Sunday, July 26, 2015

Selgin on Hayek on Free Banking

By Joseph T. Salerno

George Selgin has written an interesting post on Hayek and free banking. Unfortunately, his otherwise instructive  post is marred by a few lapses of scholarship.  In a nutshell, Selgin credits Hayek with inspiring him and others to create the "Modern Free Banking School."  Selgin argues that Hayek was a life-long opponent of free banking, but notes that two of Hayek's pamphlets on privatizing the money supply influenced him to consider free banking  on a commodity standard like gold or silver as a workable alternative to central banks.   The two pamphlets to which he refers are  Choice in Currency (1976) and the Denationalisation of Money (1978).
Selgin conflates the two very different arguments that Hayek presents in these two pamphlets.  In so doing he not only does a disservice to a great economist, but he also ignores an important proposal for restroing sound money.

Selgin characterizes Hayek's scheme of "choice in currency" as referring to
". . . competing firms issu[ing] irredeemable paper notes, with each brand representing a distinct monetary unit.  Far from resembling ordinary commercial banks, Hayek's 'banks' resemble so many modern central banks in that they issue a sort of 'fiat' money." 
But this is a fair description only of Hayek's later booklet, Denationalisation of Money.  In Choice in Currency, Hayek presents a very different, and much sounder, proposal for monetary reform--one that is still useful today as a plan for restoring the gold standard.    The crux of Hayek's proposal for free choice in currency is the abolition of legal tender for the currency issued by the domestic government and the restoration of the right of citizens to freely contract in foreign currencies or even ounces of gold or silver.  There would thus emerge competition among different currencies, with those depreciating relatively rapidly falling out of use.  Hayek does not foresee the establishment of private banks issuing private fiat currencies as a result of free choice in currency.  Far from it,  as he concludes:
It seems not unlikely that gold would reassert its place as 'the universal prize in all countries, in all cultures, in all ages'. . . if people were given complete freedom to decide what to use as their standard and general medium of exchange.
Selgin also claims that Vera Smith in her important book The Rationale of Central Banking,  written as a doctoral dissertation under Hayek's supervision, "discusses both the Canadian and the Scottish [free banking] episodes . . .  in unmistakably favorable terms."  While Smith does indeed discuss free banking in Scotland, a discussion of the Canadian experience does not appear in her book.  The only reference to Canada that I could find was a citation of the 1933 report of the Royal Commission on Banking and Currency in Canada. It appears that this lapse in scholarship may be due to Selgin's eagerness to deepen the mystery of Hayek's rejection of free banking and enhance a good narrative. To wit: "Had Hayek forgotten his own PhD student's work, if not some of his own early research?"
Finally, Selgin correctly points out that Mises favored free banking and cites a 1992 article by Larry White, "Mises on Free Banking and Fractional Reserves."  But he fails to take of account of the great deal of careful investigation of Mises's views on free banking that has occurred since then.  From this research it has become clear that Mises favored free banking precisely because he believed that it would lead to the complete suppression of additional issues of "fiduciary media,"  that is, unbacked notes and deposits.   Thus Mises was not a forerunner of the Modern Free Banking school as Selgin seemingly implies, but rather the founder of the Neo-Currency school that attributes business cycles to the issue of fiduciary media by fractional-reserve banks.  I  present an exhaustive review of Mises's  views on free banking  in my book chapter "Mises as Currency School Free Banker" published in 2013.

  Mises's belief that the issue of fiduciary media causes the business cycle and that free banking would eliminate or severely restrict such issue is summed up in one of the several  passages from Mises that I cite in my paper:
The notion of “normal” credit expansion is absurd. Issuance of additional fiduciary media, no matter what its quantity may be, always sets in motion those changes in the price structure the description of which is the task of the theory of the trade cycle. . . . Free banking is the only method available for the prevention of the dangers inherent in credit expansion. It would . . . not hinder a slow credit expansion, kept within very narrow limits . . . But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular . . . feature of the economic system. 

The above originally appeared at 


  1. Nothing is free.
    My proposal for banking is a tiered system. First tier all money in accounts, all checking, are 100% guaranteed by the institution, available on demand, no interest is paid but no more than 2% of total balances may by loaned All other tiers pay interest at different levels of reserves and risk.
    It is not a fully developed concept. I do not think it is a wacky idea that current banking regulations I do not think allows. Just a thought

    1. When I was young, checking accounts payed no interest. If you wanted interest, you opened a savings account or (later) bought a CD.
      So the CD 'locks' your money up and it can be lent out. But in exchange you get interest payments.
      I know you know this. But this can easily be cloned to a fractional / non-fractional reserve system where the CD money if fractional, but the demand checking accounts are 100% reserves.
      Or something like that.

  2. In the case of both Hayek and Mises, per the quotes provided here, they propose that gold or silver would *likely* emerge, and/or that the creation of funny currency would be kept to a minimum.

    Neither prohibits the practice of banks issuing notes backed by anything or nothing; they merely offer their individual views of likely outcomes.

    If there are other quotes from either of these two where they make a free market case for prohibiting the issuance of unbacked notes, I have not found it - and Salerno has not presented it here.

    1. There may be a wonderful building material made from straw, but as an engineer, I'd never recommend my clients build houses in Kansas or San Francisco with it.

      Same reasoning.