Alex Moseley teaches economics at the University of Evansville’s British campus at Harlaxton Manor.
An advertisement in an English newspaper offers a one-million-dollar bill for sale—at the remarkably reduced price of £29.95 (about $50.00). However, this great deal comes with the words “Not Legal Tender.” Thereby the advertisement unwittingly presents the essential problem of national currencies in a nutshell. Two magic words are all it would take for the note to become spending money. Surely, monetary policy cannot be that simple? In an age of government-issued currencies, unfortunately it is.
Government control of national currencies has not been stable or beneficial to say the least. In the last year, currency crises hit the news frequently. The resulting lack of confidence in a nation’s currency means that international investments will seek more profitable ventures where the fear of devaluation is not so acute. Devaluation follows from governments’ inflating their currencies through central banks and fractional reserve banking; as money is “created,” exchange rates are affected and investors have to reconsider their projects.
Traders have long learned to avoid a great part of exchange rate risk by employing currency futures and options. Even so, an unanticipated currency movement can have a deleterious effect on a company’s profit forecasts and its investments and employment. The ensuing effects on national economies can be disastrous; yet the cause is not difficult to define. It lies with the uncritical acceptance of legal tender rules. By maintaining those rules, national governments permit their central banks to issue base money—effectively paper, although soon it could be electronic cash—at their discretion. Any central bank has the legal power to print a run of million-dollar bills, define them as legal tender, and create new money out of thin air.
The repercussions of legal tender laws are quite visible: by printing paper the central bank inflates the currency. Some of that currency will seep into loan markets, affecting interest rates; some will affect particular price ratios in markets, causing economic dislocations; some will enter the foreign currency markets, reducing the price of the national currency in terms of other currencies. Overall, local prices will rise and the exchange rate will fall. The effects are complicated by the actual paths that the new money takes, but the overall qualitative result can be ascertained—resource allocation is distorted and irrevocable damage done. It does not matter if the central bank’s inflation was anticipated beforehand—something that modern macro theory attempts to argue—for no one is in a position to pursue the transactions of every single new note printed. Therefore, no one is in a position to establish the overall quantitative effects until afterwards, at which point the damage has been done.
The inflationary policy can only be effective if governments decree that the notes be deemed legal tender. Legal tender imposes on traders the requirement to accept the note at its face value. Therein lies the rub. If the government had to pay off a million-dollar debt but could not stomach a rise in taxation, its central bank could print the necessary legal tender bill, and the newly printed note could discharge the government’s debt. Such an action costs the government nothing but the paper and ink the note is printed on, and traders cannot discount the bill except through increasing their prices.
Legal tender thus provides national governments with a covert method of raising funds without raising taxes. But once the money seeps into the foreign currency markets to pay for increased imports or to pay off debts, the currency must depreciate, for in the international arena traders mark down the value of the currency against others.
It would be otherwise for national traders if legal tender laws were abolished. Under a free tender scenario, traders would use those currencies in national and international trade that prove to be useful to them—that is, those that keep their value. Which currency traders would choose is not something that can be determined by legislation or a priori; the choice is fully in the hands of the millions of traders in millions of markets.
If legal tender laws were abolished, traders would discount government notes in local as well as international markets, which would remove from government the possibility of earning revenue from inflation (that is, paying off debts with legal-tender devalued currency). The resulting effect is the reverse of Gresham’s Law, in which bad money drives out the good. Gresham’s Law prevails when legal tender rules apply; however, if traders were free to choose between currencies, the good money would drive out the bad, a point noted by F. A. Hayek. Ample evidence of the Hayek-Gresham Law can be found in economic history from early American currency history to pre-Revolutionary Russia and to the more recent hyperinflations in which street traders clamor for alternative currencies such as the dollar and deutschmark.
Money Can’t Be Invented
Legal tender laws effectively have nationalized currencies, making them the prerogative of the state. Economics teaches that money cannot be invented or created by decree, that it is very much the result of traders’ decisions across many markets and over much time. It is time to return currency to the market.
With free choice in currency, traders would converge on the money that best suited their needs. In the last two decades economists have conjectured what forms such money could take, from electronic cash to redeemable currencies, some redeemable against a basket of goods or even a basket of futures, or against gold and silver. What is certain is that the choice is and should be the market’s. No one can predict the media that present businesses would find most useful—most probably they will converge onto one medium or onto a few universally accepted media, but the definite result would be an end to the credit creation and inflationism of central banks and national governments. Central banks would most certainly lose their powers, but currencies would lose their chains.