Improving Money Through Competition

Report Monetary Policy

Improving Money Through Competition

July 7, 2017 14 min read Download Report
Norbert Michel
Director, Center for Data Analysis
Norbert Michel studies and writes about financial markets and monetary policy, including the reform of Fannie Mae and Freddie Mac.

Summary

Money is the means of payment for virtually all goods and services. Most innovations in the means for payment have originated in private markets, but they were later monopolized by the government, thus mitigating their benefits. Policymakers rarely think about improving money with the same competitive market forces that improve other goods and services. That competitive process is the best way to expose weaknesses and inefficiencies in existing products, thus improving people’s lives. Congress should avoid policies that single out alternative forms of money and impede people from using their preferred medium of exchange. Allowing competitive private markets to provide currency would present as powerful a check on the government’s ability to diminish the quality of money as possible.

Key Takeaways

Money is the means of payment for virtually all goods and services. Most innovations in the means for payment have originated in private markets.

The government’s poor record of monetary stewardship highlights the importance of preserving citizens’ ability to use whichever forms of money they choose.

Nothing can provide as powerful a check on the government’s ability to diminish the quality of money as allowing competitive private markets to provide it.

Money is the means of payment for virtually all goods and services, but policymakers rarely think about improving the quality of money with the same competitive market forces that improve other goods and services. These forces push entrepreneurs to innovate and improve products to satisfy customers, and they expose weaknesses and inefficiencies in existing products, thus improving people’s lives.

Economists generally acknowledge that private competitive markets produce such benefits, but many view money as an exception that should be provided by the government. Some scholars acknowledge that the “biggest threat to the value of the currency is often the government itself,” but still argue for increased centralization and government control of money.[REF] For instance, some economists want to ban the use of paper currency so that the government can easily penalize people who fail to spend money during an economic downturn.[REF]

Such conflicting views are surprising because the government’s actual record of monetary stewardship is so poor. That historical record, including recent monetary policy failures, highlights the importance of preserving citizens’ ability to use whichever forms of money they choose. Nothing can provide as powerful a check on the government’s ability to diminish the quality of money as allowing competitive private markets to provide it. Suppressing such competition, if history is any guide, only deprives citizens of beneficial innovations in the means of payments.

Competitive Money in the United States (Post-World War II)

The U.S. monetary system consists of two types of money:

  1. Base money, often referred to as outside money, is the ultimate means of payment in the economy, and it comes from outside the private sector (i.e., the government).
  2. Inside money, often called credit money, consists of claims to the underlying base money, and it comes from inside the private sector.

Private financial firms compete to provide various types of credit money, such as checkable deposits with bankcards, money market accounts, and travelers’ checks. These financial firms are heavily regulated, often to the detriment of their ability to operate,[REF] but few policymakers question whether they should actually provide money.

Even fewer policymakers question whether anyone other than the federal government should provide base money, despite its fundamental economic importance. Because the Federal Reserve is the monopoly provider of base money, the U.S. government ultimately determines the total amount—and type—of money that private firms can create.[REF] This monopoly necessarily limits the extent to which competitive processes can strengthen money, and exposes the means of payment for all goods and services to the mistakes of a single government entity.

Precisely because people are so vulnerable to the abuse of money (including modern monetary policy errors), Congress should not interfere with citizens’ ability to opt out of official currency.

The competitive process is, ultimately, the only way to discover what people view as the best means of payment.[REF] Although unregulated markets receive most of the blame for U.S. monetary instability prior to the creation of the Federal Reserve, the historical record shows otherwise. Major regulatory problems impeded the nation’s currency supply prior to the 1900s, and the actual competitive issue of money, in the form of private banknotes, worked reasonably well.[REF]

Harmful Regulation Led to Instability

The U.S. has never had a truly unregulated banking system. However, because the period from 1837 to 1863 is known as the free-banking era, free markets in money have been mistakenly associated with the nation’s monetary ills. In fact, the only thing from which these so-called free banks were freed was the patronage system whereby state legislators voted on specific bank charters.[REF] The primary cause of financial turmoil during this period was overly strict and harmful regulation, particularly restrictive bond collateral requirements and branching restrictions.[REF]

Monetary instability was not the result of these banks issuing their own banknotes, many of which traded at a discount. Indeed, by the beginning of the Civil War, paper currency in the U.S. consisted almost entirely of notes competitively issued by state-chartered banks.[REF]

In just five years, however, very few state banks remained and they did not issue notes. Instead, after a series of new federal banking laws,[REF] most of those state banks had converted to national banks that issued national bank notes. Citizens did not scorn competitively issued state banknotes for a national system of uniform government-backed banknotes.[REF]

Most state banks resisted joining the national banking system because demand for state bank currency remained relatively strong. In fact, the federal government had to impose a 10 percent tax on state bank notes specifically because customers preferred those notes to the national banknotes.[REF] As with any privately produced good or service, no inferior form of money would be expected to replace an economy’s preferred medium of exchange, and targeted government policies were clearly necessary to monopolize currency in the face of strong consumer preferences for competitively issued notes.[REF]

Failed Stabilization Policies

The federal government’s monopoly of base money and of modern monetary policies is widely believed to have stabilized the economy, although more than enough evidence suggests that this belief is erroneous.

For instance, a comparison of the entire Federal Reserve period, as opposed to only a portion of the post–World War II period, with the full pre-Fed era, shows that the frequency and severity of recessions has not decreased.[REF] Some measures even show that there is more economic volatility compared to the pre-Fed period.[REF] Furthermore, updated data suggests that economic contractions were shorter, and recoveries were faster, in the pre-Fed era than previously believed, and that the apparent decline in postwar volatility (in both output and employment) is “a figment of the data.”[REF]

Despite good reason to question the federal government’s stewardship of money, an increasing number of policymakers are actively seeking to further expand government control over money by ending deposit banking, shutting down both the Eurodollar market and the money market mutual fund industry,[REF] and even banning the use of paper currency.[REF] These policymakers want to ban paper currency to prevent people from mitigating economic stabilization policies,[REF] especially when nominal interest rates are near zero. If, for example, the government forces citizens to use only electronic money, then the Federal Reserve can always, in an effort to boost consumption, assess a direct penalty (negative interest rates) on people for saving money instead of spending it.

Ensuring a Level Playing Field

Congress should remove barriers to entry in the market for alternative monies, and ensure that no single type of money enjoys a regulatory advantage. At minimum, Congress should address the following anti-competitive issues:[REF]

  • Legal Tender Laws. Congress should amend legal tender laws because they allow courts to force acceptance of a certain amount of official currency to satisfy debts even if a contract calls for delivery in another means of payment.[REF]
  • Capital Gains Taxes. Since the Internal Revenue Service treats (effectively all) alternative currencies as assets, every such transaction is a taxable event and is reportable on Schedule D of the taxpayers’ Form 1040 (or, if a business, the analogous business tax form).[REF] Congress should amend the Internal Revenue Code to provide that gains or losses attributable to the purchase or sale of alternative currencies are not taxable.
  • Private Coinage. Congress should modify statutes concerning coinage to clarify that they do not prohibit the honest production of alternative monies for use in private transactions.[REF]
  • Bank Secrecy and Anti-Money-Laundering Rules. Congress should address bank secrecy and anti-money-laundering laws so that producers of alternative monies are not held to higher or lower standards than traditional financial companies.[REF]

Conclusion                           

Money is the means of payment for virtually all goods and services. Most innovations in the means for payment have originated in private markets, but they were later monopolized by the government, thus mitigating their benefits. Policymakers rarely think about improving money with the same competitive market forces that improve other goods and services. That competitive process is the best way to expose weaknesses and inefficiencies in existing products, thus improving people’s lives.

Congress should avoid policies that single out alternative forms of money and impede people from using their preferred medium of exchange. Although it cannot provide absolute protection, allowing competitive private markets to provide currency would present as powerful a check on the government’s ability to diminish the quality of money as possible.

Norbert J. Michel, PhD, is Director of the Center for Data Analysis, in the Institute for Economic Freedom, at The Heritage Foundation.

Authors

Norbert Michel
Norbert Michel

Director, Center for Data Analysis