Competition in Currency: The Potential for Private Money, Cato Policy Analysis No. 698

7/31/2019 Competition in Currency: The Potential for Private Money, Cato Policy Analysis No. 698

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Executive Summary

Privately issued money can benefit consum-ers in many ways, particularly in the areas of val-ue stability and product variety. Decentralizedcurrency production can benefit consumers byreducing inflation and increasing economicstability. Unlike a central bank, competing pri-vate banks must attract customers by providinginnovative products, restricting the quantityof notes issued, and limiting the riskiness of

their investing activities. Although the FederalReserve currently has a de facto monopoly onthe provision of currency in the United States,this was not always the case. Throughout mostof U.S. history, private banks issued their ownbanknotes as currency. This practice continuestoday in a few countries and could be reinstitut-ed in the United States with minimal changes tothe banking system.

This paper examines two ways in whichbanks could potentially issue private money.First, U.S. banks could issue private notes re-deemable for U.S. Federal Reserve notes. Con-sidering that banks issuing private notes inHong Kong, Scotland, and Northern Irelandearn hundreds of millions of dollars annually,it appears that U.S. banks may be missing anopportunity to earn billions of dollars in annu-

al profits. Second, recent turmoil in the finan-cial sector has increased demand for a stablealternative currency. Banks may be able to cap-ture significant portions of the domestic andinternational currency markets with a private,commodity-based currency. Legislation clarify-ing the rights of private banks to issue currencycould help clear the path toward a return to pri-vate money.

Competition in CurrencyThe Potential for Private Money

by Thomas L. Hogan

No. 698 May 23, 2012

Thomas L. Hogan is assistant professor of economics at West Texas A&M University.


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The competitiveissue of private

banknotes couldimprove price

stability in theU.S. economy.

Introduction

In the United States and most countriesaround the world, money is produced andmanaged by the governments central bank.

This paper discusses two potential oppor-tunities for creating private money: privatebanknotes and commodity-based currency.For most of U.S. history, competing privatebanks issued paper currency redeemablefor coins of gold and silver. A few countriestoday maintain similar semiprivate sys-tems in which private banks issue their ownbanknotes redeemable for government cur-rency. Allowing such a system in the UnitedStates would benefit all consumers by im-proving price stability and allowing banks to

compete for customers. Alternatively, banksmight issue money whose value is based ona commodity such as gold or silver. In inter-national trade, the U.S. dollar is often usedin transactions because of its relatively stablelong-term value. The dollar is also the domi-nant form of currency used in many less-developed countries, yet economists gener-ally agree that historically the internationalgold standard provided a more stable sys-tem of international trade than the currentsystem of national fiat currencies.1 If a com-

modity-based currency could replace the dol-lar in these foreign markets, it could improveeconomic stability and help facilitate inter-national trade.

The competitive issue of private bank-notes could improve price stability in theU.S. economy.2 Private banks have the in-centives and information necessary to pro-vide the optimal quantity of money to en-courage economic growth. In the past, thecompetitive production of currency helpedthe U.S. economy achieve high levels of

gross domestic product (GDP) growth andlow levels of price inflation. Creating a semi-private monetary system, in which privatebanknotes were redeemable for notes fromthe Federal Reserve, would reduce the gov-ernments involvement in monetary policy.The Federal Reserve would have less influ-ence on the supply of currency but would

maintain substantial power over the overallmoney supply through its standard meansof open-market operations, reserve ratiosand targeting of the federal funds rateAllowing competition in currency would

bring the United States one step closer toobtaining the full advantages of a decen-tralized system.

Private banknotes could easily be intro-duced in the United States. In Hong KongScotland, and Northern Ireland, privatebanks issue banknotes redeemable for thenational currency. Despite the availability ofcentral banknotes in these locales, consum-ers transact almost exclusively in privatecurrency.3 Private banks consequently earnhundreds of millions of dollars annually in

the private currency market. For each unit ofprivate currency withdrawn by a customer,the bank retains one unit of governmentcurrency, which can be invested or loanedout to other customers. The bank earns rev-enue on these investments and loans for aslong as its private notes remain in circula-tion. If U.S. banks were able to capture evena small percentage of the domestic marketfor banknotes, they likely could earn billionsof dollars in annual profits.

The idea that American consumers might

enjoy using private banknotes is far from im-plausible. Imagine if dollar bills carried pic-tures of local sports teams, or if Wells Fargoproduced its own dollar bills embossed withimages of stage coaches and the Old WestPerhaps customers would debate the relativemerits of the LeBron James banknote versusthe Michael Jordan, or admire a special notecommemorating Independence Day or ded-icated to American veterans. Consumers inHong Kong, Scotland, and Northern Irelandalready enjoy these experiences, with private

notes depicting heroes, sports figures, andfamous historical events. Once banks estab-lish reciprocal exchange agreements, privatebanknotes in the United States would tradeat equal value with Federal Reserve notes asthey passed from person to person through-out the economy. Banks might even pay cus-tomers to use their notes. For example, an


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The lack ofparticipantsin the privatebanknote markeappears to be duto the uncertainlegal status ofprivate note issuand the rigorous

prosecution ofcurrency-relatedcrimes.

ATM might give customers a cash bonus forwithdrawing B. of A. Bucks issued by Bankof America rather than regular U.S. dollars,or Citibank might pay interest on its privatenotes akin to earning points on a credit card.

Private note issue appears to be legal inthe United States today. The regulations pro-hibiting the issuance of private notes were re-pealed almost two decades ago, yet no bankshave chosen to enter this potential market.This may be because there is still some ques-tion as to whether private currency would beaccepted by the Federal Reserve, or whetherits producers would be subject to legal ac-tion. Private issuers might be prosecuted un-der gray areas of the law, or Congress mightchoose to resurrect the prohibitions on pri-

vate notes. A few small-scale local curren-cies have been issued with the Feds blessing.These local currencies provide examples ofhow a new private currency might be intro-duced, but since none compete directly withFederal Reserve notes, they provide littleclarification of the legal status of a large-scale private currency, and do little to informa prediction of the Feds reaction thereto.

One might ask: if a system of privately is-sued currency is profitable, why is it not al-ready in place? To answer this question, we

estimate the potential profit from the issueof private banknotes in the United States,and find that capturing even a small per-centage of this market could lead to billionsof dollars in annual profit. We then consideralternative explanations for the lack of pri-vate notes. Banks might be deterred fromentering the market for private banknotes ifthey fear a shrinking demand for paper cur-rency or a lack of demand for private noteson the part of skeptical American consum-ers. The most plausible explanation for the

lack of participants in this would-be-profit-able market, however, appears to be the un-certain legal status of private note issue, andthe rigorous federal prosecution of currency-related crimes.

Another way that banks could enter themarket for private money would be to cre-ate a new currency whose value is based on

a commodity or basket of commodities. Acommodity-based currency would likely bemost valuable for international transactions.International traders rely on the stabilityof exchange rates among nations, which in

turn rely on a vast array of variables that areaffected by each countrys economic perfor-mance. To avoid the risk of currency volatili-ty, a large percentage of trade is conducted incurrencies with stable values, such as the U.S.dollar and the Swiss franc. A new currencybased on a commodity such as gold, whosevalue is well established, might reduce cur-rency risk in international transactions andcapture some portion of this large potentialmarket. The value of such a currency wouldrely not on the economies of the countries

but on the value of gold itself, which has re-mained remarkably stable over time.

Poor performance by the Federal Reservehas motivated some policymakers to call fora return to a gold standard. Such a transi-tion would be difficult domestically sinceit would alter the entire U.S. money supply.An easier option might be to simply end theFederal Reserves monopoly on paper cur-rency by opening the market to competition.If a currency redeemable for gold were intro-duced as an alternative to the U.S. dollar, it

might become popular domestically and/orabroad. A commodity-based currency wouldhave a slower adoption rate than one basedon U.S. dollars (since the domestic marketis currently based on dollars), but the long-term advantage of value stability couldprovide greater macroeconomic benefits interms of lower inflation and increased eco-nomic stability.

There are substantial benefits to allowingcompetition in currency. In the next section,we outline the benefits of private note issue

and the costs of government note issue. Wethen discuss the history of private note is-sue in the United States; current practicesin Hong Kong, Scotland, Northern Ireland;and the use of local currencies. Finally, weevaluate the potential profitability of privatebanknotes and commodity-based currencyas well as the barriers to their introduction.


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Privatizingthe supply of

banknoteswould have both

individual andsystemic benefits.

Benefits and Costs

Benefits of Private Note IssuePrivatizing the supply of banknotes

would have both individual and systemic

benefits. Unlike a monopoly currency pro-vider, a system of competing banks mustmatch the quantity of banknotes issued tothe quantity demanded by the public, andeach bank faces incentives not to issue toomany or too few notes. Such systems havehistorically led to lower inflation and morestable economic conditions than centralbanking. These benefits would be only par-tially captured in a semiprivate system, whereprivate banknotes were redeemable for cen-tral bank currency. Any potential harm from

the Feds monetary policy, however, wouldat least be diminished. In addition, private-note-issuing banks might attempt to satisfytheir customers by competing on other mar-gins such as security and aesthetics. Theseindividual benefits would complement thesystemic improvements in price stability.

Private banks create money though frac-tional reserve lending. Banks that issue theirown banknotes have an incentive to expandtheir note issue and reduce their reserves inorder to improve profit margins. For per-

haps less obvious reasons, however, banksalso have incentives to increase reserves andrestrict their note issues. Each bank musthold some capital on reserve to pay out todepositors, or in the case of a note-issuingbank, to the redeemers of banknotes. If abank holds too few reserves, it runs the riskof defaulting on these obligations. To mostprofitably manage reserves and note issue, abank regularly assesses its optimal levels ofreserves based on the variability in redemp-tions of notes and deposits.

In a system of decentralized note issue,competing banks each issue banknotes inthe quantities they perceive as demandedby their customers. The law of large num-bers indicates that the money supply will bemore accurately set through decentralizedprovision than by a single monetary author-ity. Allowing multiple issuers of banknotes

means that, on average, the market demandfor banknotes will match the supply. TheFederal Reserve, on the other hand, has nosuch luxury. Having a monopoly supplierof banknotes means the country must rely

on a single set of experts to determine theproper supply of notes. Any underprovisionor overprovision of notes will adversely af-fect the price level and, therefore, the entireeconomy.

In setting its reserve ratio, each privatebank faces a tradeoff between its expectedreturn and its risk of default. Like any firm,a bank must finance its operations througha combination of debt and equity. Increas-ing the ratio of debt to equity amplifies thereturn to equity, making the firm more prof-

itablebut also more risky. A bank can earnmore revenue by loaning out a greater por-tion of its funds, but it must keep enoughmoney on reserve to satisfy any redemptionsdemanded by its depositors. For examplesuppose the bank offers to pay 4 percent ondeposits, can earn 12 percent on its loans,and customers have deposited $100 in thebank. If the bank uses a 10 percent reserveratio, then $10 of its funds will be kept onreserve while the other $90 is lent out tocustomers at an interest rate of 12 percent

If no customers redeem their deposits, thenthe bank earns $10.80 from its loans andmust pay $4 on its deposits, resulting in anet gain of $6.80. Had the bank kept lessmoney on reserve and made more loans, itsprofits would have been even higher. Be-cause customers can redeem their depositsat any time, however, the bank faces the riskthat many customers will choose to redeemwithin a short time period, and the bank willbe drained of its reserves. Since the bank hasonly $10 on reserve, its managers must hope

that less than $10 will be withdrawn. If morethan $10 is withdrawn, the bank will be un-able to pay its obligations and will go intodefault, or possibly even bankruptcy.4 If thebank were to hold less than $10 in reserves,then its risk of default would be even greaterThus, bank managers must choose a level ofreserves that balances the marginal benefit


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The Fed hasneither theincentive northe information

to optimize thesize of the monesupply.

of higher revenues against the marginal costof risk of default.

Any bank that issues private notes facesan additional financing decision, since itsliabilities are drawn from a combination

of both deposits and banknotes. Managersmust weigh the marginal benefits and costsof additional banknotes versus additional de-posits. Hence, managers choose a target levelof reserves for their notes and deposits andmust replenish their reserves whenever notesor deposits are redeemed. To maintain theirchosen reserve ratio, any note-issuing bankmust be careful not to issue more notes thandemanded by the market. This is particularlyimportant because note redemptions dispro-portionately decrease the holdings of reserves

relative to notes outstanding. For example,suppose that Greene Bank issues banknotesredeemable for gold, and its managers havedetermined that the optimal reserve ratio is1 over 10. This means that if the bank holds$10 worth of gold on reserve, it will issue$100 in banknotes. Now suppose a customerredeems $5 worth of banknotes for gold. Thebank now has $95 in notes outstanding, butonly $5 worth of gold on reserve. This indi-cates a reserve ratio of 1 over 19, which is farbelow the optimal rate set by the banks man-

agers. Thus, note redemptions have a muchlarger effect on the banks reserves than on itsnotes outstanding. In order to return to itsideal reserve ratio, the bank must either buy$5 worth of gold or recall $45 of its outstand-ing notes. This effect is what economists callthe law of adverse clearings.5

Adverse clearings discourage any individ-ual bank from issuing too many notes relativeto other banks in the economy. A bank mayseek to increase its profitability by reducingits reserve ratio and issuing more banknotes.

As the above example shows, however, clear-ings are adverse since, percentagewise, theyaffect the banks reserves much more thanthey affect its notes outstanding. When thebank issues more banknotes without in-creasing its reserves, the banks notes willincrease as a portion of the money supply,so more notes will be returned to the bank

and redeemed for gold. The bank will soonbe drained of its gold reserves and will beunable to support the amount of banknotesit has issued. As described above, the bankwill be forced either to acquire more gold re-

serves or to recall some of its notes outstand-ing. In this way, adverse clearings prevent theoverissue of banknotes. They also act as anindicator of the banks level of risk. Adverseclearings provide constant feedback to bankmanagers regarding their optimal quantityof notes outstanding.

There is much historical evidence thatadverse clearings prevent banks from over-extending their note issues. Lawrence H.Whites Free Banking in Britain details theemergence of a system of private banknotes

in Scotland, where multiple private bankseach issued their own notes. White explainshow the banks developed a clearinghousefor banknotes which prevented banks fromover-issuing notes. Through the law of ad-verse clearings, each bank acted as a checkon the others.6 The Suffolk Banking Systemused a similar note-clearing mechanism inNew England during the early 19th centu-ry.7 It is an oft-cited example of a stable freebanking system. Other regional clearing-houses developed after the Civil War.8 Per-

haps in response to adverse clearings, earlyAmerican banks tended to underissue ratherthan overissue banknotes. There is a lengthydiscussion in the economic literature onwhy early U.S. banks issued fewer notes thaneconomists would have predicted.9 Bankingin the 19th century was once thought to bechaotic and economically unstable. Recentevidence has shown, however, that the econ-omy was in fact equally, if not more, stablebefore the establishment of a central bank.Later sections will discuss this period of U.S.

history in more detail, along with the currentsystems of private-note issue in Hong Kong,Scotland, and Northern Ireland.

When many individual banks issue cur-rency, each has some indication of the per-centage its notes compose of the total cur-rency supply, and whether the demand forcurrency is growing or shrinking. In con-


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Even withthe collective

knowledge of theworlds foremost

monetary experts,the Fed has

a systematicdisadvantage

relative to a

system of manydecentralized

issuers.

trast, the Fed has neither the incentive northe information to optimize the size of themoney supply. Without adverse clearings,the Fed has no simple means of assessingthe optimality of its level of note issue and

faces no market discipline on the question.Although the Fed does monitor some mea-sures of currency turnover, its homogeneousbills are generally re-issued by banks withoutbeing individually tracked, and the Fed hasno incentive to initiate such a note-trackingscheme. As discussed in the next section, theFed faces different incentives than a privatebank and sometimes prioritizes other ac-tivities above the proper management of themoney supply.

In addition, the law of large numbers fa-

vors a system of many note issuers over theFeds monopoly. When many banks eachattempt to issue the right quantity ofbanknotes, some will create too many andsome too few, but they will tend to get itright on average. The Fed, in contrast, man-ages only one money supply and must do itsbest to match supply to demand. Any under-or overprovision of notes will adversely affectthe price level, and therefore, the entire econ-omy. Even with the collective knowledge ofthe worlds foremost monetary experts, the

Fed has a systematic disadvantage relative toa system of many decentralized issuers.

Private notes tend to have more stable val-ues than those produced by a central bank,even in a semiprivate system where the pri-vate banknotes are only redeemable for acentral banks notes. This is because privatebanks must respond to demand; they can-not inject more notes into the money supplythan customers are willing to accept. Whenthe central bank increases the money supply,private banks cannot increase their note is-

sue proportionately unless there is custom-er demand for these additional notes. If nosuch demand exists, private notes will losepart of their value since the money supplyas a whole has been devalued by the centralbanks excessive issue, but the resulting infla-tion is tempered at least in part by the privatebanks inability to add still more superfluous

notes to the currency supply.10 Similarly, ifthe central bank were to provide less mon-ey than demanded in the economy, privatebanks could issue more notes to compen-sate, thereby preventing deflation and fur-

thering stability.There are two main components of themoney supply: cash and deposits. The Fedcan affect the supply of money in the econ-omy by influencing either of these. Althoughthe Fed does decide how many dollars toprint, it is more likely to affect deposit hold-ings by influencing the market interest rateThe amount of money that an individualchooses to deposit in a bank and the amounthe chooses to take out in loans depends onthe interest rate he can earn on his deposits

or must pay on his loans. A lower interest ratemeans that fewer people will deposit theirmoney in the bank, and more individuals andbusinesses will take out loans. These effectscause more money to circulate in the econo-my and, therefore, more economic activity. Incontrast, a higher interest rate will cause in-dividuals to deposit more money into banksand fewer people to take out loans, thus re-ducing the amount of money in the economyand slowing economic activity.

The degree to which the Feds actions af-

fect the money supply is determined by themoney multiplier, a formula which cal-culates how much the total money supplywill be affected by a change in cash or bankreserves. The size of the multiplier dependsmostly on the reserve ratio chosen by privatebanks and on the amount of cash held byconsumers relative to deposits. The influenc-es of cash and reserves counteract one anoth-er. As the quantity of currency in the econo-my increases above the quantity demandedby consumers, banks tend to increase their

reserves, so each new influx of cash has lessof an effect on the money supply. Alterna-tively, a lack of cash in the economy causesbanks to reduce their reserves, so changes incash affect the money supply more. Thesefeedback effects help align the quantity ofmoney supplied by banks with the quantitydemanded by consumers.11


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Allowing avariety of firmsto producebanknotes woulnot necessarilyguarantee better

banknotes, butit would givecustomers morevariety in themoney they useand accept.

In a free banking system, the reserve ra-tio is optimized by bank managers as previ-ously described. Under the current system,however, banks are less sensitive to the riskof default since they do not face adverse

clearings. Bank reserve ratios are predomi-nantly determined by the minimum levelof reserves set by the FDIC. In a semiprivatesystem, the central banks monetary policywould be dampened by the feedback effectsof the money multiplier and adverse clear-ings on the quantities of currency created byprivate note issuers.

Private banks must limit the riskiness oftheir investing activities because they are ac-countable to owners and creditors. Severalempirical studies have shown that, as with

all firms, the price of a banks equity anddebt reflect perceptions of the banks riski-ness.12 Not every bank refrains from takingexcessive risk, but those that do are subjectto the discipline of the market. Unfortunate-ly, government intervention often createsdistortions in market incentives, causingbank managers to increase their risk-takingactivities. This is markedly true in the caseof banks for several reasons. First, FDIC de-posit insurance creates a problem of moralhazard. Banks increase the riskiness of their

investing activities since any losses to de-positors will be paid for by the government.Second, the governments recent too big tofail policy encourages risky investing, sincebank managers have reason to believe theywill be bailed out in times of crisis. Third,the Feds policy of maintaining artificiallylow interest rates increases the profitabilityof lending. Throughout the first decade ofthe 21st century, these policies encouragedirresponsible mortgage lending and greatlycontributed to the recent financial crisis. It

is likely that risky investing by private bankswould have been curtailed in the absence ofthese policies.

While most consumers care only aboutthe value of their money in exchange, somecustomers might prefer private notes for aes-thetic reasons, such as the colors or picturesthey carry. In Hong Kong, Scotland, and

Northern Ireland, customers have the optionof using notes issued by the central bank,but they overwhelmingly prefer those issuedby private banks.13 Since these banks mustcompete for customers, private notes feature

a variety of pictures and designs. Notes tendto be decorated in national themes, but notthose of politicians or government. HongKong notes have animals such as lions, hors-es, turtles, and dragons. Notes from North-ern Ireland and Scotland often portray no-table sportsmen or historical figures, such asfamous Scots Robert the Bruce, Lord Kelvin,and Alexander Graham Bell. Irish notes havefeatured inventor Harry Ferguson and Irishfootballer George Best. Notes in all coun-tries also show famous buildings, castles,

and landscapes, or commemorate histori-cal events, such as the launching of the U.S.Space Shuttle and the defeat of the SpanishArmada, which are portrayed on banknotesin Northern Ireland. Private notes come in avariety of colors and sizes to improve aesthet-ics, security features, and ease of use.

When customers can choose betweenmultiple banks, competition encourages in-novation. Competition does not, however,guarantee that private notes will necessarilybe more colorful or have better security than

government banknotes. Unlike the govern-ment, private banks attempt to balance themarginal benefits of additional featuresagainst the marginal increases in the costof production. Central banks, on the otherhand, are less responsive to customer prefer-ence since their spending levels are based ongovernment budgets, and they often operateas monopolies rather than facing competi-tion. Allowing a variety of firms to producebanknotes would not necessarily guaranteebetter banknotes, but it would give custom-

ers more variety in the money they use andaccept, and customers with different tasteswould be more likely to get the types of mon-ey they like best.

Costs of Public Note IssueIn contrast to private banks, central

banks do not face the competitive pressures


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Central banksare often more

focused oninfluencing

economic activitythan protecting

the value of theirbanknotes.

of the market. Having no customers to sat-isfy, they have no reason to offer better prod-ucts or protect the value of their banknotes.Having no equity holders to satisfy, theyneed not worry about the riskiness of their

note issue or investing activities. In fact, itis considered an advantage for the centralbanker to be independent and not be-holden to any individual or political party.14Without profit-maximizing incentives suchas adverse clearings to help manage reserves,central banks lack an explicit mechanism fordetermining the optimum quantity of mon-ey and can only make adjustments with whatMilton Friedman called long and variablelags.15 Some have likened the Feds adjust-ment process, dictated by past performance

rather than forward-looking indicators, todriving a car by looking in the rear-view mir-ror.16 Central banks are often more focusedon influencing economic activity than pro-tecting the value of their banknotes.

Central banks regularly devalue theirown currency by inflating the money supply.Inflation is defined as an increase in the av-erage level of prices in the economy. This oc-curs when the supply of money in the econ-omy grows faster than the supply of goods.As more money enters the economy, the

proportion of money to goods increases, sothe prices of goods tend to rise. An increasein prices is equivalent to a fall in the valueof a dollar, since it takes more dollars thanit did before to buy any particular good. Inthis way, an increase in the supply of moneyin the economy causes the value of the cur-rency to fall. Inflation is often consideredto be a hidden tax that benefits the govern-ment at the expense of money holders.17Deadweight economic losses are created asindividuals change their behavior to avoid

the effects of inflation.18 Inflation also hasa distributional effect of benefitting debtorsat the expense of creditors.19 Even moderateamounts of inflation can severely damagethe economy by distorting relative prices,redirecting resources away from their opti-mal uses, and causing businesses to makeunprofitable investments.20

In the United States, the Federal Reservemost often influences the money supplythrough its open-market operations. TheFed buys U.S. Treasury bonds, which raisesthe market price and lowers the market inter-

est rate.

21

U.S. Treasuries are considered theone and only risk-free security, since it is con-sidered unlikely that the U.S. governmentwill ever default on its obligations.22 Becauseof its size and liquidity, the Treasury marketis considered the foundation of the entirefinancial markets sector. Consequently a re-duction in the yield on Treasuries is passedon to other financial markets. These lowerrates reduce the rate at which banks are will-ing to lend, which in turn makes it moreprofitable for firms to borrow, creating an

increase in economic activity. For consum-ers, lower interest rates mean lower earningson any money they might save, so they areless likely to save and more likely to spendwhich also increases economic activity.

When the Fed increases the money sup-ply, the corresponding increase in economicactivity is due, at least in part, to confusionon the part of consumers. This is true fortwo reasons. First, businesses and consum-ers are not fully aware of the Feds monetarypolicy. When interest rates fall, managers do

not consider that the change was caused bythe Federal Reserve. All they know is thatthe low interest rate makes potential invest-ment projects more profitable. Similarly, aconsumer who is deciding how much of hiswages to put into his savings account onlyconsiders the return on his account andnot the Feds role in influencing the inter-est rate. Second, even if these parties werecompletely aware of the Feds activities, theywould be unable to perceive exactly howthey would be affected since prices do not

change uniformly throughout the economyIt would be overly simplistic to assume thatif the money supply increases by 10 percentthen all prices will rise by 10 percent. In real-ity, all prices in the economy will change bydifferent amounts, so no individual or firmcan know exactly how much they will be af-fected by an increase in the money supply.


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Not only doesthe Fed fail toprotect the valueof the dollar,but its monetarypoliciesintentionally

deceive dollarholders in orderto influencespending andeconomicactivity.

When the Fed injects money into theeconomy with the purchase of Treasurybonds, banks and financial institutions whoparticipate in the Treasury markets are thefirst to be affected by the change. These in-stitutions pass the effects on to businesses in

the form of loans, which the businesses thenuse to purchase equipment and raw mate-rials, pay wages and operating expenses, etcetera. The bank may also change the rate itpays on savings accounts, which will causeconsumers to save less and spend more onother goods. With all of these forces influ-encing prices throughout the economy, it isimpossible to know how any one business orindividual will ultimately be affected by theFeds interest rate manipulation. Only later,after the Fed ends its monetary expansion,

do consumers discover how much the valueof the dollar has fallen. This money illu-sion is widely discussed in the economic lit-erature on monetary policy.23 Not only doesthe Fed fail to protect the value of the dol-lar, but its monetary policies intentionallydeceive dollar holders in order to influencespending and economic activity.

Figure 1 shows the declining value of sev-eral major currencies since 1970. Each linerepresents the value of a particular currencyas a percentage of its purchasing power in1970.24 Since that time, the value of the U.S.dollar has fallen by 78.9 percent. The British

pound and the currencies of the EuropeanMonetary Union have fared even worse, fall-ing 94.1 percent and 87.1 percent, respective-ly, during the same period. The Japanese yenand Swiss franc both experienced large ini-tial declines, but they have recently slowedtheir devaluations, falling by only 55.3 per-cent and 66.5 percent. The problem of infla-tion is even more pronounced in less-devel-oped nations since cash payments are morecommon and central banks are more likelyto inflate national currency. As described in

the 2010 paper, Economic Developmentand the Welfare Costs of Inflation, by Ed-gar Ghossoub and Robert Reed, gains fromeliminating inflation would be the most sig-nificant in the developing world.25

One common justification for allowingcentral banks to inflate the money supply isthat they are able to use this tool to smooth

Figure 1Indexed Values of Major Currencies, 19702009

Source: Authors calculations based on World Bank GDP deflators (NY.GDP.DEFL.KD.ZG).


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The Fed hasfailed to achieve

its stated goalsof furnishing

and maintainingthe currency

and improvingeconomicstability.

the business cycle and increase economicstability. Historical evidence, however, showsthat just the opposite is true. A recent paper,Has the Fed Been a Failure? by GeorgeSelgin, William Lastrapes, and Lawrence H.

White, shows that the creation of the Fed-eral Reserve has substantially increased in-flation in the U.S. economy without improv-ing economic stability or preventing bankruns.26 Their study draws together evidencefrom several sources that have made simi-lar points to show that the Fed has failedto achieve its stated goals of furnishing andmaintaining the currency and improvingeconomic stability.27 Another paper by Sel-gin, Central Banks as Sources of Instabil-ity, compares the performance of the U.S.

economy before and after the creation of theFed, as well as to the less-regulated Canadi-an banking system. The study finds that theFed has led to worse, not better, economicperformance.28

Many economists argue that a little in-flation is not such a bad thing. The FederalReserve, for example, tends to have an in-flationary biasof which most economistsapprove. In his 2002 speech, Deflation:Making Sure It Doesnt Happen Here, Fedgovernor and future chairman Ben Bernan-

ke advised that The Fed should try to pre-serve a buffer zone for the inflation rate, thatis, during normal times it should not try topush inflation down all the way to zero.29Central bankers generally prefer to allow asmall amount of inflation rather than riskeven a small possibility of deflationwhichis often regarded as a greater danger to theeconomy.

The inflationary bias exhibited by cen-tral bankers does not exist in a free bankingsystem for several reasons. First, deflation

is not always dangerous. Although it is truethat when deflation is caused by a shortageof money it can push an economy into re-cession, deflation also occurs when real in-creases in productivity make the goods webuy less expensive to produce. For example,the episodes of mild productivity deflationin the 19th-century United States represent-

ed improvements in the economy. By con-trast, the Fed-induced monetary deflationof the 1930s led to (or at least prolonged)the Great Depression. Second, problemswith the money supply are more likely under

a central bank than under a system of com-peting private banks. When a central bankcontrols the entire money supply, it alone isresponsible for any potential harm, so bank-ers err on the side of cautionary inflation de-spite the long-term harm to consumers. Bycontrast, when money is produced by manyprivate banks, each bank attempts to maxi-mize its profits by providing the amount ofcurrency demanded in the market. If onebank produces too much, another mightproduce too little, and there is no tendency

to oversupply or undersupply. Third, al-though a small amount of inflation is notharmful in any single year, it can have graveeffects when compounded over time. Forexample, the Feds target inflation rate of 2percent per year implies that over 50 yearsthe value of the dollar will decrease by 36.4percent. As demonstrated in Figure 1, thehistorical decline in the value of the U.S. dol-lar has actually been much worse.

Central banks are unconcerned with theriskiness of their investing activities. Pri-

vate banks must balance the marginal in-creases in the return on their investmentsagainst the marginal risk of potential de-fault, but central banks face no such trad-eoff. As agents of government, they are notconstrained by the risk of potential defaultThus, central banks can often invest in anyasset they choose without reprisal. Thisproblem was once thought not to apply tothe Federal Reserve, which invested onlyin U.S. Treasuries. However, the Fed haschanged its policies dramatically in recent

years. Through its quantitative easing pro-grams and bank bailouts, the Fed intentional-ly made very risky investments with taxpayerdollars, which included loans to AIG andBear Stearns and the purchase of over $1.25trillion in mortgage-backed securities.30

Private banks cannot make such ill-ad-vised gambles because they are subject to the


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The Fed hascontinuallyexpanded itspowers while

devastating thevalue of thedollar.

discipline of the market. For private banks,risky investing is a path to bankruptcyunless the bank is rescued by governmentregulation or bailout. To satisfy sharehold-ers, private banks must invest in profitable

projects rather than subsidizing other firmsfor the general good. To satisfy customers,private banks must protect the value of thenotes they issue. In doing so, they not onlyprotect their own interests but also providea stable money supply, thereby benefittingthe entire public.31

Note Issue in Practice

U.S. History

For most of U.S. history, private banknotescomprised a significant portion of the mon-ey supply. In early American history, pri-vate, state-chartered banks issued their ownbanknotes redeemable for gold or silver dol-lars produced by the U.S. Mint.32 After theCivil War, note-issuing banks required a na-

tional charter, and their activities became in-creasingly regulated. This period of relativelyfree banking came to an end in 1913 with theestablishment of the Federal Reserve, whichmaintains a de facto monopoly on the issue

of paper currency. Since then, the Fed hascontinually expanded its powers while devas-tating the value of the dollar.

The prime era of free American bankingwas the preCivil War period from 1783 to1861, when banks issued paper banknotesredeemable for official U.S. coins. The Coin-age Act of 1792 provided that the U.S. Mintwould produce several denominations ofgold and silver coins, including the silverdollar coin (made from 371.25 grains ofpure silver) and the gold eagle coin (worth

10 dollars, with a weight of 247.50 grains ofpure gold). Private banknotes redeemablefor these coins were soon being exchangedat equal value throughout the nation. Thenumber of state-chartered banks and thequantity of notes they supplied grew strong-ly during this period. Figure 2 shows the

Figure 2Growth in Banks and Banknotes, 18001860

Source: Warren E. Weber, Early State Banks in the United States: How Many Were There and Where Did TheyExist? Federal Reserve Bank of Minneapolis Quarterly Review 30, no. 1 (2006): 2840; and John E. Gurley and E.S. Shaw, The Growth of Debt and Money in the United States, 18001950: A Suggested Interpretation,Reviewof Economics and Statistics 39, no. 3 (1957): 25062.


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The price levelduring the era

of free banking,from 1790 to

1860, was quitestable compared

with recent times.

growth in banks and banknotes from 1800to 1860.33 The solid line represents the num-ber of banks (listed on the righty axis), whilethe dotted line represents the value of notes

outstanding (listed on the left y axis) in mil-lions of dollars.

By 1860 there were more than 1,600 pri-vate corporations issuing banknotes and anestimated 8,370 varieties of notes in form,color, size, and manner of security.34 Figure3 shows indexes of GDP and the consumerprice index (CPI) from 1790 to 1860.35 TheU.S. economy grew at an average rate of 4.4percent per annum over this period, whileprices fell at an average annual rate of 0.1percent. GDP was 20 times higher at the end

of the period, while the price level remainedroughly constant, indicating that compet-ing banks provided neither too many nortoo few notes during this period of strongeconomic growth. Economists and histo-rians once considered this period an era ofuntrustworthy wildcat banks, fraught withinflation and economic instability. Recent

research, however, has shown these notionsare more popular myth than historical fact.36

Comparing figures 1 and 3, we can see thatthe price level during the era of free banking

was quite stable compared with recent timesBanknotes in this era were not issued

by state banks alone. The First Bank of theUnited States was granted a 20-year charterthat began in 1791 and lasted until 1811The charter for the Second Bank of the Unit-ed States began in 1816 and expired in 1836As Richard Timberlake described in Monetary Policy in the United States, [t]he Banks ofthe United States were not created as centralbanks, nor dared they consider themselves assuch.37 They had neither a monopoly on the

production of currency nor the responsibil-ity of regulating the banking system. Thesebanks simply acted as agents of the federalgovernment in matters of finance, particu-larly the sale of Treasury bonds. The driv-ing force for the establishment of the FirstBank of the United States was to raise fundsto finance the newly formed national gov-

Figure 3Indexes of Prices and Production, 17901860

Source: Louis Johnston and Samuel H. Williamson, What Was the U.S. GDP Then? Annual Observationsin Table and Graphical Format 1790 to the Present, MeasuringWorth, 2011, http://www.measuringworthcom/usgdp/; and Lawrence H. Officer, The Annual Consumer Price Index for the United States, 17742011,MeasuringWorth, 2012, http://www.measuringworth.com/uscpi/.


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With the onsetof the AmericanCivil War,the issuance

of privatebanknotesground to a halt

ernment; the Second Bank was establishedto finance the War of 1812. After the expi-ration of the Second Bank, the Treasury oc-casionally issued government banknotes andsmall-denomination bills that were some-

times used as currency, but these accountedfor only a small fraction of the money in theeconomy. By 1860, government currency ac-counted for less than 10 percent of circulat-ing U.S. currency and less than 4 percent ofthe total money supply.38

The Suffolk banking system is a primeexample of effective free and private bank-ing in the United States. From 1825 to 1858,the Suffolk Bank administered a clearing-house for banknotes that was used by banksthroughout New England. This system al-

lowed the notes of many competing banks tobe exchanged at equal value and preventedany bank from overextending its note sup-ply.39 At its peak, the Suffolk system in-cluded over 300 banks and was clearing $30million worth of banknotes per month.40The Suffolk system was slightly impaired byregulations on interstate banking, however.The nationally chartered Banks of the Unit-ed States had the advantage of being allowedto open branch banks nationwide, whereasthe state-chartered banks of Suffolk did not.

With the onset of the American Civil War,the issuance of private banknotes groundto a halt. To raise funds for the war, Con-gress arranged in 1861 to take out loansfrom many Northern banks; especially inNew York, Boston, and Philadelphia. TheTreasury then demanded that these loansbe paid in gold specie, and [m]uch againsttheir will the banks complied.41 This left thebanks with insufficient reserves to satisfy re-demptions for their banknotes. Most privatebanks were forced to suspend redemption of

their banknotes, and in December of 1861,the U.S. government followed suit by sus-pending redemption of government-issuedcurrency. The First Legal Tender Act of 1862allowed the U.S. government to issue largequantities of nonredeemable paper currency,commonly known as the greenback for itssingular hue. The greenback was effectively a

fiat money whose value depended upon thenumber of notes in circulation rather thanthe value of any redeemable asset. The Trea-sury proved incapable of controlling the sup-ply of greenbacks, issuing such a quantity

that their value was halved in less than fouryears.42 The government eventually resumedthe redemption of greenbacks for gold or sil-ver with the Specie Resumption Act of 1879.

During the Civil War, the governmentalso strengthened its control of the bank-ing industry with the National BankingActs of 1863 and 1864. These acts imposedstrict capital requirements and a substantialsemi-annual tax of 5 percent on the note is-suance of all state banks. This tax made theissuance of private notes prohibitively costly

and caused many state banks to seek na-tional charters. Figure 4 shows the increasein banknotes issued by national banks andthose issued by the U.S. government from1860 to 1868. The rise in national banknotesis mirrored by a decline in state banknotesover the period.43 The note supply fromstate banks fell from $207 to $3 million inthese eight years, while the note issue by na-tional banks and the U.S. government rosefrom $0 to $294 million and from $21 to394 million, respectively.

In his essay, Debate on the National BankAct of 1863, John Million shows that, like theFirst and Second Banks of the United States,[t]he immediate purpose of the NationalBanking Act was to assist in providing fundsfor war purposes.44 Banks were forced to in-vest more than 100 percent of the value oftheir outstanding notes in U.S. bonds, whichwere effectively loans to the Treasury depart-ment.45 Banks were also required to pay asemi-annual tax of 0.5 percent on their notesoutstanding (a much lower rate than the 5

percent tax on state banks). Additionally, anational banking system was a tool to stan-dardize American currency and limit the in-dependence of the states. Million notes that,[f]rom the political rather than from theeconomic side argument was often broughtforward that uniformity would prove a safebond of union between the states.46


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Since ending noteredemption, the

Feds inflationarypolicies have

caused the dollarto fall by almost80 percent of its

1970 value.

Competition in U.S. currency productionended completely with the passage of the

Federal Reserve Act of 1913, which createda new monetary authority with a monopolyon the provision of banknotes. In the centu-ry since, the Feds inflationary policies haveslowly eroded the value of the dollar. FederalReserve notes redeemable for gold were firstprinted in 1914, although previously issuednotes and certificates redeemable for goldand silver continued to circulate. In 1933,President Roosevelt issued Executive Order6102, requiring that all gold coin and bullionin the United States be confiscated by the

federal government.47 Thereafter, FederalReserve notes were altered to be redeemableonly for lawful money. In 1963, their valuewas again altered, and Federal Reserve noteswere relabeled as non-redeemable legal ten-der. The dollars final tentative link to goldwas broken in 1971, when President Rich-ard Nixon withdrew the United States from

the Bretton Woods pseudo-gold system ofinternational exchange rates. Through this

process, the dollar was reduced to a purefiat currency. The Fed now uses money as apolicy instrument and is no longer primar-ily concerned with maintaining a stable val-ue for the dollar. Since ending the practiceof note redemption, the Feds inflationarypolicies have caused the value of the dollarto fall by almost 80 percent of its 1970 pur-chasing power, as shown in Figure 1.

Over the past century, the Federal Re-serve has consistently expanded the scaleand scope of its authority. Since the recent

financial crisis, [t]he Fed has invested morethan $2 trillion in a range of unprecedentedprograms, and gained sweeping new au-thority to regulate any company whose fail-ure could endanger the U.S. economy andmarkets.48 Yet despite the Feds growingpower, changes in financial regulation mayhave inadvertently paved the way toward

Figure 4Value of State, National, and Government Banknotes, 18601868

Source: Richard H. Timberlake,Monetary Policy in the United States: An Intellectual and Institutional History (ChicagoUniversity of Chicago Press, 1978), Table 7.1, p. 90.


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Scotland andNorthernIreland employa semiprivate

system in whichprivate banksissue banknotesredeemable fornotes from theBank of England

the revival of private note issue. Accordingto the article, Note Issue by Private Banks:A Step toward Free Banking in the UnitedStates? by Kurt Schuler, recent financialreforms have actually repealed the prohibi-

tions on private banknotes. As Schuler de-scribes, Nobody seems to have noticed thatstate-chartered banks have been effectivelyfree to issue notes since 1976, and national(federally chartered) banks have been freeto issue notes since 1994.49 Specifically,the Tax Reform Act of 1976 repealed the 5percent semi-annual tax on notes issuedby state-charted banks (Public Law 94-455,1904(a)(18)). The Community Develop-ment Banking and Financial InstitutionsAct of 1994 repealed the restrictions on

note issue by nationally chartered banks(Public Law 103-325 602(e)-(h)), althoughthe semi-annual note tax of 0.5 percent (1percent annually) (12 U.S.C. 541) remains.Thus, it appears that U.S. banks have theright to issue private banknotes redeemablefor currency from the central bank, therebycreating a semiprivate currency system.

Scotland and Northern IrelandScotland and Northern Ireland employ a

semiprivate system in which private banks

issue banknotes redeemable for notes fromthe central bank, the Bank of England. Al-though Bank of England notes are legal ten-der throughout the United Kingdom, con-sumers in Scotland and Northern Irelandoverwhelmingly prefer notes issued by localprivate banks. In Scotland, private bankssupply an estimated 95 percent of notes incirculation.50 Because banks in both coun-tries fall under the regulatory authority ofthe Bank of England, we consider them asingle market for the purposes of this paper.

Private banks have issued banknotes inScotland for centuries. The Bank of Scot-land was founded in 1696 and had a mo-nopoly on note issue until the Royal Bankof Scotland was formed in 1727. As morebanks entered the market, competitionwrought increases and improvements inbranches, products, and services. Peels Act

of 1844, however, ended the era of Scottishfree banking by prohibiting new banks fromentering the market. From the total of 19note-issuing banks at that time, only threesurvive today: Bank of Scotland, Royal Bank

of Scotland, and Clydesdale Bank. The Scot-tish system was replicated in Ireland, wherebanks began issuing private banknotes in1929. Of the eight original note-issuingbanks, only four continue the practice today:Bank of Ireland, First Trust Bank, NorthernBanks, and Ulster Bank. The seven note-issuing banks in Scotland and NorthernIreland have increased their note issue con-tinuously over the last decade, as shown inFigure 5. The total quantity of private notesoutstanding in Scotland and Northern Ire-

land has been increasing since 2000 at an av-erage annual rate of 3.9 percent. The BritishTreasury estimated that in 2005, Scottishand Northern Irish banks earned 80 mil-lion (approximately $145 million) from theissue of private banknotes.51

Notes from banks in Scotland and North-ern Ireland provide many of the previouslydiscussed benefits of private banknotes. Themajor advantage to consumers is productvariety among banknotes, which they clearlyprefer to Bank of England notes. Unfortu-

nately, there are several reasons this systemdoes not capture the full advantages of freebanking. First, the Bank of England hasforbidden new banks from issuing notes.Second, since private notes are redeemablefor Bank of England notes, the central bankretains a strong influence over the moneysupply. Third, on weekends (from Fridayto Sunday) note issuing banks are requiredto hold 100 percent reserves for their notesoutstanding in the form of UK public sec-tor liabilities.52 This leaves the banks only

four days to invest the capital they gain fromtheir banknotes and thins their potentialprofits.

The British government has recentlybeen hostile in its treatment of note-issuingbanks. It has repeatedly threatened to re-quire that private banks hold 100 percent re-serves on their banknotes seven days a week,


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Since the 1860s,the vast majorityof Hong Kongs

currency has beencomposed of

privately issuedbanknotes.

rather than the current three.53 The bankshave resisted, saying that if they are requiredto hold 100 percent reserves at all times,they will be unable to profit from their noteissuance and will be forced to stop issuingbanknotes. If private notes were issued inthe United States, would the Fed be similarlyhostile? The uncertain legal situation in theUnited States is a substantial barrier to theissuance of private banknotes, but it is notinsurmountable. The potential profits fromprivate note issue may be sufficient to entice

some entrepreneurial bank to overcome thiscost and enter the market.

Hong KongThe monetary system in Hong Kong is a

semiprivate system where the money supplyand foreign exchange rate are managed by acurrency board, the Hong Kong Monetary

Authority (HKMA). Since the 1860s, however, the vast majority of Hong Kongs cur-rency has been composed of privately issuedbanknotes. Early notes were redeemable forMexican (and later American) silver dollarsIn 1935, the government established its ownindependent monetary unit, the Hong Kongdollar (HKD). The value of the HKD wasoriginally pegged at a fixed exchange rate tothe British pound sterling, but since 1971 ithas been pegged to the U.S. dollar at varyingrates. The HKMA was established in 1993 to

ensure the stability of both the currency andthe financial system.54 The government hastraditionally minted coins up to $10 and hassometimes printed notes in denominationsof $1, $5, and $10. Before seizing author-ity over Hong Kong in 1997, the PeoplesRepublic of China committed to the BasicLaw, guaranteeing that Hong Kong be al-

Figure 5Private Notes in Circulation in Scotland and Northern Ireland, 20002010

Source: Authors calculation based on the balance sheets of each bank. Ulster Bank is a subsidiary of the RoyaBank of Scotland and is included as part of their total. No data were available for Northern Bank, which is asubsidiary of Denmarks Dankse Bank Group. Data are presented in millions of British pounds sterling.


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Hong Kongseconomyhas beenspectacularly

successfulbecause ofits monetarypolicy and itsliberal economicpolicies.

lowed to function as a capitalist society untilat least the year 2047.55 This law is presumedto protect the independence of the HKMAuntil that time. The currency of Macau ismanaged through a similar system to that

of Hong Kong but on a smaller scale.Three Hong Kong banks currently issueprivate banknotes: the Hong Kong Shang-hai Banking Corporation (HSBC), StandardChartered Bank, and the Bank of China.They each issue several denominations rang-ing from $20 HKD to $1000 HKD. All threebanks have seen consistent growth over thepast two decades in their quantity of notesin circulation. In addition, the HKMA is-sues coins and some banknotes with a $10HKD denomination. In 2010, government-

issued banknotes represented approximately3.7 percent of the supply of paper currency.Figure 6 shows the growing supply of pri-vate notes issued in Hong Kong from 1993to 2010 in terms of millions of HKD.56 Thequantity of private notes outstanding in-

creased at an average annual rate of 7.3 per-cent during this period. Despite this highrate of money growth, Hong Kong has expe-rienced low levels of inflation. Unlike Scot-land and Northern Ireland, banks in Hong

Kong are required to hold 100 percent re-serves for any banknotes they issue.Hong Kongs economy has been spec-

tacularly successful not only because of itsmonetary policy but also because of its lib-eral economic policies of free trade, lightregulation, and low taxes. This special ad-ministrative region of the Peoples Repub-lic of China earned the top ranking in theEconomic Freedom of the World 2010 Annual Re-port,57 coming in first in both the size of gov-ernment and freedom of international trade

categories. Hong Kong also ranked 3rd inthe category Regulation of Credit, Labor,and Business, 10th in Access to Sound Mon-ey, and 16th in Legal Structure and Securityof Property Rights. These free-market poli-cies have caused explosive growth in Hong

Figure 6Banknotes in Circulation in Hong Kong, 19932010

Source: Authors calculation based on the annual reports of the issuing banks and the Hong Kong MonetaryAuthority.


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One exceptionto the Federal

Reservesbanknote

monopoly isthe use of local

currencies.

Kongs economy, facilitating the growth ofits GDP from $28.8 billion in 1980 to $224.5billion in 2010 (measured in 2010 U.S. dol-lars).58 Despite its small size, Hong Kongboasts the worlds 35th largest economy,

and the Hong Kong dollar is the worlds 8thmost widely traded currency.59 Hong Kongbanks account for roughly 5 percent ofworldwide currency exchange, the 6th mostof any country.60

Local CurrenciesOne exception to the Federal Reserves

banknote monopoly is the use of local cur-rencies. Local currencies are usually fidu-ciary money, meaning that they are neitherredeemable for any specific asset nor guar-

anteed by the government as a means of le-gal tender. Their only value is derived fromthe expectation that they will be accepted byother parties as a form of payment. This isgenerally achieved by establishing a groupof businesses that promise to accept the cur-rency. There are dozens of local currency sys-tems in the United States and hundreds inoperation around the world.61

Most local currencies are established toencourage citizens to buy local. They aredescribed as tools of community empower-

ment intended to support economic andsocial justice, ecology, community participa-tion and human aspirations.62 Local curren-cies have been used since at least the 1930sand endorsed since the 1960s by economistsE. F. Schumacher, Robert Swann, and JaneJacobs as a means of creating sustainable lo-cal development (though the effectiveness ofthese efforts is debatable). Two of the best-known local currencies in the United Statesare BerkShares and Ithaca Hours.

BerkShares are a local currency issued

since 2006 in the Berkshire region of Mas-sachusetts by the nonprofit organizationBerkShare, Inc. The notes have featured lo-cal heroes Norman Rockwell, Herman Mel-ville, Robyn Van En, W. E. B. Du Bois, andthe Stockbridge Indians. One BerkShare canbe purchased for $0.95 at local banks buthas a spending power of $1 at participating

businesses. This creates a 5 percent discounton local purchases which the participatingfirms hope will lead to increases in salesand therefore profits. BerkShares appear tohave gained fairly widespread acceptance in

the region. Five local banks exchange Berk-Shares for U.S. dollars at a dozen branches,almost 400 local businesses accept Berk-Shares as payment, and over 2.7 millionBerkShares have been put into circulation.63

Over the past few years, the BerkShares sys-tem has been the subject of dozens of reportsin newspapers, on television, and online.

The Ithaca Hours currency is producedby the nonprofit organization Ithaca Hours,Inc., of Ithaca, New York. It is thought to bethe oldest local currency system still in oper-

ation and has inspired dozens of similar lo-cal currencies around the world. The IthacaHour is valued at a fixed rate of 10 U.S. dol-lars to 1 Ithaca Hour, and over $10 millionworth of notes have been issued since its cre-ation in 1991. The organization reports thatover 900 businesses accept Ithaca Hoursand there are currently over $100,000 worthof notes outstanding.64 Like BerkSharesIthaca Hours have been widely publicized inthe mainstream and popular presses.

These examples send somewhat mixed

messages to for-profit banks considering is-suing their own banknotes. On one hand,local currencies show that privately pro-duced banknotes can gain some degree ofpopular acceptance in small communitiesAdditionally, each local currency has its ownsystem of acceptance and exchange, whichmight prove instructive for the introductionof private banknotes. On the other hand, lo-cal currencies are clearly intended to be lo-cal and stay local. As such, they provide littleinsight on how a privately issued currency

could achieve widespread adoption, nor dothey clarify the legal questions regardingprivate notes. Additionally, local currenciesdo not present a significant challenge to theFederal Reserves banknote monopoly. Pri-vately produced banknotes that are intend-ed as substitutes for Federal Reserve noteswill not necessarily be granted the same ex-


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Private notescould create

sizable profitsfor U.S. banksand sizablebenefits forAmericanconsumers.

emptions from regulation nor be as well re-ceived by the government.

Reviving Private Note Issue

U.S. banks could profit by issuing theirown private notes redeemable for FederalReserve notes. This practice is currently legalin the United Stateswhich begs the ques-tionwhy have no banks issued their ownnotes? One possibility is that, in their judg-ment, there is simply no profit to be had insuch an endeavor. This section estimates thepotential profits from the issue of privatebanknotes in the United States, concludingthat private notes could create sizable prof-

its for U.S. banks and sizable benefits forAmerican consumers.

Because of the preliminary nature of thisexercise, we make three profit estimates: abase case, a best case, and a worst case. Thebase case is computed using the cost and rev-enue numbers we consider most likely. Thebest case assumes low-end costs and high-end revenues, while the worst case assumeshigh-end costs and low-end revenues. As-sumptions and computations are explainedso that, should the reader disagree with the

assumptions, he might make similar calcu-lations under numbers he deems reasonable.

We also consider potential barriers toentry. First we address the declining use ofcash due to emergent payment technologies,noting that despite common perceptions,the use of paper currency has been stable orincreasing in the United States over the pastdecade, as was shown to be the case in HongKong, Scotland, and Northern Ireland. Sec-ond we consider the willingness of Ameri-can consumers to accept and use these new

products, and the level of market penetra-tion that can be expected. Considering therole of money as a medium of exchange, itseems that private notes are unlikely to besuccessful unless they gain some critical lev-el of public adoption.

The issuance of private currency is tech-nically legal, but the practical status is un-

clear since no firms have chosen to enter themarket. We assume that private note issuerswill be able to gain whatever legal exemp-tions the Fed has granted to local currencies;however, it is possible that large-scale cur-

rency producers might be treated differentlysince they would pose a threat to the Fedsde facto monopoly. Were the U.S. govern-ment to prohibit the issue of private notes,then any bank that had already entered themarket would lose its initial investment andall future profits.

Potential ProfitThe issuance of private banknotes ap-

pears to be a significant profit opportunityfor American banks. Banks earn profits on

the spread between the revenue they earnon their investments and the costs of rais-ing the funds they invest. For note-issuingbanks, the return on investment need onlybe higher than the cost of keeping notes incirculation in order for the bank to turn aprofit. This simple formula of revenues mi-nus costs has been used to estimate the his-torical profits of banks in the United Statesand Scotland, and it is used by the FederalReserve to calculate profits on its own noteissue. This section uses that formula to es-

timate the potential profit on private noteissue in the U.S. market.65

Since the Federal Reserve traditionallyinvests only in U.S. Treasuries, the Fed es-timates its annual revenues by multiplyingthe yield on Treasuries by the quantity ofits notes outstanding.66 There are currentlyabout $1 trillion U.S. Federal Reserve notesoutstanding. The current yield-to-maturityon 30-year U.S. Treasuries is about 4.2 per-cent. Using these numbers yields a quickapproximation of $42 billion in annual rev-

enue for the Fed, which could be capturedby private banks, but this overestimates po-tential profit in several ways. First, it is a rev-enue calculation, from which we must sub-tract all costs associated with issuing notesand keeping them in circulation in order toestimate profits. Second, private banks willnot capture the entire banknote market cur-


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The rateof market

penetrationprivate-note

issuing bankswould achieve inthe United States

is difficult toestimate.

rently monopolized by the Fed. Third, $42billion represents one year of the Feds po-tential revenue under the current system. Tojudge whether private currency would be aprofitable investment, we must calculate the

net present value (NPV) of the profits, firstputting the expected future profits in termsof todays dollars, then accounting for up-front costs such as legal services and market-ing. An NPV greater than zero indicates thatthe issuance of banknotes would be a profit-able opportunity for a private bank.

We begin by estimating the size of thepotential market for private banknotes interms of the current quantity of Federal Re-serve notes outstanding. We calculate theexpected money supply for each of the next

10 years and assume a constant growth rateafter that time. The Federal Reserve cur-rently has roughly $1 trillion worth of notesoutstanding worldwide.67 The optimal rateof money growth should be equal to thegrowth rate of the U.S. economy, which typi-cally averages 2 to 3 percent growth per year(although actual growth may be lower inthe coming decade). In the base case we as-sume a rate of 2 percent annual growth inthe currency base for the first 10 years andno growth thereafter. For the worst case,

we assume 2 percent growth for the first 10years and a growth rate of negative 2 percentper year forever after, and for the best casewe assume 2 percent annual growth forever.Private banks, however, could not expect tocapture all or even most of this market, atleast not in the near future. Approximate-ly 60 percent of these notes are currentlythought to be outside the United States.68U.S. banks are unlikely to capture this in-ternational market because foreigners mayhesitate to accept banknotes that are diffi-

cult or impossible to redeem in their homecountries. Therefore, we assume that only40 percent of U.S. Federal Reserve notes cur-rently circulate inside of the United Statesand that domestic banks will only be able tocapture a portion of this domestic market.

What level of adoption could banks ex-pect? In the long-term, the rate could be very

high. Private banks in Scotland and North-ern Ireland dominate the market with anestimated 95 percent adoption rate. Only asmall percent of transactions are conductedusing Bank of England notes. The same is

true in Hong Kong, where the governmentproduces only a small percentage of the notesupply. It is unlikely that U.S. banks couldcapture similarly dominant market sharesin the near future; Hong Kong, Scotland,and Northern Ireland each have long his-tories of private notes. Customers in theseregions are already accustomed to using pri-vate notes, and businesses are in the habitof accepting them without worry. Introduc-ing a new private note in the United Stateswould be much more difficult and costly

since Americans are not familiar with theseproducts, and there is no existing networkof businesses willing to accept them. Large,expensive marketing campaigns would like-ly be necessary to build customer awarenessBanks would need to build a network ofbusinesses willing to accept private notes bypaying the businesses (and maybe even thenote holders).

Since the rate of market penetrationprivate-note issuing banks would achievein the United States is difficult to estimate,

we make three estimates, each over a 10-yearterm. For the base case, we assume privatebanks will be able to capture 5 percent of themarket for banknotes over a 10-year periodFor the best case, we assume 10 percent mar-ket penetration, and 1 percent for the worstcase. These rates are very low compared tocountries that currently have private notes,but they are still fairly high in total quantityFor example, the estimate of 1 percent indi-cates that private banks will be able to issue$4 billion in private notes. This is a large

figure indeed, considering that there are $0in private notes in the United States todaybut it seems to be an achievable goal over10 years considering sales of other popularproducts. For example, the new computergame Modern Warfare 3 generated sales ofmore than $1 billion in its first 16 days onthe market.69


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It is likely thatfew customerswill chooseto adopt a

new currencywhen it is firstintroduced.

Although we assume a base rate of 5 per-cent market penetration after 10 years, wedo not assume that adoption will be linearover this period. It is likely that few custom-ers will choose to adopt a new currency when

it is first introduced. These early adoptersmight be attracted to the new designs, theexcitement of being the first to use a newcurrency, or any monetary reward for hold-ing private money instead of U.S. FederalReserve notes. Whatever the reason, eachperson who adopts the new currency anduses it in trade will make the currency easierto use for the next user. We therefore assumethat market penetration will be low in earlyyears but will increase at an accelerating rate.These increases could continue past our 10-

year timeframe, but to keep these projec-tions realistic, we assume that adoption willlevel off after the first 10 years. The rate ofmarket penetration will therefore take onan S-curve as shown in Figure 7. Adoptionwill be low in early years, then high for a fewyears, then level out by year 10. After year 10,the market penetration will stay constant asa portion of the money supply (which may

be growing, shrinking, or constant). An al-ternative estimate, assuming a linear adop-tion, would increase the projected NPV of aninvestment in private currency since profitswould be higher in the early years of the

project.For calculation purposes, we estimate thepercentage adoption in each year accordingto Table 1. For each year, we show the smallpercentage adopted out of some target rateof adoption after 10 years (the terminal rate).The quantity of private notes outstanding ineach year is calculated by multiplying the to-tal notes outstanding by 40 percent of noteswithin the country, and then by the marketpenetration rate in that year. For example,$1 trillion in U.S. notes outstanding times

40 percent circulating in the United Statestimes a rate of 5 percent would equal a totalof $20 billion private notes outstanding.

Now that we have an estimate of thequantity of private notes, we can estimatethe expected revenues and costs. First, wemust recognize that not all funds will beavailable for investment. As with deposits,some percentage of banknote funds must be

Figure 7Market Penetration over 10 Years Assuming S-curve Adoption

Source: Best-case Market Penetration Rates Given in Table 1.


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held in reserve to satisfy banknote redemp-tions in each period. We assume a reserverate of 10 percent, consistent with the cur-rent required reserve ratio for FDIC mem-

ber banks.70

Thus, a quantity of $20 billionnotes outstanding and a reserve rate of 10percent indicate a total of $18 billion worthof funds available for investment.

We calculate the annual revenue on thesenotes by multiplying the quantity of fundsavailable for investment by the banks rate ofreturn. Estimating the rate of return on as-sets can be quite subjective, but the econom-ic literature on bank profits often assumesa return of around 5 percent, which appearsto be in line with current rates.71 Annual rev-

enues over assets for the top four banks in2010 were 5.9 percent for Bank of America,4.8 percent for J.P. Morgan Chase, 3.2 per-cent for Citigroup, and 7.4 percent for WellsFargo.72 The simple average of these is 5.3percent, and these four banks together ac-count for over 60 percent of all assets anddeposits in the U.S. banking system. Onemight expect these banks to be the mostlikely to issue private currency, so it seemsreasonable to use a 5 percent rate of returnfor the base- and best-case estimates. If pri-

vate banknotes are instead issued by smallerregional banks, then their local reputationsmight allow them to earn even higher ratesof return.73 On the other hand, it may bethat note-issuing banks would receive di-minishing returns on their investments, orthat they would choose to invest in safer as-sets. As a safer form of investment, the banks

could purchase 30year U.S. Treasury bondswith a current yield-to-maturity of 4.2 per-cent. This rate will, therefore, be used as ourworst-case estimate rate of return.

Another potential source of revenue isinterest paid on reserves. Cash reserves areoften held in accounts at one of the region-al Federal Reserve banks rather than beingkept in the private banks vault. In the past,the Fed has not paid interest on these depos-its, but it began doing so (at up to 0.25 per-cent) to incentivize banks to hold more cashduring the financial crisis of 20072009.74

Although this interest provides revenue forcommercial banks, it is uncertain how longthe Fed will continue to pay it. We assume in

the best case that interest is paid on reservesat a rate of 0.25 percent, but that no inter-est is paid on reserves in the base and worstcases.

We now consider the potential costs. Themost obvious cost is the physical produc-tion and distribution of banknotes. The Fedestimates the production cost of an individ-ual note at about $0.045.75 We assume a pro-duction cost of $0.045 per note. Private noteproducers may be able to produce banknotesmore cheaply than the government, but they

may also wish to enhance their notes withadditional features that might increase thecost of production. Given this cost per note,we must also know the distribution of notesin denominations of $1, $10, $100, et cetera.We assume that the distribution is approxi-mately the same as the current money sup-ply, although banks may discover a more

Table 1Rates of Market Penetration

Year 0 1 2 3 4 5 6 7 8 9 10 Terminal

Percent of

terminal 0.0% 2.5% 7.5%

15.0%

27.5%

50.0%

72.5% 85.0%

92.5%

97.5%

100.0%

100.0%Best case 0.0% 0.3% 0.8% 1.5% 2.8% 5.0% 7.3% 8.5% 9.3% 9.8% 10.0% 10.0%

Base case 0.0% 0.1% 0.4% 0.8% 1.4% 2.5% 3.6% 4.3% 4.6% 4.9% 5.0% 5.0%

Worst case 0.0% 0.0% 0.1% 0.2% 0.3% 0.5% 0.7% 0.9% 0.9% 1.0% 1.0% 1.0%


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A systemfor clearingbanknotescould merelybe a simplifiedversion of theexisting checkclearing system.

profitable allocation over time. One finalconsideration is the durability of individualnotes. The Fed replaces roughly 4.4 percentof the currency base each year, indicatingthat each Federal Reserve note lasts about

20 years on average.

76

Since our current esti-mate covers only a 10-year span, we assumethere are no replacement costs for the first10 years and that future annual replacementcosts equal the cost of production of one-twentieth of the notes outstanding in everyyear after year 10.

The cost of producing banknotes mightchange over time, but it is difficult totell whether it would rise or fall. On onehand, competition among the suppliers ofbanknotes might reduce the cost of produc-

tion, assuming banks would have multiplepotential printing companies competing fortheir business. On the other hand, privatebanks might choose to improve the aesthet-ics or security features of their currencies inorder to attract customers. They might offernew pictures and designs, as banks in HongKong, Scotland, and Northern Ireland havedone, and this might be costly. Banks mightchoose more elaborate security featuresin order to prevent counterfeiting, or theymight create verification mechanisms that

allow shopkeepers to check the authenticityof notes before accepting them. Of course,these costs too are likely to fall over time,but costs might rise or fall in the medium-run, depending on the elasticities of the costof production and consumer demand.

The cost of keeping money in circula-tion is also likely to change, since no systemcurrently exists for the clearing of privatebanknotes. This may require substantial in-vestments in infrastructure depending onhow private note clearing is designed and in-

stituted. Note-issuing banks might be ableto clear their notes through the Federal Re-serves existing system, or they might find itnecessary to build a new system altogether.The simplest possibility is that the Fed couldcontinue to facilitate note redemption. Thiscould require new systems to sort banknotesand deliver them to the bank by which they

were issued. Building such a system mightbe costly for any individual bank, but, ifcoordinated through the Federal Reserve,the creation of a clearing system for privatebanknotes would involve the collective ac-

tion of many member banks rather than be-ing borne by any one bank alone.In effect, the Fed already has a more

complex system in place for the clearing ofchecks. A check requires verification of notonly the bank but also the individual ac-count holder and the amount of funds avail-able in the individuals account. This verifi-cation process is more complex than wouldbe necessary for a note-clearing system,which would only need to identify the issu-ing bank and not any particular account. A

system for clearing banknotes could merelybe a simplified version of the existing checkclearing system. Or, if necessary for theshort-term, banknotes could be verifiedas checks written by the issuing bank. Thebank need only hold its reserves in a simplechecking account, and its banknotes wouldeffectively become checks payable from thataccount. This option would allow the clear-ing of notes with no new investment in in-frastructure.

Beyond the costs of producing and issu-

ing banknotes, introducing a new mediumof exchange would undoubtedly require anextensive marketing campaign. Although theuse of Federal Reserve notes is ubiquitousthroughout the country, Americans are un-familiar with private banknotes and mightbe hesitant to adopt them. Customers wouldneed to be informed about this new type ofmoney, how to obtain it, and how to use it.Most of all, they would need to be assuredthat these new banknotes would be acceptedat regular places of business. The amount of

money spent on such a campaign would de-pend on the form of advertisement, the ef-fectiveness of the ads, and the market sharethe company expected to capture.

The marketing initiative might comein one large wave or successive small ones.One possibility is that a major bank mightattempt to roll out its new notes across the


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Private banknoteswould need to

be continuallymarketed to

encouragetheir continued

adoption overtime.

entire nation at once with a nationwide ad-vertising campaign. It is difficult to estimatethe cost of such an endeavor. Recent nation-al advertising campaigns with similar reachhave included $100 million efforts by Nike,

Yahoo!, and Sprint; a $150 million Tide cam-paign; and a $200 million effort to promotethe Nintendo Wii. Therefore, a national cam-paign to introduce private notes is likely to bepriced in the hundreds of millions of dollars.We assume a base-case marketing expenseof $200 million. In the best case, we assume$100 million, and in the worst case $300 mil-lion, which would be among the most ex-pensive national marketing campaigns ever.Alternative estimates, spreading this expenseover time, might increase the expected NPV

of the investment in private currency.In addition to the initial marketing cam-

paign, private banknotes would need to becontinually marketed to encourage theircontinued adoption over time. This is espe-cially true if adoption is likely to be low inearly years and increase over time as morecustomers begin using the notes. Thus, weassume a variable annual marketing expenseof 5 percent of the value of new banknotesissued in any year.77

Another method of encouraging private

note adoption might simply be to pay cus-tomers to use them. The first step mightbe to compensate businesses that acceptprivate banknotes. For example, businessescould be paid to put up signs saying Weaccept B. of A. Bucks. Consumers wouldknow where their private notes would be ac-cepted and would be more willing to with-draw and use private banknotes. Any busi-ness that promised to accept private notescould be paid to advertise their involvement.Perhaps banks could distribute banknote

readers to these businesses in order to verifythe authenticity of their notes. Smartphoneapplications for the blind are already be-ing used to read Federal Reserve notes andverify their denominations.78 Alternatively,rather than paying a fixed fee to stores foraccepting private notes, it might be possibleto pay each business based on the quantity

of private notes they earn (measured by howmuch they return to the bank). If so, busi-nesses could pass the savings on to theirconsumers by offering discounts to custom-ers using private moneyas is done with the

BerkShares local currency.Another way to incentivize the adoptionof private money would be to pay the cus-tomer directly via interest or cash bonusesA bonus could be paid each time a customerchooses to withdraw private notes from thebank instead of U.S. dollars. For example,when withdrawing money at an ATM, thescreen might ask, Would you like $101 Bof A. Bucks instead of $100 regular dollars?Customers who fear that their favorite storemight not accept the private money might

find the risk worthwhile for an extra dollarSimilar programs are already being used bybanks to attract depositors. For example,Happy State Bank of Texas offers its cus-tomers a monetary reward for using its ATMmachines. The machines are filled withtwenty-dollar bills, but they occasionally payout a fifty-dollar bill for no extra charge.79

The problem with paying an up-frontcash bonus is that it encourages note cy-cling. Customers can make money simplyby withdrawing banknotes, depositing the

banknotes back into their bank accountsand immediately withdrawing them againFor a cash bonus to be useful, it must notbe easily exploitable. Potential ways to avoidthis exploitation include paying a bonuswhen notes are returned to the bank ratherthan when they are withdrawn, or havingbonuses randomly assigned or paid out asa lottery. These strategies, however, gener-ally suffer from the same shortcoming asthe withdrawal bonus: they depend on theamount of banknotes deposited or with-

drawn rather than the time the dollars arein circulation. It is therefore unclear whethersimple cash bonuses can effectively be usedto encourage withdrawals while also keepingbanknotes in circulation.

The most effective incentive for cus-tomers to both withdraw and use privatebanknotes would be to pay them interest for


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The mosteffectiveincentive

Competition in Currency: The Potential for Private Money, Cato Policy Analysis No. 698

Documents

Transcript of Competition in Currency: The Potential for Private Money, Cato Policy Analysis No. 698