Skip to main content

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.  

Popular posts from this blog

The Failure of Herstatt Bank

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

Boom and Bust: A Global History of Financial Bubbles

Boom and Bust: A Global History of Financial Bubbles, co-authored with my colleague Will Quinn , is forthcoming in August. It is published by Cambridge University Press and is available for pre-order at Amazon , Barnes and Noble , Waterstones and Cambridge University Press . 

The Great Depression

Marginal Revolution University has a great video on the Great Depression.