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Free Banking Experiments

Free banking may be a neat theory, but is there any evidence that it would work in practice?  Are there historical examples of successful free banking systems? 

Before we answer these questions, we need to define what we mean by success.  We could use some or all of the following criteria: the absence of banking instability, a stable purchasing power of money, and efficient channelling of funds from savers to borrowers.  As the third criteria is difficult to evaluate, scholars typically focus on the first two.

We also have to define what we mean by free banking as there are some Austrians, such as Murray Rothbard, who argue that free banking means privately-issued bank currency should be backed 100% by gold, whereas others, such as Larry White, argue that banks in a free banking system can have a fractional reserve i.e., bank deposits do not have to hold £1 of gold in reserve for every £1 of deposits.  As historical examples of the former are extremely rare and belong to primitive financial systems, we are mainly concerned with the latter.  

There are many historical examples of free banking - Charlie Hickson and I provide a list of examples in our 2004 Cambridge Journal of Economics paper.  However, no historical examples of free banking are 100% pure as there are always some legal restrictions which 'pollute' the purity of the system. 

Most historical free banking systems were successful in that they delivered a money with stable purchasing power.  However, their success in terms of financial stability has been mixed.  

Probably the best known example of free banking is the banking system of Scotland prior to 1845.  This system was very stable, especially when compared to the English banking system - click here to see a recent paper of mine on this issue.

The most disastrous free banking experiment was in nineteenth-century Australia.  The Australian banking system experienced a huge crisis in 1893.  You can access my paper with Charlie Hickson on this crisis here.

Why were some free banking systems successful and others not?  My 2004 Cambridge Journal of Economics paper with Charlie Hickson suggests that the difference can be explained by the absence or presence of limited liability.  Free banking systems where banks were allowed to limit the liability of their shareholders were unstable, whereas those where shareholders had unlimited liability were stable.  

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