Throughout history, the state has typically monopolized the issuance of money. The various royal mints were once the exclusive sources of silver and gold coins, whereas today the national central banks alone are empowered to issue fiat currency. As private banks have developed alternatives to state‐​issued money (banknotes, transferrable account balances), the state has typically placed them under considerable restrictions. Many otherwise free‐​market economists have taken state control over money and banking for granted or, in some particulars, justified it; to the extent they recommend altering these monopolies, it is merely to limit their abuses. Those who have rejected “state tampering with money and banks,” as Herbert Spencer titled his essay, have been far from unanimous about what a libertarian monetary and banking system would look like.

Classical economists like Adam Smith understood that money was originally not a creature of the state, but was rather a spontaneous institution that had emerged without explicit design. As Carl Menger concluded, “Money was not created by law; in its origin it is not a governmental but a social phenomenon.” Markets in the ancient world converged on silver coins as the most commonly accepted medium of exchange. This silver coin standard prevailed across national borders without any global government. Why then did ancient and medieval monarchs insist on exclusive control over the business of producing coins? If their concern was to improve the quality of coins, they failed miserably: Royal mints were notorious for repeatedly debasing the coinage by reducing their silver content with a mix of copper and other base metals. If, however, their real concern was to raise state revenue, they succeeded. The difference between the low price paid for raw silver—for which the official mint was typically the only legal buyer—and the higher price imposed on coined silver made the mint a major source of income for the monarchy. The technical term for this profit is seigniorage inasmuch as it was considered the prerogative of the feudal lord or seigneur.

Most 19th‐​century classical liberals took this state monopoly for granted. Only the most radical of these writers—Thomas Hodgskin, William Leggett, Herbert Spencer, and William Brough—argued for the privatization of coinage. In the 20th century, F. A. Hayek reintroduced the idea of the “denationalization of money” in the context of fiat (unbacked) monetary standards. Hayek argued that competition among private producers of fiat money would keep its purchasing power more stable. Other libertarian monetary economists endorse Hayek’s call for an end to legal restrictions against private money, but they question his predictions that dozens of distinct monetary units would circulate in parallel in the same economy or that the public would prefer unbacked private money to the more traditional sort of commodity‐​backed private money. A long line of free‐​market economists has endorsed silver or gold as a market‐​chosen monetary standard that makes a laissez‐​faire monetary system feasible.

The issuance of money by banks, even were these notes secured by some metallic backing, is yet more controversial among libertarian monetary theorists. Perhaps because early banks often operated under exclusive state charters, some classical liberal thinkers, such as Thomas Jefferson and William Gouge, condemned bank‐​issued money that rested on fractional reserves as per se illegitimate. They called for a return to “hard money,” a system that relied only on coins made of precious metals or on certificates fully backed by precious metals. Others such as Leggett, Spencer, and Ludwig von Mises called for free banking, or the complete separation of banking and the state. In their view, governments should neither shelter banks from market competition nor restrict the sorts of contractual arrangements, including fractional reserves that banks may make with their customers. Central banking is prone to causing either an oversupply or under‐​supply of money, the effects of which are business cycles. Competition would better regulate the supply of money. British “Free Banking School” economists in the 19th century sharply criticized Parliament for protecting the Bank of England against failure and for giving it a monopoly of banknote issue, privileges that turned it from a commercial bank into a central bank. In the United States, Jeffersonian and Jacksonian classical liberals opposed the special privileges of the first and second Banks of the United States.

The well‐​known monetary historian and free‐​market economist Milton Friedman had argued early in his career that negative external effects associated with free banking justified a state monopoly of coin and paper currency. Under free entry, he maintained, sharp operators would find it too easy to get their notes into circulation and then abscond before they could be called on to redeem these notes. Later in his career, Friedman reconsidered and endorsed competitive note issue in light of new findings by Hugh Rockoff and others that bad results under so‐​called free banking in the United States were due to poorly conceived regulations, whereas a relatively free market in other countries showed good results.

In principle, Friedman supported a well‐​managed state fiat money over a gold standard on grounds of lower resource costs, but emphasized that—in practice, at least—fiat money has been badly managed. As the leading monetarist critic of the Keynesian argument in support of an activist monetary policy, Friedman advocated a monetary rule that would commit the U.S. Federal Reserve System to slow and steady growth in the stock of money. Later, recognizing that central bank officials have no incentive to follow such a rule, he suggested effectively abolishing the Fed by freezing the stock of Fed liabilities and sending the monetary policymakers home.

Friedman’s diagnosis of the Federal Reserve System’s contribution to the Great Depression differed from that of the Austrian economists Mises and Hayek. The Austrians regarded the Fed’s overly expansive policy in the mid‐ to late 1920s as fostering an unsustainable investment boom and thereby sowing the seeds of the 1929 downturn. Friedman and his co‐​investigator Anna Schwartz emphasized the damage done by the Fed’s failure to stem bank runs and the consequent contraction in the stock of bank‐​issued money after 1930. Having nationalized the functions formerly played by private bank clearinghouses, the Fed failed to act as the “lender of last resort,” a role played by the clearinghouses in previous monetary panics.

The leading libertarian theorist Murray Rothbard and his followers have taken the position that fractional reserve banking is illegitimate and that only “100% reserve” or warehouse banking is consistent with a libertarian legal code. Rothbard argued that a bank that promises to redeem its banknotes on demand in gold that it does not presently possess is defrauding its customers. His followers have argued that even if the customer knowingly agrees to the arrangement, the bank and the customer are conspiring to defraud third parties. In their view, “fiduciary media” (i.e., fractionally backed notes and deposit), prevail through a combination of bank trickery and legal restrictions against legitimate 100% reserve money warehouses.

In opposition to this view, modern free‐​banking theorists argue that fractionally backed notes and deposits have passed the market test: They have predominated over warehouse receipts because they offer customers a better deal. No fraud is committed by a bank that issues fiduciary media without misrepresenting them, and banks have typically not misrepresented them. Indeed, nothing on the face of the typical banknote proclaims it to be a warehouse receipt. Banks’ customers have not been duped for centuries, but have preferred to use money free of warehousing fees despite the slightly greater risk of default.

Apart from the fraud question, 100% reservers differ from free bankers on the question of the practical effects of fractional reserve banking. Following Smith and Mises, those who support free banking maintain that fractional reserve banking beneficially economizes on the labor and capital devoted to extracting precious metals that will only be tied up in bank vaults. Following Rothbard, the 100% reservers argue that such savings are trivial in comparison to the economic damage associated with the business cycles caused by the instability of fractional reserve banking. In Hans‐​Herman Hoppe’s view, “any injection of fiduciary media must result in a boom‐​bust cycle.” The free bankers counter that monetary disturbances and consequent business cycles are due to central bank monetary policy and interventions that weaken the banking system, not to fractional reserves. They argue that a competitive free‐​banking system permits “expansion of the stock of fiduciary media only to an extent consistent with the preservation of monetary equilibrium and the avoidance of the credit‐​expansion‐​induced business cycle.”

The leading argument against laissez‐​faire banking in recent years holds that unregulated banks are naturally prone to harmful runs and panics and that government deposit insurance offers a low‐​cost remedy. Defenders of unregulated banking, in contrast, have provided strong historical evidence that runs and panics are not natural: The problem has arisen only in systems, as was true of United States in the late 19th century, where government regulations have seriously weakened banks. Systems closer to a free market in banking have been more stable, whereas government deposit insurance has imposed costs in excess of its benefits.

Further Readings

Friedman, Milton, and Anna J. Schwartz. “Has Government Any Role in Money?” Journal of Monetary Economics 17 (1986): 37–62.

Hayek, F. A. The Denationalisation of Money. 2nd ed. London: Institute of Economic Affairs, 1978.

Hoppe, Hans‐​Hermann, with Jörg Guido Hülsmann and Walter Block. “Against Fiduciary Media.” Quarterly Journal of Austrian Economics 1 (1998): 19–50.

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

Selgin, George, and Lawrence H. White. “In Defense of Fiduciary Media.” Review of Austrian Economics 9 (1996): 83–107.

Smith, Vera C. The Rationale of Central Banking and the Free‐​Banking Alternative. Indianapolis, IN: Liberty Press, 1990.

Timberlake, Richard H. Monetary Policy in the United States. Chicago: University of Chicago Press, 1993.

Lawrence H. White
Originally published
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