Legal-Tender Laws

1. Fiat Equivalence and Gresham’s Law

A legal tender is money or a money certificate that may be used to make payments against the will of one of the exchange partners. Thus the law overrides private contract and provides that the legal tender shall be accepted as payment, rather than the money (or money certificate) promised to the seller or creditor.

Suppose, for example, that Paul gives a credit of 1,000 ounces of silver to John. They agree that after one year John has to pay back 1,050 ounces of silver to Paul. Now legal-tender laws might stipulate that all silver debts may be discharged in gold; or that debtors such as John can fulfill their obligations by paying with silver-denominated banknotes of the FR Bank; or that all payments may be made with copper tokens issued by the public mint, rather than with the type of money desired by the seller.^[1] As a consequence, Paul might not receive the 1,050 ounces of silver that John agreed to pay; most importantly, he would not be able to enforce his original contract with John.

Legal-tender laws would be a mere complication of exchanges were it not for an additional stipulation that is virtually always combined with them. Indeed, legal-tender laws typically establish a legal or “fiat” equivalence between the privileged money (the privileged money certificate) and other monies and money certificates. The point of this scheme is to allow debtors, usually the government among them, to gain at the expense of their creditors. Let us see how this works.

The aforesaid fiat equivalence works like a price control that establishes a legal or fiat price. As long as the fiat price coincides with the market price, everything is good and fine. But as soon as the two prices differ, people stop using the metal that in reality is more valuable than it is according to the letter of the law.

Suppose for example that both gold and silver are legal tender in Prussia, at a fiat exchange rate of 1/20. Suppose further that the market rate is 1/15. This means that people who owe 20 ounces of silver may discharge their obligation by paying only 1 ounce of gold, even though they thereby pay 33 percent less than they would have had to pay on the free market. Prussians will therefore stop making any further contracts that stipulate silver payments to protect themselves from the possibility of being paid in gold; rather they will begin to stipulate gold payments right away in all further contracts. And another mechanism operates to the same effect. People will sell their silver to the residents of other countries, say England, where the Prussian fiat exchange rate is not enforced and where they can therefore get more gold for their silver. The bottom-line is that silver vanishes from circulation in Prussia; and only gold continues to be used in domestic payments. The overvalued money (here: gold) drives the undervalued money (here: silver) out of the market. This phenomenon is called “Gresham’s Law.”^[2]

Thus we see how legal-tender laws entail an inflation of the legally privileged money, because this money is produced and held in greater quantities than would be the case in the absence of the price control. But legal-tender laws also entail a simultaneous deflation of the other monies and money certificates. In the above example, they entailed an inflation of gold and a deflation of silver.

What are the economic implications? First of all, notice that gold has a much higher purchasing power per weight unit than silver. As a consequence, the new currency cannot be conveniently used to purchase books or groceries; and it is entirely unsuitable to pay for a cup of coffee or for an ice cream. The typical solution for this sort of problem is the use of money substitutes. The market participants will abandon the use of the precious metals and resort to token coins or banknotes in their daily exchanges.

This tendency is reinforced by the fact that the currency substitution process takes time. The passage of a legal-tender law has immediate repercussions on the way people evaluate the monies that are concerned, while it takes time to substitute one of them for the other. In our example, while it takes time to export silver, people will immediately stop using it in daily exchanges; in other words, the passage of the legal-tender law increases the demand for silver at the given supply. This will entail a precipitous drop of silver prices being paid for other goods (a tremendous increase of silver’s purchasing power). Hence, such legal-tender laws force the market participants to adjust to a more or less severe decline of the price level.

A lower price level does not have any inconveniences per se. However, the process that leads to the lower price level entails ruin and hardship for debtors and businessmen who have not anticipated the event. Most debtors will not be able to pay back nominal debt contracted at a higher price level out of income that can be obtained at the new lower price level. The usual result is bankruptcy. And entrepreneurs who lack foreknowledge will find themselves in very similar circumstances. They have bought factors of production at the old higher price level based on the assumption that they would be able to sell at such higher prices. But the currency substitution forces them to sell their products at the new lower price level. The result is reduced profits, or even losses and bankruptcy.

Under such circumstances, businessmen will be more inclined than ever to use media of exchange that can be immediately substituted for the silver that is now suddenly held back. One solution is the importation of gold. But when the quantities involved are large, such imports will require a considerable logistical effort that cannot be organized at short notice. Gold imports could therefore be a short-term remedy only under circumstances that are so special that we need not deal with them. In fact, the only known technical device for the immediate replacement of the vanishing silver circulation in our example is credit money and fractional-reserve banking. Demand deposits and banknotes can be produced overnight in almost unlimited quantities, and this at virtually zero costs. This is precisely what businessmen are looking for in a situation of a large decline of the price level. They therefore start using fractional-reserve banking to a greater extent than before.

Given these gruesome consequences, the question arises why legal-tender laws have been tried so frequently in the history of monetary institutions. There are two possible answers: ignorance of the political leadership or shameless iniquity. Many economic historians have opted for the first alternative. They have portrayed kings, princes, and democratic parliaments from the Renaissance to the nineteenth century as well-intentioned reformers who were unenlightened about monetary affairs, and about the workings of legal-tender laws in particular. But this seems to be an implausible answer. Virtually all the political leaders of the Western world enjoyed the services of knowledgeable counselors. There was certainly no great lack of enlightenment in these matters after the fourteenth century. It is therefore more probable that past political leaders intentionally established legal-tender laws in order to reap personal profit from the export of the undervalued money and from the possibility of reducing debts contracted in this money. Nicholas Oresme spelled out this very possibility in his discussion of the legal exchange ratio between gold and silver. He argued that this ratio should always follow the market price. Otherwise the government could exploit the difference between legal and market price to its own advantage. This would be unfair and even tyrannical.^[3]

2. Bimetallism

When legal-tender laws establish fiat exchange ratios between coins made out of different precious metals, the resulting monetary system is called bimetallism.^[4] Usually bimetallism is implicit in the set-up of coin systems that comprise coins made out of different precious metals. This was the case, for example, in ancient Rome since the second century B.C., in the Byzantine Empire, and in Western Europe starting in the Renaissance. The operation of Gresham’s Law was not often visible in these ancient systems because the undervalued monies were not actually used in the first place. For example, when ancient Rome introduced (undervalued) gold and silver coins into its coin system, it had already a bronze currency, and the (overvalued) bronze coins continued to circulate after the reform. This was of course in accordance with Gresham’s Law, but the operation of the Law was invisible because nothing changed.

By contrast, modern history knows a number of spectacular manifestations of Gresham’s Law. A famous case in which bimetallism has entailed fiat inflation-deflation was the British currency reform of 1717, when Isaac Newton was Master of the Mint. Newton proposed a fiat exchange rate between the guinea (gold coin) and the shilling (silver coin) very much equal to the going market rate. Yet parliament, ostensibly to “round up” the exchange rate of gold, decreed a fiat exchange rate that was significantly higher than the market rate.^[5] And then some well-positioned men helped the British citizens to replace their silver currency with a gold currency.

But this was not all. The resulting deflation was a major factor in stimulating the use of fractional-reserve banknotes in the United Kingdom. It forced businessmen to cut down their prices rather drastically, to adjust to the reduced quantity of money. Many of them found themselves on the verge of bankruptcy, and thus looked out for all sorts of remedies. Accepting banknotes was a convenient solution. Initially businessmen might have believed this to be just a short-term expediency, to bridge the time until more metallic money would become available again in the country. But the bimetallist regime remained, curtailing the money supply below the level it would otherwise have reached, and thus the use of banknotes turned into an ever-more widespread institution.

Events were very similar in the U.S. In 1792, the U.S. Congress voted a bimetallist scheme into existence that decreed the exchange rate between gold and silver to be 1 to 15. The market rate was 1 to 15.5, however, and after a few years the artificially undervalued gold had all but disappeared from circulation. As in the United Kingdom, some people derived great profits from helping Americans exchanging gold for silver, and fractional-reserve banking flourished from the artificial deflation. This operation must have been so profitable that a few decades later it had to be repeated, only this time in the other direction. The U.S. Coin Act of 1834 fixed the legal exchange ratio between gold and silver at 1 to 16, and now the entire silver currency of the country was replaced with a gold currency. Again, there were eager helpers, and fractional-reserve banking received another shot in the arm.

In the second half of the nineteenth century, bimetallism found a number of advocates among well-intentioned men who sought to combat the great monetary movement of the time, namely, the trend toward making gold the monopoly money in all countries. The coercive demonetization of silver was bound to curtail the money supply very substantially—another case of fiat deflation. Opposition against these schemes was therefore quite reasonable and legitimate. But the appropriate remedy was not to establish a fiat exchange rate between gold and silver (bimetallism), but to allow both gold and silver to be produced and used at freely fluctuating exchange rates (parallel standards).

3. Legal-Tender Privileges for Money Certificates

Legal-tender laws for money certificates establish a legal equivalence between the certificates and the underlying money, along with an obligation for creditors to accept the certificates up to their full nominal amount.^[6] Suppose Brown sells his house for 1,000 ounces of gold to Black. If the notes of the Yellow Bank have legal-tender status, then Black can discharge his obligation by paying with Yellow Bank money certificates of a corresponding amount, even if his contract with Brown stipulates cash payment.

This seems to be unproblematic as far as genuine money certificates are concerned. What difference could it make to a man whether he owns 1 ounce of gold bullion or a genuine certificate for 1 ounce of gold? But it does make a difference. In our above example the demand for Yellow Bank certificates is higher than it otherwise would have been. The least we can say, therefore, is that legal-tender laws inflate one type of monetary service (banknotes) at the expense of other ones. Banknotes are in higher demand than they would have been on the free market.

People usually have a good reason when they use bullion rather than coins, or coins rather than banknotes, or the notes of the A-Bank rather than notes of the B-Bank. There was a reason why Brown stipulated payment in gold, rather than in Yellow Bank notes. Certificates are a matter of trust, and trust cannot be ordained. Where trust is lacking or unequal, there is no true equality between the different monetary objects. It follows that privileging a certificate through legal-tender laws disrupts the balance that would have been established on the market. There is then an inflation of certificates and a deflation of bullion. Certificates enjoy a wider circulation than they would have had in the intrinsic light of the trust that the market participants put into them. If the law compels Brown to accept banknotes that he does not desire, he might at some point decline certain exchanges that he would have made on a free market. Legal-tender laws therefore tend to reduce social cooperation and to impoverish society.

It is true that in the case of genuine money certificates, the quantitative dimension of these effects is negligible. But they do exist, and from a moral point of view this case is not categorically different from other cases in which the quantitative impact of legal-tender laws is incomparably greater.

Legal-tender privileges do have a significant quantitative impact when they are given to false certificates. Above we have noticed that the mere legalization of false money certificates could not per se lead to large-scale inflation as long as the market participants were free to abandon the use of the false certificates and switch to better ones, or demand payments in bullion. Even the introduction of monopoly privileges does not open the floodgates for inflation, because the monopoly does not impair the ability of the market participants to evaluate them as they see fit. Yet all these barriers to inflation collapse when false money certificates benefit from legal-tender laws.

Consider the following example. Before the institution of legal-tender laws, the Red Bank had operated on a 20 percent reserve ratio. Now the government makes its notes legal tender and thus artificially increases the demand for Red Bank notes; in other words, the owners of these notes redeem them less frequently. Suppose that as a consequence of the reduced demand for redemption, the cash reserves of the Red Bank increase by 2,000 ounces of gold. At the reserve ratio of 20 percent, this means that the Red Bank can issue additional banknotes for 10,000 ounces of gold.

The operation of the market process is perverted. Whereas on a free market there is a tendency for the best available products to be used, legal-tender laws combined with false certificates incite a race to the bottom. Since all money certificates are equal before the law, and because the legal-tender provision overrules private contract, no money user has an interest in paying the higher price for a genuine certificate. And as a consequence no producer has an interest in fabricating such certificates; each one of them now tries to operate at the lowest possible costs. Sooner or later everybody pays with debased coins and fractional-reserve notes. Bullion disappears altogether from public use; it is held back—”hoarded”—or sold abroad.

These are the general effects that result when legal-tender privileges are given to false money certificates. But there are also specific effects that depend on the type of certificate. Legal-tender laws have different consequences when applied to certificates that are physically integrated with the monetary metal (typical case: debased coins) than when applied to those that are not (typical case: fractional-reserve banknote). To these particular effects we now turn.

The Case of Debased Coins

There is no evidence that private minters have been unable to withstand the competition of princes and other governments in truly free markets. But there is a solid historical record documenting how governments have abused the trust that the citizens put into them. There was in fact hardly a dynasty that did not in this way abuse its monopoly of coinage. Ancient Greeks and Romans, medieval princes, dukes and emperors, as well as democratic parliaments have recklessly debased the coins of their country, knowing that the law imposed the bad coins on their subjects at a nominal value determined by the government.^[7]

Legal-tender laws eliminate all technical obstacles to an infinite debasement of coins. Any coin, however much it is debased, must be accepted in payment of its full nominal amount. It is therefore possible to debase coins to such an extent that they contain not a trace of precious metal anymore. They can then be made out of inexpensive metal, which allows the fabrication of great quantities before production ceases to be profitable. Consider the case of the Spanish maravedi coins. Originally, in the High Middle Ages, they were silver coins, but then the Spanish kings debased them to such an extent that by the end of the sixteenth century they were pure copper coins without a trace of silver. The example shows that legal-tender privileges for debased coins represent a significant source of revenue for the government. Nevertheless they have three great disadvantages from the government’s point of view.

First, as we have pointed out above, the production of debased coins takes time. It is impossible for the government to replace the entire existing stock of coins in one stroke. It follows that the gradual introduction of the new debased coins makes the money supply heterogeneous. Old sound coins circulate side by side with new debased coins. When the market participants realize what is happening, they will hoard the old coins and use only new coins for payments. But this means a more or less drastic reduction of the money supply available for exchanges—a sudden big fiat deflation that entails at least temporary trouble, not only for private fortunes, but also for public finance. The problem vanishes only when the coins are so much debased that they are entirely nominal (zero content of precious metal). This is one of the reasons why government mints, even when their coins enjoyed legal-tender privileges, have traditionally been as secretive about debasement as private counterfeiters.

Second, legal-tender privileges for debased coins may benefit debtors at the expense of creditors.^[8] This is of course one of the reasons why governments establish such privileges in the first place. They allow them to rid themselves of a more or less big chunk of their debts, by defrauding their creditors. The problem is that such tricks backfire. First, the fixed revenues of the government are henceforth paid in debased coin too. And second, when the government establishes a reputation as a bad debtor, it becomes very difficult, if not outright impossible, for it to obtain any further credit.

Third, legal-tender privileges for debased coins disrupt the international exchanges and thus jeopardize long-term investments in the country where the privileges are enforced. Nicholas Oresme observed that foreign merchants and capitalists avoid such a country, because “merchants, other things being equal, prefer to pass over to those places in which they receive sound and good money.”^[9] But even patriotic local entrepreneurs cannot, under such circumstances, maintain their operations if they have to buy their supplies abroad. Oresme emphasized this point:

Furthermore, in such a kingdom internal trade is disturbed and hindered in many ways by such changes, and while they last, money rents, yearly pensions, rates of hire, cesses and the like, cannot be well and justly taxed or valued, as is well known. Neither can money safely be lent or credit given. Indeed many refuse to give that charitable help on account of such alterations.^[10]

There is also a fourth implication of granting legal-tender privileges for debased coins, if these privileges, as we have so far assumed, are granted indiscriminately. This implication is that coins can no longer be produced on a competitive basis without destroying the currency. When a coin producer can debase his product indefinitely and dump it on the other market participants, the race to the bottom has no stopping point short of the resolute rejection of any further indirect exchange by the citizens, that is, short of the total disintegration of the market. This is, again, the reason why legal-tender privileges have rarely been granted under such conditions.^[11]

The Case of Fractional-Reserve Banknotes

None of the aforementioned disadvantages exists when legal-tender laws protect fractional-reserve certificates, most notably fractional-reserve banknotes.^[12] The reason is that banknotes are not physically integrated with the monetary metal.

If the monetary authorities of a dukedom decide to debase the coinage by one third, then the new coins contain 33 percent less fine metal than the old coins. As we have pointed out, this makes the dukedom’s currency heterogeneous and thus entails a deflation. But if the bank reserves of that dukedom are reduced by one third, then this affects all banknotes in the same way. The currency does not become heterogeneous and, equally important, the power of any individual banknote to provide its owner with the certified amount of bullion is not necessarily impaired. Indeed, if the banknotes are inflated with sufficient restraint, it may very well be possible to redeem them at any time for as much bullion as before.^[13]Nothing disrupts the smooth operation of the market as long as the reserves of the fractional-reserve banks are large enough to satisfy any ongoing demands for redemption.

It follows that, when legal-tender privileges are applied to banknotes (or any other money certificates that are not physically integrated with the monetary metal), they do not produce the deflationary tendencies that arise in the case of debased coins. They do not diminish the government’s other sources of income; they do not jeopardize international exchanges; they do not hurt the government’s creditors; and they do not stand in the way of a competitive production of banknotes.

It is true that fractional-reserve banking protected by legal-tender laws is a race to the bottom. Every banker has an incentive to reduce his reserves—to inflate the quantity of his notes—as far as possible. But there is a logical stopping point before the total dissolution of monetary exchanges. Every single banker can stay in business only as long as he is able to redeem his notes. Because his customers have the right to demand redemption of his notes into bullion, and because some of them exercise this right, he must keep his note issues within more or less prudent narrow limits. The monetary system as a whole is therefore highly inflationary, but inflation is still limited.

These facts are crucial to understand the last three hundred years of monetary history in the West. The reason why governments have abandoned debasement and started cooperating with fractional-reserve banks was the technical superiority of this type of fiat inflation. It allowed the governments to obtain additional revenue that they could not get from their citizens through taxation, yet without diminishing their other revenues, without hurting their creditors, without disrupting the inclusion of their countries in the international division of labor, and without abolishing competition in banking altogether.

These were great advantages from the point of view of the government. From the ordinary citizens’ point of view, the matter looked somewhat less glorious. The inflation of banknotes sucked as many resources out of the rest of the economy as debasement would have, if not more. And it established a permanent partnership between governments and banks. Fractional-reserve banking leverages the inflationary impact of legal-tender laws quite substantially. And inversely, legal-tender laws are a boon for fractional-reserve banking.

4. Legal-Tender Privileges for Credit Money

Very similar considerations come into play when legal-tender privileges are granted to credit money. We have seen that, on a free market, credit money would play a rather insignificant role because of its default risk. But if the market participants have to accept it by law in lieu of natural money, it can gain widespread circulation, precisely because it is inferior (but also less costly) to its natural competitors. Again the operation of the market process is perverted; a race to the bottom sets in, though without the inconveniences of debasement.

5. Business Cycles

As with all forms of inflation, fractional-reserve banking (and credit money) backed by legal-tender privileges brings about an illegitimate redistribution of income; and since it creates far more inflation than any other institutional set-up, the quantitative impact can be very considerable. The market economy can be understood as a great organism that caters to the needs of consumers—as expressed in money payments. When the economy is flooded with legal-tender fractional-reserve notes, the whole economic body of society begins to cater excessively for the needs of those who control the banking industry. The American economist Frank Fetter once observed that the unhampered market economy resembles a grass-roots democratic process. One penny, one market vote.^[14]From this point of view, the imposition of fractional-reserve notes through legal-tender laws creates market votes out of nothing. The bankers and their clients (usually the government in the first place) have many more votes than they would have had in a free society.^[15]

But legal-tender privileges for fractional-reserve banking also create another very harmful effect: the business cycle. The fundamental practical problem of fractional-reserve banking is that the bank can redeem only as many of its notes as it has money in its vaults. Suppose the FR Bank has issued 1,000 “one-ounce silver FR notes” promising to pay to the bearer of each note the sum of one ounce of silver on demand. Suppose further that the Bank has just 300 ounces of silver ready for redemption. Then it cannot possibly comply with redemption demands from all owners of its notes. In fact it cannot comply with any redemption demand exceeding the sum of 300 ounces of silver. Thus the entire practice of fractional-reserve banking is premised on the assumption that the market participants will not rush to redeem notes once they receive them in payment; but that at least some people will hold them, at least for some time. This assumption very often holds true, especially when such notes are not only legal, but also protected by legal-tender laws. However, because fractional-reserve banks profit from inflation, they have a great economic incentive to extend their note issues; and with each such extension the probability of redemption failure increases. Even if a banker is himself rather prudent, the competition emanating from other bankers pushes him to inflate his note supply, lest he lose market share to these competitors. And thus comes the situation in which the redemption demands for money exceeds the money available in the bank vaults. The bank is unable to meet these demands. It goes bankrupt.

Because of the manifold interconnections amongst banks and between the banks and other businesses, the bankruptcy of one bank is likely to trigger the collapse of the entire fractional-reserve banking industry. This has been observed many times in the history of fractional-reserve banking. Most banking crises of the nineteenth century were of this sort. Similarly, the international banking system that is commonly referred to as “the system of Bretton Woods” collapsed in 1971 when the U.S. Fed, which redeemed dollar notes held by other central banks into gold, refused further redemption. It goes without saying that a general bank crisis entails hardship for all people who have invested their savings in bank deposits. The collapse of the banking industry also goes hand in hand with a sharp decline of the money supply, because people now refuse to use banknotes, even legal-tender notes, for any length of time, but rush to redeem them into specie. As a consequence, there is a strong downward pressure on money prices (such as wage rates) that forces the market participants through a more or less painful adjustment process. Production is likely to be temporarily interrupted; people are likely to become temporarily unemployed.

The damage can be even greater if the inflation deludes entrepreneurs about the overall resources that are available for investment projects. Every prudent entrepreneur has to make sure that he will have enough resources to bring his production plan to completion, lest he would not only forgo any operating revenues, but also lose all the initial investment. This fundamental fact is emphasized by Jesus as quoted by St. Luke:

Which of you wishing to construct a tower does not first sit down and calculate the cost to see if there is enough for its completion? Otherwise, after laying the foundation and finding himself unable to finish the work the onlookers should laugh at him and say, “This one began to build but did not have the resources to finish.” (Luke 14: 28–30)

The way to find out whether available resources are sufficient to complete a project (such as constructing a tower) is cost calculation. Now fractional-reserve banking has the power to delude cost calculations, and thus to induce businessmen into laying foundations that are too large to be completed with the resources available in society. If the fractional-reserve banks make their banknotes available through the credit market, and if credit-taking entrepreneurs do not realize that the additional credit does not come from additional savings, but from inflation, then the interest rate is likely to be lower than it would be in market equilibrium. And because the interest rate is a major component in calculating the prospects of business projects, there are now suddenly many more investment projects that seem to be profitable even though this is not really the case. When the entrepreneurs start investing in such projects, en masse, the crisis is programmed in advance. Bringing all these projects to completion would require resources that simply do not exist. The necessary resources exist only in the imagination of businessmen who have mistaken more credit for more savings. What is more, a more or less great part of the resources that really do exist is now actually wasted on projects that cannot be completed. When the crisis sets in, there are then not just temporary interruptions of production. Rather, many projects have to be completely abandoned, and the materials and time sunk into these projects are likely to be lost forever.^[16]

6. Moral Hazard, Cartelization, and Central Banks

Above we have stated that the bankruptcy of one fractional-reserve bank is likely to trigger the bankruptcy of many other such banks. The reason is that, in times of severe drain on one bank’s cash reserves, the bank turns for short-run credit to other banks. It needs cash to comply with the redemption demands. If the other banks can accommodate its request, no systemic crisis develops. But if the other banks need their cash themselves for the daily redemption demands of their customers, they cannot grant any further credit to the other bank. Then the first-mentioned bank goes bankrupt and this launches a chain reaction: bankruptcy of some of its corporate partners, bankruptcy of some of their partners, and finally bankruptcy of other banks who have placed their money in these businesses.

It follows that, under fractional-reserve banking, the bankers have a particularly great personal incentive to support fellow-bankers in times of a redemption crisis. If they cannot extinguish the fire right where it shows up first, it risks spilling over to their own establishment. Thus they are likely to help out fellow-bankers in difficulties. And they are the more likely to be so inclined, the more they themselves operate with low cash reserves.^[17] Yet this incentive for mutual support is much less beneficial from a wider social perspective than one might imagine. For the less responsible bankers know that this incentive exists on the part of their colleagues. They know that the other bankers will pay part of the bill if they, the imprudent ones, make bad decisions. There is therefore a special temptation for them to inflate their note issues in an especially reckless manner. This is exactly what happened in many periods of unregulated fractional-reserve banking. Economists call such temptation to make others pay for our own projects “moral hazard.”^[18]

We cannot at this place provide an exhaustive account of the problems of fractional-reserve banking under legal-tender laws. Let us therefore mention only a few organizational devices that, historically, have played an important role in coping with the problems we have just pointed out:

(1) The banks can set up voluntary cartels that regulate the note issues of each cartel member. An essential element of such a cartel would be that only members have access to the inter-bank clearing system.^[19]

(2) The clearing institution of the cartel can then be turned into a common cash pool out of which all member banks can draw in times of redemption difficulties. It should be obvious that, due to this essential function, the owners of the pool have great bargaining power and political leverage over the other banks. Thus there is here a tendency for the spontaneous creation of a “central bank” and of a hierarchical banking system.^[20]

(3) Wherever it proved to be impossible to establish voluntary cartels, governments have cartelized the banking industry by more or less stringent laws, often at the behest of the most powerful banks.^[21]

Again, we cannot afford to dwell at great length on these questions of theory and history, which have been analyzed rather painstakingly in other works. The point we wish to emphasize is that the characteristic institutional features of present-day banking systems—they are national, hierarchical, and regulated by law—are anything but accidental. The cartelization, centralization, and regulation of the banking industry are but organizational techniques (however misguided) to cope with problems of fractional-reserve banking under legal-tender laws.

7. Monopoly Legal Tender

So far we have analyzed the economic impact of legal-tender laws on the assumption that these laws are applied nondiscriminatorily to several money certificates. But this case plays virtually no practical role.^[22] Our assumption merely helped us to prepare the analysis of the most relevant case, in which only one type of money certificate is legal tender. To this case we now turn.

Suppose that three different coins are produced in the fair country of Oz: the ducat, the thaler, and the guinea. Now the government makes the ducat alone legal tender, but it does not outlaw the use and production of thalers and guineas. If all three coins are genuine money certificates, the impact of this law is virtually zero. It is true that people who do not trust ducats, or do not like them for some other reason, can now be coerced into accepting them; and that the threat of this coercion will in some rare cases diminish the readiness of such people to take part in the division of labor. But such cases are truly rare.

Suppose now that debasement is legal in Oz. If all three coins were legal tender, their producers would set out for a race to the bottom, as we have seen above. But since only the ducat is legal tender, there is no race to the bottom. Rather, the ducat now comes to play the role of a standard of debasement—it sets a pace of debasement that the other two coins must slavishly follow. Assume for example that the ducat is debased to such an extent that it only contains 30 percent of its nominal content of fine silver. Then it makes no sense for the other producers to debase the thalers and guineas even further, say, to 20 percent, because everybody would refuse to accept these inferior coins as payment in the full nominal amount. But neither would it make sense for thalers and guineas to contain more silver, say, 40 percent of the nominal amount, because debtors could still pay with ducats. Nobody would then use thalers and guineas either; they would be hoarded as soon as they left the mint, or be exported abroad.

Thus we see how monopoly makes legal-tender privileges workable when applied to debased coins. This is why, historically, legal-tender laws were applied to debased coins by and large only as a monopoly—of course, as a monopoly of the government’s mint. But notice that the other disadvantages of legal-tender privileges for debased coins still remain: heterogeneity of the coin supply and fiat deflation, reduction of government revenues, economic destruction of the creditors, and disruption of the international division of labor. We have seen that these problems did not exist when legal-tender laws benefited fractional-reserve notes (and other debased money certificates that were not physically integrated with the bullion). Let us therefore now turn to see how monopoly affects the workings of a fractional-reserve banking system.

Suppose again that we find ourselves in the country of Oz. Only this time nobody in Oz makes coins, but there are three banks issuing notes that are called the pound, the mark, and the franc. Now the government makes the pound alone legal tender, but it does not outlaw the use and production of marks and francs. If all three banknotes are genuine money certificates, the impact of this law is, again, very insubstantial. By contrast, if the practice of fractional-reserve banking were legal in Oz, a legal-tender monopoly for the pound would bring about a pound-inflation, very much as in the above case there was an inflation of debased ducats.

Yet the similarities stop here. Whereas the ducat in our above example played the role of a standard of inflation, the pound in our present example does not play any such role. Legal-tender privileges for the banknotes of one bank do not prevent a race to the bottom, in the course of which each of the other banks attempts to reduce its reserves as far as possible. Assume for example that the pound bank reduces its reserves to 30 percent of its nominal issues. This in no way prevents the mark bank and the franc bank from reducing their reserves even further, say, to 20 percent. Quite to the contrary, there are very powerful incentives for the banks to do precisely that. We have noticed further that fractional-reserve banking systems labor under moral hazard. Each bank has an incentive to be especially reckless in diminishing its reserves (issuing further notes without coverage) because it can rely on the other banks as some sort of a safety net. This incentive is just as present if only one bank enjoys legal-tender privileges. All the other banks then have the tendency to use the notes of this bank, which all market participants are obliged to accept in lieu of specie, to cover their own note issues. Thus we see that, when legal-tender privileges are accorded to just one bank, the cartelization and centralization of the banking industry crystallizes quite naturally around the privileged bank, thus turning it into the central bank.

Notice that the privileged bank then comes into the awkward position that, due to its very privilege, it has to keep larger reserves than all other banks, and is therefore likely to operate less profitably, at least on that account. This was in fact the constant complaint of the Bank of England during most of the nineteenth century. It was the only bank to enjoy legal-tender privileges for its notes; yet all the other banks relied on it for cash and thus forced it to keep much larger reserves than it would have wished to keep.

Although a central bank is in many respects more powerful than the other banks, its fortunes are not independent of the latter. There is still the ultimate reality of moral hazard, inherent in the fractional-reserve principle. And it is easy to see that moral hazard has a tendency to explode the entire banking system. If the other banks are just reckless enough in reducing their reserve ratios, the central bank sooner or later must follow suit, lest it provoke a general banking crisis right away. And on the other hand, the central bank cannot indefinitely go on reducing its reserves without sooner or later jeopardizing its own liquidity, and thus also the liquidity of the entire banking system.

Thus, even if the central bank remains legally independent of the commercial banks, it is in fact their handmaiden. Even if it has no intention to spur inflation, it must play cat and mouse with the commercial banks. The fractional-reserve principle sets the banking system on an expansion path. Smart managers might be able to prevent all too many crises along the way; but such managers are rare, and even they cannot ultimately prevent that redemption demands finally exceed available money reserves. The history of nineteenth century national banking cartels, as well as the history of international banking cartels up to 1971, is very much the history of smart managers inventing ever-new institutions to delay the final bankruptcy. We will give the outline of that history in the third part of the present work.

8. The Ethics of Legal Tender

Legal-tender privileges are even more difficult to justify than the simple monopoly privileges we dealt with in the last chapter. Legal monopoly, as we defined it, diminishes the full use of one’s property. It deprives the citizens of options they would otherwise have had. It reduces the menu open for choice. However, it does not attack choice per se. The acting person is still free to choose among the remaining alternatives.

By contrast, legal-tender privileges attack individual choice at its very root. They overrule any contractual agreement that a person might make in respect to money. The government imposes the use of some privileged money or money certificate. It coerces the citizens into using these means of payments, even though they might have other contractual obligations and contractual rights. This is why Nicholas Oresme said that alterations of legal-tender money (he took it for granted that money was always legal tender) were “quite specially against nature.”^[23] They are far worse than usury, because usury, at least, springs from the voluntary agreement between a debtor and a creditor, whereas alterations are done without such an agreement and entail the interdiction of the previous money. Said Oresme:

The usurer has lent his money to one who takes it of his own free will, and can then enjoy the use of it and relieve his own necessity with it, and what he repays in excess of the principal is determined by free contract between the parties. But a prince, by unnecessary change in the coinage, plainly takes the money of his subjects against their will, because he forbids the older money to pass current, though it is better, and anyone would prefer it to the bad; and then unnecessarily and without any possible advantage to his subjects, he will give them back worse money. …In so far then as he receives more money than he gives, against and beyond the natural use of money, such gain is equivalent to usury; but is worse than usury because it is less voluntary and more against the will of his subjects, incapable of profiting them, and utterly unnecessary. And since the usurer’s interest is not so excessive, or so generally injurious to the many, as this impost, levied tyrannically and fraudulently, against the interest and against the will of the whole community, I doubt whether it should not rather be termed robbery with violence or fraudulent extortion.^[24]

Thus it is impossible to justify legal-tender laws, especially when they are applied to protect debased coins and fractional-reserve money certificates. Inflation is here at its worst. The floodgates are open and the citizens are denied any protection. Not even self-defense is allowed any more. The masters of the mint and of the banking industry have a free way to enrich themselves—and of course the government, which provides legal coverage for the entire scheme—at the expense of the citizenry. Here this passage comes to mind:

Your silver is turned to dross, your wine is mixed with water. Your princes are rebels and comrades of thieves; Each one of them loves a bribe and looks for gifts. The fatherless they defend not, and the widow’s plea does not reach them. Now, therefore, says the Lord, the LORD of hosts, the Mighty One of Israel: Ah! I will take vengeance on my foes and fully repay my enemies! I will turn my hand against you, and refine your dross in the furnace, removing all your alloy. (Isaiah 1:22–25)

Long before the age of banking, Oresme stressed the scandalous quantitative aspect of inflation protected by legal-tender laws:

… Again, if the prince has the right to make a simple alteration in the coinage and draw some profit from it, he must also have the right to make a greater alteration and draw more profit, and to do this more than once and make still more. …And it is probable that he or his successors would go on doing this either of their own motion or by the advice of their council as soon as this was permitted, because human nature is inclined and prone to heap up riches when it can do so with ease. And so the prince would be at length able to draw to himself almost all the money or riches of his subjects and reduce them to slavery. And this would be tyrannical, indeed true and absolute tyranny, as it is represented by philosophers and in ancient history.^[25]

One wonders what this great mind might have said about the monetary institutions of our time. Already in his day, Oresme stated that institutionalized inflation—as it can only exist under the protection of government—turns such a government into a tyrant. And this tyranny becomes perfect if the government can enshrine inflation into law.