Lecture 10 min.
Free banking is a monetary arrangement in which banks are free to issue their own paper currency (banknotes), but are not otherwise subject to any special rules beyond those that apply to most enterprises.
In a free banking system, market forces control the supply of the total quantity of banknotes and deposits that can be supported by any given stock of money reserves, where such reserves consist either of a scarce commodity (for example, gold) or of an artificially limited supply of paper money issued by a central bank.
However, in the strictest versions of free banking, the central bank either plays no role at all, or the central bank's money supply must be permanently "frozen." Consequently, there is no agency able to act as a "lender of last resort" in the usual sense of the term. There is also no state insurance of banknotes or bank deposit accounts.
Proponents include Fred Foldvary, David D. Friedman, Friedrich Hayek, George Selgin, Lawrence H. White, Steven Horwitz, and Richard Timberlake.
Free banking is an environment in which there is no special banking regulation and no regulators, and banks are subject to the same regulation as most ordinary companies or enterprises. Operating within such a regulatory environment, banks also have the right to issue their own paper money (banknotes).In a free banking environment, market mechanisms naturally regulate the quantity of banknotes and deposits that can be backed by a given cash reserve. Such cash reserves hold either a finite-volume or finite-quantity commodity (for example, gold) or an artificially limited volume of fiat cash issued by a central bank. Moreover, in the absolute version of a free banking environment, the central bank plays no role whatsoever and issues no money at all. Thus the market has neither a central bank nor any other institution responsible for the stability of the banking system and the monetary unit in the usual sense of these terms.
Banking was more regulated at some times and in some places than in others, and in some cases and places it was almost entirely unregulated, which provides some experience of more or less free banking. Free banking systems have existed in more than 60 countries. The first system of competitive note issuance began more than 1,000 years ago in China (see below). Free banking was widespread in the 19th and early 20th centuries. Dowd, Kevin, ed. (1992), The Experience of Free Banking, London: Routledge lists the most well-known episodes of free banking known today and discusses several of them in detail, including Canada, Colombia, Fuzhou, France, and Ireland. Monetary arrangements with monopoly note issuance, including issuance by a state treasury, currency boards, and a central bank, replaced all episodes of free banking by the mid-20th century. There were several reasons for the decline of free banking: (1) Economic theories asserting the superiority of a central bank. (2) A desire to imitate the institutions of more developed countries, especially Great Britain. The Bank of England served as a model for many later central banks, even outside the British Empire. (3) A desire of national governments to obtain seigniorage (revenue from money issuance) from the issuance of banknotes. (4) Financial crises in some free banking systems, which prompted demands to replace free banking with another system that its advocates hoped would have fewer problems.
Some prominent economists of the 18th and 19th centuries advocated free banking, most notably Adam Smith, as opposed to the real bills doctrine. However, after the mid-19th century economists interested in monetary problems turned their attention elsewhere, and little attention was paid to free banking. Free banking as a subject of renewed debate among economists had its modern start in 1976 with a report by economist Friedrich Hayek, "Denationalisation of Money", which advocated that national governments stop claiming a monopoly on currency issuance and allow private issuers, such as banks, to voluntarily compete to do so.
In the 1980s this expanded into an increasingly sophisticated theory of free-market money and banking, with proponents Lawrence White, George Selgin, and Richard Timberlake increasingly focusing their work and research on this concept, whether concerning modern theory and application or research into the history of spontaneous free banking.
In the late 19th century, banking in Australia was practically unregulated. There were four major banks with more than 100 branches each, which together accounted for about half of the banking business, and branch banking and deposit operations were far more developed than in other countries with more heavily regulated legislation, such as Great Britain and the United States. Banks accepted each other's bills at face value. The interest margin was about 4% per year. In the 1890s, a collapse in land prices led to the bankruptcy of many small banks and building societies. Bankruptcy legislation passed at the time gave debtor banks generous terms on which to restructure, and most banks used this as a means of restructuring their debts in their own favor, although in reality they did not need to.
In the 19th century, several Swiss cantons abolished banking regulation, allowing free entry and note issuance. The cantons retained jurisdiction over banking activity until the adoption of the Federal Banking Act of 1881. Centralization of note issuance reduced the problem of a "bewildering variety of banknotes of varying quality ... amid fluctuating exchange rates."
Scottish free banking existed between 1716 and 1845 and is perhaps the most studied and developed example of free banking. The system was organized around three chartered banks, the Bank of Scotland, the Royal Bank of Scotland, and the British Linen Company, as well as numerous unchartered banks. The result was a very stable and competitive banking system.
Although the period from 1837 to 1864 in the United States is often called the era of free banking, the term is a misnomer relative to the definition of "free banking" given above. Free banking in the United States before the Civil War refers to various state banking systems based on what were then called "free banking" laws. These laws forced new entrants to obtain charters, each subject to a vote in the state legislature, with obvious opportunities for corruption. These general banking laws also significantly restricted banks' activities. Most importantly, free banks in the US could have only one office and were required to secure their banknotes with gold reserves, as well as by purchasing and transferring to state banking authorities certain securities that state law deemed acceptable for this purpose. The securities usually included state government bonds. Depreciation of these bonds was the main cause of free bank failures in various episodes, when many banks in a state failed. The lack of branches, in turn, caused state-issued banknotes to depreciate at different rates once they moved a significant distance from their source, which was an inconvenience. Depreciation of assets more generally is also used to explain the failures. Some authors ultimately explain the high rate of bank failures in the era of free banking in the US by restrictions on banks' asset portfolios. . Then, from 1863 to 1913, known as the National Banking Era, state-chartered banks operated under a free banking system. Some scholars have found that the system was largely stable compared to the national banks of that era. [23]
Sweden had two periods of free banking: 1830–1960 and 1860–1902. After the banking crisis of 1857, public support for private banks and private money issuers (especially Stockholms Enskilda Bank, founded in 1856) increased. In 1864 parliament passed a new banking law deregulating the interest rate. The following decades marked the peak of Sweden's free banking era. After 1874 no new private banks were established. In 1901 the issuance of private money was banned. Studies of Sweden's free banking era point to stability, with a single bank failure linked to fraud over 70 years.
Jiaozi is a form of banknote that appeared around the 10th century in Chengdu, the capital of Sichuan province, China. Between 960 and 1004, banknotes belonged entirely to private merchants, until the government decided to regulate the business due to a perceived increase in fraud cases and disputes, and issued 16 licenses to the largest merchants.
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