Mr Issing's speech entitled "Hayek - currency competition and European monetary union"*
Text of the Annual Hayek memorial lecture delivered by Mr Otmar Issing, a member of the Executive
Board of the European Central Bank, hosted by the Institute of Economic Affairs in London on
27 May 1999.
1. Introduction
As a young student I read "The Road to Serfdom". It was the first book written by Hayek I came
across, and it has left a deep and lasting influence on me. Only 11 years after the Hitler regime and the
war I suddenly started to understand the interdependence between totalitarianism and economic
policy. Since then I have read most of Hayek's publications. Many left their marks, only to mention
the impressive "The Constitution of Liberty".
But, perhaps more than anything else, it was the perception of "competition as a discovery process"
which has shaped my thinking. This approach is of extreme relevance for economics but goes far
beyond this. Related to this "discovery" is "pretence of knowledge" as a permanent danger for
societies. All those in public office responsible for making decisions should never forget this
message.
Against this background you can imagine that it is a great honour for me to be invited to give this
lecture on the occasion of Hayek's 100th birthday. Even more so as the invitation came from the
Institute of Economic Affairs, an institution devoted to the study and propagation of liberal ideas - to
the idea of liberty. I accepted immediately, not reflecting on the obvious time constraints.
It was the Institute of Economic Affairs which in 1976 published Hayek's "Choice in Currency: A
Way to Stop Inflation". I chose the subject for my lecture for the following reasons. First of all
because I might have some comparative advantage in a subject related to monetary economics.
Having joined the Executive Board of the European Central Bank, the relations of Hayek's ideas on
currency offer a special kind of interest. And, finally, it was the publication mentioned which brought
me into personal contact with Hayek. Fascinated (but, to indicate already, not convinced) by the
approach, which was out of line with anything discussed in mainstream monetary theory at that time, I
wished to include this paper in a reader on monetary policy issues I was preparing.
I proposed to put in front of the text a quote by Hayek: "Inflation is made by government and its
agents. Nobody else can do anything about it". But we could not agree on the translation of the word
"government" into German. After an extended correspondence we finally came to the conclusion over
the phone that this quote should remain, but not be translated.1
It only comes home to us fully how long and fruitful Hayek's career was when we realise that his
rightly renowned monograph on the denationalisation of money was published some 60 years after his
pioneering contribution to the theory of intertemporal equilibrium in Weltwirtschaftliches Archiv2 in
1928.
The monograph has to be seen against the background of decades of worldwide inflation. Hayek
himself mentioned the great German inflation of 1923. After the second World War, prices had
moved worldwide only in one direction. In the course of the 1960s "booming" US Federal
Government expenditure, which was partly associated with the Vietnam War, led to a sustained
period of strong growth in nominal aggregate demand. This, in turn, led to an increase in inflation in
the United States. In 1969 the inflation rate was already up to almost 6%, after having been less than
2% at the start of the decade. Given the Bretton Woods system of fixed exchange rates, the
inflationary pressures emanating from the United States spread to other areas of the world, including
Europe. The strain in the Bretton Woods system became apparent in the late 1960s. In 1973 the
*
I wish to thank Frank Browne and Vitor Gaspar for the valuable co-operation in preparing this article.
1
See Jürgen Badura und Otmar Issing, Geldpolitik, Stuttgart 1980.
system finally collapsed. The problems created were magnified by the increase in oil and commodity
prices in 1973. This led to soaring inflation.3
A few years later the industrial world was caught in a combination of high inflation and substantially
increased unemployment. The policy that had brought the world to such an unfavourable conjuncture,
and that could be characterised by a belief that "money does not matter" and a hubris of excessive
reliance on demand management, had ostensibly failed. As Robert Lucas commented: "This is the
legacy of stagflation: a general loss of confidence, whether warranted or not, in the formerly accepted
framework guiding discretionary economic management".4
Hayek's view about these developments becomes clear from, for example, an excerpt of his Nobel
Lecture, delivered in December 1974: "Economists are, at this moment, called upon to say how to
extricate the free world from the serious threat of accelerating inflation which, it must be admitted,
has been brought about by policies that the majority of economists recommended or even urged
governments to pursue. We have indeed at the moment little cause for pride: as a profession we made
a mess of things." He expanded upon this in 1976:5 "practically all governments of history have used
their exclusive power to issue money in order to defraud and plunder the people".
It was against this background that Hayek proposed his radical solution. It called for no less than the
complete abolition of the government's monopoly over the issue of fiat money, leaving the way open
for comprehensive competition in its supply by the private sector. In his Hobart Paper Special No. 70,
he spelt out his philosophy with respect to free competition in the supply of money: "The purpose of
this scheme is to impose upon existing monetary and financial agencies a very much needed discipline
by making it impossible for any of them, or for any length of time, to issue a kind of money
substantially less reliable and useful than the money of any other. As soon as the public became
familiar with the new possibilities, any deviations from the straight path of providing an honest
money would at once lead to the rapid displacement of the offending currency by others. And the
individual countries, being deprived of the various dodges by which they are now able temporarily to
conceal the effects of their actions by 'protecting' their currency, would be constrained to keep the
value of their currencies tolerably stable" (p.125).
Although his proposal was not implemented, his contribution kindled a lively and far-reaching debate
on the role of government in the monetary system, a debate that addressed the choice between a free
market monetary regime and government management of the monetary system via a central bank. The
proposal was so profound and radical in its conception that some leading advocates of a laissez-faire
approach to most aspects of economic life (Milton Friedman, for example) were put on the defensive.
As it happened, Hayek also held some pretty strong views on Monetary Union in Europe, an idea
which was still only in a rather embryonic stage when he commented on it in 1978: his own scheme of
competing currencies seemed to him "... both preferable and more practicable than the utopian
scheme of introducing a new European currency, which would ultimately only have the effect of more
deeply entrenching the source and root of all monetary evil, the government monopoly on the issue
and control of money" (p. 126).
2. Summary presentation and assessment of Hayek's proposal for competing currencies
The proposal put forward by Hayek, that is, full competition between private issuers of currency, is an
extremely interesting concept. It relates to the debate on the viability of unregulated banking and to
the literature on the historical experience with free banking.6
The basic idea seems to be as follows: creating the possibility of banks issuing currency would open
the way to competition. Banks could issue non-interest-bearing certificates and open cheque accounts
on the basis of their own distinct registered trade mark. Different banks would issue different
certificates, that is currencies. The currencies of different banks would trade at variable exchange
rates. Competition and profit maximisation would lead to an equilibrium in which only banks paying
a competitive return on liabilities could survive. Since currency corresponds here to
non-interestbearing certificates, the crucial requirement is the maintenance of the value of the currency. So, in
equilibrium, only currencies guaranteeing a stable purchasing power would exist. Banks that failed to
build up such a reputation for their currency would lose customers and be driven out of business.
Hayek was of the opinion that his proposal would, if implemented, contribute to the overall stability
of the economy. In his monograph he wrote: "The past instability of the market economy is the
consequence of the exclusion of the most important regulator of the market mechanism, money, from
itself being regulated by the market process" (Denationalisation of Money - the Argument Refined,
p. 192; Hobart Paper Special No. 70, 2nd (Extended) Edition, IEA (1978); italics in the original).
Let me now examine the characteristics of the equilibrium envisaged in Hayek's proposal.7 The
marginal costs of producing and issuing a currency (in the form of notes and coin) are rather low
(close to zero).8 In the context of the type of competition envisaged by Hayek, the nominal rate of
interest would be driven (close) to zero. If the real rate of interest required by lenders to lend funds to
borrowers were positive (say 3%), equilibrium in the loan market would require that lenders would
have to be rewarded by a rate of deflation equal to this real rate. This would produce an outcome that
has been advocated as a normative rule for inflation by Friedman in the past, that is, in a situation in
which money is non-interest-bearing, the optimal rate of inflation should be set equal to the negative
of the real rate of interest. This is analogous, in this context, to the well-known correlation between
free competition and efficiency (Pareto optimality).
Hayek's privatisation proposal would, initially at least, involve a multiplicity of privately issued
moneys. If these failed to trade at par, which is not unlikely given that the financial health of the
different issuers is likely to be different, then it is also likely that a multiplicity of exchange rates will
also emerge between these privately issued currencies. So long as there is no restriction imposed on
the holding of the different currencies, those that are likely to depreciate in value would, according to
Hayek's logic, be driven out of existence, leading to a situation in which only currencies with stable
values would remain in existence.
Hayek believed that such competition between currencies was a discovery process, which would lead
to a stable non-inflationary outcome. In this respect, it may be best to let Hayek speak for himself,
which I do by quoting from his Denationalisation of Money: "Indeed, if, as I am convinced, the main
6
Hayek's proposal must be distinguished from free banking, which refers to a monetary system without a
central bank, in which private banks would be allowed to issue currency and bank deposits without
restriction. As practised in the 19th century, this version of free banking involved banknotes being
redeemable in gold and silver coin. (see Lawrence H White, Free Banking in Britain, Theory, Experience,
and Debate, 1800 - 1845. Institute of Economic Affairs, London, 1995).
7
It should be noted that, in Hayek's proposal, equilibrium is assumed to exist and to be stable, and information
is complete, symmetric and acquired at no cost. See Charles Goodhart, The Evolution of Central Banks, MIT
Press, 1988.
8
This is the assumption made by Milton Friedman in his seminal paper, "The Optimum Quantity of Money" in
"The Optimum Quantity of Money and other Essays", Aldine Publishing Company, Chicago, 1969.
advantage of the market order is that prices will convey to the acting individuals the relevant
information, only the constant observation of the course of current prices of particular commodities
can provide information on the direction in which more or less money ought to be spent. Money is not
a tool of policy that can achieve particular foreseeable results by control of its quantity. But it should
be part of the self-steering mechanism by which individuals are constantly induced to adjust their
activities to circumstances on which they have information only through the abstract signals of prices.
It should be a serviceable link in the process that communicates the effects of events never wholly
known to anybody and that is required to maintain an order in which the plans of participating persons
match" (p. 192/193).
Nevertheless, despite Hayek's claims for this discovery process, most economists would argue that
free competition with respect to money couldn't guarantee either a stable or an efficient outcome.
This is the fundamental point.
In order to try to understand and assess Hayek's proposal, it is essential to take a closer look at money
and its role in the economy. This is best done by, as it were, first breaking money up into its
constituent functions. The classic textbook treatment of the functions of money is still valid: money
fulfils three functions, namely that of (i) a unit of account, (ii) a means of payment and (iii) a store of
value.
The use of money as a unit of account is, arguably, the most basic monetary function. It is the
numeraire, that is, the unit for quoting prices, for drawing funds, for negotiating contracts, and for
performing economic calculations. In this regard, money is a basic convention of society, such as the
language and the standards for measurement. This seems to be a very Hayek-like way of looking at
money.
Indeed, the fundamental problem in economics for Hayek is that of co-ordinating the plans of many
independent individuals. Competition through the market system leads to such a co-ordination.
Individuals, acting in their own self-interest, respond to price signals. Prices, in turn, reflect the
information available in society. Price signals allow the transmission of previously unknown
information in the most synthetic and relevant way for the purpose of economic calculus. Now, prices
- impersonal signals that provide for an extensive social division of labour - are expressed in terms of
money. Irving Fisher coined the term "money yardstick".9
The unit of account represented by the respective unit of money (that is, the euro, the US dollar, the
Japanese yen, etc.) is a metric or measuring tape. With inflation or deflation, the measuring tape keeps
changing all the time. The unit of account, as represented by money, becomes elastic and of uncertain
dimension at any one time and of even more uncertain dimension over extended periods of time into
the future. Inflation or deflation, therefore, means that the common unit-of-account language or, say,
money language, for which the unit of account provides the foundations, is changing all the time. And
uncertain inflation, which tends to accompany high inflation, means that the unit of account is
changing in uncertain ways.
This impairs the efficiency of the common money language and, therefore, communication and
coordination in the economy. "Its undependability impairs the meeting of minds between borrowers and
lenders and other transactors; it impairs economic calculation and co-ordination" (Greenfield and
Yeager, 1983).10 One of these authors (Yeager, 1983)11 invites his readers to "consider how difficult
constructing a house would be (ordering and fitting together the components, appliances, and all the
rest) if the unit of length, the metre or the foot, kept changing and accordingly were perceived by
different persons to have different sizes. Consider how preposterous it would be for the length of the
metre to fluctuate according to supply and demand in the market for metre sticks. Yet our dollar
suffers from a comparable absurdity - or a worse one, in view of the associated macroeconomic
disorders."
Money used as a unit of account has characteristics of a public good. Given the unit-of-account
function, the medium-of-exchange and store-of-value functions have traditionally, but not exclusively,
been supplied by private enterprise.
Just as stable money is of crucial importance for a stable price level in a macroeconomic context, a
stable price level is of equal significance for the efficient performance of money in a microeconomic
context. A stable price level is, in principle, of central importance in ensuring that the three famous
microeconomic functions which money provides are allowed to operate with maximum efficiency.12
From the point of view of the public involvement in the economy, the unit of account is of the greatest
importance.
Efficient co-ordination in the economy cannot occur unless the various agents involved (that is,
virtually everybody) speak the same money language. The institution that allows them to do so is
money itself, but more specifically the unit-of-account function of money. The decentralised plans of
hundreds of millions of consumers and millions of producers and distributors cannot mesh
harmoniously in the aggregate if this common money language, as encapsulated in the unit-of-account
function of money, is missing. The efficiency of this language in performing this vital co-ordination
role depends crucially on whether the unit of account always means the same thing to different
individuals both at one and the same moment and over time. A necessary condition for it to mean the
same thing is that price stability prevails both at any moment in time and with a credible commitment
that it will continue to prevail into the indefinite future. From this point of view, the commitment to
maintaining price stability is like the standardisation of units of measurement.
It is not difficult to imagine problems in the Hayek proposal arising from the inherent dynamics
behind the discovery process, which would characterise competition between banks in the supply of
currency. There are many questions left unanswered by Hayek about how the discovery process
would work in practice. How would the economy function during this discovery process? Since bad
issuers are, according to the theory, driven out by the fact that they have recourse to inflationary
issuance, this suggests that the discovery process would itself be characterised by inflation.
Furthermore, if, say, a single stable currency did initially emerge from the discovery process, how
could one be sure that, having established a monopoly, the private issuer would not then, in a
timeinconsistent fashion that has become all too familiar under politically dependent central banks, start to
engage in inflationary over-issue so as to maximise seigniorage? And even if a few issuers were to
survive, how could one be sure that the resulting oligopoly situation would not result in collusion
and/or instabilities?
Another potential problem with the Hayek proposal is that the real rate of interest would tend to vary
across the business cycle in response to the short-run pressures of supply and demand for loans and so
too, according to his scheme, would the rate of deflation. And, of course, a steady rate of deflation
would only emerge if the whole private sector discovery process is itself stable, which any reasonable
person might be permitted to doubt. It would therefore appear that the outcome earnestly desired by
Hayek, a money of stable value, would not be achieved in practice by his own proposal of competing
currencies.
In a situation in which money were to be issued by many different issuers as in Hayek's proposal and,
either because of over-issuing by some agents or because of poor investment decisions, these issues
failed to trade at parity, then many different numeraires could emerge. In principle, there could, in the
end, be as many numeraires as there are issuers. In the presence of many numeraires or, more
meaningfully, in the absence of a single numeraire, financial communication, based on the common
money language which would be provided by a single numeraire, would degenerate. This would
probably result in very poor co-ordination in the economy, with the efficiency of the decentralised
decision-making of firms and households, which is the hallmark of capitalist economies, being
jeopardised and the productive potential of the economy being gravely endangered. The purely private
provision of a public good (the unit-of-account function of money) would, in this case, be sub-optimal
since private issuers cannot easily underpin the single numeraire. Nor do they have an incentive to do
so since they cannot capture the vast social benefits of the common monetary language provided by
the unit-of-account function of money.
There are further issues that any proposal in the spirit of Hayek would have to confront. First, the use
of money in transactions makes it subject to network externalities. Network externalities, in turn, may
inhibit free competition and may make it difficult, if not impossible, to dislodge an incumbent issuer
who has resorted to inflationary issuance. In other words, networking externalities would inhibit
Hayek's discovery process from working as he envisaged it. Network externalities also provide a
rationale for regulation. Second, the assumption of complete, symmetric and free information
implicitly assumed in the Hayek proposal does not apply to banking. The remark is equally valid in
terms of banking activities (for example, a fundamental activity in banking is the evaluation of the
creditworthiness of borrowers) and banks themselves (the special nature of the balance sheets of
banks makes their valuation and risk assessment particularly difficult). In the absence of symmetric
information, important issues of moral hazard, adverse selection and systemic stability become
relevant.13
Networking externalities therefore mean that there is no guarantee that new entrants into the market
for supplying money would be able to dislodge the incumbent issuer(s) if these resorted to
inflationary issuance, given the inertia that is an inherent part of phenomena subject to networking
effects such as currencies. In any case, why should people be willing to believe the claims of any
potential new entrant that its currency will, unlike that of the incumbent(s), turn out to be stable? In
my opinion, there are too many unanswered questions for Hayek's proposal for currency competition
to be a viable candidate for society searching for a stable monetary system.
Furthermore, it is very unlikely that the kind of uncertainty about future prices which Hayek wanted
to banish with his proposal ("..a money of stable value is really the best we can hope for") would be
the outcome if his proposal were to be implemented. Hayek's discovery process could, on the
contrary, entail substantial costs in practice. According to his own logic of free competition in
privately issued currencies, the nominal interest rate would be driven to zero with, as already
explained, deflation being the outcome. Hayek's proposal would not therefore deliver what it seems to
promise, namely price stability. Under his proposal, there would still be uncertainty about the future
price level.
3. Hayek and Gresham's Law
Under Hayek's scheme, market forces would determine the relative values of the different competing
currencies. In other words, the exchange rates between the competing currencies would float freely.
People would not want to hold on to the currency of an issuer that was expected to depreciate relative
to one that was expected to hold its value in terms of purchasing power over goods and services.
Therefore, good money that maintained its purchasing power would drive out the depreciation- and
inflation-prone bad money. However, it is not inconceivable that competing private issuers would
decide to collude by fixing the relative values of their currencies. They would do this by agreeing to
intervene mutually whenever any of the currencies in question came under pressure in the market for
these currencies. This would be easier to do, and would be more likely to succeed, if there were only a
few issuers left after the Hayekian discovery process has reached some equilibrium state.
Although this could be the outcome in a Hayek world of competing private currencies, it would
clearly not be appreciated by Hayek himself. This is because if some arrangement were to be arrived
at by private issuers to counter the tendency for the values of the different moneys to fluctuate against
each other, then the bad money would begin to drive out the good money, the exact opposite of what
Hayek himself espoused. In other words, Gresham's Law would, most likely, start to apply.
As Hayek himself put it: "If the law makes two kinds of money perfect substitutes for the payment of
debts and forces creditors to accept a coin of smaller content of gold in the place of one with a larger
content, debtors will, of course, pay only in the former and find a more profitable use for the
substance of the latter".14 And: "(Gresham's Law) is not false, but it applies only if a fixed rate of
exchange between the different forms of money is enforced" (italics in original15). The bad (i.e.
overissued and inflation-prone) money would start to drive out the good (i.e. well-managed and
maintaining stable purchasing power) money. More of the bad money would be produced at the
expense of the good money and inflation would accelerate.
In principle, Hayek's proposal also works with national currencies produced monopolistically by
central banks, provided the currencies in question are convertible and can be freely exchanged against
each other on foreign exchange markets. In such settings, good national currencies will tend to
increase in importance relative to bad, inflation-prone, national currencies. This naturally constrains
the ability of national governments to use "their exclusive power to issue money in order to defraud
and plunder the people" (op. cit.). In this context, I think it is fair to say that the widespread use of the
Deutschmark, for example, as an international investment currency is symptomatic of the enduring
success of the Bundesbank in maintaining, in relative terms, the internal purchasing power of the
Deutschmark. However, as long as national currencies remain legal tender only within their own
national boundaries, the scope for good national currencies to drive out bad national currencies may
not be as complete as in the Hayek world of competing private currencies where none of these
currencies has the status of legal tender. In other words, Hayek's competition between currencies goes
beyond the limited competition we have seen on foreign exchange markets between national
currencies.
If this limited competition between national currencies is not sufficient to constrain domestic
monetary policy not to engage in excessive monetary creation, then a government may decide to tie its
hands further by opting for a currency board arrangement. This would eliminate the possibility of any
discretionary domestic monetary policy action since the domestic component of the monetary base
could only change in response to a change in the foreign currency component of the base. Despite the
only limited experience with the currency board arrangement to date, the experience would
nevertheless allow us to declare it, provisionally, to be a success.
Some governments which have opted for this arrangement have found, however, that during the recent
financial market turbulence, their economies were not immune from contagious spillover despite
having fairly healthy economic fundamentals. This is the result of the currency board arrangement not
being an unequivocal one since the government in question retains the option of revoking the
arrangement. Financial markets will therefore factor this possibility into their calculations and
actions, ensuring that these countries suffer some contagious effects. This has stimulated a debate as
to whether it would not be better for such currency board countries to go beyond the currency board
arrangement and opt for full "dollarisation", and allow the domestic currency to be replaced entirely
by the "dollar" for all transactions.
Hayek espoused the denationalisation of currencies. He recommended that this be achieved through a
comprehensive privatisation of the supply of money. It is notable that, of the two routes to
denationalisation of currencies that have been taken so far, neither follows the route recommended by
Hayek. One is the route taken by the governments of the EU11 through an international agreement of
equals, which has resulted in the arrival of the euro. Another route is through so-called
"dollarisation", whereby a country voluntarily relinquishes its own currency in favour of adopting a
foreign currency, the "dollar".
It appears to me, therefore, that under the Hayek proposal, we are likely to get either one or other of
the following unfavourable outcomes. On the one hand, we could see the emergence of floating
exchange rates between different privately issued moneys, resulting in an uncertain discovery process
without any guarantee of a stable outcome, along with a deterioration in economic communication
and co-ordination in the economy overall. On the other hand, any attempt by private issuers to
preempt these outcomes by fixing the exchange rates between their currencies would probably trigger
Gresham's Law and result in accelerating inflation.
4. The importance of inside money
Since the birth of central banking, governments - via the central bank - have supplied financial
instruments that have simultaneously fulfilled all of the three functions of money I have already
mentioned. They have suppressed competition in the supply of currency and bank reserves (that is,
socalled outside money). However, they have not suppressed competition in the supply of the other
components of money, that is, so-called inside money, which has been supplied exclusively by the
private sector. Until just recently, inside money consisted exclusively of bank deposits which were
supplied competitively by banks. However, governments have nevertheless restricted the supply of
means of payment and stores of value by the private sector in the past. But this has been very
substantially liberalised over the last 20 years or so. The result is that the availability of efficient
means of payment that can also serve as good stores of value (and thus as a hedge against inflation)
has improved almost beyond recognition compared with what was available during the period of
financial repression.
Although governments have retained a monopoly on the production of high-powered money, they
have always permitted and indeed increasingly encouraged competition in the production of inside
money. The upshot of this is that outside money now comprises only a rather small fraction of total
money balances (taking, say, a broad definition of the money stock). After undergoing a dramatic
decline, particularly in the period following the Second World War, it now ranges from about 1% in
the United States and about 5% in the United Kingdom to about 6% in Germany.16 Governments have
retained a monopoly over the production of high-powered money. There are very good reasons for
this. Notes and coin issued by the central bank and, in some cases, by the government are unique in
the following sense: they are the only instrument that can mediate a transaction and settle it with
finality at one and the same time, which it does by virtue of its legal tender status. Currency is also
unique in that it supplies the unit of account for the whole economy.
Although privately supplied inside money and publicly supplied outside money compete with one
another as transaction media and stores of value, there is nevertheless a kind of symbiotic relationship
between the two. This is, first, because inside money (predominantly bank deposits) may owe its
acceptability to the fact that its issuers promise, and indeed are legally bound, to redeem it [either
immediately (sight deposits), upon maturity (time deposits) or after a period of notice (savings
deposits)] in outside money and, second, because outside money provides the unit of account for the
whole system without which inside money might be less acceptable in the absence of a single
(commodity) numeraire.
Seen in this light, it ap