I owe a heckuva lot to Friedrich Hayek. Had it not been for him, I might never have heard of “free banking,” meaning the genuine article rather than the phony antebellum U.S. version. Certainly I would never have found myself writing about it. Nor, perhaps, would any other modern economist.

It was two pamphlets that Hayek published in the 1970s — first, Choice in Currency (1976) and then Denationalisation of Money (1978) — that caused the scales to fall off of my eyes and of those of some other economists, thereby encouraging us to reconsider the merits of private and competitive currency systems. That reconsideration in turn led to a revival of interest in former free banking episodes, including those of Scotland and Canada, which monetary economists had previously neglected or overlooked. In short, were it not for Hayek, there’d be no such thing as a Modern Free Banking School.

Yet Hayek himself was no free banker. For starters, his own vision of “choice in currency” had little if anything in common with historical free banking arrangements. In those arrangements, banks dealt in established, precious-metal monetary units, like the British pound and the American dollar, receiving deposits of metallic money, or claims to such, and offering in place their own readily-redeemable liabilities, including circulating banknotes. In Hayek’s scheme, in contrast, competing firms issue 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 they differ from actual central banks in enjoying neither monopoly privileges nor the power to compel anyone to accept their products.¹

Competition, Hayek claimed, would force private issuers of irredeemable currencies to maintain those currencies’ purchasing power, or else go out of business. An overexpanding free bank, in contrast, is disciplined, not by an eventual loss of reputation, but by the more immediate prospect of running out of cash reserves. Hayek’s claims have always been controversial, even among persons (myself among them) who are inclined to favor competitive currency arrangements over monopolistic ones. It isn’t clear that a Hayekian money issuer would ever manage to get its paper accepted, or that it would resist the temptation to hyperinflate if it did.²

But Hayek didn’t merely differ from free bankers in proposing a form of currency competition distinct from free banking. He expressly opposed free banking. Asked, during a 1945 radio interview, whether he considered the Federal Reserve System a step along “the road to serfdom,” he unhesitatingly replied, “No. That the monetary system must be under central control has never, to my mind, been denied by any sensible person.“³ And although by the 1970s he had come to believe it both possible and desirable to have a currency stock consisting of the irredeemable paper of numerous private firms, he also continued to maintain that, so long as government authorities supplied a nation’s standard money, private firms should not be able to issue circulating paper claims denominated and redeemable in that money.

The most explicit, later statement of Hayek’s views on free banking occurs in a lecture he gave at a conference in New Orleans in 1977, just as Denationalisation of Money was in press:

We have indeed given government, and for fairly good reasons, the exclusive right to issue gold coins. And after we had given the government that right, I think it was equally understandable that we also gave the government the control over any money or any claims, paper claims, for coins or money of that definition. That people other than the government are not allowed to issue dollars if the government issues dollars is a perfectly reasonable arrangement, even if it has not turned out to be completely beneficial. And I am not suggesting that other people should be entitled to issue dollars. All the discussion in the past about free banking was really about the idea that not only the government or government institutions but others should also be able to issue dollar notes. That, of course, would not work.⁴

Actually, governments monopolized the coining of gold and other metals, not for any good reasons, but because doing so gave them the opportunity to manipulate precious-metal standards in pursuit of narrow fiscal ends. But it is the last sentence of this quote that’s most surprising, for what Hayek declares “unworkable” is an arrangement that worked quite successfully in many places, including Canada, where it survived well into Hayek’s own lifetime. Canada’s banking and currency system had in fact been remarkably stable, altogether avoiding the crises by which the U.S. was afflicted in the decades leading to the Fed’s establishment, and weathering the Great Depression far better than the U.S. system did despite having lacked a central bank until after that episode’s nadir.⁵

That Hayek should have written as if he was quite unaware of the Canadian experience or, for that matter, of the still more famous Scottish free banking episode is extremely puzzling. It was Hayek, after all, who supervised, and signed off on, Vera Smith’s 1935 doctoral dissertation on “The Rationale of Central Banking” (subsequently published by P.S. King & Son, and reprinted by LibertyPress) in which she discusses both the Canadian and the Scottish episodes, as well as some other free banking episodes, in unmistakably favorable terms.

Had Hayek forgotten his own PhD student’s work, if not some of his own early research? Had he simply changed his mind, reverting to conventional wisdom after a brief interval during which he had entertained a more favorable view of free banking? Or had he never accepted Free Banking School arguments?

Larry White, who drew attention to Hayek’s anti free-banking stance some years ago in a History of Political Economy article entitled, “Why Didn’t Hayek Favor Laissez Faire in Banking?,” favors the third hypothesis, tracing Hayek’s position to his unwavering belief that a free banking system would manage the stock of bank money in a procyclical manner. Whereas for Mises, who did favor free banking,⁶ a cyclical boom was most likely to be set off by a central bank, for Hayek it is the competitive commercial banks that are most likely to overissue. Unlike Mises, Hayek subscribed to the popular view that banks might expand credit without limit so long as they expanded in unison, and that they would in fact be inclined to overexpand, while allowing their reserve ratios to decline, in response to cyclical increases in the demand for loans.

But Hayek was mistaken. The popular view, according to which banks can expand credit all they like so long as they expand it in unison, incorrectly equates a bank’s demand for reserves with its net demand for such — that is, with its need for reserves to cover expected or deterministic outflows. This overlooks banks’ need for “precautionary” reserves, or reserves that serve to protect against an undue risk of stochastic or random reserves losses. Even a well-coordinated, industry-wide expansion of bank credit will involve some increase in banks’ collective demand for precautionary reserves. For that reason such a coordinated expansion isn’t sustainable unless it’s accompanied by an increase in the nominal quantity of bank reserves. That is why, if one examines the record of so-called bank lending “manias,” one finds that they typically involve, not a substantial decline in bank reserve ratios, but a substantial increase in the nominal quantity of bank reserves.

Whether Hayek was right to reject free banking or not, and tempting as it may be for fans of free banking to claim him as one of their own, doing so would hardly be doing justice to that great economist. We may credit him for inspiring us all; but we mustn’t otherwise associate him with opinions that, rightly or wrongly, he flatly rejected.

______________________________________

[1] The modern cybercurrency market, consisting of Bitcoin and its many less well-known rivals (“altcoins”) offers something close to a real-world counterpart of Hayek’s scheme.

[2] For criticisms of Hayek’s scheme, and others like it, see George Selgin and Lawrence H. White, “How Would the Invisible Hand Handle Money?,” Journal of Economic Literature 32 (4) (December 1994), and Lawrence H. White, The Theory of Monetary Institutions, Part XII, “Competitive Supply of Fiat-Type Money” (New York: Blackwell, 1999).

[3] Hayek on Hayek: An Autobiographical Dialogue, ed. Stephen Kresge and Leif Wenar (Chicago: University of Chicago Press, 1994), p. 116; quoted in White, “Why Didn’t Hayek Favor Laissez Faire in Banking?, p. 763 n12.

[4] F. A. Hayek, “Toward a Free Market Monetary System.” Journal of Libertarian Studies 5 (1) (Fall 1979). Whether Hayek, like Friedman before him, imagines that private banks’ circulating paper dollars would be indistinguishable from the fiat dollars issued by the central authority, is unclear from this passage. If so, he committed the crude error of equating free banking with counterfeiting.

[5] On Canada’s decision, despite its monetary system’s good record, to establish a central bank in 1935, see Bordo and Redish.

[6] See Lawrence H. White, “Mises on Free Banking and Fractional Reserves,” in John W. Robbins and Mark Spangler, eds., A Man of Principle: Essays in Honor of Hans F. Sennholz (Grove City: Grove City College Press).