Why Does the State Have a Monopoly on Money?

How can we explain what seems to be the most durable of all state monopolies?

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In the past, I have written about central banks and the state monopoly over money. The main point of that previous post is that although economists tend to dislike monopoly and extol the virtues of competition, there is surprisingly little criticism of central banks among these same economists. A central bank has a monopoly over currency. Yet, as that post details, the issuance of money does not seem to have any of the characteristics traditionally used to justify a monopoly. This naturally begs the question: Why has the state’s monopoly over money persisted for so long? Why is this monopoly so durable?

One place to start is with political motivations. A common answer that people will provide is that the state’s monopoly over money is motivated by its desire for revenue. If one has a monopoly over money, one could debase the currency (e.g., turn 100 silver coins into 110 silver coins by reducing the silver content of the coins) or one could simply print more money to increase revenue. However, that argument is incomplete as it leaves several questions unanswered.

For example, a state monopoly on shoes or steel or baseball cards would also generate revenue. What makes a monopoly on money different from these other hypothetical monopolies? Also, if the primary motivation is revenue, why do so few states seem like they’re trying to maximize the revenue they get from the monopoly? Debasing money and printing money cause inflation, which in turn causes people to hold less money. Thus, if inflation is a “tax” on money, wouldn’t inflationary policy reduce the tax base over time?

Let’s start with what makes money different. Unlike revenue generated from other hypothetical monopolies, the monopoly on money provides the unique ability to the state of generating a lot of revenue quickly. A one-time (or short-term) increase in the money supply provides significant revenue. When the state is operating on a pure commodity standard, this can be done through debasement, or turning 100 gold or silver coins into say 150 gold or silver coins. Under a fiat system, this can be done by expanding the money supply. As George Selgin and Larry White highlight, estimates from the Medieval Europe suggest rulers generated as much as 92% of their revenue from debasement during times of war. This certainly seems to lend credence to the idea that the state’s monopoly is motivated by emergency financing.

Of course, as stated above, debasement and money printing cause inflation. If people know the state will resort to inflation in an emergency, they will hold less money and inflation provides less emergency funding for the state. This seems to suggest that the ability to use money printing and debasement over the long term is limited.

To solve this problem, rulers have to commit to something we would now call long-run price stability. In the days of pure commodity standards, a king might follow a period of debasement by converting the debased coins to full-bodied coins. (There is evidence that kings used recoinage as a commitment device.) A commitment to do so is tantamount to promising that any inflation will be followed by a corresponding deflation. Thus, over the long run, the coins would maintain their purchasing power and anchor money demand. Rulers could then use debasement in an emergency without the concern of limiting the future “tax base.” It is hard to provide another explanation for why rulers would commit to recoinage.

As Earl Thompson explained, an innovation of the Bank of England was applying the same logic to convertible paper money. During wartime the British would suspend the convertibility of bank notes with the promise to restore convertibility at the previous parity after the war. This allowed the Bank of England to help finance the war with note issuance without the fear of a wave of redemptions at the Bank and a drain of its gold reserves. In addition, the commitment to restore the previous parity was equivalent to a promise to offset any inflation created during the war from note issuance with a corresponding deflation after the war. Many people, including many economists, have criticized this practice since the policy-induced deflations were particularly costly. They argue that after the war it might be best to let bygones be bygones and simply devalue the unit of account to avoid the costly deflation. However, if one recognizes the state’s desire for emergency financing, it is obvious that this commitment to restore the previous parity is necessary for long-term emergency financing. Without that commitment, money demand would decline over time in anticipation that the currency would be permanently devalued in an emergency and this would make it difficult for the state to use the same tool of emergency finance in the future.

In my own work, I have shown the importance of these commitments to effectively financing war with money creation. In particular, I contrast the experience of Sweden and the early Riksbank with the Bank of England. It is evident that Sweden’s military failures were tied to financing constraints created by their parliament and the Riksbank and an unwillingness to use the gold standard in the same way as the British.

As people like David Glasner have pointed out, the idea that the state monopoly on money is really about emergency financing for things like wars can also help us to understand why counterfeiting has historically been treated as treasonous. Why should the crime of counterfeiting be treated as treason? Well, if one thinks that the state’s monopoly on money is necessary to provide emergency financing for war, then counterfeiting is an impediment to adequate financing. When presented in that light, it is not surprising that it would be treated as treasonous.

Thus, the story of the state monopoly over money is a political economy story. Yet, an understanding of price theory is necessary to put the pieces of that story together. It is important to understand how markets respond to policy and how people’s expectations shape their demand decisions. Armed with this knowledge, one can not only begin to understand why the state desires a monopoly on money, but also why the state’s monopoly on money has persisted for such a long period of time.