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