essays

Sep 1, 1982

British Free Banking & Monetary Theory

“Free banking dispenses with government authority over money, and allows an orderly yet unmanipulated monetary system.”

Lawrence Henry White
University of California, Los Angeles

“Free Banking in Britain: Theory, Experience, and Debate, 1800–1845.” Ph.D. thesis; University of California, Los Angeles, 1982.

Free banking—the system under which the paper currency of an area is issued by unregulated and competitive private banks on the basis of convertibility into standard coin—was widely advocated in the nineteenth century. White’s dissertation studies the question of free banking as it confronted policy makers and economic writers in Britain in the first half of the nineteenth century. The study intertwines monetary theory, economic history, and the history of economic doctrine.

Chapter 1 undertakes to build a theory of free banking as a framework for the historical and doctrine-historical discussions of later chapters. The author models the individual bank of issue as a profit-maximizing firm and finds that the desired banknote circulation of the bank is limited by cost considerations. He next models the system as a whole, viewing it as a small open economy on an international specie standard, and finds its nominal magnitudes determinate. He then examines the equilibrating mechanisms which restrain banks from over-issuing by bringing about a “reflux” of excess notes. Reflux occurs as holders of excess notes re-establish their asset-holding preferences. Commonly the route of reflux passes through a note-exchange system, an inter-bank clearing mechanism whose origins are explained in an invisible-hand fashion.

Chapter 2 examines the record of free banking in Scotland, the world’s clearest-cut example of free banking in practice. The author traces the evolution of the Scottish banking industry, emphasizing competitive entry and innovation. He then contrasts the arrangement, legal framework, and macroeconomic record of Scottish banking in its heyday with those of contemporary English banking, and finds the Scottish system superior.

The third chapter shows that the question of free banking versus central banking as the remedy for business cycles was a focal point of British monetary policy debates between 1820 and 1845. He revises the standard “Currency School-Banking School” picture of these debates by identifying the Free Banking School as an important third body of monetary thought. He traces the debates chronologically. Adam Smith and then the Bullionist controversy of 1800–1820 are treated as precursors. He next examines the free banking controversy of 1820–1845 in detail, placing the major contributors and their contributions against two sets of background events, the era’s successive business cycles and its Acts of banking legislation.

Chapter 4 deals issue-by-issue with the major analytical differences dividing the Currency, Banking, and Free Banking School theorists. The issues treated are: (1) free trade in the production of currency; (2) over-issues under free banking and under central banking; (3) the origin and transmission of business cycles; (4) the “currency principle,” the monetary rule proposed by the Currency School; (5) “banking principles,” among which the author distinguishes the real bills doctrine, the needs of trade doctrine, and the “law of the reflux”; and (6) spontaneous (undesigned) order versus constructed order in monetary systems. In general the positions of the Free Banking School on these issues are found to have the greatest cogency.

The final chapter argues the relevance of free banking to contemporary discussion—particularly Hayek’s call for “denationalization of money”—of alternative monetary institutions. White pictures free banking as a means of escaping the problem that a government monetary authority must be dangerously flexible or dangerously inflexible. Free banking dispenses with government authority over money, and allows an orderly yet unmanipulated monetary system. Its use of precious metals as a monetary base is not inefficient when consumers prefer speciebased currency for its greater trustworthiness. A free market in currency is the only means of discovering the monetary system most preferred by consumers.