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Abstract
Recent central bank experience with inflation targeting is used to restate Hayek's reform proposal as a performance contract. This requires banks to first state an explicit inflation target and then promise to perform a set of actions whenever an independent forecast departs from target. Making such actions explicit and observable makes the promise of price stability offered by competing banks operational and enforceable. Competition among banks then leads to convergence on current best practice in the short term and to faster performance evolution as the incentive to innovate induces improvements over the long term.
Notes
1 We would like to thank two referees from this journal for perceptive and insightful comments on an earlier draft of this paper. In addition, we thank T.K. Rymes, Amir Kia, and particularly Professor Charles Goodhart for comments that led to the refinement of parts of our analysis.
2 For many free bankers, these two separate points coincide. That is, if all competitive banks offered money redeemable at par in terms of the same real commodity, then relative money prices would remain fixed and the seeming complexity of the free banking system would be considerably reduced.
3 Note that we are not arguing that the non-redemption contract will necessarily be superior to a redeemable money contract. That would require a more explicit examination of the full benefits and costs of the two contracts and is beyond the scope of this paper. Rather, here we make the more limited claim that in all its essential characteristics, the non-redemption performance contract can be made just as feasible as the more traditionally accepted redeemable money contract.
4 As Hayek writes (Citation1990: 23): ‘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’. We also follow Hayek in using ‘currency’ to mean both notes and deposits, unless mentioned explicitly otherwise.
5 Hayek (Citation1990: 46) writes that if he were in charge of an issuing bank: ‘ … I would announce … my intention to regulate the quantity of ducats so as to keep their (precisely defined) purchasing power as nearly as possible constant. I would also explain to the public that I was fully aware I could keep these notes in circulation only if I fulfilled the expectation that their real value would be kept approximately constant’.
6 The use of bank specific money and variable money prices was earlier used by Ben Klein (Citation1975) to emphasize that it was the ability to distinguish among monies that allowed circumvention of Gresham's Law and countered the argument that competitive banking would necessarily result in an infinite price level. Unlike Hayek, Klein had no assumption about the optimal inflation rate arguing that predictability rather than stability was the valued attribute of money and that distinguishable monies could provide that feature whatever the inflation rate customers desired.
7 See Hayek (Citation1976: 39) in section VIII, Putting Private Token Money into Circulation. Each money unit then has its own distinct trademark.
8 Hayek (Citation1978: 123 – 4) writes: ‘Considerations of convenience would probably also lead to the adoption of a standard unit, i.e. based not only on the same collection of commodities but also of the same magnitude’. See the discussion in section 4.
9 While the basket needs to be specified, its contents need not remain fixed forever. Hayek (Citation1976: 39) writes: ‘I would announce that I propose from time to time to state the precise commodity equivalent in terms of which I intended to keep the value of the ducat constant, but that I reserved the right, after announcement, to alter the composition of the commodity standard as experience and the revealed preferences of the public suggested’.
10 Here it is assumed that an outside market will arise for the different currencies whose exchange prices reflect the purchasing power of each bank's money in terms of each other. One of the referee's points to the following quote from Hayek (Citation1978: 49): ‘The competition between the issuing banks would be made very acute by the close scrutiny of their conduct by the press and at the currency exchange. For a decision so important for business as which currency to use in contracts and accounts, all possible information would be supplied daily in the financial press, and have to be provided by the issuing banks themselves for the information of the public’.
11 For Hayek the exchange value of a bank's notes becomes a sufficient statistic to monitor relative bank performance.
12 There is little doubt that Hayek himself believed that the promise of price stability would be credible. Hayek (Citation1990: 48) writes: ‘The kind of trust on which private money would rest would not be very different from the trust on which today all banking rests (or in the United States rested before the governmental deposit insurance scheme!). People today trust that a bank, to preserve its business, will arrange its affairs so that it will at all times be able to exchange demand deposits for cash, although they know that banks do not have enough cash do so if everyone exercised his right to demand instant payment at the same time. Similarly, under the proposed scheme, the managers of the bank would learn that its business depended on the unshakable confidence that it would continue to regulate its issue of ducats … so that their purchasing power remained approximately constant’.
13 In Klein and Leffler (Citation1981), these trade-off possibilities are set out formally and while Klein (Citation1975) argues that with distinct monies and flexible money exchange prices, brand name capital may be sufficient to overcome this cheating problem. In essence, that requires each bank to post a bond in terms of specific capital that would be lost should an attempt at cheating be discovered. In White (Citation1999: 236) this potential solution is challenged. For White, the gain that can be made by capitalizing on any temporary departure between actual and expected prices can always be made infinitely large, making this the predictable profit maximizing outcome. Foreknowledge of this result will prevent a pure fiduciary bank money system from ever being established.
14 Note that the historical-evolutionary approach used in much of the free banking literature tends to rule out non-redeemable money from the start, at least partially on the grounds that this path was not an actual historical outcome for free banks (Selgin and White 1987). Hayek avoids the seeming inevitability of this argument by beginning in a world already accustomed to non-redeemable money, albeit under central bank control.
15 Hayek, himself, believed that making the promise of price stability into a contract was unnecessary and would unnecessarily restrict the flexibility of the bank. In one passage Hayek writes (Citation1990: 47): ‘It would, however, be clearly necessary, though it seems neither necessary nor desirable that the issuing bank legally commits itself to maintaining the value of its unit, it should in its loan contracts specify that any loan could be repaid either at the nominal figure in its own currency, or by corresponding amounts of any currency or currencies sufficient to buy in the market the commodity equivalent which at the time of making the loan it had used as its standard’.
16 Note that the strength of the redemption contract arises precisely because it does not promise what consumer's ultimately desire, that is, the stable purchasing power of the notes (deposits) that they hold. Rather, a second (or third) best mechanism for producing price stability is accepted by money holders because the transparency the contract allows for low cost third party observation and hence enforcement.
17 ‘Summary diligence is a provision in Scottish Law that arises when a contract contains a clause providing for registration of the contract in the Books of Council and Session for preservation and execution. So, where summary diligence is available, it is not necessary to go through normal court procedures. This precludes a debtor from trying to defend a debt action on spurious grounds, thus preventing the creditor from obtaining decree and enforcing it quickly … The principal advantage of summary diligence is the short-circuiting of court debt recovery procedures and the “shock tactic” approach will often result in early repayment if money is available.’ Commentary on Scottish Law, available online at: http://www/legal500.com/devs/uk/sl/uksl_029.htm
18 White (1996: 24) writes ‘The Bank [of Scotland]'s pound note now promised to the bearer “one pound sterling on demand, or in the option of the Directors, one pound and six pence sterling at the end of six months after the day of demand”’.
19 Checkland (Citation1975: 121) writes: ‘The statute of 1765 was entitled “An Act to prevent the inconvenience arising from the present method of issuing notes and bills by banks, banking companies, and bankers, in that part of Great Britain called Scotland”. It killed the option clause and the very small notes. But it left Scotland with its one pound and one guinea notes. Moreover, it cleared up, once and for all, the question of “summary diligence” against bank notes (made applicable to bills of exchange in 1681); all such notes were to be subject to protest at law by “summary diligence”. This meant that there could be no more questioning by the public banks or anyone else of the legal status of the notes of any bank, banker, or banking company’.
20 Even if a reneging bank could be put into bankruptcy instantly and costlessly, the ultimate recovery of deposits funds is typically neither. In relation to US banking experience prior to deposit insurance, Kaufman (Citation2004: 243) writes ‘Between 1865 and 1933, receiverships, during which depositors were paid in installments as the assets were sold, lasted as long as 21 years and averaged 6 years in length… As a result the loss of liquidity became an increasingly important public policy concern’. This consideration, however, is common to the two contract types discussed here.
21 Under the redeemable promise, the comparable early warning sign would be the abnormal accumulation of an expanding bank's notes and deposits throughout the clearing system. This reflux mechanism allows other banks, but not necessarily the offending bank's own customers, an early sign of a potential breach of contract.
22 The argument in the text assumes that all banks follow Hayek in promising price level constancy so that failure by one bank to maintain that promise will result in exchange rate depreciation. However, the argument generalizes for cases where, for example, the bank's price stability promise is a two percent per annum inflation rate and all other banks promise four. In this case the market would expect a two percent appreciation rate of the first bank's money each period so that failure to maintain that promise would result in the depreciation of that bank's money exchange rate relative to that trend.
23 For this argument it is not essential what the particular monetary control mechanism is as long as it is mutually acceptable and clearly visible. Hayek, himself, preferred a control method other than simply fixing an explicit money growth rate (Hayek Citation1990: 81). Once a behaviour contract was first adopted, however, competition among independent banks would allow experimentation so that the final control mechanism would be the one resulting in more predictable and stable money prices.
24 For a more extended analysis of these steps in relation to an interest rate control mechanism under indirect convertibility, see Ferris and Galbraith (Citation2003).
25 This is again similar to the second best accomplishment of a redeemable money regime. That is, by promising redemption in terms of a commodity such as gold, only the bank money price of gold is held fixed directly. Given that changes in either the demand or supply of gold do occur, bank money prices will change proportionally. Only to the extent that the relative price of gold stays fixed will the gold redemption contract deliver the desired stability of the purchasing power of bank money.
26 See the quotation in footnote 9.
27 Because the current value of the bank's money depends upon the market's perception of the future usefulness of each bank's money, any change in performance characteristics of bank money will impact immediately on the exchange value of each bank's money. This implies that all recognized improvements will increase the value of the money held by current holders (and so will be welcomed by current holders) but also implies that there will be immediate losses if the market generally does not see the future change as an improvement. In this sense, simple notice of a future change cannot protect current money holders from such negative consequences. A requirement for having the bank convince some proportion of its depositors of the value of the change is then some protection against mistakes made by banks attempting to innovative ahead of the market.
28 Even if multiple prices for each product did exist, transaction costs could be reduced by having each store adopt only one of the currencies as its unit of account and upon purchase apply the current exchange rate to convert to into any of the economy's active medium of exchange.
29 Hayek, himself, did not believe that the multiplicity of bank prices would cause any insurmountable problem. He writes (Citation1990: 67): ‘Shopkeepers … so long as they know they can instantaneously exchange any currency at a known rate of exchange against any other, would be only too willing to accept any currency at an appropriate price. Electronic cash registered would probably be developed rapidly not only to show instantaneously the equivalent of any price in any currency desired, but also to be connected through the computer with banks so that firms would immediately be credited with the equivalent in the currency in which they kept their accounts … ’.
30 See footnote 8.
31 Under these circumstances, exchange rate changes arise only for idiosyncratic bank-specific events and lead to departures from par that are only transitory. In such cases, arbitrage would be expected to keep inter-bank exchange rate deviations within the narrow band about par, the size of which is dictated by the real costs of arbitrage activity.
32 ‘The availability of current accounts, credit cards and similar devices makes it possible to offer a stable unit available for most transactions without issuing it in the form of circulating pieces of metal or paper. The offer of current accounts in a stable unit – redeemable on demand in such amounts of the currencies generally used as are required to buy a “basket” of raw materials and foodstuffs at spot prices determined at the international commodity exchanges and measured bay a weighted index – would achieve the same result … The ideal name for the new unit of account, clearly making its function universally intelligible, would be the proverbial term Standard, a rather obvious name which, however, has so far never been used as the designation of a particular monetary unit’ (Hayek Citation1986: 9).
33 For Hayek, it was important to preserve the information function of the money exchange market by not allowing the emergence of a clearinghouse to result in the fixing of exchange rates between bank monies. Hayek (Citation1990: 65) writes: ‘ … the dealings of an issue bank in other currencies would therefore never be a purely mechanical affair (buying and selling at constant prices) guided only by the observed changes in the purchasing power of the other currencies; nor could such a bank undertake to buy any other currency at a rate corresponding to its current buying power over the standard batch of commodities; but it would require a good deal of judgment effectively to defend the short run stability of one's own currency, and the business will have to be guided in some measure by predictions of the future development of the value of other currencies’.
34 Aside from attempts to expand artificially, an accumulation of excessive settlement commitments being returned to a bank would signal a reduction in the real demand for that bank's currency relative to other banks in the system. Hence, to remain within the clearinghouse system, the bank would have to contract the real scale if its activity to restore the convertibility of its monetary units at par. Otherwise the bank would have to renegotiate the terms of its notes convertibility at permanent discount.
35 It is the preservation of individual bank prices that polices any collusive attempt by the banks as a group to renege on their promise of price stability. That is, even though joint expansion would not be observed in relative price changes in the money exchange markets (if all expanded proportionally), independent bank forecasts would reveal the forthcoming problem and allow individual banks to profit by following its established procedures for correcting such a departure.