, 1985.

White, Lawrence H. The Theory of Monetary Institutions. Oxford: Blackwell, 1999.

Originally published