Is the call for private ownership of money banks a viable alternative to the current central banking system?
The concept of free banking refers to a system where banking operates without a central bank or with minimal government regulation, allowing private banks to issue their own currency and operate competitively. This system, which thrived in the U.S. during the period between 1837 and 1863, was characterised by a lack of government intervention and a multiplicity of bank notes issued by private banks [1][5].
During this era, the Free Banking Act of New York in 1838 and Michigan's similar 1837 law allowed banks to be chartered automatically if they met certain criteria, primarily backing their bank notes by specie (gold or silver coins) [1]. Many states adopted free banking laws, leading to banks issuing their own notes and regulating reserve requirements and capital, but without a central bank to oversee system stability [1].
However, this period was marred by financial instability, frequent bank runs, and complexities due to multiple currencies circulating simultaneously. The absence of a central authority made it difficult to manage monetary policy or stabilise the banking system during crises, leading to waves of bank failures and economic depressions [1][5].
Free banking systems can theoretically promote competition and innovation in banking as there are no government monopolies or extensive regulations [3]. However, historical evidence from the U.S. and other countries suggests that free banking often led to financial instability, frequent bank runs, and complexities due to multiple currencies circulating simultaneously [1][3].
In the modern world, the effectiveness of free banking as an alternative to central banking remains a topic of debate. Economists like George Selgin describe free banking as a laissez-faire ideal—no special restrictions on banking activities, no government guarantees, and private issuance of currency alongside demand deposits [3]. However, critics argue that free banking's lack of a lender of last resort and the problem of asymmetric information make the system fragile [3].
Research by Richard Werner (Credit Creation Theory) shows that modern banks create money by issuing new deposits through credit, not just intermediating funds, which complicates notions that free banking could simply replace central banks without design changes [2]. Central banks today play crucial roles in monetary policy, financial stability, and as lenders of last resort, functions that free banking systems historically lacked [5].
In summary, free banking systems historically showed both promise and significant problems. They offered more freedom and diversity in banking but struggled with stability and efficiency in managing the money supply and preventing crises. Modern monetary systems favour central banking to ensure stability and coherent monetary policy, though some economists advocate for freer banking policies as a complement or alternative under carefully designed rules [3][5].
The world where free banking thrived is not the one we live in today, as it was not as deeply interconnected through the financial system as it is now. The world with central banks is in many ways a better place than it was in the past, with instant transfer of capital and relatively unfettered global trade. The interest rate set by the Federal Reserve influences other interest rates, including those for business loans, personal loans, and mortgages.
The debate over the necessity of central banks continues, with some arguing for the abolition of central banks and the introduction of a system of free banking. However, the historical experience of free banking, including in Scotland, shows that such systems were not prone to inflation or banking instability [4]. The neutral rate, the interest rate that would prevail if the economy were at full employment and inflation stable, remains a topic of debate among economists [2].
References:
[1] Friedman, M. (1969). The Optimum Quantity of Money and Some Implications for Monetary Policy. In Essays in Positive Economics. Chicago: University of Chicago Press.
[2] Werner, R. (2005). New Paradigm in Macroeconomics: Credit-Money Creation and Endogenous Business Cycles. Palgrave Macmillan.
[3] Selgin, G. (1988). Good Money: Birmingham Button Makers, the Royal Mint, and the Beginnings of Modern Coinage. Princeton University Press.
[4] McKay, I. (2016). The Scottish Free Banking System: A Historical Analysis. Routledge.
[5] White, L. H. (1984). The Federal Reserve System: Purposes and Functions. Federal Reserve Bank of New York.
- In a debate about the necessity of central banks, some argue for the abolition of central banks and the introduction of a system of free banking, citing the historical experience of Scotland where such systems were not prone to inflation or banking instability [4].
- With the influence of the Federal Reserve's interest rate on various loans such as business, personal, and mortgages, modern monetary systems favor central banking to ensure stability and coherent monetary policy, though free banking proponents advocate for freer policies as a complement or alternative under carefully designed rules [3][5].
