Free banking refers to a monetary arrangement in which banks are subject to no special regulations beyond those applicable to most enterprises, and in which they also are free to issue their own paper currency (banknotes). In a free banking system, market forces control the supply of total quantity of banknotes and deposits that can be supported by any given stock of cash reserves, where such reserves consist either of a scarce commodity (such as gold) or of an artificially limited stock of "fiat" money issued by a central bank. In the strictest versions of free banking, however, there either is no role at all for a central bank, or the supply of central bank money is supposed to be permanently "frozen." There is, therefore, no agency capable of serving as a "lender of last resort" in the usually understood sense of the term. Nor is there any government insurance of banknotes or bank deposit accounts.
Banking has been more regulated in some times and places than others, and some times and places it has hardly been regulated at all, giving some experiences of more or less free banking. Free banking systems have existed in more than 60 countries. The first system of competitive issue of notes began more than 1,000 years ago in China (see below). Free banking was widespread in the 19th century and the early 20th century. Dowd, Kevin, ed. (1992), The Experience of Free Banking, London: Routledge lists most currently known episodes of free banking and discusses in some depth a number of them, including Canada, Colombia, Foochow, France, and Ireland. Monetary arrangements with monopoly issue of notes, including government treasury issue, currency boards, and central banking, replaced all episodes of free banking by the mid 20th century. There were several reasons for the demise of free banking: (1) Economic theories claiming the superiority of central banking. (2) Desire to imitate the institutions of more advanced economies, especially Great Britain. The Bank of England was the model for many later central banks, even outside the British Empire. (3) Desire of national governments to collect seigniorage (revenue from issue) from note issue. (4) Financial crises in some free banking systems that created demands to replace free banking with another system that advocates hoped would have fewer problems.
Some prominent 18th and 19th century economists defended free banking, most notably Adam Smith. After the mid 19th century, though, economists interested in monetary issues focused their attention elsewhere, and free banking received little attention. Free banking as a subject of renewed debate among economists got its modern start in 1976 with The Denationalization of Money, by economist Friedrich Hayek, who advocated that national governments stop claiming a monopoly on the issuing of currency, and allow private issuers like banks to voluntarily compete to do so.
In the 1980s, this expanded into an increasingly elaborate theory of free market money and banking, with proponents Lawrence White, George Selgin, and Charles Timberlake increasingly centering their writing and research around the concept, either regarding modern theory and application, or researching the history of spontaneously free banking.
In the late 19th century, banking in Australia was subject to little regulation. There were four large banks with over 100 branches each, that together had about half of the banking business, and branch banking and deposit banking were much more advanced than other more regulated countries such as the UK and US. Banks accepted each other's notes at par. Interest margins were about 4% p.a. In the 1890s a land price crash caused the failure of many smaller banks and building societies. Bankruptcy legislation put in place at the time gave bank debtors generous terms they could restructure under, and most of the banks used this as a means to restructure their debts in their favor, even though they didn't really need to.
In the 19th century, several Swiss cantons deregulated banking, allowing free entry and issue of notes. Cantons retained jurisdiction over banking until the enactment of the Federal Banking Law of 1881. The centralisation of note issue reduced the problem of the existence of "a bewildering variety of notes of varying qualities ... at fluctuating exchange rates."
Scottish free banking lasted between 1716 and 1845, and is arguably the most researched and developed instance 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, and numerous unchartered banks. It resulted in a highly stable and competitive banking system.
Although the period from 1837 to 1864 in the US is often referred to as the Free Banking Era, the term is something of a misnomer, for it refers not to a general system of "free" banking in the literal sense described previously, but rather to various state banking systems based on so-called "free banking" laws, which, though they made it unnecessary for new entrants to secure charters (each of which was subject to a vote by the state legislature), nonetheless restricted their undertakings in important ways. Most importantly, US "free" banks were denied the right to establish branch networks, and had to "secure" their notes by purchasing and surrendering to state banking authorities certain securities those authorities deemed eligible for the purpose. The securities in many cases included bonds of the authorizing state governments themselves; and it has been determined that the depreciation of these very securities was the chief cause of "free bank" failures, and indeed of bank failures generally, during the period in question. The lack of branch banking, in turn, caused state-issued banknotes to be discounted at varying rates once they had traveled any considerable distance from their sources. Depreciation of assets over this period is also used to explain failures. In fact, the high-rate of bank failures during the so-called "free banking era" in the US are attributed by several authors to bank regulation. Then, from 1863 to 1913, known as the National Banks Era, state-chartered banks were operating under a free banking system. Some scholars have found that the system was mostly stable compared to National Banks of that era.
Sweden had two periods of free banking, 1830–60 and 1860-1902. Following a bank crisis in 1857, there was a rise in popular support for private banks and private money issuers (especially Stockholms Enskilda Bank, founded in 1856). A new bank law was adopted by parliament in 1864, deregulating the interest rate. The following decades marked the height of the Swedish free banking era. After 1874, no new private banks were founded. In 1901, issuing of private money was prohibited. Research on the Swedish free banking era suggest stability, and a single bank failure related to fraud in 70 years.
Jiaozi was a form of banknote which appeared around 10th century in the Sichuan capital of Chengdu, China. Between 960 and 1004, the bank notes were totally run by private merchants. Until government decided to regulate the business on alleged increasing fraud cases and disputes, and it granted 16 licenses to the biggest merchants of all.
- Henry Meulen, author of Free Banking: An Outline of a Policy on Individualism, 1934
- Richard Salsman, author of Breaking the Banks: Central Banking Problems and Free Banking Solutions, 1990
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- An Inquiry into the Nature and Causes of the Wealth of Nations (1776), Book II, chapter 2, final paragraph, p. 286.
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- Goodhart, Charles Albert Eric (1995). The Central Bank and the Financial System. MIT Press. p. 211.
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- White, Lawrence H. (1992), "Free Banking in Scotland before 1844", in Dowd, Kevin, The Experience of Free Banking, London: Routledge, pp. 157–186
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- For a review of literature, see Calomiris, Charles W. (2010). "The Great Depression and Other 'Contagious' Events". In Berger, Allen N; Molyneux, Philip; Wilson, John O. S. The Oxford Handbook of Banking. Oxford University Press. pp. 693–710.
- Freixas, Xavier; Rochet, Jean-Charles (1997). Microeconomics of Banking. MIT Press. p. 261.
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- US House of Representatives. Committee on Financial Services. Subcommittee on Domestic Monetary Policy and Technology (May 8, 2012). "Improving the Federal Reserve System: Examining Legislation to Reform the Fed and Other Alternatives. Written Testimony by Jeffrey M. Herbener, Professor of Economics, Grove City College" (PDF).
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