Free Banking

Government control of money seems as natural to most people as the air we breathe. Open the average money-and-banking textbook and you will find a statement such as this: “We now take for granted the goals of full employment, economic growth, and stable prices as almost the sine qua non of monetary policy” (Harry D. Hutchinson, Money, Banking and the United States Economy [Englewood Cliffs, N.J.: Prentice-Hall, 1984], p. 99). The clear implication is that without a centralized monetary policy the economy would slide into stagnation.

A look at the recent history of monetary policy, however, raises doubts about the necessity, efficiency, or inevitability of centralized monetary control. The record of government-currency management has been uniformly poor in the last two decades. Foreign exchange rates have fluctuated wildly, central-bank policy has had no clear direction, and inflation, though lower than it was several years ago, has not gone away. The unpredictability of government monetary policies has caused enormous expansion of speculative financial markets, for instance in gold futures, foreign currency, and international bank lending (“Eurodollars”). These markets, which offer new ways of spreading financial risks, are often beyond the reach of any government regulation. Central banks are thus finding that their control over monetary policy is rapidly diminishing; financial markets have so much momentum that the best thing is for central banks to do may be to stay out of their way.

As a result, some economists have begun to examine the received wisdom about the alleged necessity of government control of money. This has resulted in the current worldwide trend toward deregulation of financial services. The most thoroughgoing approach to monetary deregulation is known as “free banking,” which contends that government control, far from being desirable, destabilizes what would otherwise be a smoothly working monetary system. Free-banking advocates call for abolishing central banks and letting competing private producers issue currency. With astonishing speed, free banking has gone from being a concept unfamiliar even to experts in monetary theory a few years ago to being endorsed by two Nobel Prize-winning economists and receiving attention from the business press (see for example, Peter Brimelow’s excellent article “Do You Want to be Paid in Rockefellers? In Wristons? or How About a Hayek?” in Forbes, May 30, 1988).

Historical episodes of free banking

Despite its radical-sounding character, free banking is not an impractical and untried theoretical ideal. Many countries actually had free-banking systems once. Indeed, free banking and central banking have many basic features in common. In both systems, banks combine small and often erratic acts of saving by individuals into large masses whose overall extent is fairly predictable. Statistically, the larger the number of savers holding a bank’s deposits (and notes, if it issues its own notes), the smaller is the chance that many of them will stop saving all at once. This enables banks to lend out most of the savings entrusted to them, keeping on hand a small amount of reserves—lower than 1 percent in some recorded cases—that is still enough to meet demands for redemption from depositors who no longer wish to save. When bank depositors will support more loans to borrowers, banks can lower their ratio of reserves to deposits. When depositors wish to reduce the amount of saving, banks must curtail loans, which they usually accomplish by raising interest rates charged to borrowers. That boosts the “reserve ratio,” ensuring that banks will continue to meet redemption demands and avoid bankruptcy. Free banking differs from central banking in the way banks hold reserves. In a free-banking system each bank holds it own reserves, which in the past were most frequently gold. In a central-banking system, on the other hand, commercial banks such as Chase Manhattan or Wells Fargo hold notes or deposits issued by the state-chartered central bank, which holds the gold reserves for the entire system (if the country is on a gold standard) or has the sole right to create new reserves (if the country is on a fiat-money standard). Advocates of free banking believe that compulsory reserve centralization reduces healthy competitive checks against inflation; advocates of central banking believe it increases government’s power to exert benevolent control over the economy.

It is only now becoming apparent just how widespread free banking was and how well it performed. Countries as diverse as Sweden, China, Canada, Australia, and South Africa all had smoothly functioning free-banking systems. When central banks were later established, free banking was consigned to the dustbin of antiquated ideas. Arguments from economic theory were later invented to justify arrangements that had sprung into existence purely out of political expediency. Once central banking became part of orthodox economic theory, economic historians interpreted banking history in light of that perspective. The facts of history are rarely so plain as to fall into place without extensive underlying assumptions on the historian’s part; hence it is understandable that free-banking episodes came to be viewed as chaotic early stages of a natural evolution towards central banking.

So little research has been done on the history of free banking that the best general source is still Charles A. Conant’s History of Modern Banks of Issue (6th ed., New York: Augustus M. Kelley, 1969 [reprint of 1927]). Conant is not explicit about the differences between the ways free banking and central banking operate, so it is frequently necessary to read between the lines to discover the cases of free banking.

Concerning particular countries, the greatest amount of work so far has been on the Scottish free-banking episode, which was the oldest and longest lived of any. Interestingly, Scottish banking was at first a monopoly; competition was a later development. The Bank of Scotland, founded in 1695, was granted a twenty-one year monopoly of note issue in Scotland by the British Parliament. At the end of that period Parliament allowed the monopoly to expire because it suspected the bank’s directors of treasonous political leanings. The bank did not protest much, apparently thinking no other firm would enter the business. When the rival Royal Bank of Scotland formed in 1727 the old bank tried first to block its Parliamentary charter, then to drive it out of business, and finally to merge with it, but was unsuccessful at every turn. Other banks soon entered the field. Most operated without charters, meaning that stockholders had unlimited liability for the debts of their bank should it fail. The system was stable enough that unlimited liability (which at that time was the rule in most other industries as well) did not greatly discourage stock ownership. By 1750 there were fourteen banks, by 1800 about twenty.

While Scotland was developing the first free-banking system, England was developing the paradigmatic central-banking system. The Bank of England, founded shortly before the Bank of Scotland, was given certain monopoly privileges in return for a loan to the British government. In later years the privileges were enlarged as the bank made further loans. Within a 65-mile radius of London the Bank of England was the only bank allowed to issue notes, and it was the only note-issuing bank in all of England and Wales allowed to have more than six partners. A banking panic in 1825, which caused many of the small note-issuing banks to fail, suggested the wisdom of abolishing the six-partner rule to promote the formation of larger, stronger banks.

Vigorous debate sprang up about whether the panic had been caused by the Bank of England, the other note-issuing banks (including those of Scotland), or both. This controversy, which lasted for twenty years, raised questions that monetary theorists have been wrestling with ever since. In retrospect, the participants in the debate can be divided into three groups, though at the time the lines between them were not always so clear. The Free-Banking School was composed of Scottish bankers, who were passionately attached to their system, and English bankers and economists opposed to the Bank of England’s monopoly privileges. It laid blame for the 1825 panic and others in later decades on the Bank of England alone. Its main opponent was the Currency School, composed of Bank of England officials, along with some prominent economists and politicians. The Currency School blamed all banks for the panics, claiming that unregulated note issue was intrinsically disruptive. It sought regulated note issue, which it believed was best achieved by centralizing all British note issue with the Bank of England. The final group, the Banking School, was made up mainly of economists. It maintained implausibly that no bank was to blame for the panics, and did not much care whether note issue was centralized or not. The chief accounts of the British monetary controversy are Lloyd Mints, A History of Banking Theory (Chicago: University of Chicago Press, 1945); Frank W. Fetter, Development of the British Monetary Orthodoxy, than relieved the panics, there was no thought of a return to free banking. Walter Bagehot, the father of central-banking monetary policy, thought free banking was the more desirable system, but believed that it was politically impossible to reinstate it, and devised his policy recommendations as a second-best solution. In Lombard Street: A Description of the Money Market [1873; New York: Arno Press, 1979] he emphasized that

the natural system of banking is that of many banks keeping their own cash reserve, with the penalty of failure before them if they neglect it. I have shown that our system is that of a single bank keeping the whole reserve under no effectual penalty of failure. And yet I propose to retain that system, and only attempt to mend and palliate it. I can only reply that I propose to retain this system because I am quite sure that it is of no manner of use proposing to alter it... You might as well, or better, try to alter the English monarchy and substitute a republic, as to alter the present constitution of the English money market, founded on the Bank of England.... (pp. 328-329)

Walter Bagehot, the father of central-banking monetary policy, thought free banking was the more desirable system, but believed that it was politically impossible to reinstate it, and devised his policy recommendations as a second-best solution. 1797-1875 (Cambridge, Mass.: Harvard University Press, 1965); Vera C. Smith, The Rationale of Central Banking (London: P.S. King and Son, 1936); and Lawrence H. White, Free Banking in Britain: Theory, Experience, and Debate, 1800-1845 (New York: Cambridge University Press, 1984).

As evidence for its case, the Free-Banking School pointed to the excellent performance of Scotland’s system. The rate of bank failures was about one-quarter that of England. Losses to note holders and depositors were £32,000 for the entire free-banking era (1727-1844), compared to twice that much or more for banks in the London area alone during single years of the same period. The number of bank branches per capita was nearly 50-percent higher in Scotland than in England. Only Scottish banks paid interest on small deposits. Their notes were so well-trusted that they were preferred to English bank notes in the border regions of England (White, pp. 26, 34, 41, 43, 48).

Bond-deposit banking provided government with a ready market for bonds, and worked well enough compared to other, even-more-regulated systems that the Union government adopted it on a national scale during the Civil War. As the nineteenth century drew to a close it became apparent that bond-deposit limits on note issue were causing note shortages and financial instability. When people realized that bank notes were becoming scarce they hoarded them, causing notes to disappear from circulation entirely. Trade would have ground to a halt had not private-bank clearinghouse associations stepped in with makeshift temporary currency. The note-issue shortages of 1893 and 1907 were particularly severe and led to pressure to reform the banking system. (The classic work on the note-issue shortages is Oliver M. W. Sprague’s History of Crises Under the National Bank Banking System [1910; Fairfield, N.J.: Augustus M. Kelley, 1977]; on clearinghouses see Richard Timberlake, “The Central Banking Role of Clearing House Associations,” Journal of Money, Credit and Banking, May 1984, and Gary Gorton, “Clearinghouses and the Origin of Central Banking in the United States,” Journal of Economic History, June 1985).

Canada’s free-banking system did not experience the note shortages that plagued the United States. However, though some writers advocated deregulating the American system along Canadian lines, central banking carried the day because it had far more support in important banking circles. Commercial banks were placed under the Federal Reserve System, which became the sole note issuer beginning in 1914. The Fed eliminated note-shortage problems, but also caused the previously nonexistent problem of inflation. Furthermore, interstate branch banking was still prohibited; the resulting network of small, weak banks was unable to withstand the stress of the Great Depression. In contrast, no banks failed in Canada, which enjoyed nationwide branch banking. Eugene Nelson White’s Regulation and Reform of the American Banking System, 1900-1929 (Princeton: Princeton University Press, 1983) and “A Reinterpretation of the Banking Crisis of 1930,” Journal of Economic History, March 1984, analyze the American system’s defects.

American discussions of free banking in the mid-1800s were far inferior to those in Britain, France, and Germany. Towards the close of the century, though, economists of the Sound Currency Committee of the New York Reform Club produced some valuable writings in Sound Currency magazine (published from 1891 to 1905 and available in many old, large university libraries). Horace White, Charles Conant, and L. Carroll Root were the outstanding members of the group. Like other countries’ nineteenth-century theoretical debates, those of the United States are today mainly of interest for their place in the history of economic thought. With the revival of interest in free banking during the 1980s their most important insights have been reformulated and fused with the great advances in other fields of economic theory that have taken place in the meantime.

Years of Dormancy

Free banking ended with World War I. Government demands for war finance through other means besides direct taxation led to the establishment of central banks in nations that did not already have them. After the war the new nations that came into existence also founded central banks, encouraged by the League of Nations. Free banking became simply unthinkable as economists came to believe that “money will not manage itself,” ignoring that it had done just that for two centuries all over the world.

The sole work of importance examining the merits of free banking that appeared from the turn of the century until the 1970s was The Rationale of Central Banking by Vera C. Smith (London: P.S. King & Son, 1936). Smith was a student of Friedrich A. Hayek, and this wonderful book was her dissertation. (She later married another of Hayek’s students, Friedrich Lutz, who was likewise a keen monetary theorist.) Sadly, it has never been reprinted in its entirety and is very hard to find.

Smith examined the theoretical debates and the history of free banking in Britain, France, Germany, and the United States. She showed that “in most countries a combination of political motives and historical accident...played a much more important part than any well-considered economic principle” in leading to central banking (p. 2). But her greatest achievement was to analyze the difference in credit expansion under the two systems. The experience of World War I and the postwar period had made it obvious that central banking could lead to a form of legalized national bankruptcy because central banks were willing to use their powers of inflation to finance government deficits.

Besides such “public choice” arguments, Smith also brought to bear Knut Wicksell’s theory of the natural rate of interest. Around the turn of the century Wicksell had argued that there was a “natural” rate of interest determined by the extent of consumers’ preferences for present goods over future goods. Attempts to make the market rate of interest deviate from the natural rate could not last because profit and loss signals would bring the two rates back into line. The idea of the natural rate caught on quickly and by the 1920s dominated discussion of monetary theory. Hayek claimed that inflation makes the market rate fall below the natural rate, encouraging investment in projects that have to be liquidated because they are unprofitable when the market rate rises back to the “natural” level. That, he argued, is what causes business cycles. (See F. A. Hayek, Monetary Theory and the Trade Cycles [1937; Clifton N.J.: Augustus M. Kelley, 1975].) Smith used Hayek’s theory in her discussion of the effects of reserve centralization. She pointed out that forced centralization makes the link between reserves and liabilities looser than it is under free banking, affording a central bank much greater leeway to lower bank interest rates below the “natural” rate determined by people’s willingness to save. Hence central banks can cause, or at least aggravate, business cycles.

Smith’s book received little attention because it appeared at a time when laissez faire was in discredit. Furthermore, though she dwelt on central banking’s inflationary potential, she was silent about its equally harmful deflationary potential. During the Great Depression, inflation hardly seemed a pressing problem: monetary expansion was the order of the day, and it seemed that the concern with “sound money” that was part of the free-banking position would cause contraction. In common with other economists influenced by Wicksell’s natural-rate hypothesis, she devoted her attention exclusively to inflation instead of seeing it as just one of several monetary disorders possible under central banking.

Mention should also be made of Ludwig von Mises’s treatment of free banking in Human Action (3rd rev. ed., Chicago: Henry Regnery, 1966; the first edition appeared in 1949). Mises touched on the subject only briefly (pp. 444-448), and his position was ambiguous. Though he advocated open entry into the banking business and unrestricted right of note issue, he believed that all banks except those that have notes backed 100 percent by reserves (he had in mind gold or silver) would be forced out of business by demands from the note-holding public to redeem notes. There is, however, no historical evidence to support Mises’s contention; the free-banking systems mentioned above had reserve ratios as low as a few percent of total liabilities, yet they met their legal obligation to redeem deposits and bank notes on demand. If fractional-reserve banking were so precarious, banks would not be able to offer interest-bearing demand deposits because deposits operate on the same principle as competitive note issue formerly did: banks can generally count on their customers as a whole to leave a large and fairly stable amount on deposit, enabling banks to re-lend it to borrowers and keep only a small proportion of reserves on hand to meet demands for withdrawal. Mises’s student Murray Rothbard has added to the economic argument for 100-percent reserve banking a moral argument, which claims that keeping only fractional reserves is fraudulent. (See “The Case for a 100 Percent Gold Dollar” in Leland B. Yeager, ed., In Search of a Monetary Constitution [Cambridge, Mass.: Harvard University Press, 1962] and “The Myth of Free Banking in Scotland” in the Review of Austrian Economics, [2] [Lexington, Mass.: Lexington Books, 1988]).

Present-day free banking theory

The lonely handful of economists in favor of free banking failed to offer a convincing analysis of the Great Depression that challenged the prevailing consensus for central banking. Following World War II the Bretton Woods international monetary system worked well enough for some years that considering an alternative did not seem worthwhile. What happened to shatter the consensus can be stated in one word: inflation. Keynesian neoclassical economics at the time claimed that simultaneous inflation and high unemployment were impossible. Each was supposed to be the cure for the other: if unemployment became unacceptably great, all the central bank had to do was inflate a bit to get the economy rolling again; conversely, when inflation became too high, all it had to do was reduce the growth of the money supply and tolerate greater unemployment for awhile. Beginning in the late 1960s inflation and unemployment increased in all Western nations, and mainstream theory was unable to explain why. Rival theories, notably monetarism, began to attract increasing attention.

Credit for reopening debate on whether central banking is necessary belongs to Benjamin Klein and Friedrich A. Hayek. Klein’s article “The Competitive Supply of Money” (Journal of Money Credit and Banking, November 1974) developed an analysis of money as a good having a brand-name reputation. Just as people buy a particular brand of toothpaste because the manufacturer has earned their confidence, so they would use the currency issued by the bank that achieved a reputation they trusted. Klein concluded that arguments asserting that government can produce confidence less expensively than private issuers, or that the issue of money is a natural monopoly, do not justify prohibiting private currency issue. However, he left open the possibility that government control of currency might be desirable from the standpoint of macroeconomic stability.

Hayek had touched on the possibility of competitive currency issue in his 1948 book Individualism and Economic Order (Chicago: University of Chicago Press). He enlarged on the theme in a 1976 pamphlet, Choice in Currency: A Way to Stop Inflation, which was later expanded and retitled Denationalisation of Money—The Argument Refined (London: Institute of Economic Affairs, 1978). Whereas Klein wrote in a specialist publication, Hayek aimed at a wide audience, which his status as a recent Nobel Laureate helped him reach. His proposal, which caused a great stir, was that government monopoly over the issue of money should be abolished. He envisioned that private issuers would then enter the field in competition with one another and that the profit motive would lead them to offer stability of value as an important characteristic of their product. Government would then have to stop inflating or see people desert to private currencies. (Ultimately Hayek wished to eliminate government currency altogether because the temptation to make it fiat money is always present.) He also claimed that competitive currency issue would also avoid deflation and eliminate monetarily caused business cycles. And, reiterating a point he has made throughout his career, he stressed the nature of money as a social institution that evolves in ways that cannot be satisfactorily predicted or controlled by a central authority. Money is fundamentally a creation of markets and is best handled by markets.

Hayek envisioned a system of competing fiat currencies kept constant in relation to the value of “baskets” of wholesale commodity prices. Among the problems with such a system is that it has never been tried. Lawrence H. White put forth an alternative, more historically based vision of how a free banking system might work in Free Banking in Britain: Theory, Experience, and Debate, 1800-1845 (Cambridge: Cambridge University Press, 1984). White explained what made the Scottish system work so well; particularly important was his description of how the clearing system for notes and checks kept bank liabilities close to the amount the public desired to hold. Central banking, he contended, attenuates the discipline of the clearing system because a monopoly bank holding the reserves of a whole system suffers losses (or gains) only after inflating (or deflating) much longer than free banks holding reserves independently can afford to do.

White’s book broke new ground on three fronts. It was the first to look at the historical record of a truly free-banking system. It re-examined the British monetary debates at far greater length than Vera Smith had, summarized them, and extracted most of what they contain that is relevant to current monetary theory. Finally, it proposed that free banking would not necessarily mean trying an untested system, as in Hayek’s proposal, but that it could be a return (with minor modifications) to a system that had already proved itself practical, sound, and efficient. White’s work suggested new paths of exploration in many directions, some of which are treated in a forthcoming collection of his essays, Competition and Currency (New York: New York University Press).

At this point, an astounding conversion took place. Milton Friedman, who despite his strongly laissez-faire views on other topics had believed in the desirability of a central bank (though one whose actions were bound tightly by fixed rules), came out for free banking. Apparently, the work of Vera Smith and White, which he cites and discusses, had much to do with his change of mind. Friedman now advocates a radical program: “abolish the money-creating powers of the Federal Reserve, freeze the quality of high-powered money, and deregulate the financial system” (“Monetary Policy: Tactics versus Strategy,” in James A. Dorn and Anna J. Schwartz, eds., The Search for Stable Money [Chicago: University of Chicago Press, 1987], p. 381; see also “Has Government Any Role in Money?” Journal of Monetary Economics, January 1986 [cowritten with Anna Schwartz]; and “The Resource Cost of Irredeemable Paper Money,” Journal of Political Economy, June 1986). Friedman is causing other monetarists to rethink their position and, I believe, will eventually lead many of that school to become advocates of free banking.

White’s success in bringing the insights of the long-overlooked British monetary writers to bear on current issues has prepared the way for re-exploration of another hitherto neglected body of monetary theory. White’s student George A. Selgin, now a professor at the University of Hong Kong, takes up the task in The Theory of Free Banking: Money Supply Under Competitive Note Issue (Totowa, N.J.: Rowman & Littlefield, 1988). Selgin revives several key ideas developed by writers of the 1920s and early 1930s, such as Hayek, Mises, Dennis Robertson, and John G. Koopmans, who used as their common base Knut Wicksell’s theory of the natural rate of interest. Selgin extends these ideas to free banking and combines them powerfully and coherently. In many respects, mainstream monetary theory has retrogressed since Keynesian economics overwhelmed the “Wicksellian tradition,” so Selgin’s work is as sophisticated as any appearing today.

At the heart of his book is a fresh understanding of the link between banks’ reserves and their liabilities. Selgin shows first that the demand for money is a demand to hold bank liabilities (deposits and, in a free-banking system, issuing banks’ notes), so that insofar as banks act “properly” they are simply intermediaries of credit between lenders and borrowers. Next, he upsets a long-held belief that bank-credit intermediation is linked in a mechanical way to reserves. Prevailing theory claims that if the reserve ratio is, say, five percent of liabilities, then the only way for bank liabilities to increase in response to greater public demand to hold them is for new supplies of reserves to come on-stream, and that the same five percent ratio somehow prevents bank liabilities from falling below twenty times reserves. In reality, under a system without statutory reserve requirements, the ratio is highly variable and adjusts in harmony with the demand to hold money. So if reserves are constant the reserve tail does not wag the liability dog after all.

Applying these findings to an analysis of the clearing system, Selgin answers a question that has long nagged free-banking theorists: can free banks acting in unison imitate a central banking system and inflate? He shows that they cannot because all would suffer a greater chance of losing reserves and going bankrupt, even if the system as a whole does not lose reserves. Under central banking, however, a single entity controls all the ultimate reserves of the system, so this check operates at a level further removed from consumer deposits. Diffuse ownership of reserves under free banking allows the clearing system to generate price signals (namely, reserve losses or gains) that inform banks whether the public’s desire to hold their liabilities is increasing or decreasing. Central banks, in common with other kinds of central planning, lack such information and hence are prone to make big mistakes instead of just the little ones that entrepreneurs in a free market often do. (On a related point, see Selgin’s article “Accommodating Change in the Relative Demand for Money: Free Banking versus Central Banking,” Cato Journal, Winter 1988.) Consequently, central banking works about as well as Soviet agricultural planning. This thesis is an application to banking of the Austrian School argument about the difficulty inherent in socialist economic calculation. Interestingly, Mises and Hayek first advanced the socialist calculation argument at the same time that the Wicksellian tradition in monetary theory flourished, but never connected the two explicitly. The best defense of central banking against such attacks as those made by White and Selgin is Charles A. E. Goodhart’s Central Banking: A Natural Development? [London: London School of Economics, 1985].

David Glasner takes a more practice-oriented approach to free banking in his forthcoming work Tomorrow’s Money (New York: Cambridge University Press), which concentrates on the influence that economic theory and the day-today workings of various monetary systems have had on each other. He reinterprets monetary theory since Adam Smith in terms of how it has handled the question of competition versus monopoly in money. Since to a great extent our interpretation of past writers guides our present thought, this aspect of Glasner’s book is as much a provocation to central-banking theory as his other major theme, which is that recent developments in banking are eroding central-bank power. He points to the rise of the Eurodollar market, which now handles over $1 trillion of loans per year entirely outside of the United States and beyond the reach of the Federal Reserve System. Similar markets have come into being for other leading currencies. Glasner also discusses advances in technology that have drawn financial markets closer together, increasing the rapidity with which capital flees when government actions are perceived as harmful. Unquestionably, new technology is easing the tight grip central banks once had over the supply of money, making it harder for them to serve as the instruments of government finance they were intended to be. But technology will not bring about unfettered competition by itself; it will only increase choice among more or less inferior national currencies. This is apparent in foreign-exchange markets. Attempts by central banks to stabilize rates there have been swamped by the volume of trading, so that in a limited sense the free market prevails; but it is not clear how beneficial the resulting volatility has been for businesses, which cannot count on rates being the same next week as they are this week. Glasner has made a start at understanding the changes now happening in the international monetary system, but the field is immense and rapidly evolving. So it will be a continuing source of challenges to our understanding.

Another forthcoming book, Kevin Dowd’s The State and the Monetary System (Oxford: Philip Allan), is a sort of summary of the case for free banking. It is brief and quite well-written, making it an ideal introduction to the field. (In this respect, it supplants Pamela J. Brown’s article “Constitution or Competition? Alternative Views on Monetary Reform,” Literature of Liberty, Autumn 1982, which remains valuable for its bibliography.) Dowd, who teaches at the University of Sheffield (England), develops good original arguments concerning bank runs and how free banks could handle them. He suggests that it is not true that banking systems need a “lender of last resort” to bail them out in times of trouble. Since the need for a lender of last resort has been accepted by orthodox banking theory for over a century, Dowd’s thesis will surely provoke heated replies, perhaps along lines already laid out by Richard Cothren, who has claimed that deregulated banks will tend to hold inadequate reserves (“Asymmetric Information and Optimal Bank Reserves,” Journal of Money, Credit and Banking, Feb. 1987. Dowd anticipates and answers some objections to his ideas in his article “Automatic Stabilizing Mechanism under Free Banking,” Cato Journal, Winter 1988).

Almost every one of the writers discussed here has advanced plan for monetary reform. All favor allowing private currency issue; they disagree about what would probably follow, though they are unanimous that market forces should be the judge. Hayek, Glasner, and Dowd envision a commodity-basket standard; White, a gold standard; Friedman and Selgin, a frozen fiat-money-base standard. Circumstances of time and place may result in all three, or other standards that nobody has yet thought of. A comparative analysis of the standards and a detailed explana-tion of how to accomplish the transition from central banking to each is urgently needed. To have a realistic flavor it should draw on past experience of monetary reform. That also would help avoid the errors that have often been committed during previous reforms. If the moment for monetary reform comes, it will be brief, and unless free-banking theorists have well conceived proposals they can unite behind, it will pass them by.

Another matter that requires hard thinking is the contention raised by “legal-restrictions theory.” This view, which springs from the “rational expectations” school of economic thought, claims that money as we know it is so much a creature of regulation that removing restrictions on note issue would result in the separation of money’s functions as a means of payment from its functions as a unit of account. Bank notes would then become in effect low-denomination, interest-bearing bonds. The free-banking writers mentioned do not agree with the legal-restrictions theory, but many other economists have been persuaded by it, so the theory will be important in future thinking about monetary deregulation. The best summary of the theory is an article by one of its originators, Neil Wallace, “A Legal Restrictions Theory of the Demand for ‘Money’ and the Role of Monetary Policy,” Federal Reserve Bank of Minneapolis Quarterly Review, Winter 1983. Two pieces that discuss the connection between the theory and monetary deregulation are Y.C. Jao, “A Libertarian Approach to Monetary Theory and Policy,” Hong Kong Economic Papers, 1984, and Tyler Cowen and Randall Kroszner, “The Development of the New Monetary Economics,” Journal of Political Economy, June 1987.

Free-banking theory in its modern incarnation is a young and wide-open field of research. Almost everything in it remains to be done, or at least to be done better. A short list of some of the leading questions in the field illustrates the wide range of topics to be addressed: Should a free-banking system’s reserves grow in response to changes in demand for money arising from population growth? How can the Federal Reserve’s clearing functions be privatized? What is the history of plural note-issue systems in (to list a few little-explored cases) Italy, Spain, Switzerland, Australia, New Zealand, Argentina, Bolivia, Honduras, Jamaica, South Africa, or Korea? How free were such systems over the course of their existence? Is it possible to develop institutional structures that will give a free-banking system the best of the monetary “flexibility” claimed as an advantage for central banks in times of crises without their capricious potential for inflation and deflation? Did the original advocates of central banking in various countries have any inkling of its dangers?

As the idea of free banking continues to gather momentum, it will become one of the three or four most widely debated topics in economics. Scholars who begin their research on it now can benefit by being acknowledged pioneers of this promising body of thought, which holds great potential for the advancement of liberty.

Kurt Schuler is a graduate student in the Department of Economics at the University of Georgia.