FRIEDMAN VERSUS HAYEK ON PRIVATE

OUTSIDE MONIES: NEW EVIDENCE FOR

*
THE DEBATE

WILLIAM J. LUTHER‡
KENYON COLLEGE

ABSTRACT:
Friedrich Hayek is often credited with the resurgence of interest in alternative monetary
systems. His own proposal, however, received sharp criticism from Milton Friedman,
Stanley Fischer, and others at the outset and never gained much support among academic
economists or the wider population. According to Friedman, Hayek erred in believing
that the mere admission of competing private currencies will spontaneously generate a
more stable monetary system. In Friedman’s view, network effects and switching costs
discourage an alternative system from emerging in general and prevent Hayek’s system
from functioning as desired in particular. I offer new evidence provided by recent events
in Somalia as support for Friedman’s initial doubts.

JEL CODES: B20, B22, B25, B30, B31, B53, E02, E42, G28
KEYWORDS: Competitive Monies, Friedman, Government and the Monetary System,
Hayek, Monetary Standards, Monetary Regimes, Network Effects

*
The author wishes to thank the Mercatus Center at George Mason University for generously supporting
this research. Gerald P. O’Driscoll, Jr., George A. Selgin, Lawrence H. White and seminar participants at
Mercatus and the American Institute for Economic Research provided valuable comments on an earlier
draft of this paper. Any remaining errors should be attributed to the author.
‡
Email: lutherw@kenyon.edu Address: Department of Economics, Kenyon College, Gambier, OH 43022
Phone: 740.222.1242

Electronic copy available at: http://ssrn.com/abstract=1831347

 FRIEDMAN VERSUS HAYEK ON PRIVATE OUTSIDE MONIES:
NEW EVIDENCE FOR THE DEBATE

“We have always had bad money because private enterprise was
not permitted to give us a better one.” — F. A. Hayek1

Although Friedrich Hayek is often credited with initiating the resurgence of

research in alternative monetary systems, his own proposal received sharp criticism from

Milton Friedman (1984), Stanley Fischer (1986), and others at the outset and never

gained much support among academic economists or the wider population. According to

Friedman, Hayek erred in believing that the mere admission of competing private

currencies will spontaneously generate a more stable monetary system. In Friedman’s

view, network effects and switching costs discourage an alternative system from

emerging in general and prevent Hayek’s system from functioning as desired in

particular.

After briefly reviewing models of network effects favoring an incumbent money

over alternatives, I turn to Hayek’s proposal and the major criticism levied against it.

Then, I offer new evidence supporting Friedman’s initial doubts. Specifically, I argue that

the recent historical experience of Somalia provides valuable insight concerning the

network effects and switching costs of money. Despite relatively large changes in

purchasing power, and with no government to prevent switching, Somalis generally

continued accepting Somali shillings. I conclude by discussing the implications of

1
Hayek (1990, p. 131).

Electronic copy available at: http://ssrn.com/abstract=1831347

network effects and switching costs for Hayek’s proposal and alternative monetary

systems more broadly.

1. NETWORK EFFECTS FOR MONEY

Given its importance for the debate between Friedman and Hayek discussed

below, it is worth clarifying precisely what is meant by the term “network effects” in the

context of money. In general, a network effect results when the desirability of an item

depends on others using it. Attention is usually given to the number of other users (i.e.,

the size of the network). Since one’s demand for money depends, at least in part, on the

number of others willing to accept it for payment in the future, money would seem to fit

the bill. Of course, individuals are not merely concerned with how many others are using

a particular money, but also with who is using it (i.e., the location of the network).

Unnecessary transaction costs can be avoided by employing the same medium of

exchange as your trading partners, a medium that need not correspond to that most

commonly accepted by all traders. The more of one’s trading partners using a particular

money, the easier it is to transact with that money; the easier it is to transact with a

particular money, the more desirable it is to transactors. In other words, accepting a

particular money increases its desirability and thereby encourages others to accept it,

further increasing its desirability.2 Once a particular money has gained widespread

acceptance, the regenerative process described above results in a weak form of path

dependency or lock-in—that is, after convergence, the system tends to favor an

2
This is essentially the view expressed by Menger (1892), wherein money is thought to emerge from
barter. See also: Selgin and White (1987).

3
incumbent money over potential alternatives.3 Hence, in the context of money, the term

network effects denotes that money users are concerned with the size and location of a

money’s network and, as a result, a superior alternative might fail to supplant a money

already enjoying widespread circulation.

There are at least two ways to model network effects favoring an incumbent

money. One way is to include a fixed cost of switching between media of exchange (e.g.,

Dowd and Greenaway 1993). The fixed cost might be interpreted as the costs of

exchanging notes, changing prices to reflect the new medium of account, learning to

think in terms of a new medium of account, changing record-keeping processes, and/or

modifying existing machines to accept, store, and give out new notes and coins. The

fixed cost approach yields four implications:

1. An economic actor will not choose to switch monies if the benefits of

switching do not exceed his fixed costs even if everyone else switches.
2. An economic actor will choose to switch monies if the benefits of
switching exceed his fixed costs even if no one else switches.
3. An economic actor will not choose to switch monies if the benefits of
switching do not exceed his fixed costs given his expectations about the
number of others choosing to switch.
4. An economic actor will choose to switch monies if the benefits of
switching exceed his fixed costs given his expectations about the number
of others choosing to switch.
Cases (1) and (2) describe peripheral scenarios where non-network inferiority or

superiority dominates one’s decision to switch—that is, when the benefits of switching

are sufficiently small or large to render network effects inconsequential. In contrast,

network effects are important in cases (3) and (4). As a result, outcomes in cases (3) and

3
As Farrell and Saloner (1986) point out, network effects might lead to either “excess inertia” or “excess
momentum” depending on the expectations of economic actors. However, monetary economists tend to
stress the likelihood of excess inertia. The fixed cost network effects model reviewed below is capable of
producing either suboptimal result.

4
(4) are sensitive to expectations. In all four cases, the fixed cost of switching favors the

incumbent money over potential alternatives.

Another way to model network effects favoring an incumbent money amounts to

limiting the cognitive capacity of economic actors in the model. Selgin (2003), for

example, assumes economic actors employ an adaptive learning algorithm to form

beliefs. Whereas Selgin’s model yields implications similar to the four cases discussed

above (except, of course, that switching costs equal zero), his solution strategy—that is,

the way he assumes particular symmetric subgame-perfect equilibria will be chosen over

others—effectively constrains the set of feasible expectations economic actors can hold.

Specifically, he precludes economic actors from surveying the set of equilibria and

choosing a Pareto-dominant equilibrium in lockstep with all other economic actors.

Instead, he assumes the number of economic actors expected to employ a particular

exchange strategy in current and future periods is equal to the number subscribing to that

strategy in the previous period. By preventing hyperrational solutions to the complex

problem of currency acceptance, Selgin highlights the underlying coordination problem

encountered by human subjects.4

Adaptive learning algorithms favor incumbents by limiting the beliefs of

economic actors to past experience. An argument in favor of this modeling technique

which need not imply that individuals are exclusively backward-looking emphasizes the

shared-experiences of individuals in providing a salient focal point on which to

coordinate. Simply put, the experience of employing a particular money for several past

periods makes the money an especially salient option in the present period. It is a familiar

option to the economic actor and all of her trading partners. Moreover, everyone knows it
4
See: Duffy (1998, 2001) and Duffy and Ochs (1999, 2002).

5
is a familiar option (and everyone knows that everyone knows it is a familiar option…).

Hence, agents might reasonably expect continued acceptance of the prevailing money and

an alternative money will only be able to supplant the incumbent if it becomes

particularly salient.

Both fixed cost and cognitive approaches to modeling network effects suggest

economic actors might be reluctant to switch from one money to another. In the first case,

path dependency can result because of the fixed cost of switching or expectations about

the likelihood others will switch. In the cognitive model, expectations do all the work. In

both models, suboptimal outcomes are possible. Having clarified precisely what the term

network effects means, it is now rather straightforward to explain the disagreement

between Friedman and Hayek.

2. FRIEDMAN VERSUS HAYEK

The novel approach advocated by Hayek (1976, 1978, 1984, 1990) was to allow

concurrent, competitively issued currencies.5 Hayek’s system of competitive note issue

differs significantly from historical episodes of laissez faire banking in that issuers are

not contractually obligated to redeem their notes for some underlying commodity.6

Rather, private banks provide the economy with outside money as the central bank does

in most modern systems. The unbacked, irredeemable notes issued by private banks then

trade against each other (and against commodities) at floating exchange rates on the open

market.

5
In addressing Hayek’s proposal, I refer exclusively to the third (and final) edition of Denationalisation of
Money. No substantive changes were made to the text between the second and third editions. As such,
either might be viewed as Hayek’s final statement on the topic.
6
White (1999b) addresses Hayek’s rejection of free banking.

6
 According to Hayek, note issuers in such a system are dissuaded from

manipulating the money supply in undesirable ways. “The chief attraction the issuer of a

competitive currency has to offer to his customers,” Hayek (1990, p. 59) claimed, “is the

assurance that its value will be kept stable (or otherwise made to behave in a predictable

manner).” As a result, note issuers expand and contract the amount of their notes in

circulation to keep the value of their notes equal to a unique, predetermined basket of

commodities.7 Issuers who fail to stabilize the value of their notes are expected to lose

market share. In the aggregate, Hayek contended, the decentralized targeting of multiple

commodity baskets and the competition for market shares more effectively achieves

stability in the general price-level than would a central bank, and at a lower cost than

alternative systems.8

It is useful to consider Hayek’s proposal in light of the four cases outlined above

in Section 1. Hayek implicitly argued that network effects and switching costs are small.

Hence, the benefits of switching need not be very large to render network effects and

switching costs inconsequential. Similarly, the benefits need not be very small to prevent

switching when switching is suboptimal. In Hayek’s view, then, most situations fall into

either Case (1) or Case (2) where non-network inferiority or superiority dominates one’s

decision to switch. Moreover, the costs of switching are believed to be too small to result

in monetary mismanagement comparable to that observed under central banking.

Although Friedman (1984, p. 43) expressed support for the changes in legislation

Hayek recommended, he was “very much less optimistic […] that such a system would

7
Klein (1974) developed a remarkably similar proposal independent of Hayek.
8
White (1999a, p. 117) notes that Hayek’s defense of a system of competitive issues on the grounds that it
would “more effectively achieve price-level stability” represents a clear departure from the view espoused
by Hayek in earlier works, where price-level stability was rejected in favor of stabilizing M (e.g., Hayek
1928, 1929) or MV (e.g., Hayek 1935, 1937). See also: Hayek (1990, p. 87)

7
lead to a money of constant purchasing-power and of high quality.” Money users,

Friedman (1984, p. 44) explained, are not hypersensitive to changes in purchasing power:

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

purchasing power is not the only consideration on which to base one’s decision to use a

particular money. Money users are also concerned with its degree of acceptability among

their trading partners—or, to use the modern terminology, the size and location of the

money’s network—and the costs of switching. Therefore, a private issuer would have to

regulate the value of its money even better than Germany and Switzerland (and, hence,

the United States) for spontaneous switching from US dollars to result. Exactly how

much better, Friedman could not be sure—but he expected it was a lot.

Accepting that individuals are not concerned exclusively with stability of

purchasing power, the relevant question is to what extent network effects and switching

costs render money users insensitive to changes in purchasing power. “The large revenue

that governments have been able to extract by introducing fiat elements into outside

money,” Friedman and Schwartz (1986, p. 44) argued, “is one measure of the price that

economic agents are willing to pay to preserve the unit of account and the medium of

exchange to which they have become habituated.” Spontaneous switching, the authors

noted, is only observed in times of severe changes in purchasing power—that is, when the

incumbent money is managed significantly worse than the relevant alternative. As

Friedman (1984, p. 46) concluded, “There is little basis in experience for expecting any

8
widely used private moneys to emerge in major countries unless governmental monetary

management becomes far worse than it has been in the post-World War II period.”

Returning again to the four cases presented in Section 1, one might characterize

Friedman’s position for comparison. Unlike Hayek, Friedman argued that network effects

and switching costs are large. Hence, most situations fall into either Case (3) or Case (4)

and are not merely decided on the basis of non-network inferiority or superiority.

Moreover, Friedman seems to suggest economic actors are more likely to expect others

will continue using the currency “to which they have become habituated” and, as a result,

they will continue using the currency as well. Finally, since the costs of switching are

also believed to be large, Friedman maintains that monetary mismanagement could

become quite severe before prompting economic actors to switch in accordance with

Cases (2) or (4).

Hayek (1990, p. 85) replied to Friedman’s criticism by reaffirming his view that

economic actors are sensitive to changes in purchasing power when alternatives are

present:

Americans may be fortunate in never having experienced a time when everybody

in their country regarded some national currency other than their own as safer.
But on the European Continent there were many occasions in which, if people had
only been permitted, they would have used dollars rather than their national
currencies. They did in fact do so to a much larger extent than was legally
permitted, and the most severe penalties had to be threatened to prevent this habit
from spreading rapidly—witness the billions of unaccounted-for dollar notes
undoubtedly held in private hands all over the world.
However, Hayek could not produce evidence sufficient to falsify Friedman’s view that

network effects and switching costs are substantial.

Unable to refute Friedman empirically, Hayek instead offered an alternative

interpretation of the existing evidence. As the above passage shows, Hayek recognized

9
that frictions existed in historical cases, thereby discouraging switching to a more stable

money. But whereas Friedman credited network effects and switching costs, Hayek

pointed to legal restrictions. In this view, the historically observed price economic agents

are willing to pay to stay in their existing network is larger than it might otherwise be, as

it in part reflects the price they are willing to pay to avoid legal sanctions imposed should

they exit that network. In the absence of legal restrictions, Hayek maintained, individuals

would be much more sensitive to changes in purchasing power than has been historically

observed. Although Hayek could not resolve the dispute, his reinterpretation of the

available data prevented the unquestionable rejection of his own view. The authors

reached an empirical impasse.

3. NEW EVIDENCE

In the time since, most economists have come to accept Friedman’s position.

However, the lack of recorded historical episodes where legal restrictions (or the threat of

legal restrictions) are absent has left the empirical dispute between Friedman and Hayek

unsettled. Given the state of the debate, one might reasonably invoke network effects or

legal restrictions to explain the historically observed reluctance to switch to a new outside

money. The case of Somalia following state collapse provides a rare opportunity to

disentangle the two potential frictions identified by Friedman and Hayek.

In January 1991, with the fall of the Barre regime, Somalia entered a period of

statelessness. The simultaneous collapse of the state-run banking system would prove

both a blessing and a curse for Somalis. On the one hand, the purchasing power of the

Somali shilling was relatively stable in the immediate post-1991 period. From 1991 to

10
1997, the exchange rate fluctuated around US$0.12.9 On the other hand, the quality of

notes deteriorated rapidly. Without a central bank to maintain notes in circulation, the

exchange media became worn—and, in some cases, notes were too fragile to be accepted

(Mubarak 2003, p. 316-17). Even without legal restrictions, the diminishing quality of

notes was insufficient to prompt switching to a meaningful extent. In large part, Somalis

continued to use the un-backed paper Somali shillings notes.10

Further support for Friedman’s skepticism soon followed. By 1996, the difference

between the purchasing power and cost of producing Somali shillings notes had been

recognized. High-quality forgeries soon found their way to the market. Mohammed Farah

Aideed ordered roughly 165 billion Somali shillings in 1996 from the British American

Banknote Company. Mogadishu businessmen imported another 60 billion in 2001. Symes

(2006, p. 29) estimates that, since 1991, roughly 481 billion in unofficial Somali shilling

notes have been printed. Produced by foreign high-security printing firms, these notes are

very difficult to distinguish from authentic pre-1991 notes.11

As the number of forgeries entering circulation picked up, the purchasing power

of Somali shillings fell. By 2002, a 1000 Somali shillings note, which had traded for

roughly US$0.13 in 1997, was worth only US$0.04 (Mubarak 2003, p. 321). It was quite

literally worth the paper it was printed on—plus ink and transportation costs.12 And

9
Official IMF rates are not available immediately following state collapse. Mubarak (2003, p. 314)
provides open market rates.
10
Although foreign currencies had begun to circulate in the area as inflation picked up under the Barre
regime, their use before and after the state collapsed was primarily for large transactions where use of low-
valued Somali shillings notes was cumbersome. Somali shillings notes remain the primary medium of
exchange for small businesses, market traders, and the poorer sections of the community (Symes 2006, p.
26). See also: Luther (2012a)
11
New notes commonly circulated at a small discount, which decreased as the notes became worn and,
therefore, harder to distinguish from the older, authentic notes.
12
See: Luther (2012b).

11
although no legal authority existed to prevent individuals from switching to an alternative

currency while its value fell, Somali shillings continued to circulate.

Why did Somalis continue to accept inferior notes? It would be difficult to argue

legal restrictions played a significant role. The Polity IV project has consistently

classified Somalia as “interregnum” (i.e., between sovereigns) since 1991 (Marshall and

Jaggers 2009).13 More likely, I contend, is that network effects and/or switching costs

made spontaneous switching untenable or unattractive. As Luther and White (2011)

explain, they typical Somali had become accustomed to transacting with Somali shillings

and knew that her trading partners were similarly accustomed. Moreover, the typical

Somali knew that her trading partners knew she was accustomed to using shillings (and

they knew that she knew that they knew…). Presented with the costly alternative of

switching to a less salient alternative, most Somalis opted to stick with the familiar

Somali shilling notes.

The case of Somalia provides empirical support for the initial doubts of Friedman,

Fischer, and others. In the absence of legal restrictions, Somalis continued to accept

Somali shillings even though the quality and purchasing power of the notes decreased

significantly. If this historical episode is generalizable, one should not expect the mere

admission of alternative outside monies to lead to high quality notes with a roughly

constant purchasing-power, as Hayek claimed. However, two caveats are in order. First,

it is possible that the historical episode presented above is an anomaly; or, that there is

some hitherto unidentified mitigating circumstance that explains why these notes

persisted where others would not. Admittedly, Somalia is a poor country with an

13
Luther and White (2011) present a more qualified account, detailing the pockets of government existing
at times over the period. Even accepting these occasions—and it is not obvious that one should—distinct
periods without sovereign support remain.

12
underdeveloped financial system. As such, it may be inappropriate to extrapolate from

the experience therein to other, richer countries with complex financial systems.

Second, the available evidence only sheds light on the functionality of the

mechanism central to Hayek’s proposal outside the relevant context of Hayek’s proposal.

Hayek seemed to believe that network effects and switching costs were always and

everywhere small such that removing legal restrictions in any context would suffice to

bring about a better alternative—be it from public or private issuers. In that regard, he is

almost certainly wrong. However, accepting that Hayek is wrong in one context need not

imply that he is wrong in all contexts. Alternative monies widely available to Somalis

were not typically privately provided; rather, they were currencies issued by other

governments (e.g., US dollars, Ethiopian birr, Saudi riyals, UAE dirham). Moreover, the

legal institutions prevailing during the Somali episode arguably depart markedly from

Hayek’s ideal. To my knowledge, nothing resembling Hayek’s proposal has ever been

introduced. Based on the available evidence, it is impossible to conclude whether

economic actors would be hypersensitive to changes in purchasing power in an

institutional environment closer to what Hayek had in mind.

Despite these two caveats, it is important to recognize that the available evidence

is consistent with the widely-held view that network effects and switching costs dissuade

money users from switching to a marginally better alternative. This evidence is

inconsistent with Hayek’s view that the historically observed reluctance to switch is

almost entirely the product of legal restrictions and, therefore, casts doubt on the

mechanism central to Hayek’s proposal. Moving forward, the burden of proof would

seem to fall on proponents of Hayek’s proposal.

13
4. CONCLUSION

Having observed spontaneous switching in Germany and the (restricted) desire to

switch at times elsewhere in Europe, Hayek proposed an alternative monetary system

governed primarily by the money users’ sensitivity to changes in purchasing power. No

one denies that individuals react to large changes in the purchasing power of money by

switching to an alternative medium of exchange. However, Friedman, Fischer, and others

expressed doubts that individuals would respond to small changes in purchasing power,

as would be necessary for Hayek’s system to outperform modern monetary systems in

developed countries.

Recent experience in Somalia supports the initial doubts regarding the mechanism

Hayek claimed would govern his system. Indeed, this evidence directly contradicts his

view that switching would result if only legal restrictions did not prevent such behavior.

Despite significant changes in purchasing power, and with no government to prevent

switching, Somalis generally continued accepting Somali shillings.

If generalizable, the implications of this evidence are two-fold. First, it suggests

that Hayek’s system, at least to the extent that it relies on individuals being

hypersensitive to changes in the purchasing power, is unlikely to outperform modern

monetary systems. Efforts to amend Hayek’s proposal should address how such a system

would overcome the problem created by network effects and switching costs. At a

minimum, the burden of proof falls on those in favor of Hayek’s proposal to demonstrate

empirically that individuals are sensitive enough to changes in purchasing power to

prevent significant monetary mismanagement in Hayek’s proposed system.

14
 Second, to the extent that this evidence confirms the significance of network

effects and switching costs, it implies that once a standard has been established a superior

monetary system is unlikely to come about spontaneously. Those dissatisfied with the

monetary status quo should not expect their favored alternative monetary system to

spontaneously supplant the existing regime, even in the absence of legal restrictions,

except in cases of extreme fluctuations in the value of the prevailing currency. As a

result, advocates of alternative monetary systems would do well to articulate precisely

how their favored system might be adopted.

15
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