Ordinary debates about monetary and banking policy take it for granted that a government central bank like the, Federal Reserve System, will continue to provide money and that government regulators will continue to limit what banks may do in the payment system. Here I don’t want to take that for granted. I want to help you think about the idea of free banking, a system where we replace the central bank with competitive firms and free markets that provide the full range of monetary and banking services. We have to go outside the box, as they say, to think about the consequences of allowing private banks to issue money unrestrictedly and having a monetary system without a government central bank.
Fortunately, this isn’t social-science fiction. We can draw on a rich history of free-banking experiences. The successful free-banking system of Scotland before 1844 is a leading illustration of the results of minimizing government restrictions on banking and money issue. But we can also look at New England before the U.S. Civil War, Canada before the First World War, more than 50 other places where money was issued by competing private banks subject to minimal restrictions.
In historical free-banking systems, the basic money was gold or silver coin. The coins could be privately minted, although governments usually monopolized the minting industry. Banks issued currency notes and checkable accounts denominated in standard coin and redeemable for it. To attract customers, each bank tried hard to make its notes and checks accepted at 100 cents on the dollar everywhere its customers went, because people wouldn’t want to carry a money that fell to a discount or fluctuated in value. Trustworthy bankers made agreements with one another: if you accept my notes at face value, I’ll accept yours at face value. As a result, bank notes became interchangeable, and retailers had no more trouble dealing with many brands of bank notes than they have today dealing with checks written on many banks.
Private bank notes proved more reliable over the years than government bank notes. Unlike a sovereign issuer, that can devalue its own currency if it so chooses or quit redeeming entirely. No private bank can renounce its contractual obligation to redeem in full and get away with it in a court of law. And unlike a bank with a government-sheltered monopoly, no private bank in a free-banking system can attract customers if it undertakes risky strategies, like holding inadequate reserves or making risky investments that would make the public worry about its reliability. Each bank has its reputation to protect in a system where its customers can easily turn elsewhere for money and banking services.
So here’s the takeaway: money is not an exception to the rule that a free market is the most efficient system for providing goods and services. Free banking worked well. Central banks like the Fed did not come on the scene because of any free-market failure to achieve efficiency. In many countries, the government created a central bank in order to have an institution willing and able to lend it money on easy terms. Today the pressure continues on central banks to print money to pay the government’s bills. As the failures of central-banking systems continue to mount, the alternative of free banking deserves our reconsideration.