The type of free banking espoused by Ron Paul and Larry White has bank money convertible into gold. In other words, gold is the base money. Chris Colvin (a future colleague and reader of this blog) emailed me to ask whether a gold standard is essential for free banking. Chris, like many other economic historians, has problems with the costs of the classical gold standard, particularly in the inter-war period. The classical gold standard is often criticised for driving the business cycle and generating real income instability. The economic decline suffered by economies after they came back unto gold after periods of conflict was particularly severe.
As an undergraduate, I was taught about the failure of Herstatt Bank in 1974 and Herstatt risk. This bank was only the 35th largest bank in Germany at the time so why would anyone be interested in studying its failure? Herstatt failed because of its involvement in risky foreign exchange business. When it closed its doors on 26 June 1974, counterparty banks (mainly in New York) had not received dollars due to them because of time-zone differences - this is known as settlement risk. The cross-jurisdictional implications of its failure resulted in the Bank for International Settlements setting up the Basel Committee on Banking Supervision and Herstatt's failure was a key reason for the establishment of real-time gross settlements systems, which ensures that payments between two banks are executed in real time. The Bank of England's Ben Norman has an interesting post on Herstatt over at the Bank's new blog ( Bank Underground ). As well as giving an excellent overview of