Competing Currencies and Digital Money: How Hayekian Are Cryptocurrencies?

Competing Currencies and Digital Money: How Hayekian Are Cryptocurrencies?

The Government Monopoly on Money – For a Long Time Unquestioned

“I do not think that it is an exaggeration to say that history is largely a history of inflation, and usually of inflations engineered by governments and for the gain of governments.”

Friedrich August von Hayek

It is a truism that monopolies are detrimental to economies. They are inefficient with respect to quality and cost, their price fixing generates welfare losses, and beyond this, they occasionally waste substantial resources merely on erecting barriers to entry for competitors.[1] In an efficient economic order, monopolies are therefore either prohibited or are at least subject to curbs.

Natural monopolies[2] and government monopolies represent special cases. The latter are based on the notion that the state is able to fulfill certain tasks either more efficiently or in a more “social” manner than private suppliers are. These tasks include security (the monopoly on the legitimate use of physical force), state-run health insurance schemes, and the provision of transport infrastructure.

The monopoly on money is a very powerful tool at the state’s disposal,[3] and it’s a monopoly that has been abused for about as long as it has existed.[4] Already in antiquity the funding of wars was accomplished by systematically diluting the precious metal content of coins, which over time pushed the value of their precious metal content ever further below their nominal value.[5] Rulers across history have succumbed to the temptation of increasing their seigniorage income or of generating indirect tax revenues by means of inflation. Such behavior was eventually institutionalized in the form of the two-tiered banking system we know today — with money creation through the interplay between central banks (issuance of central bank money) and commercial banks (deposit money creation through lending of circulation credit) also known as fractional-reserve banking – which drapes a veil over the collection of seigniorage profits.[6] Latter-day efforts to stabilize the financial system and save the euro in response to the financial crisis are blending seamlessly into this history of abuse.

Thus, it is hardly surprising that criticism of the monetary and financial system has a long tradition as well. However, even intellectuals who placed individual liberty at the center of their deliberations hardly ever questioned and question the state monopoly on money as such – despite all the criticism leveled at the monetary system.[7]

Hayek’s Proposal of Introducing Competing Private Currencies

“Everything comes down to the question: Which forms of order promote liberty?”

Walter Eucken

When Richard Nixon suspended the US dollar’s convertibility to gold in 1971, it became obvious that the attempt to establish a monetary system based on a gold-exchange standard had failed due to over issuance of uncovered money substitutes. Upon this event Friedrich August von Hayek felt compelled to reexamine the question of what constituted an expedient monetary order.[8] In Hayek’s opinion, not only the abolition of the tie between the US dollar and gold but also the proliferation of Keynesian economic thinking at the time worsened the prospect of a stable, noninflationary money ever emerging under a government-run currency monopoly.[9] In 1975 Hayek eventually gave a lecture entitled “Choice of Currency”[10], in which he articulated for the first time the provocative demand that the state monopoly on money should be repealed. The publication of the monographs Free Choice in Currency and The Denationalization of Money followed a year later, in which he expanded in greater detail on his ideas on competition between private money issuers.

Hayek’s core thesis was that the entrenched abuse of the state monopoly on money for the purposes of enriching selected private groups, making good on fiscal deficits, or financing wars illustrates that concentrating the power of money issuance in the hands of the state (or any other centralized entity) does not work. Hence government has to be deprived of its monopoly on money creation, which should be replaced by a market-based monetary order that constitutes a system of power-sharing among competing entities.

What shape would an order reflecting these power-sharing principles take, and how could it emerge? Hayek argues that such an order would take shape if the following liberties were granted:

  • Private money producers would be free to issue money and enter into currency competition.
  • Citizens would be free to choose which currencies they want to use.

Banks would, for instance, issue their own currencies – in any amount they wished. While Hayek regarded money backed by gold or commodities as ideal, he explicitly allowed for the possibility of banks engaging in excessive creation of uncovered deposit money. However, he believed that this practice would fail to survive in a competitive market. In an unhampered market, banks would find that the incentive to boost their asset base over and above the amount of savings deposited with them would be curtailed. The preference of money users for an easy to use money with stable purchasing power would force banks to fulfill these expectations in the best possible way. Money suppliers issuing uncovered money substitutes would eventually face an exit of customers and disappear from the market.

Competition would – analogous to competition in nonmonetary goods and services – exert discipline. The structure of incentives would be optimal, as general welfare would increase as a result of numerous competing actors pursuing their own interests.[11] Hayek famously concluded:

“Money is the one thing competition would not make cheap, because its attractiveness rests on it preserving its ‘dearness’.”[12]

What role would a central bank play in such a competitive order? It would become obsolete. This prospect is welcomed by Hayek, as government-run monetary policy is precisely what he regards as the major source of economic instability. According to Hayek, historical economic crises were time and again attributable to the distorting effects of monetary policy implemented by governments, rather than to so-called market failures:

“The past instability of the market economy is the consequence of the exclusion of the most important regulator of the market mechanism, money, from itself being regulated by the market process.”[13]

However, the central bank would not necessarily have to stop operating right away. It could continue to issue (government) currency. However, it would be in competition with commercial banks and other private money producers and would therefore have a strong incentive to supply citizens with a stable currency.

Cryptocurrencies – Free Currency Competition in Practice?

“Cryptocurrencies are a use case of competing private currencies as envisaged by Friedrich August von Hayek.”[14]

Norbert F. Tofall

Initially the debate over the idea of competing private currencies was purely theoretical, as the government monopoly on money had been so deeply rooted for such a long time that the public at large never thought of seriously questioning it. When Hayek published his proposal, the voluntary abolition of the money monopoly would have been required to adopt it, which was tantamount to governments relinquishing a great deal of their power – a highly unrealistic prospect.[15]

Since then, conditions have fundamentally changed, though, as a result of the pervasive spread of the Internet. After the near-collapse of the monetary and financial system in the 2008 financial crisis and the erosion of confidence in government currencies and central banks in its wake, the first private digital currency in the form of Bitcoin made its entrance in the realm of Web 2.0. Since then more than 1,500 cryptocurrencies (in their entirety better described as crypto assets) with a market capitalization totaling roughly USD400bn have entered the market. As cryptocurrencies are largely outside of government control – at least until now –, a kind of laboratory for private currency competition could be established. In fact, the ECB suspects (rightly) that Hayek’s theoretical work was the spiritus rector of today’s cryptocurrencies.[16]

Decentralization: The Cryptocurrency Killer App

What makes cryptocurrencies so interesting is that they are so contrary to the mental image many people have of money.[17] The most famous cryptocurrency, Bitcoin, functions as a payment system based on monetary units that consist of themselves and are not redeemable for gold or any other commodity. Bitcoin is accepted as currency, though in line with the definition of Ludwig von Mises it has to be considered as pure fiat money [18], that is not run by the state and is not tied to a commodity. Many monetary theorists were convinced that such a currency could not possibly emerge in a free market. Hayek himself believed that currencies tied to commodities would prevail in a system of free competition. What is the reason, then, for the growing acceptance of cryptocurrencies?

The secret of their success that is at the core of an accepted currency is a result of their decentralized nature. Cryptocurrencies such as Bitcoin, Monero, and Litecoin are not issued by a single private institution; they are based on a source code protocol and maintained through a decentralized network of widely dispersed market participants. Unlike a currency issued by a private money producer, whose paper money represents a promise to pay, Bitcoin is a fiat money that is no one’s liability. In this respect, a cryptocurrency like Bitcoin is similar to gold.

An interesting aspect of the currency competition launched by the emergence of cryptocurrencies is also that it differs from Hayek’s proposal in one decisive respect. The situation as envisaged by Hayek would always carry the latent risk that a – centralized – money-issuing entity could fail.

In the case of a cryptocurrency such as Bitcoin, no such central entity exists. The smooth operation of a cryptocurrency is safeguarded by geographically dispersed interest groups such as developers, miners, traders, users, and others working within the ecosystem. Trust and risk are distributed across a network of numerous parties pursuing their own interests.[19] Those purchasing a cryptocurrency ultimately place their trust in mathematical and encryption protocols that maintain a system of incentives, which in turn provides all participating entities or groups with a motive to ensure the currency’s integrity. Hence the slogan “In Code We Trust”[20]. To this day this system of incentives has worked splendidly, and not one of the numerous attempts to destroy it has been successful.

The Quest for Stability

A problem plaguing many cryptocurrencies – and, as a proxy for them, Bitcoin – is their excessive price volatility. Bitcoin’s inelastic supply, coupled with a demand shock triggered by the rapid diffusion of “crypto-ideology” and the associated speculative hype,[21] has temporarily led to an enormous increase in the purchasing power. Leaving aside the recent correction, the history of Bitcoin is a history of hyper-deflation[22] – and in a time of strong deflation it makes more sense to hoard a currency than to use it as a means of payment. As a result Bitcoin and other new cryptocurrencies are barely fulfilling the function of media of exchange at the moment.[23]

The same feature that underpins the currency’s store of value function hampers its use as a unit of account. As the supply of Bitcoin and other cryptocurrencies is as a rule limited, with no central entity able to balance excess demand by boosting supply, cryptocurrencies are occasionally highly volatile.[24] Contrary to Mises’ belief that an inelastic supply would go hand in hand with comparatively small fluctuations in demand and price, cryptocurrencies have not proved suitable for fulfilling unit of account functions such as drawing up corporate balance sheets – at least so far.[25]

In line with Hayek, one could counter that a cryptocurrency that is undergoing a process of monetization has to be regarded as an object of speculation in the early stages of the process, which will inevitably involve volatility. It seems logical that speculative demand and reservation demand will be strong at an early stage. However, the importance of speculative demand should diminish over time, as ownership of the cryptocurrency in question broadens. If they are successful, emerging cryptocurrencies should eventually manage the transition from speculative assets to currencies that function reliably as media of exchange.[26]

A number of cryptocurrency enthusiasts who don’t want to simply wait and see whether this will happen are working on creating cryptocurrencies with stable values, so-called “stablecoins”.[27] These currencies have a flexible supply, which is adjusted to fluctuations in demand with the aim of achieving purchasing power stability. But – and here is the problem – how is it possible to guarantee “price stability” without being forced to restrict or abandon the decentralized and therefore intervention-resistant structure of a cryptocurrency? Simply decreeing an “inflation target” from on high is precisely what central banks are doing and is contradictory to the spirit of cryptocurrencies.[28]

The solution to this problem may be DAO, which stands for “decentralized autonomous organization”. Members of such a DAO organize independently. With respect to managing a stable-coin, members of a DAO would be tasked with ensuring the stability of its purchasing power. Stability would be promoted through a structure of incentives embedded in the coin’s programming code. The recently launched Maker DAO project[29] appears to hold promise in this regard. Maker’s stablecoin, called Dai, is still very young, but has already become popular with many users.[30]


“Humanity’s progress always involved a small minority deviating from the ideas and customs of the majority, until its example finally persuaded others to adopt its innovations as well.”

Ludwig von Mises

In our opinion Hayek has bequeathed us a vital body of preliminary theoretical work for a future, more crisis-resistant monetary order. In order to create full freedom of choice for money producers and users, the money monopoly of the state has to be repealed and replaced by an environment in which private currencies can be developed and can compete in a decentralized discovery procedure. As money users would punish producers of unsound (i.e., inflationary) money by abandoning it, both government and private currency suppliers would be motivated to keep their seigniorage income low and to issue sound money.

As governments would no longer be able to mitigate their debt burdens through inflation, such a monetary order would be highly effective in enforcing fiscal discipline. The chronic debt-crisis of our times, namely the overindebtedness of governments, could never emerge in such a system – thus currency competition would be the most powerful debt brake imaginable.[31]

For a long time, such competing currencies were unthinkable, as governments have not been inclined to voluntarily abandon their monopoly on money. With cryptocurrencies, which could emerge only due to the spread of the internet and which cannot be effectively suppressed or prohibited due to their decentralized structure, currency competition in the spirit of Hayek has become possible even in the absence of self-limitation by governments.

[1] A special case is temporary monopolies, which generate so-called “pioneer profits”. Companies can, for instance, obtain patents for innovations, which protect them for a limited time from imitations of their products made by competitors. The idea is that the state temporarily restricts competition for a time via the patent system in order to promote competition over the long term, since many companies won’t regard the required R&D spending as economically viable if there is no prospect of making temporary monopoly profits. See “Theory of Economic Development”, Joseph Schumpeter, 1911.

[2] Natural monopolies are the result of a cost structure (in most cases involving high fixed and low marginal costs) in which competitors are held to raise the total cost of supplying a good. Examples for this are railways, which have high fixed costs in the form of rail networks, and power and water utilities, which require electrical grids or piping systems for distribution.

[3] We are going to refer to the “state (or government) monopoly on money” in this section, even though it is nowadays usually not the central bank itself that produces new money. (Exceptions are QE, repos, and coupon passes, which affect the money supply directly and indirectly over a wide range of time frames.) Most money production results from inflationary lending by fractionally reserved private commercial banks (with central bank support), i.e., it is so to speak the result of a private-public partnership. Regardless, the government ultimately decides what may be used as legal tender.

[4] See “Monetary Regimes and Inflation. History, Economic and Political Relationships”, Peter Bernholz, Cheltenham, 2003.

[5] See “The Monetary Aspect of the Fall of Rome”In Gold We Trust report 2016, pp. 98-103, or “The Frogs”, Aristophanes, pp. 719-737.

[6] See The Zero Interest Rate Trap: Sustainable Wealth Accumulation in a Non-Sustainable Monetary System, Ronald-Peter Stöferle and Mark J. Valek, 2018 (to be published shortly).

[7] Hayek noted that the economic literature offered no answer to the question of why a government monopoly for the provision of money was deemed indispensable, nor was there any academic discussion examining the abolition of this monopoly (The Denationalization of Money, Friedrich A. von Hayek, 1976, pp. 26 ff). He attributed the notion that governments had a quasi-natural prerogative to be the exclusive suppliers of money to the historical fact that they had usurped the right to mint coins a very long time ago and then simply retained it as if this were a perfectly natural state of affairs (The Denationalization of Money, Friedrich A. von Hayek, p. 28).

[8] What makes this very interesting is the fact that Hayek previously espoused quite contrary views: “[A] really rational monetary policy could be carried out only by an international monetary authority […] [S]o long as an effective international monetary authority remains an Utopian dream, any mechanical principle (such as the gold standard) … is far preferable to numerous independent and independently regulated national currencies” (Monetary Nationalism and International Stability, Friedrich A. von Hayek, 1937, pp.93ff). Later Hayek wrote that a free currency market was “not only politically impracticable today but would probably be undesirable if it were possible” (The Constitution of Liberty, Friedrich A. von Hayek, 1960, pp.324ff). Nevertheless, what unites the different positions Hayek has taken over time is his desire to create a noninflationary monetary order. Moreover, the evolution of his position illustrates his growing skepticism with respect to the state.

[9] See “Toward a Free Market Monetary System”, Friedrich A. von Hayek, p.2.

[10] See “Choice of Currency: A Way to Stop Inflation“, Friedrich A. von Hayek, The Institute of Economic Affairs, 1976.

[11] See The Denationalization of Money, An Analysis of the Theory and Practice of Concurrent Currencies, Friedrich A. von Hayek, 1977, p. 57.

[12] See The Denationalization of Money, An Analysis of the Theory and Practice of Concurrent Currencies, Friedrich A. von Hayek, 1977, p. 94.

[13] See The Denationalization of Money, An Analysis of the Theory and Practice of Concurrent Currencies, Friedrich A. von Hayek, 1977, p. 102.

[14] See “Währungsverfassungsfragen sind Freiheitsfragen: Mit Kryptowährungen zu einer marktwirtschaftlichen Geldordnung?,“ Norbert F. Tofall, Flossbach von Storch Research Institute, 2018, p. 4 (Currency questions are questions of liberty: Toward a market-based monetary order with cryptocurrencies?).

[15] See “A praxeological analysis reveals that currency competition is simply not in the state’s interest.” Thorsten Polleit: “Hayek’s ‘Denationalization of Money’ – a Praxeological Reassessment”, Journal of Prices and Markets, p. 79.

[16] See “ECB: ‘Roots Of Bitcoin Can Be Found In The Austrian School Of Economics,“ Jon Matonis, Forbes, 2012.

[17] The success of cryptocurrencies does not only irritate a number of laypersons. For instance, the well-versed monetary theoretician (and Austrian School representative) Guido Hülsmann stated in 2007 that a money “that is defined entirely in terms of bits and bytes is unlikely ever to be produced spontaneously on a free market.” (“The Ethics of Money Production”, Ludwig von Mises Institute, 2008, p. 33).

[18] See The Theory of Money and Credit, Ludwig von Mises, Yale University Press, 1953.

[19] See “Trustless is a Misnomer”, Nick Tomaino, Medium, July 21, 2016.

[20] See “The Bitcoin Boom: In Code We Trust”, Tim Wu, The New York Times, December 18, 2017. (Coincidentally a play on words on the title of this report, which was first published well before Bitcoin was born.)

[21] Thus, many people believe that cryptocurrencies, which are still at the beginning of more widespread adoption, will continue to gain in value in coming years and are buying them as speculative buy-and-hold investments.

[22] See “Bubble or Hyperdeflation“, Incrementum AG, Crypto Research Report.

[23] Several people in the crypto community argue that Bitcoin is not at all predestined to become a widely adopted medium of exchange for day-to-day use. Rather, they say, Bitcoin represents a decentralized and therefore intervention-resistant store of value. The original source code of Bitcoin, which can be altered only if the extremely disparate Bitcoin community arrives at a consensus, provides the best possible conditions for the currency’s store-of-value function: The total amount of Bitcoin that can be mined is restricted to 21 million units (some of which have already been lost forever – e.g. a famous hard disk drive containing 70,000 BTC is known to be peacefully collecting rust in a UK landfill). It takes around 10 minutes for a new bitcoin to be created. Since the emergence of Bitcoin in 2008, the quantity of newly created bitcoins has been declining by half every four years. According to estimates, by 2140 all bitcoins that will ever exist will have been mined. This continually strengthening deflationary tendency strongly underpins the store-of-value function of BTC.

[24] Cryptocurrencies are affected to a greater extent by this volatility than, for example, gold, as gold is subject to countercyclical buffers through jewellery and fabrication demand (declining demand when prices rise and vice versa) as well as through fluctuations in the gold supply (growth in mine supply and rising sales from existing stocks when prices increase and vice versa).

[25] See Human Action: A Treatise in Economics, Ludwig von Mises, Auburn, Alabama: Ludwig von Mises Institute, 1998, pp. 225ff.

[26] As discussed in this section, relatively supply-inelastic gold is not immune against periodic high speculative demand, either: If in the course of an emerging currency competition currencies backed by gold were to turn out to be preferred by most users, surging demand for gold would rapidly boost its price – and presumably also its volatility – which would at least temporarily suspend suitability of the precious metal as a means of payment and unit of account. (See The Denationalization of Money, An Analysis of the Theory and Practice of Concurrent Currencies, Friedrich A. von Hayek, 1977, pp. 102/127.).

[27] See the chapter Crypto: Friend or Foe?

[28] See “The Search for a Stable Cryptocurrency”, Vitalik Buterin, Ethereum Blog, November 11, 2014.

[29]: See “Maker for Dummies: A Plain English Explanation of the Dai Stablecoin“, Gregory DiPrisco, Medium, November 20, 2017.

[30]: See “Stablecoins: A Holy Grail in Digital Currency“, Nick Tomaino, The Control, April 3, 2017.

[31]: See “Währungsverfassungsfragen sind Freiheitsfragen: Mit Kryptowährungen zu einer marktwirtschaftlichen Geldordnung?“, Norbert F. Tofall, Flossbach von Storch Research Institute, 2018, p. 5 (“Currency questions are questions of liberty: Toward a market-based monetary order with cryptocurrencies?”).