Is legal tender an imposition on free markets or a free market institution?

Robert the Bruce: Scottish  £20 issued by Clydesdale Bank. Not legal tender

This is my last post on legal tender. It builds on my initial posts on legal tender, various comments, and discussion at Bob Murphy's blog. If you're getting to the debate a bit late, here are the first two posts.

1. Legal Tender 101
2. How do legal tender laws affect purchasing power?

Are today's legal tender laws an imposition on monetary freedom?

My short answer: not really. In the US, legal tender is comprised of Federal Reserve notes and United States coin. That means that all debts can be discharged with government coins and notes. It might seem that this would impose the circulation of coins and notes on the marketplace. But as I pointed out in my initial post, debtor and creditor can easily get around legal tender rules by negotiating their own settlement media into the terms of a debt contract.

As commenter MF points out, there is one debt obligation that's tough to negotiate around: the government's tax obligation. Since citizens must pay taxes, and the government sets legal tender, surely notes and coin are forced upon the populace. In theory yes, but in practice no. The IRS asks that people do not send notes or coin to discharge their tax obligation. As a result, most taxes are paid with non-legal tender like cheques, direct deposit etc. Legal tender laws, it would seem, have no bite since the IRS itself ignores them.

But let's assume the government did indeed require tax payments in legal tender coin and notes. Let's return to my favorite McDonald's analogy (see here and here). Imagine that McDonald's Corporation forces customers to pay their "Big Mac tax" with McDonald-issued coupons. This is equivalent to a government that requires people to submit legal tender in order to discharge a tax obligation.

As I pointed out, people don't have to submit to McDonald's tax requirements, insofar as they are willing to eat at Burger King which (let's say) doesn't require coupons to pay for Whoppers. The same goes for US legal tender. If the US government requires citizens to settle their taxes with US legal tender (which, as I've pointed out above, is not the case in practice), then people can avoid this imposition by no longer doing business with the US. Go live in Scotland, which like Burger King, has no legal tender rules. Or find some other nation that doesn't have legal tender. You'll still have to pay taxes, of course, but settlement media won't be dictated to you.

As we know from Lawrence White's Free Banking in Britain, Scotland has a long history of free banking. Even today the majority of bank notes that circulate in Scotland are issued by three private banks—The Bank of Scotland, the Royal Bank of Scotland, and the Clydesdale Bank. These notes aren't legal tender. Nor are Bank of England notes, which also circulate in Scotland. For a brief time between 1954 and 1988, Bank of England notes with denominations below £5 were legal tender. But the withdrawal of the £1 notes from circulation in 1988 left Scotland with no paper legal tender. Scots accept both local Scottish notes and Bank of England notes as settlement media not because they must, but because it's convenient.

Legal tender as a free market institution?

Having shown that modern legal tender laws aren't necessarily a huge imposition on the free choice of payment media, I'll go one further and say that in a world characterized by free banking and governed by lex mercatoria (i.e. private merchant law) legal tender laws might evolve naturally as the result of market choice.

Huge amounts of debts are created in a day’s worth of business. Negotiating settlement media into each and every contract takes time, so transactors may choose to omit that bit. If so, a subsequent situation may arise in which a debtor arrives to pay a creditor, but the creditor refuses to accept the proffered settlement media, thereby forcing the debtor into unnecessary default. To avoid having court rooms being swamped by frivolous default cases, I could imagine merchant law evolving a list of common media that must always be accepted in the settlement of those debts for which a settlement medium was not already specified. If the marketplace were to accept these laws, then legal tender rules would arise in the same way that VHS beat Beta—they provide a cheap and useful set of standards around which everyone can coordinate their plans and actions.

Naturally, all sorts of interested parties would lobby jurists to have that list include their preferred asset. Nevertheless, there seems to me to be a certain “market” logic to legal tender. The real barriers to monetary freedom are not legal tender laws, but laws that restrict the issuance of notes to a monopoly issuer, and laws that force private banks to join a monopoly clearing house. But that's a different post.