The Theory of Free Banking: Money Supply under Competitive Note Issue
by George A. Selgin 
Totowa, NJ: Roman and Littlefield, 1988, pp. xiv, 218 

During the monetary expansion of the 1970s, F. A. Hayek [1] made the suggestion�he later described it as a "bitter joke"�that allowing the market to provide a "choice in currency" may be the only way to stop inflation. Joke or no joke, both Hayek [2] and notable others have since addressed themselves to the economics of competitive note issue. Prominent among the notable others are Lawrence H. White [3], who examined the experience with and debate about free banking in early nineteenth-century Britain, and now George A. Selgin, who has developed the ideas of Hayek and White into a comprehensive theory of free banking. 
        Selgin has produced a bitter-sweet analysis of actual and potential banking institutions in their capacities for achieving and maintaining monetary equilibrium. Bitter, because it demonstrates in the most fundamental way the futility of maintaining monetary equilibrium through central direction. Neither a simple monetary rule religiously observed by the central bank nor a well intentioned discretionary policy implemented by an enlightened monetary authority is capable of making the appropriate adjustments in the money supply. Sweet, because it demonstrates that the monetary equilibrium which remains outside the reach of any central bank is the unintended consequence of competitive note issue. The market forces that govern the issue and retirement of private bank notes in response to changing market conditions are spelled out in sufficient detail so as to make free banking seem institutionally viable�if only the political obstacles (not discussed by Selgin) could be overcome. 
        Economists who generally rate market forces above central direction have long been willing to endorse as an exception a centrally managed medium of exchange. Until recently, competition among note-issuing banks has been considered only to show why monopolization is necessary. If the bank notes issued by a multiplicity of competing banks are wholly generic, then each bank stands to gain by expanding its note issue even though the collective effect is unbounded inflation. If, alternatively, the notes are treated as bank-specific liabilities, then each bank's notes are bartered against the notes of each competing bank in a market process that fails to yield a commonly accepted medium of exchange. Selgin directs attention away from these two polar cases in his discussion of note-brand discrimination (pp. 42-47). He identifies a broad middle ground in which (1) a multiplicity of notes are readily accepted as a means of payment, but (2) some note-brand discrimination affects their acceptability as a store of value. By distinguishing between  money to spend and money to hold, Selgin is able to show how competing banks can provide both viable money and monetary stability. 
        But Selgin does more than provide a fresh hearing for free banking. By framing monetary questions in the broadest context, he contributes importantly toward the integration of price theory and monetary theory. Drawing on Hayek, Selgin portrays the price system as an efficient means of disseminating information about changing preferences and resource availabilities and as a rational basis for evaluating entrepreneurial decisions (pp. 89-94). Then, with no loss of continuity, he applies these Hayekian insights to the supply of money under conditions of competitive note issue. Guided by changing demands, where the changes may favor money over other assets or currency over checkable deposits, individual banks take actions whose collective effect is a continuous adjustment of the money supply (both quantity and
currency/deposit mix) to money demand. 
        The problems encountered by a central bank attempting to replicate these money-supply adjustments are shown to be fully analogous to those encountered by a central-planning agent attempting to adjust resource usage in response to changing demands for goods and services [p. 103 and passim]. Evaluating money-management policies in the same way that we evaluate resource-management policies enhances our understanding of such problems. Identifying problems faced by, say, an energy czar requires that we understand how the energy market would function in his absence. Similarly, identifying problems faced by the Federal Reserve Chairman requires that we understand free banking. Hence, The Theory of Free Banking has value wholly independent of prospects for banking reform. 
        The macroeconomics that underlies Selgin's analysis of free banking is at odds with conventional views about monetary stability. The conventional judgment, for instance, that monetary stability requires an unchanging price-level is called into question (pp. 97-103). Typically, the goal of price-level constancy is justified by reference to a long monetary tradition or defended with analogies between the dollar as a measure of value and the pound, foot, and bushel as measures of weight, length, and volume. Constancy is held to be the sine qua non of the physical measures�and likewise of the measure of value. 
        Selgin rejects the analogy and argues instead in terms of money as a medium of exchange which facilitates the coordination of economic activity. Building on the ideas of Haberler, Hayek, Machlup and others, Selgin defines a monetary equilibrium in which money-supply adjustments keep constant the product of the money supply and its velocity of circulation. Any increase in the demand for money requires an equivalent increase in supply. But with MV�and hence PQ�held constant, growth in real output is to be accommodated not by monetary growth but by downward price adjustments. Monetary equilibrium so-conceived is defended as being the most conducive to economic coordination (despite the changing value of money) and is argued to be the outcome of free banking. 
        There are some perplexities in Selgin's book. His account of the evolution of free banking in the imaginary society of Ruritania, for example, involves a ghost-of-gold that may be more haunting than Selgin realizes. Following Menger, Selgin accounts for the transformation of gold from its purely non-monetary to its dominantly monetary character. But then, with the maturing of the free-banking system, the demand for monetary gold fades away leaving the value of money to be governed by gold's non-monetary uses [p. 31]. It is not clear, however, that characteristics associated with a more conventionally conceived gold standard can be associated with the gold standard in Ruritania. 
        Selgin avoids dealing with this issue in later chapters by shifting the analysis from a gold-based to a fiat-based free-banking system. Questions about the role of gold in a free-banking system, however, do not detract significantly from the central message of Selgin's book. Instead, these and many other points to ponder suggest that the economics of free banking has a growing research agenda.

1. Hayek, Friedrich A. Choice in Currency: A Way to Stop Inflation. London: Institute for Economic Affairs, 1976. 

2. __________. Denationalization of Money, Second (Extended) Edition. London: Institute for Economic Affairs, 1978 [first ed., 1976]. 

3. White, Lawrence H. Free Banking in Britain: Theory, Experience, and Debate, 1800-1845. New York: Cambridge University Press, 1984.