Hayek versus Friedman: Concurrent Currencies

by Finbar Feehan-Fitzgerald

Friedrich HayekEconomist Milton Friedman

Although Friedrich Hayek is often accredited with initiating a resurgence of research in the area of concurrent currencies, he was also the recipient of sharp criticisms from Milton Friedman, Stanley Fischer, and others from the outset. His theory of concurrent currencies failed to gain any significant support among academic economists or the population in general.

Hayek, according to Friedman, erred in believing that a new, more stable monetary system would spontaneously emerge as a result of competing private currencies. It was the view of Friedman, that network effects and/or switching costs would hamper the emergence of a new monetary system in general and prevent Hayek’s system from operating as desired in particular.

Network effects for money

Due to its importance for the rest of this article, it is worth taking a moment to clarify exactly what ‘’network effects’’ means in the context of money. In general, a network effect results when the desirability of an item depends upon the amount of others using it. Since money is demanded due to its acceptability among others for future payment, money would appear to have network effects. Attention is usually paid to the amount of others using it (i.e., the size of the network). One must remember, however, that individuals are not just concerned with how many others are using a particular money, but also with who is using it (i.e., the location of the network).

In order to avoid unnecessary transaction costs it is expedient to employ the same medium of exchange as your trading partner. The more of one’s trading partners using a particular medium of exchange, the easier it is to transact with that currency; and the easier it is to transact with a particular money, the more desirable that money becomes to transactors. In other words, accepting a particular currency increases its desirability and thereby encourages others to accept it, further increasing its desirability. This was essentially the view expressed by Menger, wherein money is thought to emerge from barter.

Once a particular currency gains widespread acceptance, the above process results in a weak form of path dependency or lock-in – that is, after convergence, the system tends to favour an incumbent money over potential alternatives. Thus, in the context of money, network effects denotes that money users are concerned with the size and location of a particular network. Under such circumstances, a superior alternative may fail to supplant a money already enjoying widespread circulation.

According to William J. Luther:

There are at least two ways to model network effects favouring an incumbent money. One way is to include a fixed cost of switching between media of exchange […] The fixed cost might be interpreted as the cost of exchanging notes, changing prices to reflect the new medium of account, learning to think in terms of a new medium of account, changing record-keeping processes, and/or modifying existing machines to accept, store, and give out new notes and coins. The fixed cost approach yields four implications:

  1. 1.      An economic actor will not choose to switch monies if the benefits of switching do not exceed his fixed costs even if everyone else switches.
  2. 2.      An economic actor will choose to switch monies if the benefits of switching exceed his fixed costs even if no one else switches.
  3. 3.      An economic actor will not choose to switch monies if the benefits of switching do not exceed his fixed costs given his expectations about the number of others choosing to switch.
  4. 4.      An economic actor will choose to switch monies if the benefits of switching exceed his fixed costs given his expectations about the number of others choosing to switch.

Cases (1) and (2) describe peripheral scenarios where non-network inferiority or superiority dominates one’s decision to switch – that is, when the benefits of switching are sufficiently small or large to render network effects inconsequential. In contrast, network effects are important in cases (3) and (4). As a result, outcomes in cases (3) and (4) are sensitive to expectations. In all four cases, the fixed cost of switching favours the incumbent money over potential alternatives.1

Friedman versus Hayek

It was the novel approach, advocated by Hayek, to allow concurrent, competitive currencies. In Hayek’s system there was no contractual obligation on the part of the money issuers to redeem their notes with some underlying commodity. The unbacked, irredeemable notes then trade against each other and other commodities at fluctuating exchange rates on the open market.

It was the belief of Hayek that competition for customers would force issuers of particular currencies to maintain a stable exchange rate and desist from engaging in reckless monetary practices. According to Hayek, ‘’the chief attraction the issuer of a competitive currency has to offer his customers is the assurance that its value will be kept stable (or otherwise made to behave in a predictable manner).’’2

In others words, issuers of notes would be careful to maintain a constant price between a predetermined basket of goods and their currency in order to retain current, and gain new, customers. Issuers who fail to maintain a stable exchange rate are then expected to lose market share. Hayek contended that the maintenance of exchange rates in the quest for market share would better regulate monetary value than a central bank.

It is worth looking at Hayek’s proposal in light of the four situations outlined above. Hayek argued, although not explicitly, that network effects and switching costs are small, making them almost, or even totally, inconsequential. Thus, the benefits of switching need not be very large to warrant spontaneous switching of currencies. Hence, it was the opinion of Hayek that cases usually fell into either Case (1) or Case (2), where non network inferiority or superiority dominates one’s decision to switch. Furthermore, he believed the cost of switching to be too miniscule to result in monetary mismanagement to the extent of that observed in central banking.

Although Friedman supported the changes in legislation sought by Hayek, he was ‘’very much less optimistic […] that such a system would lead to a money of constant purchasing-power and of high quality.’’3 Money users, Freidman expounded, are not hypersensitive to changes in purchasing power:

Both German marks and Swiss francs have for many years maintained their purchasing power better, and with less fluctuations, than U.S. dollars. Many residents of the U.S. hold German marks and Swiss francs, or claims denominated in those currencies, as part of their portfolio of assets. But, with perhaps rare exceptions, only those who engage in trade with Germany or Switzerland, or travel to those countries, use the currencies as a medium of circulation.4

As experience with international currencies presumably demonstrates, stability of purchasing power is not the only consideration on which to base one’s decision to use a particular money. Money users are also concerned with its degree of acceptability among their trading partners – or, to use modern terminology, the size and location of the money’s network – and the cost of switching. Therefore, a private issuer would have to regulate the value of its money even better than Germany and Switzerland (and, hence, the United States) for spontaneous switching from US dollars to result. Exactly how much better, Friedman did not know – but he expected it was a lot.

Accepting that individuals are not concerned exclusively with purchasing power stability, it seems pertinent to ask the question: to what extent are individuals insensitive to changes in purchasing power as a result of networking effects and switching costs? Friedman and Schwartz argued that spontaneous switching is only observed in times of extreme changes in purchasing power – that is, when the incumbent money is managed significantly worse than the relative alternative.5

Returning, again, to the four situations outlined above, it might be useful to outline Friedman’s position, as opposed to Hayek’s, for comparison. Unlike Hayek, Friedman believed that network effects and switching costs are large. In other words, Friedman felt that most scenarios fell into either Case (3) or Case (4), and were not merely decided on the basis of non-network inferiority or superiority. Friedman, believing the cost of switching currencies to be high, thought monetary mismanagement would have to become quite severe in order to warrant either Case (2) or (4).

Hayek did respond to Friedman’s criticisms, however, stating:

Americans may be fortunate in never having experienced a time when everyone in their country regarded some national currency other than their own as safer. But on the European continent there were many occasions in which, if people had only been permitted, they would have used dollars rather than their national currencies. They did in fact do so to a much larger extent than was legally permitted, and the most severe penalties had to be threatened to prevent this habit from spreading rapidly – witness the billions in unaccounted-for dollar notes undoubtedly held in private hands all over the world.6

It is clear from the above passage that whereas Friedman blamed networking effects and switching costs for preventing people from switching currencies, Hayek blamed legal restrictions.

The Somali Shilling

Since Hayek and Friedman’s debate, most economists have come to accept Friedman’s position. There has, however, until recently, been no way to test the opposing views empirically. Any example of poor monetary management in the past has been marred by significant legal restrictions on the use of other currencies.

Now, although the aforementioned debate cannot be solved empirically; a real life example of concurrent currencies circulating absent of any legal restrictions would contain some heuristic value.

The example we shall be using for this article will be that of the Somalia. The collapse Mohamed Siad Barre’s Democratic Republic of Somalia in 1991 gave us the unique opportunity to observe concurrent currencies absent of any legal restrictions in practice.

The collapse of the state in Somalia included the collapse of the Somali Central Bank. Since the collapse of the Somali Central Bank in 1991, four new currencies have gone into circulation in Somalia: the Somaliland Shilling, the Na’ Shilling, the Balweyn I, and the Balweyn II.

Since 1991, Somaliland has established its own Central Bank, and declared the Somaliland Shilling legal tender. For this reason we may omit Somaliland and its respective currency from our study.

The Na’ shilling, on the other hand, would appear to contain the very network effects that Friedman had warned of; circulating mainly within a single clan, and failing to gain any significant foothold elsewhere.

In 1997, however, a south Mogadishu leader issued the Balweyn I note, which is a forgery of the pre-1991 Central Bank notes. Similarly, a Puntland administration (central bank) issued the Balweyn II, another forgery of the pre-1991 Somali Shilling (SoSh). Both notes are widely accepted forgeries of the pre-1991 SoSh.

Although the Balweyn notes can be distinguished from each other and the pre-1991 currency, the Somali public have treated them all as the same currency – which we may call the Somali Shilling. This would appear to suggest that all three currencies, similar in appearance, have bypassed the problem of network effects and/or switching costs because of their similarities.

This led to a peculiar situation where, rather than competition between monies limiting the amount of inflation and seigniorage in each currency, the recognition of all three currencies as just the one led to a tragedy of the commons – a situation where there has been competition for seigniorage in the same currency.

In the space of just four years the Somali Shilling depreciated by a staggering 67%. Despite these facts the Somali Shilling remains the most used currency in Somalia. The question is why did the Somali public continue to use a currency which was experiencing such horrendous inflation? Well, the reason for the Somali public’s continued use the Somali Shilling ultimately boils down to network effects and/or switching costs.

Nonetheless, one must remember that within the Somali Shilling there were essentially three currencies operating under no network effects or switching costs. Was there any competition for market share among these three currencies? In short, no. Why? To the answer to this question we must first increase our understanding the Somali Shilling.

As previously stated, within the Somali Shilling there were essentially three currencies. These three currencies were: the pre-1991 SoSh, the Balweyn I, and the Balweyn II. Out of these three currencies the pre-1991 SoSh was the most stable. The pre-1991 currency’s secret was that it was out of production, and it was seemingly impossible to create high quality forgeries. The Balweyn I and Balweyn II, on the other hand, were spectacularly unstable and were depreciating rapidly.

Why, then, was there no exodus of capital from the Balweyn I and Balweyn II to the increasingly attractive pre-1991 currency? Well, the secret to the pre-1991 SoSh’s success as a stable currency is also the secret to its failure to gain market share. It was because new prints of the pre-1991 SoSh could not be produced, its notes were (and are) slowly, but surely, being removed from circulation due to wear and tear. The pre-1991 SoSh notes are notoriously fragile, and are sometimes so decrepit they cannot be accepted in trade. This has prevented any increase in market share for the pre-1991 SoSh.

The Balweyn I and Balweyn II are, nevertheless, competing for market share. Even so, this fact has failed to allow the price of either of these currencies to be better regulated. One might be prompted to ask why? Well, the reasons for this could be manifold. I suspect, however, that it could have been due to the fact that the producers of each currency realised that each currency was being accepted at parity and as the one, and that they realised they were, in fact, competing for seigniorage, and possibly not market share; and this led to a tragedy of the commons as earlier described. On the other hand, the producers of these currencies could have thought that it would be more profitable to run down the currency into, what has become, a commodity money – a money worth its paper, ink and transport costs.

Whatever the reasons for the Balweyn I and Balweyn II not becoming more stable due to competition, we must first accept that they were, nevertheless, accepted before other competing currencies. This leaves us with the question as to why did Somalis continue to trade using two inferior currencies (the Balweyn I and Balweyn II) as opposed to other, superiorly managed, currencies operating inside and outside of Somalia? Well, it would be hard to argue it was due to legal restrictions.

Instead, we must deduce that Somalis had become accustomed to trading using Somali Shillings, and knew that their fellow Somalis had become similarly accustomed. Somalis rebuffed the option of switching currencies as costly and unattractive. Presented with this costly option of trading in a less salient alternative, they chose to use the more familiar Somali Shilling.


So, in the end we are forced to conclude that the ‘’success’’ of the Balweyn I and Balweyn II notes is probably the result of network effects and/or switching costs, and is most definitely not due to their superior stability.

Now, although it must be stressed that empirical analyses says nothing about Friedman and Hayek’s debate in general, we can say that in the very unique case of Somalia, that Friedman, at least, appears to have been correct, and network effects and/or switching costs have, in fact, prevented superior currencies from gaining market share.


  1. Luther, William J. 2011. Friedman Versus Hayek on Private Outside Monies: New Evidence for the Debate. Kenyon College.
  2. Hayek, Friedrich A. 1990. Denationalisation of Money – The Argument Refined: An Analyses of the Theory and Practice of Concurrent Currencies, 3rd edition. London: Institute of Economic Affairs.
  3. Friedman, Milton. 1984. ‘’Currency Competition: A Skeptical View.’’ Currency Competition and Monetary Union, P. Salin, ed. Martinus Nijhoff: Hague, 43.
  4. Friedman, Milton. 1984. ‘’Currency Competition: A Skeptical View.’’ Currency Competition and Monetary Union, P. Salin, ed. Martinus Nijhoff: Hague, 44.
  5. Friedman, Milton and Anna J. Schwatz. 1986. ‘’ Has Government Any Role in Money?’’ Journal of Monetary Economics, 17(1): 44.
  6. Hayek, Friedrich A. 1990. Denationalisation of Money – The Argument Refined: An Analyses of the Theory and Practice of Concurrent Currencies, 3rd edition. London: Institute of Economic Affairs.



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