Editor’s note: This essay is an excerpt from the new Hoover Press book The Structural Foundations of Monetary Policy.
In 1976, F. A. Hayek published a short pamphlet, “The Denationalization of Money.” Worried that the high inflation of the 1970s in Western countries would not be tackled by central banks because of political constraints, Hayek argued that money issuing should be opened to market forces and that the government monopoly on the provision of means of exchange should be abolished. He envisioned a system of private monies where the forces of competition would induce banks to provide a stable means of exchange. Despite some attention from a group of market-oriented economists, Hayek’s proposal languished for decades as more a curiosity than a workable idea.
Technological developments over the last few years have made Hayek’s proposal a reality, but as the result of many individual decisions and not the outcome of a planned policy change (a process Hayek would have appreciated). Nowadays it is straightforward to create a cryptocurrency, a privately issued money. Thanks to fascinating advances in cryptography and computer science, cryptocurrencies are robust to over-issuing, the double-spending problem—the holder of the currency should not be able to spend the same token twice—and counterfeiting. These cryptocurrencies are different from the notes issued by financial institutions during the era of free banking for three reasons. First, most cryptocurrencies are fully fiduciary, while notes in the free banking era usually represented claims against deposits in gold or other assets. Second, cryptocurrencies are not directly related to credit but are issued by computer networks according to some predetermined criteria (such as a “proof-of-work,” i.e., the solution of a complex mathematical problem). Third, cryptocurrencies such as Etherium can also work as a sophisticated automatic escrow account. It is effortless to add to the code that controls the cryptocurrency a condition that states, “Peter will pay Mary ten ethers if, tomorrow at noon, the weather in Philadelphia according to weatherunderground.com is over eighty degrees.” Once we have that piece of code in place, the verification of the condition and the payment, if the condition is satisfied, are automatically implemented.
Today, any person with Internet access can use a bewildering array of cryptocurrencies as means of exchange. Everyone has heard about Bitcoin, whose market capitalization (the price per unit times the circulating supply) as of July 6, 2017, exceeds $42 billion, only slightly below the market capitalization of Ford Motor Company. But six other cryptocurrencies (Etherium, Ripple, Litecoin, Etherium Classic, NEM, and Dash) have market capitalizations over $1 billion, and another thirty-seven have between $100 and $999.99 million. While it is true that cryptocurrencies represent only a trivial fraction of all payments in the world economy, it is not inconceivable that such shares may exponentially increase over the next few years and even become widespread in emerging economies with dysfunctional government monies.
This observation opens many positive and normative questions about how currency competition may work that Hayek did not address using modern economic theory (he admitted that his idea was more a springboard for further discussion than a thorough analysis). Among the positive questions: Will currency competition among private monies yield a stable price level? Will we have a “winner-take-all” situation where one currency dominates the market? Or will we observe a landscape of several currencies, each with a significant market share? How important are network effects? Can we have in the long run fully fiduciary private monies or will commodity-backed currencies dominate? Will we have the “right” amount of money in equilibrium? Can private monies and a government-issued money coexist? Among the normative questions: How should governments react to private monies? Should governments have an “industrial policy” regarding private cryptocurrencies? Should they favor one cryptocurrency over others? Or should they follow a policy of “benign neglect”? There are even questions relevant for would-be entrepreneurs: What is the best strategy to issue currency? What are the competitive advantages that a new cryptocurrency requires to flourish? A formal theory of currency competition is surely needed.
In a paper from 2016, we took a first pass at this problem. We built a model of competition between privately issued fiduciary currencies by extending Lagos and Wright’s environment, a workhorse of modern monetary economics. The standard Lagos and Wright model was augmented by including entrepreneurs who can issue their own currencies to maximize profits or by automata following a predetermined algorithm (as in Bitcoin). Otherwise, the model is standard. In our framework, competition is perfect: all private currencies have the same ability to settle payments, and each entrepreneur behaves parametrically with respect to prices.
Despite its simplicity, our analysis offers several valuable insights. In the interest of space, we highlight only a few of them. First, in general, a monetary equilibrium with private monies will not deliver price stability. When money is issued by a profit-maximizing entrepreneur, she will try to maximize the real value of seigniorage. With many cost functions of minting money, this maximization does not imply that the entrepreneur delivers a stable currency. For example, if the cost function is strictly convex, entrepreneurs will always have an incentive to mint additional units of the currency. Hayek’s conjecture that a system of private monies competing among themselves would provide a stable means of exchange is, in general, wrong. When money is issued by an automaton, there is no particular reason why the quantity of money would be compatible with price stability (except, perhaps, by “divine coincidence”). Bitcoin has already decided how many new units of currency will be issued in 2022 even though nobody knows what the demand for currency will be in that year.
Second, even when the cost function of minting money is such that we have an equilibrium with price stability, there is a continuum of equilibrium trajectories where the value of private monies monotonically converges to zero. In other words, the self-fulfilling inflationary episodes construed by Obstfeld and Rogoff (1983) and Lagos and Wright (2003) in economies with government-issued money and a money-growth rule are not an exclusive feature of public monies. Self-fulfilling inflationary episodes are, instead, the consequence of using intrinsically useless tokens (even if electronic and issued by private profit-maximizing, long-lived entrepreneurs) whose valuation can change depending on expectations about the future.
But, as economists, we do not care about price stability per se. The goal of a well-behaved monetary system must be to achieve some efficiency goal. Our third, and perhaps most important, result is that a purely private monetary system does not provide the socially optimum quantity of money even in the equilibrium with stable prices. Despite having entrepreneurs that take prices parametrically, competition cannot provide an optimal outcome because entrepreneurs do not internalize, by minting additional tokens, the pecuniary externalities they create in the market with trading frictions at the core of all essential models of money. These pecuniary externalities mean that, at a fundamental level, the market for currencies is very different from the market for goods such as wheat, and the forces that drive optimal outcomes under perfect competition in the latter fail in the former. The “price” of money itself does not play a fully allocative role: if one believes that money is used because there are frictions in transactions, one should not believe that the market can provide the right amount of money.
These three results cast serious doubts on Hayek’s proposal of currency competition. In most cases, a system of private monies will not deliver price stability, and even when it does, it will always be subject to self-fulfilling inflationary episodes, and it will supply a suboptimal amount of money. Currency competition works only sometimes and partially.
How can Hayek be vindicated? A simple possibility is to think about the existence of productive capital. If entrepreneurs use the seigniorage to purchase productive capital and this capital is sufficiently productive, then there is an equilibrium in which a system of private monies may achieve social efficiency. Other possibilities would include the presence of market power (different currencies are slightly different from each other in their ability to make payments) and, thus, a franchise value that a private entrepreneur may want to preserve (allegedly, this environment may be closer to what Hayek envisioned than our perfect competition world). However, we also know that long-run market power does not necessarily deliver the right outcomes and that incentives to “cheat” always exist.
Finally, what are the effects of cryptocurrencies on government monetary policy? (Government-issued money is different from private money because it has fiscal backing.) How is monetary policy changed by the presence of alternative means of exchange? The first case of interest is when the government follows a rather standard money-growth rule. Under this policy, profit-maximizing entrepreneurs will frustrate the government’s attempt to implement a positive real return on money through deflation when the public is willing to hold private currencies. There are, fortunately, alternative policies that can promote stability and efficiency simultaneously. For example, the government may peg the real value of its money. Under this rule, the government can implement an efficient allocation (i.e., supply the amount of money that maximizes social welfare) as the unique equilibrium outcome, although it requires driving private money out of the economy.
There is an important lesson here: the threat of competition from private monies imposes some market discipline on any government involved in issuing currency. If a central bank, for example, does not provide a sufficiently “good” money, then it will have difficulties in the implementation of allocations. This may be the best feature of cryptocurrencies: in a world where we can switch to Bitcoin or Etherium, central banks need to provide, paraphrasing Adam Smith, a tolerable administration of money. Currency competition may have, after all, a large upside for human welfare.