Skip to main content

Free Banking vs Central Banking


Why do free bankers believe that central banks should be abolished and that banks should be free to issue competitive currency? 

1. According to Carl Menger and free bankers, money has evolved organically over time.  Gradually, human societies adopted precious commodities such as gold and silver as their medium of exchange or money.  In this Mengerian story of the evolution of money, there is no role for government - “money is not an invention of the state.  It is not the product of a legislative act” (Carl Menger, “On the Origin of Money”)

2. Free bankers argue that the reason governments establish central banks is financial self-interest.  The early central banks (Bank of England and Banque de France) were clearly set up for fiscal reasons as they had to invest most of their capital in government bonds and provide cheap finance whenever required.  According to free bankers, this is the only rationale for central banks.  The mainstream view on central banks is that they exist to stabilise the banking and financial system.  

3. Free bankers argue that central banks with a monopoly issue of the currency results in unstable banking systems.  The free banking position is that banking panics are a product of legal restrictions on currency issue and on the banking system.  In the absence of these restrictions, the invisible hand of market forces would produce a panic-free banking system.  In addition, the presence of lenders of last resort and deposit insurance also has a tendency to destabilise the banking system.

4. Free bankers argue that central banks with a monopoly issue of the currency results in inflation.  Such an outcome would not occur in a free banking system where banks issue a competitive currency fully redeemable for gold.  According to Selgin and White (1994), this redemption of competitively-issued currency for a precious commodity ensures that the cost of any over-issue of liabilities is internalised by an errant bank, and thus banks have an incentive to issue only the optimum quantity of liabilities, with the result that there is no inflation.  Ultimately, the price level in such a system will be determined by the market for gold.  According to free bankers, as demand shifts in the gold market are met entirely by adjustments in quantity and not the purchasing power of gold, a gold standard monetary system will result in a relatively stable price level in the long run.  

Some further reading:


The Rationale of Central Banking: and the Free Banking Alternative
Competition and Currency: Essays on Free Banking and Money (Cato Institute Book Series)
The Theory of Monetary Institutions

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.