A third type of spurious argument is that banking is a natural monopoly because of economies of scale in building public ‘confidence.’ A well-known version is the Klein-Melvin (1982) argument that public confidence in the value of a currency depends on confidence-building expenditures that involve certain fixed costs, the presence of which implies that one bank could always produce confidence more cheaply than two or more could. Klein and Melvin go on to suggest that the government would have an advantage in providing this confidence because its ability to tax implies that it does not need to hold reserves to maintain confidence as private banks would. There are a number of problems with this argument:
It depends on the assumption that competitive banks would issue inconvertible currencies, but competitive issues would actually be convertible, as discussed already, and convertibility undermines the whole thrust of the Klein-Melvin analysis. If competition leads to a credible convertibility guarantee, there should be no lack of public confidence regarding the value of the currency, and the problem that Klein and Melvin discuss does not arise. . . .
To put it mildly, it is very difficult to make out a serious case that government intervention in the monetary system has helped promote confidence in the currency. The very problem that Klein and Melvin discuss — the question of confidence in an inconvertible currency — only arises in the first place because governments have suppressed the convertibility ‘guarantee’ of the value of the currency that private competition would have provided. Far from providing the public with currencies in which they could have confidence or promoting public confidence in private currencies, government policy has often been designed to compel the public to use currencies in which they had little or no confidence.
—Kevin Dowd, Competition and Finance: A Reinterpretation of Financial and Monetary Economics (Houndmills, UK: Macmillan Press, 1996), 202-203.
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