The banking crisis resurrected the idea of free banks – a concept as old as Adam Smith’s The Wealth of Nations. What are free banks? And are they a good idea? Simon Wilson reports.
What’s free banking?
A system where the state treats a bank just like any other commercial business. So there are no special regulations, for example, specifying the reserves they must hold and how much they can lend. Crucially, they are also allowed to issue their own paper currencies, leaving the market – not a central bank – to set both the price of money (ie, interest rates) and determine its supply. If borrowing surges under this kind of free-market system, rates rise to choke off demand – and vice versa. Plus having no state lender of last resort cuts the moral hazard: no bank is too big to fail.
Is this a new idea?
Far from it. Arguments in favour of free banking can be found in Adam Smith’s foundational text of modern economics, The Wealth of Nations (1776). Smith, who was born in Kirkcaldy and spent most of his career at the University of Glasgow, was writing during Scotland’s own long period of free banking, between 1716 and 1845. The Bank of Scotland (the country’s original bank charter) and the Royal Bank of Scotland (chartered by England) issued competitive currencies; a truce was only declared after the ‘currency war’ of 1727.
Where else has free banking operated?
Sweden operated a broadly successful free banking policy from 1830-1902. Only one bank went bust – due to fraud. Countries as diverse as Australia and Switzerland also operated a similar system, while in America the years 1837-1864 are known as the Free Banking Era (although the banks were under more local state controls than the term implies). In Britain, the 19th century was dominated by debates between the Free Banking School (who wanted to end the Bank of England’s monopoly and follow the Scottish practice of letting banks issue competing notes); the Currency School (who argued that notes should be strictly limited by the amount of gold possessed by the Bank of England); and the Banking School (who held that notes should only be issued to cover real transactions).
Who won?
Not the free bankers. Instead, the Banking School was the one that convinced the then prime minister Sir Robert Peel. So the Bank of England continued to enjoy its monopoly, and the Bank Charter Act of 1844 provided the framework for many of the operations of UK banking until the late 20th century. For most of that century, free banking never got much of a look-in. Those economists who have championed it – principally Austrian School free-marketeers such as Ludwig von Mises and Mrs Thatcher’s favourite economist Friedrich Hayek – have been seen by many economists as libertarian dreamers.
Why did the idea die away?
First, the rise of state-centred and Keynesian macroeconomics saw a long 20th century bull market in central banks. In 1900, only 18 countries had one; now everyone has got one, from Afghanistan to Zimbabwe. When state institutions are – more or less successfully – doing everything, from setting monetary policy to acting as a lender of last resort, their monopoly tends to get accepted as the natural order of things.
What changed?
The prestige and authority of central banks, including the Fed, has collapsed over the past 15 years or so in the face of the stock and housing bubbles as well as the global financial crisis. Such events have made the arguments of the Austrian School much harder to dismiss – the view that central bankers wreak inflationary havoc by systematically devaluing a fiat currency by printing too much of it is now almost an article of faith for disillusioned investors. The Austrians are also the principal critics of fractional reserve banking – ie, the standard form of commercial banking in which funds deposited can be loaned on to other customers, creating a (reserve ratio) discrepancy between deposits and available funds – a structural weakness that means central banks in effect insure the whole system and protect it from collapsing.
Should we move to a free banking system?
Yes
1. Pre-Fed, there were still lots of banking crises in 19th century America. Now, as then, free banking does not magic away errors of judgement and waves of fear, greed, panic and euphoria amongst investors.
2. In today’s complex and globally interdependent banking system, a lender of last resort is a critical player.
3. Too much deregulation was what caused the banking crisis; it can’t also be the solution. And who would like it if failed banks such as RBS or Lehman Brothers issued their own currencies?
No
1. Free banking could hardly produce a banking system that’s less stable than the present one, which collapsed in 2008/9 with disastrous global consequences.
2. Without the safety net of a central bank, moral hazard is reduced or avoided. Banks would be forced to be more prudent, reducing the risk of financial crises.
3. In future, the rise of secure electronic money may encourage a new form of free banking as it will be easier for the market to set the price of money.