Since this is often a topic of discussion on many lists I participate in, I've decided to put together a FAQ on the subject. This is by no means the last word on the subject. I hope those interesting in free banking will read some of the works listed below. (Don't start with the Cohen book! It's a bit technical and focuses, as you might guess, on Ancient Athens. In my opinion, the best places to start are Dowd 1993 and Selgin 1988.)
What is free banking?
Free banking – also known as laissez-faire banking and fractional reserve free banking – is banking under free market conditions, where governments do not regulate or control the money supply or banking over and above laws against force and fraud. I.e., there are no special laws governing banking, currency, note issues, and the like.
Current banking systems are mostly central bank systems where a government run bank sets interest rates and reserve requirements. This system is also imbedded in a host of other specific regulations on banking, from portfolio requirements (what a bank can invest in) to minimum capitalization limits (the total assets a bank must have to operate legally), from limits on branching and mergers to legal tender laws (laws specifying what is acceptable as money), and a host of other regulations. These vary from country to country and in certain countries from region to region. (In the US, banking laws vary from state to state.) There are other extant alternatives to central banking – such as currency boards and just plain old heavily regulated systems – but there currently exists no free banking system on the planet.
How is money exchanged in free banking?
Much the same as under the current banking system. Money will be used in buying goods and services. Some will be used, no doubt, to convert to the standard(s) – e.g., gold and silver. Since each bank can print money, banks will exchange each other's notes at par if they have confidence in each other. A bank that does not hold such confidence will have its note trade below par (or in the limit case, not at all) unless and until it can gain it. There would also be no limit to entry into the currency issuing market, so new banks could form and non-banks could issue currency as well.
Do banks in a free-banking system print notes?
In the past, banks printed notes and these notes were basically debt on the banks reserves. Of course, now, there might no need to actually print notes or do so on as vast a scale as was done in the past or as is now done by government mints. Instead, some form of digital cash might be used. Already, there are shades of this with people using check and ATM cards to make purchases offline. (These are not the exact equivalent of cash, since they are not anonymous and trade between ATM users is not as simple as trading cash. For instance, it's still much easier to hand someone a piece of paper currency or even coins – from a panhandler to peddler – than to give her or him money electronically in many cases.)
How do private banks coin money?
There would be no laws stopping them from doing so. Of course, history shows people prefer paper currency – fiduciary notes – over coins, since the latter are bulky as well as hard to store and transport. Money would be coined, if at all, by private mints and this would probably function no differently than coinage does today, though it would be more demand specific. I.e., coins would not be printed willy-nilly, but mostly based on consumer demand for them. Likewise, coins would have to be evaluated on their fineness and the like. Chances are, under free banking, coined money would not play a major role in the money system.
Isn't free banking inherently unstable?
The claim that free banks are inherently unstable lacks a theoretical or empirical foundation. From a theoretical point of view, free banks have an incentive to be stable – to keep customers and investors. Unstable banks are less likely to attract depositors and investors. Their more stable rivals will take their business away from them, all other things being equal. In the rare event that all banks are less stable, people would switch to the money standard. (There are no historical examples of all banks failing or being unstable under free banking.)
The historical record is quite clear: free banks are more stable than regulated and central banks. When bad banks are allowed to fail, good banks remain and both customers and investors become aware of signals on how to separate quality from its lack in banking. Under such a regime, both customers and investors have a strong incentive as well to pay attention to such signals to insure quality. (See the works of Dowd, Selgin, and White listed below for more on historical studies of free banks. See also Schwartz 1999 on how on a global scale, central banking creates instabilities.)
How would customers and investors, especially small investors, be able to rate banks?
This would be no different from any other business. Again, banking presents no special problems in this area. Customers are able, e.g., to buy cars without being automobile engineers. Banks, too, would have an incentive to display important traits about themselves to customers and rating agencies. Banks that do not do so or are known to deceive the public and rating agencies would tend to lose customers and public confidence. (Rating agencies would depend on their reputation for accuracy and honesty. Thus, a rating agency that was either incompetent or dishonest would lose its credibility. After all, a rating agency's product is accurate and clear information about whatever it rates. On a free market, people would be free to patronize only those rating agencies they believed to be competent and honest.)
Investors, even small ones, would also be able to rate banks, either through third parties – rating agencies again – or just by looking at publicly available information. This would be no different than investing in any other business. Again, there is no special case against banks as businesses in comparison to other types of businesses. In fact, banks that tried to hide behind some sort of special complexity would probably be viewed by savvier investors as too risky to invest in.
Wouldn't free banks have a tendency to inflate?
Free banks have an incentive not to inflate because this would lead to banks that did not inflate acquiring more reserves in the short run and being less likely to fail in the long run. Inflating banks would lose reserves as other banks and note holders converted the inflating banks notes in the standard. If the bank were continuously unable to meet such demands, its notes would be seen as less valuable. That might precipitate a run. An inflating bank under a free market system would be devaluing its own currency and risking its own future. (Other banks, rating agencies, investors, and the general public would most likely catch on very quickly to what was going on. Those who caught on the quickest would also be in a position to profit, helping to signal the inflation problem to the rest of the market in short order.)
Note: a free bank has this incentive not to inflate at the micro-level of everyday transactions. There's no need to wait for months to see the macro-level changes of price levels and wages. Instead, inflating banks would know pretty quickly that they were inflating via the outflow of reserves. Other market observers – customers, merchants, investors, competitors, and rating agencies – would likewise notice this rather quickly, perhaps on a daily basis. This would discipline free banks far more effectively than governments can discipline central banks, especially when politicians tend to favor inflationary policies.
Wouldn't free banks have a tendency to deflate?
Free banks also have an incentive not to deflate because this would lower their profits compared to banks that did not deflate and it would also decrease their market share. A deflating bank would run the risk of inviting its competitors taking over its market. It would have lower profits and, to investors, look like a bad investment.
Likewise, this incentive would be immediately noticed. Again, it would be micro-level signals not marco-level ones driving free banks not to deflate.
Wouldn't free banks collude?
Though under any system collusion is possible, free banks have an incentive not to collude because of loss of profits. Any attempt to lock in an interest rate or other policy between banks in a market that's open to newcomers runs two risks. One is that banks not colluding will be able to benefit from not following the policies of the colluding banks, especially when these will turn a profit. The other is that, since a free banking system has no legal barriers to entry in the banking or currency system, there's nothing to stop a new bank from forming to compete against the colluding – again, especially when this challenge will turn a profit. (Without any specific laws on banking, there would also be the chance for non-banking firms to enter the banking business.)
That said, there might certain spontaneous standardizations and the like under free banking. If these were at all injurious to bank customers or investors, there will be both the chance (no legal barriers to entry) and the incentive (higher profits) for other banks (or new banks to arise) to compete with the colluding banks. If they not injurious, then there's no problem. (Surely, even were collusion more likely as well as damaging, the worst policy solution would be to centralize the banking system, which only leads to one bank controlling the whole system – the very thing those against collusion desire.)
Wouldn't free banks suffer from the herd-mentality?
There is no empirical evidence that free banks suffer a herd mentality. In fact, the variety of free banks and the variety of their reactions to economic changes backs my claim. There are also sound theoretical reasons to believe this would be so under future free banking regimes. Why? It is in the self-interest of the sound banks to distance themselves from their unsound competitors. When less sound banks fail, the tendency would be for their customers and investors to flee to quality.
What about deposit insurance?
Private deposit insurance would most likely not exist under free banking. The ability to switch banks for consumers and investors and the ability for banks to branch and diversify would lessen the need for such insurance than under current systems. This makes it less likely for a free banking system to need or develop such insurance.
Government deposit insurance does not fit into a free banking system. It would represent a government interference with such a system. But aside from this, it also creates many problems, especially that of a moral hazard. By shoring up weak banks, government deposit insurance encourages risky behavior and taxes prudent institutions. In the long run, it corrupts the whole system by rewarding bad banking at the expense of good banking.
Also, under the various historical examples of free banking, banks in general did not need insurance. They used capitalization and contractual obligations to meet demands in excess of their reserves. (The ones that couldn't do so were sometimes bailed out, but they often failed. This is how the bad banks are weeded out.) It's been partly restrictions on such instruments and not absence of insurance that caused runs and panics.
Didn't central banks evolve because of the problems with free banking?
Central banks arose because of either seeming problems of free banking led to them being legally mandated (in America through Act of Congress) or through giving more and more legal privileges to a specific bank (as happened in England and Australia). In this sense, they could be said to evolve, but only in the most trivial meaning of evolution. They came about because of government intrusions in the market – not because of some inherent tendency of the market toward a central bank. (See Dowd 1993 for more on how central banks arose. See also Glasner 1998 for an argument on why governments have almost always tried to have a hand in the money system.)
What are some salient historical examples of free banking?
The best historical example of free banking is Scotland during the 19th century. Other examples include the United States from the collapse of the Second Bank of US in the 1830s to the Civil War and Australia during the 19th century. The American example is highly variable because banking laws varied from state to state. Even in this example, there were some special laws for banking, but these were not as intrusive as central banking or as far-reaching as the heavy regulation present today. (See Dowd 1993 for details on all of these. See Selgin 1988 for other examples of free banking. See Bodenhorn 2000 for an overview of banking and business practices in the Antebellum Era.)
If free banks are so great, why aren't there any today?
Mostly because of the legal and political context that arose during the 19th and early 20th centuries. This includes government supporting central banks. Legal tender laws also prevent free market monies from arising via Gresham's Law (see the next question).
Central banks also tend to be government friendly, usually by supporting government debt (deficit spending) and inflationary policies. So, there's a positive feedback loop between government on one hand and central banking on the other. Central banks can extend credit to governments or change monetary policy in a way that helps governments, especially when taxation is unpopular or when undertaking large spending programs.
David Glasner argues that states early on gained and maintained control of the money supply specifically to fund armies, thereby to defend or extend their power. This might explain the staying power of government mints and central banks once they arise. In today's world, this would extend, in democracies, to keeping or expanding support for the regime or the political system by using the money system to dole out favors tp special interests without the need to always raise taxes. (See Glasner 1998 for his full argument. See also Goodhart 1995 for some specific political problems with instituting free banking today.)
What about Gresham's Law – that bad money drives out the good?
Gresham's Law only applies to legal tender systems, since under such systems the legally mandated money can drive out competitors. Only when people are forced to use certain types of money will it apply. Here's why. Imagine there are two currencies, one from Bank A and the other from Bank B. Let's say there are legal tender laws demanding that Bank A's currency be accepted as legal tender and also setting the value that currency. Under such a system, Bank A has less of an incentive to maintain the value of its currency, since its money is now protected by the law from competition. Now, a debtor, e.g., having both currencies at her disposal will use the less valuable money – Bank A's – to pay off debts rather than the more valuable money – Bank B's. Thus, even if Bank B's currency is more valuable – because of, perhaps, good reserve policies, more prudent investments, no tendency to inflate – people will generally choose Bank A's to give lower value for each trade.
Now, if there were no legal tender laws, Bank A's currency being of lesser value would be used less, since creditors, merchants, and other banks would not accept its notes over Bank B's. In fact, the situation would be reversed. People would be more likely to use Bank B's currency and not trust A's – or trade Bank A's currency below par with Bank B's. So, Gresham's Law only holds when legal tender laws are in force – or where there is some other legal regulation that favors one currency over another. (See Selgin 2003 for more on this.)
What about the gold standard?
The gold standard arose somewhat spontaneously, though this by no means makes it the only possibility for a money standard. A gold standard under current banking regimes – central banking ones – might curb some of the pressure for a central bank to inflate and otherwise manipulate the economy. That said, it should be remembered that this would only be a partial brake and that a gold standard by itself would not alleviate all the problems of regulation and central banking.
The gold standard is not a cure all and, under free banking, it may or may not exist, depending on how well it works and how many people decide to put their trust in gold over other standards.
What about silver?
Silver was basically championed to stop shocks from gold, though silver has a long history of use as money dating back to ancient times. (See Cohen 1992 and White 1999.) In fact, the world was more on a silver standard since the Greeks. The same logic applies to silver as to gold – and it applies to any other commodity or even non-commodity standard.
Wouldn't 100% gold standard banking be better than free banking?
Fractional gold reserve banking arose spontaneously. 100% gold reserve banking has not. It's basically a theoretical construct. This should at least make one suspicious, but by no means dismissive. A 100% gold standard – or any other full reserve standard – is when the bank is not allowed to create more exchange media (e.g., paper money) than it can back by reserves at every moment.
This might seem like a good thing, but, in essence, it's deflationary. Why? It would keep money below the amount people actually wanted to use. Since the purpose of money is mostly for exchange on the market, anything that attacks this role is generally bad for money and the economy. This does not mean that government needs to step in to enforce this role. Rather, the market itself will sweep away banks that go against it because more stable and profitable banks will benefit from more and better ways of facilitating that role. Less stable banks and less profitable ones will either change their policies (in light of losses) or disappear (if they do not correct their policies in time). (See Horwitz 2000.)
The ultimate test, of course, is whether people on a market would use a full reserve bank's or a fractional reserve bank's money. Historically, full reserve banks did not survive – or where they did exist in recent history, the government mandated them. Dowd 1993 sees the full reserve policy foisted on the Bank of England through an Act of Parliament partly responsible for three panics there. So, it would seem fractional reserve free banking would be much better than full reserve banking – more stable and desired by the rest of the market.
Works Cited:
Howard Bodenhorn. 2000. A History of Banking in Antebellum America: Financial Markets and Economic Development in an Era of Nation-Building. Cambridge: Cambridge.
Edward E. Cohen. 1992. Athenian Economy and Society: A Banking Perspective. Princeton: Princeton.
Kevin Dowd. 1993. Laissez-Faire Banking. Routledge: New York.
Kevin Dowd. 1996. Competition and Finance: A Reinterpretation of Financial and Monetary Economics. St. Martin's: New York.
Kevin Dowd. 2001. Money and Markets: Essays on Free Banking. Routledge: New York.
David Glasner. 1998. "An Evolutionary Theory of the State Monopoly Over Money" in Money and the Nation State: The Financial Revolution, Government, and the World Monetary System, pp21-45. Transaction: New Brunswick, NJ.
Charles Albert Eric Goodhart. 1995. The Central Bank and the Financial System. MIT: Cambridge, MA.
Stephen Horwitz. 2000. Microfoundations and Macroeconomics: An Austrian Perspective. Routledge: New York.
Anna J. Schwartz. 1999. "Is There a Need for an International Lender of Last Resort?" in The Cato Journal 19(1).
George A. Selgin. 1988. The Theory of Free Banking: Money Supply under Competitive Note Issue. Rowman & Littlefield: Totowa, NJ.
George A. Selgin. 2003. "Gresham's Law" in EH.Net Encyclopedia, edited by Robert Whaples. 2003 June 10.
Lawrence H. White. 1995 [1984]. Free Banking in Britain: Theory, Experience, and Debate, 1800-1845. Institute of Economic Affairs: London.
Lawrence H. White. 1999. The Theory of Monetary Institutions. Blackwell: Malden, MA.