This article was published in the Winter 1994-95 issue of Formulations
by the Free Nation Foundation
The Spontaneous Order of Money
by Eric-Charles Banfield
A review of
Monetary Evolution, Free Banking, & Economic Order
by Steven Horwitz
Westview Press, 1992

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Most people, even some libertarians, accept that the functions of government include "things the market cannot provide." Anarchists quickly cite the many scholars who have demonstrated that, indeed, markets can and do provide charity, roads, schools, and even courts and defense. Recently, economists have addressed the more difficult issue of free banking and competitive note issue. Apparently, we don't really need government to provide money, either. The market can and has provided it.

Prominent free-banking theory architects include Friedrich Hayek, Richard Timberlake, Lawrence H. White, George Selgin, Richard Salsman, and Kevin Dowd, Each welding more solid girders to the free-money framework. Now Steven Horwitz weighs in with Monetary Evolution, Free Banking, & Economic Order (1992, Westview press, Inc., 5500 Central Avenue, Boulder, CO 80301-2877, 201 pp., $63 publisher's list, but $24.95 from Laissez Faire Books at 800-326-0996). Horwitz politely and professionally shatters the fundarnental basis on which people believe only government can provide money. To Horwitz, money evolves via a Mengerian process of creative adaptation into an institution, a social function that helps people coordinate their actions and deal with complexity. Horwitz shows that government-provided money must be inherently unstable, and that a free market in money allows the highest degree of order.

Written from his doctoral thesis and rich with references, Horwitz's book starts off developing a solid theoretical foundation, resting on the role of individuals in developing social mechanisms, much like language, that allow institutions like money to communicate knowledge. Only with this understanding, Horowitz argues, can we establish what money means; only then can we understand money's "centrality to economic order" [p.2]. That crucial step is omitted by all theorists who in the past have proposed increased government control over money.

Chapter One explains what's wrong with current monetary economic orthodoxy. Classical and neoclassical economists attempt a "scientific rendering" of the invisible hand [p.16], using Walrasian and Marshallian general-equilibrium models that assume perfectly liquid markets and inherently imply no need for money! Those models ignor 1) that all things have a degree of "moneyness," [p.22]; 2) why certain goods do become money [p.26]; 3) how monetary feedback affects choices [p.25]; and 4) the possible imperfections of government [p.37].  To Horowitz, money reduces the information needed to communicate [p.27], providing information about excess supplies [p.28] and allowing more complexity to be coordinated [p.30].

Chapter Two focuses the reader on the evolution of order instead of on the attainment of "equilibrium" (always a questionable economic modeling requirement) Economic conventions such as money are natural processes, and so should not be compared against some non-existent ideal standard, but rather on how well they provide order [pp.49,66]. People in a society develop behavioral rules as recognizable modes of behavior that allow players to interact [pp 51-54] "Successful rules l become crystallized and regularized" [p 55]. Order evolves as people use creativity to institute coordinating mechanisms to deal with increasing complexity [p 59]. Those three "C's" provide the basis for much of the analysis throughout. Horwitz also cites Hayek's distinction about law (open-ended guides about what not to do) versus legislation (closed-ended dictates of what one must do), noting wryly that America's current product-liability system has lots of formal "laws" (legislation) but no real rules or order [pp, 68,71].

Chapter Three beautifully compares the evolution of money to that of language -- a communicative processes arising naturally out of an "unconscious power of adaptation" [p.91] that "expands the range of freedom available to an individual" Ip. 94]. More than a tool, money is an institution, a "tradition" [p. 9]. Both money and language make private information socially available" [p 971; markets are the text, and money is the context [pp. 102-104].

Chapter Four examines how money can evolve spontaneously. He points out, to the surprise (or dismay?) of gold bugs and 100% - reservers, that some degree of fractional-reserve banking is a natural and perhaps necessary part of the evolution of the market process. Banks evolve because people want more than just gold warehouses. The free market theoretically and empirically allows deposit expansion and permits the money stock to exceed the existing stock of "specie" (the underlying commodity, e.g., gold) [p115]. As he puts it later, opportunity cost. not central banking per se, is the driving force behind the evolution toward fractional-reserve banking [p. 136]. Not all of the "inflation" of money (via central banks' artificially-low reserve requirements) is without economic basis, Horwitz implies here.

As part of this monetary evolution, "brand names" and clearinghouses perform valuable social functions by reducing information costs. They unintentionally help increase the general acceptability of notes. Among banks, refusal to clear mutually each other's currency notes would be harmful to both parties. [pp 118-119].

Horwitz shatters the "false dichotomy" (false choice) between central bank rules and central bank discretion in monetary policymaking [pp. 126-133]: Neither can work well. He follows with a clear explanation of how free banking would work in the context of the "monetary equation of exchange," or MV=PY. In that tautology (true by definition), money (M) times its turnover (V, for velocity) must equal the prices of all goods (P) times the quantity sold (Y). A free-banking system holds the quantity MV constant (adjusting one to offset the other). Since MV must equal PY, as the economy (Y) moves, prices move the other way [p. 134]. Growth would lead to lowering prices. But then wouldn't downturns accompany inflation? Horwitz doesn't say. But his illustration is still an exercise in clear thinking.

Free banking, notes Horwitz, has built-in safeguards against excessive note issuance, as the clearing system internalizes the costs of overissuing notes to the specific offending bank. Clearings and redemptions offer an immediate, condensed indicator of how the market values a bank's notes [pp. 138-139]. All of this natural, harmonious balance comes from "the polycentric actions of multiple note issuers" [p. 140].

Chapter Five shows in good detail how the banking panics of 1893 and 1907, which led to the creation of the Federal Reserve and fiat money, are shining examples of how increased legal restrictions created currency shortages and how the "unplanned and fragmentary coordination of the private sector" [p. 149] worked to ameliorate the problems. State bond-collateral requirements, reserve requirements, and branching prohibitions prevented the system from providing currency as the market demanded [pp. 150-154]. Much of that demand was stoked by the Sherman Silver Purchase Act of 1890, which, by introducing silver-backed notes, dramatically increased the money supply, and, in Horwitz's terms, "created uncertainty about the future of the money standard" [p. 156].

But markets, skirting the silly laws [p. 124], created currency substitutes to restore order. Small-denomination clearing certificates, cashier's checks, bearer paychecks, and other notes circulated as currency. The informational content of money was enhanced by endorsements, advertisements, editorials, store acceptance policies, and note discounts and premiums. Bank directors even personally endorsed checks at other locations, and some banks refused to accept large bundles of notes if they were drawn on sound banks [pp. 164-166]. Even J.P. Morgan, despite his apparent abuses of political power, played a private-sector role in re-establishing trust in the monetary system [pp. 168- 169]. In sum, in the real world, markets did what theorists said they wouldn't: provide order out of chaos [p. 168]. That's because "money is what people decide it is" [p. 170], and "order emerges as part of an undesigned process of evolution" [p. 173].

For a work based on a doctoral dissertation, Monetary Evolution is remarkably clear and accessible, even to monetary- theory neophytes. Readers encounter only a few minor problems. On page 135, Horwitz explains how, in a free-market process, unclaimed reserves properly become the basis for further loans, or what he calls a natural, internal "pyramiding" of more liabilities (deposits) on current reserves. Later, on p. 156, he says a factor in the 1893 and 1907 panics was the external "domino effect of reserve pyramiding," a process that results, presumably, from artificial legal restrictions. Horwitz did not distinguish clearly these differing phenomena. Also, he uses the term "high-powered money," assuming the reader knows that's reserve money (gold or notes) that can be used to increase the money supply.

Otherwise, readers familiar with some economics will have few problems. It's a great book for any economist, banker, or investor, if they like thinking theoretically or if they seek real-world examples of spontaneous monetary order. Monetary Evolution is highly-interdisciplinary, focusing, on social science, economics, evolution, history, and language. Horwitz moves easily among the stylings of Menger, Hayek, Mises, Gadamer, Polanyi, and even Marx, Lange, and Keynes.

For the anarchist, Horwitz's fine work carries a clear, academic, professional tone, politely smashing statist arguments without any of the acid-tongued sarcasm or hatred offered by many anti-government writers. Otherwise, any student of human spontaneous order will benefit from Horwitz's clear and eloquent expositions on how individuals work without central direction to develop ways of making our lives better. D

This review originally ran in Nomos: Studies in Spontaneous Order, No. 45. Copyright (c) 1994 by Banfield Analytical Services. Please do not publish, reprint, or excerpt from this article without the author's permission. To request such permission, please call (USA) 708-960-1552.
Eric-Charles Banfield, owner of Banfield Analytical Services in Westmont, IL, specializes in writing, speaking, and analysis of financial, economic, and public-policy issues. A former bank assistant treasurer, Eric has spoken before the Federal Reserve Bank of St. Louis and is author of The Bailout of the FSLIC: How The Government Defrauded the Taxpayers.

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