(Reprinted from HKCER Letters, Vol. 10, September 1991)
The World History Of Free Banking
Free banking is the principle of free trade applied to the banking profession. In particular, this means a system of competitive issue of bank notes. Free banking was quite widespread during the 19th century. In fact, there were about 55 countries that had such a system at one time or another, although no country today has free banking any more.
Free banking evolved from earlier money-lending arrangements. In England, for instance, the activities of goldsmiths, people who would take gold and warehouse it, were the origin of free banking. England, however, had a prototypical central banking system. The Bank of England was founded in 1694 exclusively as an institution to help finance the government.
In Scotland, on the other hand, other than a few chartered banks, there were many unchartered, unlimited liability banks. In fact, there were over 100 during the course of the Scottish free banking period, which lasted from 1727 up until 1844. Scotland had one of the freest free banking systems in Europe. Other European countries that had quite unregulated free banking systems were Sweden, Belgium, and France for a few years right after the French Revolution. There were other European countries that had free banking but with more regulations. These included Germany, Italy, Switzerland, Spain, Portugal, and Greece.
Moving on to the Americas, all of the independent countries of North and South America, except for Haiti and the Dominican Republic, had free banking at some point during the 19th century. In Europe, there was no ideological rationale behind the establishment of free banking systems. In the Americas, however, countries like the United States, Canada, Brazil, and Argentina all had terrible experiences with government issue of currency before they established free banking systems.
Among the places in the Americas that had free banking were several British colonies. Free banking was widespread throughout the British Empire, and Britain was the only colonial power to allow free banking. Other British colonies such as Malta, Mauritius, Hong Kong, Ceylon, and India all had free banking for a time. Countries in the Orient besides British colonies that had free banking included China, Japan, Thailand, and the Philippines. In total, there were about 55 cases of free banking all over the world.
Briefly speaking, competitive forces in a banking system work similarly to those in other industries to generate a certain kind of order. Free banking is not chaos any more than, say, the computer business is chaos.
There are no good studies of how well or how poorly free banking affected the economy. However, my impression from reading a lot of banking histories of various countries is that free banking was certainly just as good as central banking in ensuring that there was economic growth and full employment, and perhaps better.
Where free banking clearly was superior to the performance of central banks was in maintaining exchange rates. In the 19th century, free banking always meant a system where the liabilities of banks were convertible into gold or silver. Foreign currency arbitrage was extremely efficient in keeping the gold points of the banking system within a very small range of parity.
Free banking systems generally experienced stable banking. There were few system-wide peacetime bank runs. It is true that there were cases when dozens of U.S. or English banks failed. I would, however, attribute that to regulation. In these two countries there were regulations that inhibited the growth of large, stable banks such as those limiting branching. In comparison, the free banking systems were less regulated in Scotland and Canada. These systems went through the panics that England and the U.S. experienced virtually unscathed, and bank failures were fewer and far less disastrous. In wartime there were often runs on free banks. However, the same was true in central banking systems where there was convertibility into gold.
Free banking systems had their own ways of helping out their members in times of crises. There were interbank lending markets, just as there are today. Also, sometimes banks would form syndicates to bail out one of their members. Banks also would cope with crises by merging, a less sound bank joining with a sound one. Finally, on extreme occasions, free banks would suspend convertibility into gold and silver for brief periods. However, it is worth stressing that they did so only when the banking system was under extreme stress. Many of the legal systems of the time did not allow for any sort of contractual compromise between the note holders and the banks. If there had been a contractual mechanism in existence, some sort of compromise would have been worked out, as in the Scottish banking system. When a note holder demanded gold from a Scottish bank, the bank could delay payment of the gold for up to six months, provided it would pay a penalty rate of interest in the meantime. The profit incentive was for the bank to resume convertibility into gold or silver soon, to avoid having to keep on paying this penalty rate.
Banking systems that were not hindered by limitations on branch banking tended to have somewhere between two and twenty banks, which is a rather small number. However, that apparently did not inhibit competition. In the few cases I have been able to find reference to, attempts to cartelize the banking systems were unsuccessful. Nor do I find any evidence that free banking systems had natural monopoly tendencies. All systems that allowed competitive note issue had more than one note-issuing bank.
Free banking was fairly successful, but it declined and it does not exist anywhere today. One can classify the causes of free banking's decline into three broad categories. First of all, in the largest number of cases, central banking was the product of some sort of theoretical and political debate, fairly long and drawn out, often prompted by perceived defects in the existing free banking system. A classic example was the debate between the "currency school" and the "free banking school" in Britain. The former had more influence with the British government of Sir Robert Peel, and they persuaded the government to monopolize all note issue (in both England and Scotland) in the Bank of England.
In a second group of cases, there was some sort of crisis in the banking system which led to political pressure on the government to "do something," and central banking was introduced as more or less an emergency measure. After it was established, it gained institutional momentum and so persisted until the present.
In some other cases, governments monopolized note issue as a means of extracting revenue to finance their expenditures. This occurred in France in 1803 when Napoleon gave a monopoly of note issue to the Bank of France.
World War I was a turning point in free banking history. Countries like Canada and New Zealand, which had had free banking systems, adopted forms of government control of the money supply to help finance their involvement in the war. The League of Nations recommended in an influential memorandum that all nations that did not have a central bank got one. The last free banking system, as far as I can tell, was that of Venezuela, which was replaced by central banking in 1940.
The lessons that I draw from the world history of free banking are two. First, free banking was in a sense the natural system. There was no inherent economic tendency towards central banking. I think central banking was established in just about all cases as a political measure. There was no apparent need that I can see, for example, for a lender of last resort, or for control of the money supply to ensure macroeconomic stability. The other lesson is that free banking was widespread, much more common than people have supposed, and generally worked quite well. The economic logic that underlies free banking is timeless, and the same forces that made free banking a stable and efficient system in the 19th century would equally well apply today.
Dr. Kurt Schuler gave the above speech at a luncheon address organized by the Hong Kong Centre for Economic Research when he visited Hong Kong as an Institute of Humane Studies scholar.