Why Private Banks and Not Central Banks Should Issue Currency, Especially in Less Developed Countries

George Selgin and La rence !" White

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In all but a few areas of the world today (Northern Ireland, Scotland, and for the time being Hong Kong), currency is a nationalized industry. Treasury de artments issue coins! the state"owned enter rises #nown as central ban#s issue a er notes. It was not always so. $ri%ate ban#s were the main issuers of a er currency in the &nited States and 'anada a century ago, and were the sole issuers in %irtually e%ery country two centuries ago. Nationalization of currency is largely ta#en for granted today, but it shouldn(t be. )dam Smith raised ri%ate currency for the benefits it had brought to his nati%e Scotland. *ost economists would agree that a legally enforced go%ernment mono oly is generally an inefficient way to roduce ri%ate goods and ser%ices. The ost office is a rime e+am le! other e+am les range from state"owned lantations to national railroads. 'urrency is no e+ce tion to the rule. )s with other nationalized roducts, ,uality is lower than it would be under ri%ate com etition. The inefficiencies associated with go%ernment mono oly in currency are es ecially large in de%elo ing countries, where the reliability of the e+change rate (an im ortant as ect of currency ,uality) is often ,uite low.

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)n im ortant ,uality dimension of a currency is the reliability of the redem tion ledge-namely, the issuer(s romise to e+change it for another money on demand at a s ecified rate. In de%elo ing countries, domestic currency ty ically deri%es its %alue from its redeemability at a fi+ed rate for &.S. dollars. To the e+tent that the central ban# actually res ects this agreement, a fi+ed e+change rate constrains monetary e+ ansion and thus hel s a%oid the high inflation to which unanchored regimes in the de%elo ing world ha%e often succumbed. The dramatic

de%aluations in Southeast )sia in .//0 illustrate how unreliable are the redem tion ledges made by central ban#s in de%elo ing countries. $ri%ate commercial ban#s are more reliable. $ri%atizing currency means lea%ing it to commercial ban#s to issue media of e+change that are claims to the reser%e asset that defines the monetary standard, and ma#es the enforcement of these claims a matter of commercial law rather than of ublic olicy. It corres ondingly decentralizes the res onsibility for holding ade,uate reser%es. 1utside of 2crony ca italism2 (where nominally ri%ate ban#s recei%e s ecial dis ensation to renege on contracts), ri%ate currency issuers face incenti%es for ,uality control that do not face go%ernment mono oly issuers. The chief wea#ness of central ban#s as currency issuers is their inability to bind themsel%es to their redem tion romises. Their ublic mono oly status gi%es them immunity from the legal and mar#et lace sanctions that ordinarily re%ent commercial ban#s from reneging on their commitments to honor their debts in full. ) central ban# en3oys 2so%ereign immunity2 from claimholder lawsuits, and legal restrictions on the ublic(s choice in currency mean that the central ban# has little fear of losing customers for bad beha%ior. )t the same time, central ban#ers-es ecially in de%elo ing countries-face olitical ressure to ro%ide the short"run benefits that sur rise monetary e+ ansion can deli%er (namely e+tra re%enue to ay the go%ernment(s bills, e+tra stimulus to the economy, or e+tra li,uidity for the ban#ing system). . 4hen de%aluation is relati%ely costless, central ban#s are tem ted to engage in e+ ansionary monetary olicies that ultimately force de%aluation. $ri%ate commercial ban#ers, by contrast, can be sued by holders of their claims when they fail to redeem those claims at ar. 5%en if a ri%ate ban# could de%alue its liabilities (re ay less than .66 cents on the dollar) with legal im unity, such a de%aluation would deal a se%ere blow to its re utation, and in a com etiti%e en%ironment its clientele would go elsewhere. Shareholders would suffer losses. The shareholders( incenti%e to a%oid de%aluation or default com els them to limit the %olume of the ban#(s liabilities, and ma#es the ban#(s redem tion commitments credible. ) larger enalty for de%aluing means that a ri%ate ban# will choose to run a lower de%aluation ris# than will a central ban#. 'entral"ban# de%aluations are conse,uently more fre,uent than autonomous commercial ban#ing defaults (i.e., defaults not

associated with central ban# de%aluation or attac#s on the central ban# eg). 4hat would a ri%ate currency system loo# li#e7 )s in Scotland and Northern Ireland today, domestic ban#s would issue circulating notes denominated in and directly redeemable for foreign"currency assets (there, 8an# of 5ngland notes).9 5ach note would clearly carry the name of the issuing ban# whose liability it is. )ny ban# that tried to issue too many notes would find them being de osited into other ban#s, and returning %ia the clearing system for redem tion in reser%e money. In many de%elo ing countries, where we already obser%e unofficial dollarization of transactions in both financial mar#ets and commodity mar#ets, the &.S. dollar is the mar#et(s li#ely choice for the reser%e currency. There the ublic demonstrably refers the dollar to the money roduced domestically. The domestic central ban# currency, ha%ing failed the mar#et test, sur%i%es at all only because of legal restrictions that com el domestic transactors to acce t and use its currency for some ur oses. :emo%e those restrictions, and the leading domestic and foreign commercial ban#s would ro%ide dollar"denominated currency 3ust as they now ro%ide tra%eler(s chec#s. ) common ob3ection to dollarization is that it transfers seigniorage (the rofit from currency issue) to the &.S. go%ernment. That is true only if ;ederal :eser%e notes are used as currency, as they are in $anama today. It is not true if commercial ban#s are allowed to issue currency notes. &nder com etiti%e note"issue, seigniorage is transferred to the &nited States only to the e+tent ( resumably %ery small, unless the domestic go%ernment im oses a high re,uired reser%e ratio) that the ban#s hold reser%es of ;ederal :eser%e notes. The bul# of otential seigniorage is #e t at home, where com etition among the ban#s distributes it to currency holders in the form of un riced ban#ing ser%ices. ;or e+am le, as in Northern Ireland, com eting ban#s of issue could see# customers by wai%ing fees for withdrawing notes from their widely distributed automatic teller machines. < If domestic citizens want high",uality redeemable currency, they are better ser%ed by ri%atization of note"issue than by a central ban# dollar eg. 4here does this rescri tion a ly7 There is little o ortunity to ri%atize currency in a country wedded to state"owned ban#ing. =ess of a gain in ,uality is to be e+ ected where the olitical authorities ha%e hea%ily restricted entry into ban#ing and ha%e se%erely corru ted the

legal system. 1ur rescri tion therefore a lies most immediately in the set of countries that ha%e had oor monetary olicy and re eated de%aluation, but that also ha%e (or could ha%e) com etiti%e commercial ban#ing under a regime of effecti%e contract enforcement and the rule of law. 'asual em iricism suggests that this is not an em ty set. Such countries are found in central and eastern 5uro e, =atin )merica, )frica, and )sia. In some countries the most im ortant reason for unreliable money has been that the fiscal authorities rely hea%ily on the seigniorage re%enue from rinting money. In se%eral de%elo ing countries, seigniorage has funded .> to 96 ercent of state s ending. In such a country dollarization and ri%atization of note"issue would necessitate fiscal reforms that either ro%ide re lacement re%enues or cut state s ending. The olitical economy of how to secure such reforms is beyond the sco e of our discussion here. Howe%er, if re lacement re%enues must be found, one otential source is a ta+ on ri%ate note"issue. Such a ta+ would inefficiently su ress non" rice com etition in currency issue, but it would not undo the greater credibility of ri%ate currency, and it would still be better than nationalization.

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)n im ortance source of o osition to the idea of ha%ing commercial ban#s su ly a er currency is the belief, based on a %ery artial reading of history, that such currency tends to circulate at less than its face %alue and thus im oses substantial e+change costs. The history of ri%ate currencies in Scotland, Sweden, 'anada, and many other nations shows otherwise. )s a rule, ban#"issued currencies circulated at ar (face %alue). &.S. e+ erience rior to the 'i%il 4ar, when the &.S. currency stoc# consisted mainly of notes issued by some .>66 state"chartered ban#s, is the ma3or e+ce tion to the rule. Instead of commanding their full face %alue, many state ban# notes traded at discounts. The discounts reflected non"tri%ial costs of redeeming the notes for gold or sil%er, and in some cases a ris# of non"redem tion. 8efore modern economic historians (Hugh :oc#off and others) began re"e+amining the eriod,? ty ical accounts blamed the lac# of ar acce tance on 2laissez"faire2 ban#ing olicies, which su osedly

fostered fraudulent 2wildcat2 ban#ing. In addition, as if fraud by the ban#ers themsel%es wasn(t bad enough, counterfeiters are #nown to ha%e routinely imitated their notes, ma#ing it necessary for merchants and consumers to consult 2ban#note re orter2 eriodicals for lists of s urious notes. The older accounts cited such roblems as the e+ lanation for why federal authorities finally rohibited state ban#s from issuing notes after )ugust .@AA. &nfortunately, such myths ersist. In fact, state ban# notes weren(t nearly as bad as the older accounts ma#e out, and their su ression by the ;ederal go%ernment wasn(t really moti%ated by ,uality concerns. 8y the outbrea# of the 'i%il 4ar, sound state ban# currencies were the norm. 1n the whole, the failure rate among antebellum ban#s was not much worse than the rate during other eriods of &.S. ban#ing history. ) few state ban#ing systems did roduce notoriously ris#y currencies, es ecially during the .@>6s, but laissez"faire olicies weren(t to blame (because they didn(t e+ist), and fraud was rare. The ma3or cause of ban# failures was an inter%entionist regulatory regime (ironically called 2free ban#ing2) that com elled ban#s to bac# their notes with high"ris# state bonds. 5arly on, it is true, e%en the notes of the better state ban#s sometimes circulated at a discount once they had tra%eled far from home. The discounts on these notes were ne%er %ery large, and they fell o%er time with im ro%ements in trans ortation and communications, articularly with the s read of railroads and telegra h lines. 8y late .@A<, the entire stoc# of northern ban#notes, if urchased and traded for legal tender in the New Bor# or 'hicago mar#et, would ha%e fetched o%er // ercent of its face %alue. The reason why there were any discounts at all was not a lac# of go%ernment restrictions on ban#ing, but 3ust the o osite. State laws generally rohibited branch ban#ing, so that most ban#notes could only be redeemed at a single location. The discounts mainly reflected the cost of returning the notes to that location for redem tion. Had antebellum &.S. ban#s been able to branch nationwide, as they were in other countries (and finally are in the &nited States today), their notes could ha%e been easily redeemed at multi le oints across the country, allowing them to circulate nationwide at ar. The non"uniformity of &.S. currency rior to the 'i%il 4ar was a by roduct of go%ernment interference with o en com etition in ban#ing.

4hat about counterfeiting7 It is true that counterfeiters imitated and altered the notes of many state ban#s. 8ut they also imitated and altered later National 8an# notes, and today they are no less inclined (technological ad%ances notwithstanding) to imitate and alter ;ederal :eser%e Notes. The counterfeiting of state ban# notes was generally less rofitable than the counterfeiting of today(s central ban# currencies, because ri%ate ban# notes don(t stay in circulation long. *uch li#e tra%elers chec#s, they ,uic#ly return to issuer. 'ounterfeits are therefore li#ely to be detected by e+ erts while the trail is still warm. ;ederal :eser%e Notes are today fre,uently counterfeited, but currency users don(t (yet) ha%e the o tion of a%oiding them in fa%or of safer ri%ate substitutes. If state ban# notes weren(t really so bad, why were they ta+ed out of e+istence7 To finance the 'i%il 4ar, the 'ongress first em owered the &nion(s Treasury Ce artment to issue o%er D?66 million worth of &.S. Notes or 2greenbac#s.2 'ongress then went on to establish a new system of federally chartered ban#s, which were authorized to issue another D<66 million of National 8an# notes ro%ided they urchased federal bonds as bac#ing. The Treasury realized that all this new currency threatened to cause a substantial increase in rices, but was unwilling to deny itself the fiscal ad%antages that the new currency would ro%ide. Instead of issuing fewer greenbac#s or further limiting the stoc# of National 8an# notes, it made the state ban#s into sca egoats, forcing them to retire all D966 million of their notes, including some of the best currency the nation had e%er #nown.>

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Today(s central ban# currency mono olies ha%e grown not from attem ts to rectify mar#et failures but from go%ernment(s a etite for re%enue. 'ontrary to myth, the &nited States( e+ erience in the nineteenth century does not su ly any grounds for restricting ri%ate ban#s from issuing currency. It instead oints to the harmful conse,uences of go%ernment restrictions on ban#"issued currency. Eust as it is efficient to lea%e the ro%ision of chec#ing accounts to com eting ri%ate ban#s, rather than ha%e a single go%ernment mono oly ro%ider of chec#able ban# liabilities, it would be efficient to (re") ri%atize the issue of circulating currency. 8y com arison to ublic mono oly, ri%atization raises the ,uality of currency. In de%elo ing

countries, ri%ate currency can articularly im ro%e the reliability of the issuer(s ledge to redeem currency for dollars at a fi+ed rate.

$E2E$ENCES
:oc#off, Hugh (.//.). 2=essons from the )merican 5+ erience with ;ree 8an#ing,2 in ;orrest 'a ie and Feoffrey 5. 4ood, eds., &nregulated 8an#ingG 'haos or 1rder7 (=ondonG *acmillan), 0<".6/. :olnic#, )rthur E., and 4arren 5. 4eber (./@A). 2Inherent Instability in 8an#ingG The ;ree 8an#ing 5+ erience,2 'ato Eournal > (4inter), @00" /6. Selgin, Feorge (9666). 2The Su ression of State 8an# NotesG ) :econsideration,2 5conomic In,uiry (forthcoming). 4hite, =awrence H. (./@A). 2:egulatory Sources of Instability in 8an#ingG 'omment on :olnic# and 4eber,2 'ato Eournal > (4inter), @/."/0. 4hite, =awrence H. (.///). The Theory of *onetary Institutions (1+fordG 8lac#well). 4hite, =awrence H., and Conald E. 8oudreau+ (.//@). 2Is Non rice 'om etition in 'urrency Inefficient72, Eournal of *oney, 'redit, and 8an#ing <6 (*ay), 9>9"A6. -- (9666). 2Is Non rice 'om etition in 'urrency Inefficient7G :e ly2, Eournal of *oney, 'redit, and 8an#ing <9 (;ebruary), .>6"><.

2--)N-)ES
.. ;or an e+ lanation of the go%ernment re%enue from monetary e+ ansion, or 2seigniorage2, see 4hite (.///, ch. 0). 9. The ri%ate ban#s that retain the right of note"issue in Scotland and Northern Ireland today face a binding marginal re,uired reser%e ratio of .66H beyond a s ecified 2unco%ered2 issue. This clearly tends to wea#en the com etition for note"holding customers. <. Stoc#ing its )T*s with its own notes is one non rice"com etiti%e de%ice a ban# can use to get the ublic to hold them in reference to the

reser%e currency for which they are redeemable. 1ther ways are to ma#e them hysically more attracti%e and lower in counterfeit ris#. 'om etition on rice (interest return) a ears to be economically ruled out by transactions costsG the otential interest earnings are tri%ial relati%e to the greater con%enience of ha%ing a currency of a fi+ed face %alue. 1n the general efficiency of non rice com etition in currency see 4hite and 8oudreau+ (.//@) and (9666). ?. ;or a sur%ey and e+tension of the 2re"e+amination2 literature see :oc#off (.//.). See also :olnic# and 4eber (./@A) and 4hite (./@A). >. 1n the story behind the su (9666). ression of state ban# notes see Selgin

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