From Demonetization to the Denationalization of Money

Ujwal Batra explores the legitimacy crisis of state-issued currency in the aftermath of monetary measures such as demonetization, and the exciting alternatives to state monopoly on currency.

Ask people to list out the legitimate functions of government, and nearly everyone would have the issuance and management of currency somewhere at the top of their list: even those who believe that the state should have a limited mandate. After all, it is impossible to conceive of an alternative to state-issued currency. How would it be provided? And how would it gain its legitimacy?

Stability and certainty are the virtues that are supposed to accompany any currency for it to be viable. If anything, the recent demonetization exercise in India ought to make one question the reliability of state-issued currency. If the state can render invalid 86% of the currency overnight with the stroke of a pen, how reliable is our currency? If the government already possesses the power to issue such a diktat, what is to prevent them from doing it again in say, 10 years?

This isn’t the first instance of monetary policy causing havoc in a nation’s currency. There are even instances of currencies failing — the hyperinflation in Zimbabwe and more recently, Venezuela come to mind. Furthermore, the state’s monetary policy is intimately connected with business cycles and depressions in the economy. An alternate set of institutions may lead to a framework for monetary policy that is more robust and reliable than the centralisation of such power with the state.

Yet, modern-day economists rarely question the state-monopoly of currency. The question among economists has been on how the state should exercise its monopoly over monetary policy, such monopoly being assumed. But many free-market economists, from Adam Smith to F A Hayek, have questioned this assumption. Hayek was one of the first to systematically treat the subject in his 1976 book ‘The Denationalization of Money’, where he proposed replacing the state monopoly of currency with a system of competing currencies: a system in which commercial banks are free to compete and offer currencies to the public.

So what would money without the state look like?

There is historical as well as present-day evidence that such a system would work pretty well. Indeed, the institution of money predates the institution of the state, with central banks being a relatively recent historical development.

Laissez faire in currency would rest on competition. And just as competition works to provide a myriad of goods and services in a free-market, so it would provide currency. Money is, after all, just another good — the most liquid and tradeable good that serves as a medium of exchange for all other goods and services. Just as competition leads to better quality goods at lower prices, so would competition between banks leads to a more robust currency.

Scotland, for instance, had a free-banking system from 1716–1845: a system that was fairly stable and successful. Summarizing the account of free-banking systems all over the world, Kevin Dowd notes that most of these systems were ‘reasonably successful’, ‘not prone to inflation’, did not show signs of natural monopoly and boosted economic growth.

In a competitive system, players cannot make the kind of decisions that can be made in a monopoly system. The government, having a monopoly over the issuance of currency, could go ahead with demonetization simply because there was no competition in place to check it. This simply would not have been prudent in a free-banking system, where a bank withdrawing its money would have tarnished its reputation, leading consumers to favour other competing currencies. Competition results in the most rigorous of restraints, and no one player can dictate the terms of the game. That kind of feedback mechanism simply is not present in a monopolistic system. A free-market system leads the players to internalise the costs and benefits of their decisions. Monopolies just don’t produce that kind of rigour. In demonization, the primary consideration for the government was merely political, whereas the costs were externalised and borne by the people. One would have imagined that in the absence of competitive restraints, there would have been legal or constitutional constraints would have sufficed in keeping the state’s actions in check. But this was patently not the case. The government indulged in a big gamble with huge costs for an uncertain benefit. Such a gamble simply would not have been prudent for any commercial bank in a free-banking system. Indeed, there is little evidence to show that demonetisation would accrue any benefits for the economy, or any political benefits for the ruling party.

Many may complain that there is little value in engaging in such discussions, given that it is inconceivable that we’ll ever see the end of central banking. Two things may be said in this regard. One, as the economist George Selgin points out, just as you need a theory of free trade to understand why tariffs are bad (whether or not a system of free-trade exists), so you need a theory of free-banking through which you can understand the follies of central banking (whether or not a system of free-banking exists). Two, we can never predict the course of history or the evolution of institutions. Propositions that seem inconceivable today may well become inevitable tomorrow, which is why we need to ask impossible questions — especially to unaccountable powers.