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Policy Report

Monetary Nationalism Reconsidered


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Table of Contents

The rational choice would seem to lie between either a system of “free banking,” which not only gives all banks the right of note issue and at the same time makes it necessary for them to rely on their own reserves, but also leaves them free to choose their field of operation and their correspondents without regard to national boundaries, and on the other hand, an international central bank.
—F. A. Hayek (1937, 77) 

Two basic types of international monetary regimes are possible: those based on various independent national base moneys, and those based on a unified international base money. Regimes of the unified type can differ in at least two dimensions: (1) There may be distinct national deposit-transfer and currency systems variously regulated by national governments, that is, national “inside moneys.” Alternatively, checkable deposits and banknotes denominated in international money may be provided by private banks operating internationally. The former option exhibits what Hayek in 1937 called “monetary nationalism.” The latter option allows international inside moneys. (2) A common international base money can emerge from the free acceptance in various nations of a common base money supplied apolitically (for example, a commodity money such as gold). Joined to transnational banking, the result is international free banking: a global payment system with a single monetary standard, regulated by market institutions, that is, not dependent on any national or supranational government. Alternatively, an international money can be created by an international central bank. This is the “rational choice” Hayek describes in the epigraph above: international free banking or an international central bank.

This report explores these distinctions and the practical differences associated with them. As a vehicle for doing so, it critically reconstructs the arguments of Hayek’s 1937 book Monetary Nationalism and International Stability, a largely neglected work on the topic by one of this century’s leading economists.[1] Hayek set out, more than half a century ago, to dissect the policy doctrine he labeled “monetary nationalism” in a series of lectures. The lectures were given at the Graduate Institute of International Studies in Geneva and were subsequently published as a slim volume. At that time, monetary nationalism was a leading belief system in the world of economic policy ideas and an incipient trend in the world of realpolitik.

Hayek (1937, 4) defined “monetary nationalism” as “the doctrine that a country’s share in the world’s supply of money should not be left to be determined by the same principles and the same mechanism as those which determine the relative amounts of money in its different regions or localities.” In other words, the stock of money within national boundaries is not to be freely altered by movements of money through interlocal payment systems. Money is not to cross national borders, at least not in the same guises that it circulates in domestically. It is characteristic of a regime of monetary nationalism that a currency’s sphere of circulation is coextensive with the borders of the nation whose central bank issues it.

With the breakdown of the Bretton Woods and stopgap Smithsonian systems in 1971 and 1973, full-blown monetary nationalism became the status quo in both the realm of policy and the realm of ideas. Today its dominance is qualified by the European Monetary System (EMS) and the movement toward a European Central Bank. Still, the quantity of basic money in each major nation remains controlled by the national monetary authority within its borders, there being no international money that flows across borders from the banks of one nation to the banks of another.[2] Until the movement toward a European Central Bank began, few thought seriously of questioning this state of affairs. The central debating point had instead been the degree to which national monetary authorities should coordinate their policies.

Full-blown monetary internationalism—the antithesis of monetary nationalism—entails a globally homogeneous monetary system. Hayek (1937, 4) spoke in this regard of a “truly International Monetary System...where the whole world possessed a homogeneous currency such as obtains within separate countries and where its flow between regions was left to be determined by the results of the action of all individuals.” In such a system ordinary money (including deposits as well as currency) crosses national borders freely to settle international payments; money can flow among regions without hindrance, regardless of whether the regions are part of the same nation-state.

In the world of a globally homogeneous monetary system, there are no national monetary authorities who control national monetary aggregates. There is, indeed, little point in even compiling statistical records of national monetary aggregates, no more point than there would be today in compiling separate monetary aggregates for each of the 50 United States. Such an effort would be inconsequential (not to mention its practical difficulties) because it would be unreliable for prediction of regional economic activity. Dollar holders stand ready to make purchases from vendors anywhere in the dollar region, not only within their home states. Tracking of the aggregates could not be used in an effort at their control. To anticipate a point we will return to later, control of the national money stock in a globally homogeneous monetary system is not necessary for desirable macroeconomic performance, nor would people have reason to feel that it was necessary. Money flows from nation to nation are no more a cause for macroeconomic concern than flows within national boundaries.

In the choice between the two routes to a truly international monetary system, Hayek in 1937 expressed a preference for an international central bank over international free banking. This is surprising given the outlook on economic policy for which he was well known, a classical liberal appreciation for the profound limitations of government activism.[3]

The language Hayek used is even more surprising in light of his more recent (1973, 1988) critiques of “constructivist rationalism” in social thought. In the 1937 lectures, he spoke (p. 74) of “the ideal” of “a rationally regulated world monetary system,” and commented (p. 93) that “a really rational monetary policy could be carried out only by an international monetary authority, or at any rate by the closest cooperation of the national authorities and with the common aim of making the circulation of each country behave as nearly as possible as if it were part of an intelligently regulated international system.” His preference for such a system is implicit in the following statement (pp. 93–94):

[S]o long as an effective international monetary authority remains an utopian dream, any mechanical principle (such as the gold standard) which at least secures some conformity of monetary changes in the national area to what would happen under a truly international monetary system is far preferable to numerous independent and independently regulated national currencies. If it does not provide a really rational regulation of the quantity of money, it at any rate tends to make it behave on roughly foreseeable lines, which is of the greatest importance.

The final section of this report attempts to puzzle out (since he was less than fully explicit about it) what concrete policy would, in Hayek’s 1937 view, represent “really rational regulation of the quantity of money,” and to consider whether such a policy is in fact more desirable than the behavior of the quantity of money under an international free banking system. The purpose is not primarily to set the doctrine-historical record straight, but rather to analyze a live issue of monetary policy. Arguments for an international central bank have achieved political dominance in Europe today, and are being made in America by such economists as Richard N. Cooper (1988) and Ronald I. McKinnon (1988). It remains to be seen to what extent those sympathetic to Hayek's basic outlook on economic policy share a common cause with advocates of an international central bank.

This report will not address directly the relative merits of a common international money as against numerous independent currencies with floating exchange rates. But the argument made below, that the major defects in the performance of the historical gold standard are remediable by allowing greater international integration of banking, may, if persuasive, remove some important misgivings about a common international money.


Monetary internationalism is in several respects a matter of degree. The simplest example of a “truly” international system, to use Hayek’s phrase (and something close to his example), would be a world of two countries where only uniform gold coins were used as money in both countries. The system’s internationalism might be compromised if there were distinct national coinages; however, as Hayek (1937,p. 5) noted, nationalistic markings and denominations of coins would be irrelevant in practice if local mints would restrike foreign coins at a zero price and thereby allow unlimited interchanging of coins. A fully integrated currency system would then exist, with international movements of coins no more inhibited (unless transportation costs were discontinuously greater) than movements within each country.

Hayek’s discussion here may be read as assuming that minting services are nationally monopolized by law. Regionally specific standard coins (and standard units of account) can be expected to emerge spontaneously in the early stages of a system with coinage provided entirely by competitive private mints (see Selgin and White 1987). The process of market standardization of coins could conceivably follow national borders even without specific legal compulsion if such borders happened to correspond to boundaries of distinct linguistic, trade, or legal regions.[4]

With competitive mints, the price of coin restriking services will not be quite zero. What really matters for full integration, however, is zero-spread interchangeability (par acceptance) between the coins in trade. If this prevails, international currency flows will not be inhibited. The exchange rate between two coins will naturally correspond to their relative bullion contents. Coins of both denominations may even circulate widely in both countries. This is especially likely if the bullion content of one standard coin is a simple multiple of the other, so that the computational difficulties of dealing in both coins are minimal.


As Hayek emphasized at length (1937, 4–16), the historical world monetary system as organized under the gold standard prior to World War I fell far short of the ideal of true monetary internationalism despite the global acceptance of gold. It is important to recognize this point because the macroeconomic problems associated with the historical system have wrongly been thought to be inherent to any system making use of a common international money. In fact, as Hayek argued, those problems were due to the system’s failure to live up fully to the ideal of international money. Shortcomings appeared in two areas: (1) nonmetallic moneys gained circulation nationally but not internationally, and (2) the gold reserves held against bank-issued moneys came to be held by national central banks, rather than by transnational private banks.

In addition to gold, bank liabilities redeemable for gold (banknotes and checkable deposits) were generally accepted as media of exchange, and indeed formed the bulk of the money supply, in every commercially developed area. That a monetary system is “mixed” (as 19th-century writers characterized it) of coin, paper currency, and deposits is not itself a barrier to full international monetary integration. The circulation of a bank’s notes and checks could easily be international if the bank had branch offices in more than one country. Because banks were legally constrained to operate only within national boundaries, however, the money they issued was effectively irredeemable abroad and did not circulate there. The banknotes and checks of a French bank, for example, did not function as money in England.[5] Thus, only a fraction of the stock of money in circulation (namely, the coins held by the public) plus bank reserves, which constituted only a fraction of monetary bank liabilities, served as international money.

The difference made by the national specificity of bank-issued moneys was twofold. First, it altered the equilibrium distribution of gold around the world. More importantly, in conjunction with the national pooling of reserves, it altered the process through which a new equilibrium would be approached following a disturbance.

In any system with a basic money accepted internationally, the world stock of basic money comes to be distributed among various regions in accordance with the depth of demands to hold it by individuals and firms in those regions. For the sake of concreteness, let us assume for now that gold is accepted internationally as basic money, whatever the various national banking structures. In any international gold standard system, gold tends to flow in exchange for other goods into any area whose residents currently value it comparatively highly at the margin and thereby give it a comparatively high purchasing power (or, alternatively, whose residents experience an excess demand for gold). These gold flows are self-limiting, because the marginal value of gold falls for the recipients as more gold is gained and rises for the senders as more gold is lost.

In stock equilibrium the purchasing power of gold is everywhere the same (within the narrow limits set by transportation costs). The concepts of an equilibrating specie flow mechanism and an equilibrium distribution of basic money among the nations in accordance with the distribution of demand are well-known ideas emphasized by David Hume and David Ricardo in their respective analyses of the international gold standard.

The advent of bank-issued money naturally reduced the real demand for gold by providing a close substitute for some money-holding purposes. Where bank-issued money circulated locally or nationally, it provided a substitute more convenient than gold for most local or national payments. The global pattern of demand would not have been altered (though real demand would have been everywhere reduced) if in every nation at every date members of the public had regarded bank money as preferable to gold for exactly the same class of transactions (e.g., all but international transactions), if those transactions had constituted the same fraction of total transactions, and if banks had held identical fractional reserves of gold against their liabilities. In actuality these conditions did not hold, and deviations from them were not mutually offsetting (which would, of course, have been extremely unlikely).

The effect of the availability of banknotes and checkable deposits on the demand for gold by both the public and the banks clearly varied from nation to nation, as bank-mediated payment practices developed in different ways and at different paces.[6] These differences were due at least in part to the variety of legislated restrictions and regulations that produced the growth of banking systems along strictly national lines. Had international branch banking been allowed, and had banking been placed on the same regulatory footing in all nations, banking practices would not have varied so much from nation to nation. The global pattern of demand for gold and the equilibrium allocation of the stock were therefore different from what they would have been in the absence of monetary nationalism.


The national specificity of bank-issued money also altered importantly the process by which money flowed from one nation to another. The relevant benchmark here is a system of free international branch banking rather than the purely metallic international system considered above, for our focus is on the difference made by monetary nationalism, not by the existence of bank-issued money as such. We need to go beyond Hayek’s treatment of “the function and mechanism of international flows of money” in his second lecture (1937, 17–34), where he contrasted the historical gold standard with a purely metallic system rather than with an international free banking system. His discussion did not clearly separate the difference made by bank-issued money from the differences made by national specificity of that money and by the existence of national reserve systems.

Hayek (1937, 10) made the important point that the development of bank-issued money “would have made little difference [for international monetary relations] if the banks had not developed in a way which led to their organization into banking ‘systems’ along national lines.” He was not clear, however, concerning the characteristics of the relevant benchmark non-nationalistic banking system. He continued:

Whether there existed only a system of comparatively small local unit banks, or whether there were numerous systems of branch banks which covered different areas freely overlapping and with-out respect to national boundaries, there would be no reason why all the monetary transactions within a country should be more closely knit together than those in different countries.

Hayek’s point here was that in neither case would all the inhabitants of a country become dependent on “the same amount of more liquid assets held for them collectively as a national reserve,” as they did historically.

Contrary to Hayek, there are reasons to expect systems of “small local unit banks” to be knit together nationally. Local unit banking (certainly in the United States, and probably generally) represents not a free market outcome but the result of interventionist banking policies. Such policies are the work of national or subnational governments. No two governments are likely to pursue them in such a way that domestic banks may interact—in clearing systems, for instance—as easily with banks across the border as with other similarly regulated domestic banks. U.S. experience shows clearly that the development of a national reserve system is perfectly congenial with, and in several ways encouraged by, unit banking. The Federal Reserve System was in large part designed in deference to unit banking interests as a substitute for the management and interlocal allocation of reserves that in freer banking systems (such as Canada’s) was conducted by the head offices of widely branched banks (see Eugene White 1983).

In effect, a policy of local unit banking, by drawing the lines a bank may not cross even more narrowly than does a policy of monetary nationalism, and thereby circumscribing to an even greater degree the circulation of bank-issued money, represents an even further regression from the ideal of a truly international monetary system. The relevant benchmark for assessing monetary nationalism is the second system Hayek mentions in the extract above, a system of free international branch banking.

To draw the most immediate but certainly not the most important contrast first, clearing and settlement mechanisms for individual payments differ between the systems of free international branch banking and of monetary nationalism. In the first system, but not in the second, it is possible for any particular international payment to involve two customers of the same bank, so the simple transfer of a claim on that bank settles the payment. In such a case no movement of reserve money from bank to bank is necessary. Bank-issued money can serve as international money. We may assume that regional unit-of-account differences would not persist, or would prove no obstacle given two-way par convertibility. A bank presumably would be indifferent to conversion of a dollar-denominated claim against it into a bullion-equivalent franc-denominated claim.

Now consider an international payment that involves an inter-bank transfer. Under either system a payment from a customer of domestic Bank X to a customer of foreign Bank Y means at the margin a loss of reserve money by Bank X and a gain by Bank Y. In the limiting case of fully integrated international branch banking, where all competing banks operate globally and all belong to a single global clearing system, all international payments would be cleared and settled in exactly the same manner as intranational payments. Bank X’s reserve loss would become Bank Y’s gain directly through the clearinghouse, with no third bank involved.

Under the monetary nationalism attending the historical gold standard, commercial banks seldom were allowed to branch abroad or to belong to multiple national clearing systems. Rather, correspondent arrangements linked pairs of banks in different nations. Two intermediary banks were thus typically needed for international clearing and settlement.

In the less pure case of partially integrated international branch banking, where some banks are internationally branched while others have limited range, and where distinct national clearing-houses therefore still exist, direct settlement can occur for checks and wire transfers against deposits in the internationally branched banks that belong to both the domestic and the relevant foreign clearing system. International Banks can also, for a fee, perform the service of linking the two clearinghouses for the other banks. International Bank Z can transfer reserve money from its foreign branch to foreign Bank Y through the foreign clearinghouse in exchange for receiving matching reserves domestically from Bank X. In the section that follows, the case of partial integration will be neglected in order to focus on the cleaner contrast between full international banking integration and complete monetary nationalism.


The primary concern in this contrast of monetary processes under the two systems is not with the settlement of individual transactions, but with how the systems as wholes would respond to large-scale disturbances to money supply or demand. Following Hayek’s example, consider a shift in demand away from a particular product produced in Country A in favor of a product produced in Country B. The resulting gain in real income by workers and investors in the favored industry, and in turn by their trading partners as increased real spending spreads outward from the favored industry, will normally mean an increase in Country B’s real money demand. The reverse process will   spread from the disfavored industry in Country A.[7] Some    further adjustment is needed to satisfy these shifts in money demand.

The regeneration of monetary equilibrium, given the above hypothesized shifts in money demand, calls for a redistribution of real money balances: an increase in the real quantity of money in Country B and a decrease in Country A. With a common money accepted in both countries and able to flow from one to the other, as characterizes both of the banking systems we are considering here, an actual transfer of some kind of money from A to B will constitute at least part of the equilibrating process that brings about the requisite changes in both countries.

Under a system of fully integrated international branch banking, the redistribution of money can be made completely in the same manner as a redistribution between two neighborhoods within a single country, namely, by what appear to be simple transfers of bank-issued money. Country B residents will accept payment for their net exports in banknotes and checks issued by Country A bank branches, because the same parent banks do business in their own country. The same brands of banknotes and checks are current in both countries. Country B bank branches will accept at par banknotes and checks issued by Country A bank branches. Transnational Banks X and Y find the liabilities issued by their Country A branches contracting in volume, while the liabilities issued by their Country B branches expand. No crisis arises for either bank. These transfers of bank-issued money are not the entire international story: they will be accompanied by small international movements of reserve money from A to B to the extent that the banks perceive marginal shifts in that direction in the prudent levels of their vault cash reserves at branches in the two countries.

The process of international redistribution of money may incidentally favor one bank over another. Country B residents may for whatever reason prefer to divide the additions to their balances among the various banks in proportions different from those chosen by the Country A residents who are reducing their balances. Perfect equality of proportions is indeed improbable. In the likely case of a slight change in the market shares of the various banks, there will be an interbank transfer of reserve money. Suppose that in the two countries put together, Bank X experiences a reduction in the volume of its monetary liabilities held by the public, whereas Bank Y on net gains deposits and enjoys greater circulation for its banknotes, and all other banks are unaffected in the aggregate. The result will be a net transfer of clearing reserves from X to Y. There is net “destruction” of X-money and “creation” of Y-money, to use the textbook terminology, though these events are more appropriately thought of in this case as instigating rather than resulting from the reserve flow.

The important point to be made is that these events involved with an interbank redistribution of money do not themselves constitute an international monetary redistribution, nor are they an essential part of the process of international adjustment discussed two paragraphs back. Under the assumption that both banks are multinational, the expansion of Bank Y’s share of the market for bank-issued money at the expense of Bank X’s share is not as such a movement of money from one nation to another. Bank moneys in the system we are hypothesizing are not nationally specific, but circulate globally. (If international circulation seems implausible, consider that Visa, MasterCard, and American Express are globally accepted today.)

Under the assumption of an international clearing system, the reserves held for clearing are not nationally specific either, so transfer of ownership of them from one multinational bank to another does not constitute an international transfer of reserve money. The process of interbank redistribution may create difficulties for the contracting bank, but interbank transfers as such do not create any of the macroeconomic problems associated with monetary contraction in a specific regional economy. While one bank is contracting, another is expanding alongside it. No banking system is losing reserves.

In a system with all bank moneys restricted to national circulation, by contrast, international monetary redistribution must take a route other than transfers of bank-issued money. Assuming that in both countries the bank-issued moneys are fractionally backed, the appropriate redistribution could not come about through a transfer of reserve money to the full amount of the warranted money stock changes (assuming the positive and negative changes in money demand to be equal in absolute value). Such a large transfer would lead the banks in Country B to expand their liabilities by a multiple of the reserves gained, and the reverse for the banks in Country A. Total money stock changes would then exceed the amounts appropriate for reestablishing monetary equilibrium.

The redistribution must, to paraphrase Hayek (1937, 17), be brought about partly by an actual transfer of reserve money from country to country, but largely by a contraction of the quantity of bank-issued money in one country and a corresponding expansion in the other. With nationally restricted rather than multinational banks, the redistribution of bank-issued money from one nation to is unavoidably associated with redistribution from one set of banks to another nonintersecting set, and thereby with transfers of clearing reserves from one set of banks to another and from one nation another. One banking system is contracting, and another is expanding, with potentially momentous macroeconomic consequences (discussed in more detail below).


This contrast between the mechanism of monetary redistribution that operated under the monetary nationalism prevailing during the classical gold standard era, and the mechanism that is available under a free international banking system, was sharpened by the historical development of what Walter Bagehot called the “one-reserve system of banking,” or what Hayek (1937, 76) called “the organization of banking on the ‘national reserve’ principle.” A single institution, the central bank, came to hold the entire gold reserve of a nation’s banking system. This was not a natural development, but rather the result (not always deliberate) of banking legislation. In Britain, as Bagehot explained in his celebrated Lombard Street (1873, pp. 99–100), it grew out of the legal privileges bestowed on the Bank of England. Until the 1830s,

 the Bank of England had among companies not only the exclusive privilege of note issue, but that of deposit banking too. It was in every sense the only banking company in London. With so many advantages over all competitors, it is quite natural that the Bank of England should have far outstripped them all. Inevitably it became the bank in London; all the other bankers grouped themselves round it, and lodged their reserve with it. Thus our one-reserve system of banking was not deliberately founded upon definite reasons; it was the gradual consequence of many singular events, and of an accumulation of legal privileges on a single bank ... which no one would now defend.

Other nations in the later 19th and early 20th centuries, taking Britain as their model, more deliberately fostered exclusive gold reserve holding by a central bank.

It is a central theme of Bagehot’s book that, as he opens his concluding chapter (p. 329), “the natural system of banking is that of many banks keeping their own cash reserve, with the penalty of failure before them if they neglect it,” whereas England had through the privileges bestowed upon the Bank of England arrived at the system “of a single bank keeping the whole reserve under no effectual penalty of failure.” Hayek’s treatment of this aspect of the contrast between the natural banking system that would arise in the absence of legislative interference, and the system that results from centralizing privileges, is unfortunately muddied.

Hayek suggested (1937, 11) that the centralization of reserves is “only partly due to deliberate legislative interference” and is “partly due to less obvious institutional factors,” such as “the fact that a country usually has one financial centre” where excess reserves can most readily be invested in liquid earning assets. He cited the United States prior to the founding of the Federal Reserve System as an example of a country where such a centralization of reserves took place “in spite of the absence of branch banking.” He added that the tendency toward centralization “is considerably strengthened if instead of a system of small unit banks there are a few large joint stock banks with many branches; still more if the whole system is crowned by a single central bank, holder of the ultimate cash reserve.”

Hayek’s discussion here is problematic in several respects. The congregation of banks’ head offices in a financial center, which can be expected to occur under a system of unrestricted branch banking, does not in fact represent centralization of reserves in the sense that Hayek (1937, 10) himself rightly insisted is relevant: it does not mean that “all the inhabitants of a country” become “dependent on the same amount of more liquid assets held for them collectively as a national reserve.” Each of the many widely branched banks will hold its own distinct reserves. In the United States it was precisely the fact that banks from the hinterlands were legally barred from opening New York offices, and vice versa, that led country banks to deposit their reserves with city banks. Only as a result of such restriction-driven interbank deposits were reserves treated as a collective resource or common pool. Many separate banks counted on the availability of reserve funds that could not in fact be made available to them all in the event of simultaneous need. Country banks had to play preemptive strategies of claiming reserves before others could do so when even the possibility of a coming reserve stringency was perceived. Branch banking is an alternative to this treatment of reserves, not a “strengthening” of it. Much less is it a way station between unit banking and central banking.

Branch banking eliminates the problems of strategic behavior among independent claimants to a pool of reserves by bringing the various claimants within the same firm. Many branch banks rely on the same central pool of reserves, as did the several country banks who had deposits in the same city bank, but potential conflicts among the satellite banks are internalized by unitary ownership. In the terminology of industrial organization theory, we have another case where vertical integration eliminates the problem of a potential for postcontractual opportunistic behavior between contracting firms (see Klein, Crawford, and Alchian 1978). In branch banking we have vertical integration between reserve-holding and reserve-claiming bank offices.

The industrial organization perspective is useful here because it enables us to see that central banking does not really solve the problem at hand, but instead perpetuates the division of responsibility between the reserve holder and the reserve claimants. Central banking changes only the form of the problem. Given that a central bank has the power to create new reserves for the domestic commercial banks,[8] its problem is not to ration a fixed stock of reserves when there are multiple independent banks laying claim, but to limit the creation of new reserves when they are sure to be called for by near-illiquid banks (and possibly by other claimants). Under a gold standard, such a limitation is needed to prevent an external drain from carrying away all of the central bank's gold reserves. In a fiat money system, the limitation is needed to prevent uncontrolled inflation.

In a passage separate from the last one quoted, Hayek (1937, 13) referred to what is essentially the problem of opportunistic claimants faced by a central bank on a gold standard:

[T]he fundamental dilemma of all central banking policy has hardly ever been really faced: the only effective means by which a central bank can control an expansion of the generally used media of circulation is by making it clear in advance that it will not provide the cash (in the narrower sense) which will be required in consequence of such expansion, but at the same time it is recognized as the paramount duty of a central bank to provide that cash once the expansion of bank deposits has actually occurred and the public begins to demand that they should be converted into notes or gold.

Hayek’s capsulization of it can easily be read as emphasizing the fact that this dilemma—the classic conflict between fighting external and internal drains placed in a dynamic context—is a case where conflicting strategic claims on the central bank’s reserves arise. The dilemma arises from the central bank’s inability, given a duty to fight internal drain, to credibly precommit itself not to create reserves. To borrow a term from the modern literature (Kydland and Prescott 1977), the central bank faces a time-consistency problem even under a gold standard regime. The head office of a branch banking firm has no such problem.


International redistributions of money under the one-national-reserve system are potentially momentous. The initial outflow means a loss of central-bank reserves. The central bank’s reserves are typically too slender to allow the outflow to run its natural course unaided, that is, to allow the volume of central bank liabilities (which serve as reserves for the commercial banks) to shrink merely unit for unit with its reserves. The cumulative loss of international reserve money under that process would exhaust the central bank’s reserves.

Thus, the central bank must artificially accelerate the process that curtails the net export of international reserve money. It can do so by (1) selling securities in its portfolio, (2) taking the route that Hayek (1937, 27) emphasized, “compelling people to repay loans,” which likewise shrinks its portfolio, or (3) raising its discount rate in the manner of classical central-banking policy. Each of these measures contracts the national supplies of high-powered money and loanable funds, and temporarily raises short-term interest rates, with the dual effects of suppressing spending on imports (by suppressing spending generally) and attracting inflows of funds from abroad.

Hayek (1937, 28–30) emphasized that such a credit squeeze changes the allocational impact of the process of international monetary redistribution. The contraction in loans “will mean that the full force of the reduction of the money stream will have to fall on investment activity.” The engineered rise in the interest rate will put it “above the equilibrium or ‘natural’ rate of interest” for a time. (Once the natural flow-limiting process acting through income and expenditure reductions, which continues to run its course, has progressed far enough, the credit squeeze becomes overkill and can be discontinued.) Investors “who would otherwise not have been affected by the change” are thus compelled “to give up money which they would have invested productively.” Investment plans are disappointed, and a spell of unemployment of capital and complementary labor—a recession—results.

Those familiar with the business cycle theory of Hayek’s Prices and Production (1931) will recognize this account as the inverse of the unsustainable Hayekian boom fueled by artificially low interest rates. The central point of this discussion, however, does not depend on the empirical importance of interestrate-linked allocational effects in accounting for business cycle phenomena (about which many economists are skeptical). Within the framework of almost any monetary theory of business cycles, the central bank causes a disturbance when it engineers a contraction of the domestic money supply that outruns the cumulative reduction in money demand from the chain of income reductions set in motion by the real shift initially postulated.

Viewed in a monetary disequilibrium framework (see Yeager 1986), the critical feature of the external-drain-curtailing central-bank policy is that it creates an excess demand for money, which implies an excess supply of commodities and labor, and which instigates a recession. Alternatively viewed in a continual-market-clearing framework, the policy creates a negative price-level shock.[9] In either of these frameworks, we have “a disturbance which possesses all the characteristics of a purely monetary disturbance, namely that it induces changes ... which ... are not based on any corresponding change in the underlying real facts” of tastes, technology, or resources (Hayek 1937, 31).

As Hayek (1937, 33) emphasized, monetary disturbances of this sort are “defects inherent in the system of the collective holding of proportional [fractional] cash reserves for national areas, whatever the policy adopted by the central bank or the banking system,” short of reserves being kept “large enough to allow them to vary by the full amount by which the total circulation of the country might possibly change.” The national limitation of bank-issued money will inevitably mean that international flows of money are attended by money supply disturbances (unless the classical Currency Principle of 100 percent marginal gold reserve requirements, which would force the money supply to shrink precisely one for one with exports of gold, is applied to all forms of bank-issued money).

International redistributions of money within a system of fully integrated international branch banking would involve no such worrisome side effects. An interlocal money transfer, prompted, for example, by a change in spending patterns and relative money demands of the sort considered above, would reduce the quantity of money in one area and raise it in another. There is no reason to believe, however, that it would create a monetary disturbance in either place the way accelerated money destruction or creation within a national banking system does. The absence of disequilibration that Hayek (1937, 24) affirmed for interregional money flows under a purely metallic international monetary system holds also for an international branch banking system with bank-issued money.

As already discussed, the process of international money redistribution under global free banking is likely to (although it logically need not) involve a net expansion of monetary liabilities for some banks, a contraction for others, and a corresponding interbank reserve flow. The aggregate of all the contractions is much smaller in magnitude than it is under monetary nationalism, because the typical transnational bank will have inflows of money at some branches to offset at least partially the losses of its branches in the outflow region. The banks that contract on net may individually be forced to sell off marketable securities or actively call in loans in order to offset their losses of reserves.

This process does not mean a credit crunch for the region of net monetary outflow, however, nor the creation of an excess demand for money there. Even if bond and loan markets retain some regional specificity, no interest rate rise should be created by the actions of the contracting banks. Recall that the banks enjoying net expansion also have branches in the outflow region. Those banks will be in a position to buy an equivalent volume of securities and to extend loans to the borrowers turned away by the contracting banks. The profit motive will prompt them to take just such actions at the initially prevailing interest rate.

Alternatively, the expanding banks are in a position to lend reserves to the contracting banks to enable them to contract their assets at an optimizing pace not requiring hasty securities sales or calling in of loans. Being members of the same international clearing system or, in the case of partial integration, being linked by membership of at least some banks in multiple national clearing systems, the banks involved can be expected already to be regular players in an interbank reserve loan market (like the present-day Federal Funds market) that makes such loans extremely easy to arrange.

Taking the branches of net-contracting and net-expanding banks in the outflow region together, then, there is no reason for an exaggerated regional contraction of bank assets or monetary liabilities. Market forces will act to prevent any such occurrence. No excess demand for money will tend to afflict one nation while an excess supply crops up in another.

International integration of banking on a common monetary standard, furthermore, would promote the international integration of financial markets. International interest arbitrage would be even more complete than it is today, unburdened by exchange rate risk. Thus, an excess demand for loanable funds in one nation matched by an excess supply in another could not persist for any significant period. Interest rates would be less influenced by nationally distinct supply and demand conditions under international free banking than under a national reserve system.

To forestall possible misunderstanding, the argument advanced here does not involve the following two claims. First, it does not claim that all monetary disturbances are ruled out in a truly international monetary system. Exogenous region-to-region shifts in money demand can still occur, as the case discussed illustrates. The argument claims only that an international free banking system, unlike a system of national central banks, does not amplify such disturbances by adding money supply shocks to the process of adjustment. Interregional integration, whether across nations or across parts of a single nation, promotes the smoothest possible adjustment to interregional money demand shifts. Interregional shifts in the demand for dollars are presumably going on all the time within the United States as growth rates vary among parts of the country, but U.S. citizens hardly notice. Interregional monetary redistributions within an integrated banking system create no balance-of-payments crises.

Second, the argument here does not claim that the process of international monetary redistribution goes smoothly in an integrated system because each unit of money transferred necessarily reflects, and simultaneously relieves, excess supply of money in the sending country and excess demand in the recipient country. A shift in spending patterns of the type we have discussed may result in an outflow of money in the intermediate run greater than the final outflow, due to the “shock absorber” function of money balances. (This fact contributes to the difficulty a central bank faces in simply letting the outflow run its course.) Money balances may fall in the first country below the long-run desired level of money balances, and the reverse may happen in the second country, because individuals do not immediately decide upon or execute the changes in spending and income-earning activities necessary to reestablish the desired levels. A “long and variable lag” may transpire before the senders replenish excessively depleted balances and before the recipients dissipate an excess accumulation.

The gradualness of these adjustments is part and parcel of a process of economic coordination. Though in this sense there may be “overshooting” of national money stocks, no rationale emerges for a counteracting official policy. It is a demerit of the accelerated stanching of reserve flows that is characteristic of monetary nationalism that, as Hayek (1937, 29) put it, the transfer of only a fraction of the amount of money which would have been transferred under a purely metallic system, and the substitution of a multiple credit contraction for the rest, as it were, deprives the individuals in the country concerned of the possibility of delaying the adaptation by temporarily paying for an excess of imports in cash.

The international acceptance of bank-issued moneys, and the presence of branches of expanding banks even in the region from which money is flowing, furnishes the possibility of optimally gradual adaptation under a system of international free banking.

To put the argument of this section in a slightly different way, the process of international redistribution of money does not, with global branch banking, involve a deflation in one country and an inflation in another as those terms are today usually understood. For this reason, one is not compelled toward regarding independent national currencies with floating exchange rates as the best feasible option among international monetary arrangements, even upon accepting for an unalterable fact, as did Milton Friedman (1953, 171) in his classic essay ”The Case for Flexible Exchange Rates,” that “nations have been unwilling to allow [balance of payments] deficits to exert any deflationary effect.”[10]


The basic flaw underlying the doctrine of monetary nationalism, in Hayek’s critical interpretation (1937, 35), is to be found in the premise “that the criteria of a good monetary policy which are applicable to a closed system are equally valid for a single country” within a network of global trade. This premise is false, whatever the criteria of good monetary policy might be.

The rational choice between alternative truly international monetary systems to which Hayek referred in this report’s opening epigraph—the choice between free banking without regard to national borders and an international central bank—depends crucially on spelling out the criteria of good monetary policy and comparing the alternative systems’ abilities to fulfill them. If indeed “there is no rational basis for the separate regulation of the quantity of money in a national area which remains a part of a wider economic system” (Hayek 1937, 73), is there yet a rational basis for the deliberate regulation of the quantity of money by a world central bank?

It should be noted that Hayek, unlike Cooper, McKinnon, and advocates of the European Central Bank project, did not endorse the establishment of a multinational fiat money, at least not until the political realities change. So long as contending national states and the temptations of inflationary finance continue to exist, the benefits of an international commodity money exceed its costs:

On purely economic grounds it must be said that there are hardly any arguments which can be advanced for, and many serious objections which can be raised against, the use of gold as the international money. In a securely established world State with a government immune against the temptations of inflation it might be absurd to spend enormous effort in extracting gold out of the earth if cheap tokens would render the same service as gold with equal or greater efficiency. Yet in a world consisting of sovereign national States there seem to me to exist compelling political reasons why gold (or the precious metals) alone and no kind of artificial international currency, issued by some international authority, could be used successfully as the international money (Hayek 1937, 74–75).

Hayek elaborated (1937, 75) that a suitable reserve money is one that “in all eventualities will remain universally acceptable in international transactions.” The threat of war and other crises will loom “so long as there are separate sovereign States.” Against such threats people will want to hold:

the one thing which by age-long custom civilized as well as uncivilized people are ready to accept—that is, since gold alone will serve one of the purposes for which stocks of money are held ... and since to some extent gold will always be held for this purpose, there can be little doubt that it is the only sort of international standard which in the present world has any chance of surviving.

This is a powerful argument against proposals for an international fiat money issued by a coalition of central banks, because coalitions among national governments are notoriously fragile. It also suggests that there are natural obstacles to the market acceptance of a newfangled international money issued privately. Gold has the virtue of being no issuer’s liability, and therefore of being independent of any issuer’s solvency, probity, reputation, or political fortunes. Gold has a history that assures potential holders of its future acceptability.

Hayek’s argument alerts us to the likelihood that so long as nations exist, gold is going to continue to be held in both official reserves and private portfolios, as we have indeed seen since its official demonetization in 1971. Given that the real demand to hold gold is going to persist under any fiat money regime, and may even grow (as the rise in gold’s relative price since 1971 suggests has occurred) due to the uncertainty inherently surrounding fiat money, monetization of gold is not costly. One of the leading objections to the monetary use of gold, the additional resource cost it is supposed to entail by comparison to fiat money, rests on empirically false premises (see Garrison 1985).

With the basic money of the world being furnished outside the banking system by gold mines and private mints, a world central bank could act on the quantity of money through the “money multiplier” that links the quantity of bank-issued money to the quantity of gold. Hayek’s statements concerning the desirable characteristics of a monetary system suggest that he considered it desirable for a world central bank to act so as to offset changes that would otherwise raise or lower the multiplier. For each nation taken individually, he espoused the Currency Principle ideal (1937, 86, 90) that the money stock should change only one-for-one with flows of gold, “making the credit money provided by the private banks behave as a purely metallic circulation would behave under similar circumstances.” Following that principle, changes in a money multiplier should be avoided for the global stock of money. Hayek’s ideal of “really rational regulation of the quantity of money” may consist largely in this.

This interpretation is reinforced by reading the fourth lecture of Hayek’s 1931 Prices and Production, in which a more explicit guide to “neutral” monetary policy is offered. Hayek argued there (108–11) that prima facie “the supply of money should be invariable” in the face of changes in production. Though changes in the quantity of money in an open economy serve an important function, that “of enabling the inhabitants to draw a larger or smaller share of the total product of the world,” no such function is served by changes in the quantity of money in a closed economy. “An increase of its monetary circulation either for [an isolated] community or for the world as a whole” is “useless.” The fact that changes in the quantity of money can come about through changes in a money multiplier, and the fact that the multiplier shows a well-known procyclical pattern, creates a role for the central bank (1937, 117): it should contract its own high-powered liabilities to offset increases in the multiplier due to reductions in commercial bank reserve ratios during the upswing.

Hayek also argued that the central bank of a closed economy should, for the sake of monetary neutrality, vary the quantity of money reciprocally with movements in velocity, so as to keep constant “the volume of payments made during a period of time” (1937, 123); that is, the central bank ideally should follow a rule of keeping constant what the quantity equation denotes MV. But he conceded (1937, 124–25) that this rule “can never be a practical maxim of currency policy,” as it is impossible to translate into operational guidelines. Hence “the only practical maxim for monetary policy” is that the bank should not expand its liabilities either to allow for a boom or to combat a recession.

It is not possible to offer a thorough examination of various policy criteria here. George A. Selgin (1988, 1991) has discussed at some length the concept of monetary equilibrium and has argued that a free banking system is better equipped than a central banking system to maintain it.[11] Selgin does not deny that the ratio of bank-issued money to gold would vary in a free banking system, but argues that unregulated competition would tend to allow such variations only in response to changes in demand for bank-issued money, and thereby would promote equilibrating rather than disequilibrating adjustments. A central bank, by contrast, inherently lacks the knowledge necessary to simulate the competitive result.

Quite apart from the informational problems of central banks, anyone who shares Hayek’s “practical” concern with counteracting central banks’ tendency toward unwarranted expansions of the quantity of money may well find a free banking system to be the best practical alternative, given the temptations to which central banks are prone. A world central bank, and to a slightly lesser extent a pan-European central bank, would be a monopolist without any competitive discipline. It is difficult to imagine how effective incentives could be created for its managers to adhere to an ideal policy, or why its sponsoring governments would even want to tie its hands, since they would thereby limit its ability to serve their changing wants. If inflationary biases are as inherent to a multinational central bank sponsored by a consortium of nation-states as they are to the fiat-money-issuing central banks individually sponsored by those states, then the fundamental obstacle to a sound international monetary system is not so much monetary nationalism as it is monetary statism.


Bagehot, Walter. 1873. Lombard Street: A Description of the Money Market. London: Henry S. King.

Berman, Harold J. 1983. Law and Revolution: The Formation of the Western Legal Tradition. Cambridge: Harvard University Press.

Cooper, Richard N. 1988. “Toward an International Commodity Standard?” Cato Journal 8 (Fall): 315–38.

Ebeling, Richard M. 1991. “Commentary: Stable Prices, Falling Prices, and Market-Determined Prices.” In Richard M. Ebeling, ed., Austrian Economics: Perspectives on the Past and Prospects for the Future. Hillsdale, Mich.: Hillsdale College Press.

Friedman, Milton. 1953. Essays in Positive Economics. Chicago: University of Chicago Press.

———. 1984. “Comment [on McCloskey and Zecher 1984].” In Michael D. Bordo and Anna J. Schwartz, eds., A Retrospective on the Classical Gold Standard, 1821–1931. Chicago: University of Chicago Press.

Garrison, Roger. 1985. “The Costs of a Gold Standard.” In Llewellyn H. Rockwell, Jr., The Gold Standard: An Austrian Perspective. Lexington, Mass.: Lexington Books.

Hayek, F. A. 1935. Prices and Production, 2nd ed. New York: Augustus M. Kelley, 1967 reprint.

———. 1937. Monetary Nationalism and International Stability. New York: Augustus M. Kelley, 1971 reprint.

———. 1960. The Constitution of Liberty. Chicago: University of Chicago Press.

———. 1973. Law, Legislation, and Liberty, vol. 1, Rules and Order. Chicago: University of Chicago Press.

———. 1978. The Denationalisation of Money, 2nd ed. London: Institute of Economic Affairs.

———. 1988. The Fatal Conceit: The Errors of Socialism. Edited by W. W. Bartley III. Vol. 1 of the Collected Works of F. A. Hayek. London: Routledge.

Kagin, Donald H. 1981. Private Gold Coins and Patterns of the United States. New York: Arco.

Klein, Benjamin, Robert Crawford, and Armen Alchian. 1978. “Vertical Integration, Appropriable Rents, and the Competitive Contracting Process,” Journal of Law and Economics 21 (October): 297–326.

McCloskey, D. N., and J. Richard Zecher. 1984. “The Success of Purchasing-Power Parity: Historical Evidence and Its Implications for Macroeconomics.” In Michael D. Bordo and Anna J. Schwartz. eds., A Retrospective on the Classical Gold Standard, 1821–1931. Chicago: University of Chicago Press.

McKinnon, Ronald I. 1988. “An International Gold Standard Without Gold” Cato Journal 8 (Fall): 351–73.

Ruiz, Jose Luis Garcia. 1989. “Comment on ‘Monetary Nationalism Reconsidered.’” Unpublished manuscript., Universidad Complutense, Madrid.

Selgin, George A. 1988. The Theory of Free Banking: Money Supply Under Competitive Note Issue. Totowa, N.J.: Rowman and Littlefield.

———. 1991. “Monetary Equilibrium and the ‘Productivity Norm’ of Price-Level Policy.” In Richard M. Ebeling, ed., Austrian Economics: Perspectives on the Past and Prospects for the Future. Hillsdale, Mich.: Hilldale College Press.

Selgin, George A., and Lawrence H. White. 1987. “The Evolution of a Free Banking System.” Economic Inquiry 25 (July): 439–57.

Smith, Adam. 1976. An Inquiry into the Nature and Causes of the Wealth of Nations. Edited. R. H. Campbell, A. S. Skinner, and W. B. Todd. Oxford: Oxford University Press.

White, Eugene Nelson. 1983. The Regulation and Reform of the American Banking System. Princeton: Princeton University Press.

White, Lawrence H. 1984. Free Banking in Britain: Theory, Experience, and Debate, 1800–45. Cambridge: Cambridge University Press.

———. 1991. “Commentary: Norms for Monetary Policy.” In Richard M. Ebeling, ed., Austrian Economics: Perspectives on the Past and Prospects for the Future. Hillsdale, Mich.: Hillsdale College Press.


[1]. As Ruiz (1989) notes, Hayek (1978, p. 104 n. 1) has provided the following retrospective view of his own 1937 work: “It contains a series of lectures hastily and badly written on a topic to which I had earlier committed myself but which I had to write when I was pre-occupied with other problems. I still believe that it contains important arguments against flexible exchange rates between national currencies which have never been adequately answered, but I am not surprised that few people appear ever to have read it.”

[2]. An exception might be made here for the informal use of dollars and other foreign currencies, especially in financially repressed and high-inflation countries. The central bank’s control over the quantity of money is of course constrained more or less tightly where it commits to a pegged exchange rate, as in the EMS, the West African franc zone, and in countries like Argentina which at the moment are pegged to the U. S. dollar.

[3]. Ruiz (1989) reminds us that Hayek endorsed central banking in The Constitution of Liberty (1960, chap. 21). But that endorsement may be viewed as acquiescence to the status quo, whereas advocacy of an international central bank in 1937 amounted to pushing for an expansion of state control over money.

[4]. The geographical domain of a legal system need not be coextensive with that of a nation-state. Nor vice-versa. On the history of non-nationalistic legal systems in Europe, see Berman 1983. On the history of private mints in the United States, see Kagin 1981.

[5]. An interesting exception that qualifies the rule was the circulation of Scottish banknotes in northern English counties during the early 19th century despite the prohibition of cross-border branching. Because their circulation was limited to counties adjacent to the border, the episode actually illustrates the point that the area of circulation for a bank’s liabilities is normally limited by the extent of its branch network. See White 1984, 42.

[6]. The comparatively early spread of gold-economizing bank liabilities in Scotland, for example, allowed that country to export gold and silver in exchange for consumable and capital goods in the manner discussed at length by Adam Smith (1976, 292–98, 320–21).

[7]. Hayek (1937, 21–23) rightly pointed out that it can be misleading to leap from the hypothesized shift in product demands to reasoning in terms of aggregate shifts in real income, money demand, and money supply, and especially to movements in national price levels. The particular B residents whose incomes directly rise may spend some of their increased incomes on imports of certain goods from Country A, rather than simply increase the demand for the products of their B neighbors generally. The income losers in Country A may cut back on particular imports from Country B. There will generally be both winners and losers within each country from the relative price and income movements finally brought about by the sequence of spending adjustments prompted by the initial shift.

[8]. Even under the international gold standard, a central bank could create new reserves for the domestic banking system by issuing more of its own liabilities, at least in the short run before the price–specie-flow mechanism would begin to drain it of its own gold reserves and thereby force it to reverse course. It could ignore even that limit if it were prepared to suspend redeemability.

[9]. The hypothesis that markets continually clear, combined with the hypothesis (found in the “Iowa City” model of McCloskey and Zecher [1984, 124–25]) that the law of one price continually reigns internationally, would, however, seem to rule out the possibility that a national central bank could ever create a monetary disturbance. For criticism of the historical applicability of such a combination, see Friedman 1984.

[10]. One can, in similar fashion, make a case against independent national currencies by accepting as unalterable the fact that national governments have been unwilling to allow rapid exchange rate appreciations (which cheapen imports) to exert any strongly negative effect on the position of domestic import-competing industries, but instead have moved to protectionism and exchange rate intervention. Hayek (1937, 65, 73–74) anticipated such a case.

[11]. For discussion of the Hayek and Selgin norms for monetary policy, see Ebeling 1991 and White 1991.

Lawrence H. White is a Research Fellow at The Independent Institute, Professor of Economics at George Mason University, author of Monetary Nationalism Reconsidered, and contributing author to Money and the Nation State: The Financial Revolution, Government and the World Monetary System.

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