Locust outlines the intriguing case for a totally deregulated monetary system

Over the past quarter of a century, banking has come to symbolise free market economics. There is much to this symbolism. With such moves as the “big bang” reforms of the London Stock Exchange in 1986 and the repeal of the Glass-Steagall Act in the US in 1999, the Anglo-American financial industry has, to an extent, been a significant experiment in deregulation over recent years. Along the way it has ditched its risk-averse, rather mundane characteristics of the post-war period and turned into the thrusting, innovating and risk-maximising sector that the public has come to know so well during the current financial crisis.

But there is also a lot wrong with the picture of banking as a pure form of capitalism. Despite the deregulation of recent years, banks are still heavily regulated. And two non-market institutions in particular may have made it very difficult for banks to resist taking on too much credit risk: deposit insurance and the lender-of-last-resort function that central banks implicitly guarantee to take on should the credit markets freeze.

Furthermore, the combination of central banks’ monopoly in note issue and the lack of a commodity anchor such as gold means there is no market mechanism that can automatically determine interest rates. A world in which interest rates are set at a central banking board’s discretion or according to a rule is a world in which bubbles are likely to form.


Conversely, a world in which interest rates, the amount in notes in circulation, and the amount of credit offered to the public is strictly constrained by market forces is, according to one very interesting school of thought, a world in which bubbles could hardly form at all.

The kind of world in which banking and money are left entirely to the market may seem a little far-fetched. It is a world in which, according to most accounts, banking would not be divided up into a central bank that issues the currency and other banks that deal with deposit banking (the system in place today).

Instead, there would be no central bank, and individual banks, each with its own branch network, would issue their own notes (or, looking ahead, their own electronic equivalent of notes) while also offering all the usual high street banking products and services, such as checking accounts and loans.

In a sense there would still be only one type of “real” money, this being the commodity (such as gold) of which the notes issued by the banks would be a promise to pay a certain amount on demand (as with the gold standard). Only, rather than there being just one promiser – the central bank – a note would be a promise solely from the bank from which it was issued. This issuing bank would honour any redemption requests by dipping into its own gold reserves.

Strange as it may appear today, to date dozens of historical episodes have been identified of more or less laissez-faire banking, also known, among other things, as “free banking”. These have included episodes in Canada, Colombia, China, France, Ireland, Switzerland and the US.

While the respective free banking systems were rarely entirely free of government interference, with for example the US system of the 19th century crippled to a great extent by a government ban on branch banking, they all operated without a central bank and without any insurance-like government guarantees.

The free banking episode that has created perhaps the most interest, though, and which may provide food for thought for today’s banking policymakers, is the one that took place in Scotland from about the mid-1700s to the mid-1800s. This period begins with the emergence of the first non-chartered note-issuing banks in Scotland and ends with the two British banking acts of the 1840s that called time on the almost entirely laissez-faire system enjoyed north of the border. A legacy of this period in fact lives on in the form of Scottish bank notes, which today are still issued by three Scottish banks, yet with a legal requirement that almost all of them are backed by Bank of England notes held by the issuing bank.

The Scottish experience

Modern banking in Scotland began in 1695 (one year after the foundation of the Bank of England) when the Bank of Scotland was created by an act of the Scottish parliament. This act gave the bank a legal monopoly on banking and right to note issue for 21 years. According to the leading expert on the Scottish free banking episode, the US economist Lawrence White, the Bank of Scotland, despite its name, was unique among European banks at the time in not being a state institution, and it did no business with the Scottish government and was not regulated by it. In fact, after the Scottish parliament merged with the English one in 1707, following the Act of Union that created the UK, there was no local government with which it could become entangled.

To the relative freedom of Scottish banking, even under a monopoly bank of issue, was added the element of competition with the chartering of the Royal Bank of Scotland in 1727 as a second note-issuing institution. The competition between the established bank and the new arrival fuelled a wave of innovation, including the introduction of a type of overdraft account that David Hume described as “one of the most ingenious ideas that has been executed in commerce”. Then, from the 1730s onward, competition was further increased by the establishment of non-chartered non-issuing banks and then, in the 1740s, by the appearance of the first non-chartered banks in Scotland that would go on to issue their own notes.

A third chartered bank was also established at this time, called (since it was not primarily conceived as a bank) the British Linen Company. This went on, according to White, to become the first bank in history to enjoy success in branch banking, thereby introducing an innovation that added further stability to Scotland’s by now very stable, efficient, yet almost completely free banking system.

Another feature that greatly added to the stability of the Scottish banking system and that lies at the heart of modern proposals for free banking based on the Scottish experience is the clearing system that spontaneously developed among Scotland’s banks. This system, which first emerged in 1751 as an agreement between the Bank of Scotland and the Royal Bank of Scotland, proved a great success. By the mid-1770s all Scottish banks were involved in a single clearing system that allowed for the paying-in or redemption of notes from one bank at any other bank.

Inter-bank cooperation

Universal membership of the clearing scheme was driven by an understanding that exchanging notes on a regular basis – that is to say, the interbank returning of notes to their respective issuers in exchange for their nominal value in gold – was more convenient than irregular transfers. Membership of the clearing scheme also bestowed respectability and engendered trust, benefiting not just the members but the banking system as a whole.

The clearing system, while making it easier for banks to agree to accept each other’s notes and thereby benefiting customers and making the banking system more efficient, had the much more important effect of realising an immediate check on any bank that started to recklessly expand its note issue.

The clearing system and the interbank agreements upon which it was based ensured that notes could be redeemed or paid in by a member of the public at any bank in Scotland. This meant that excess notes would very swiftly drop out of circulation. Then, once a note was returned to the banking system, it would very quickly find its way back to the issuing bank and be presented for interbank redemption. If that bank had overissued, then, through a process known as “adverse clearings”, it would find its reserves diminishing as gold flowed out to its competitors.

This automatic check is perhaps the most attractive aspect of free banking, since it rules out the possibility of interest rates being held too low (or too high) over the long term. With the fine tuning of the clearing system, the market determines how many notes and how much credit there should be in existence, and interest rates are thereby set automatically without any discretionary power on the part of bankers or the need for any kind of monetary policy. This mechanism for avoiding inflation (and deflation) simply cannot exist in a central banking system.

A central bank tied to the gold standard can rely only on the much slower mechanism of gold outflow abroad to alert it to overissue, and, since it lacks direct competition, it can still choose to ignore this alert. Modern central banks with no commodity anchor but with ultra-efficient printing presses have no timely alert mechanism for overissue. There are some ifs and buts in the theory regarding whether the clearing system would ensure that overissuing banks would not collaterally damage their competitors and whether it could stop all banks expanding in tandem. But the bottom line is that for decades in Scotland it worked a charm.


It should be emphasised that, for all its freedoms compared with central banking systems, the Scottish system was never entirely free. The three chartered banks had an artificial privilege that non-chartered banks did not have, notably limited liability for their shareholders.

The unlimited liability of the owners of non-chartered banks is considered an important pillar of Scottish banking’s success and a reason why there were so few bank failures, since the penalty for overexpansion and too-aggressive risk-taking could be personal ruin. The chartered banks, with their limited liability, would have felt less constrained by market forces than the non-chartereds, and would have been more willing to take unreasonable risks, suggesting that the system was not as robust as it could have been.

The government prohibition in 1765 of notes bearing an option clause that would give the issuing bank the right not to redeem it for gold immediately on presentation was another measure that, it has been argued, made Scottish banking less purely laissez-faire than had it been left to evolve free of interference. The appearance of option clauses had been a natural consequence of fractional reserve banking (itself a natural development), which sees many more notes getting issued than could be redeemed at once.

Modern economists building on the Scottish model of free banking and the work of Lawrence White, such as the US economist George Selgin and the UK economist Kevin Dowd, therefore tend to propose banking systems that lack the arbitrary restrictions or imperfections placed on the Scottish system. They have suggested, for example, that no banker should have limited liability in an optimal free banking system, and that options clauses should be permitted to help deal with bank runs while avoiding unnecessarily large gold reserves.

What these and other contemporary free banking theorists propose no doubt bears close resemblance to the system that the 19th century journalist Walter Bagehot had in mind when he wrote his seminal book Lombard Street, published in 1873. Bagehot argued that entrusting the country’s reserve to the directors of a single bank was “very anomalous” and “very dangerous”. He then added that, despite his acceptance that central banking was here to stay (hence his writing a book setting out how central bankers should act), his own preference was for a system like the Scottish system, namely one “which would have sprung up if government had let banking alone”.

Lessons for today

In today’s fiat money regimes, notes are no longer redeemable for a commodity and are instead simply declared to be legal tender by their government (with modern Scottish notes again being an exception, since they are not legal tender but must be backed by Bank of England notes, which are). From the point of view of a proponent of free banking, these regimes can display almost none of the characteristics that should be present in a sound monetary system.

The near-complete taxpayer-funded insurance against bank insolvency (in the direct form of lender-of-last-resort activities by the central bank, and the indirect form of state-backed deposit insurance) would not be present or even considered necessary in a laissez-faire system. And in a system in which bankers have unlimited liability, it is unlikely that any of today’s Scottish bankers would walk away from their insolvent companies with their multimillion-pound pension packages intact.

Most significantly, though, in a world of free banking, no bank or government could print money at will regardless of the state of the economy. It is a world in which, according to those who have studied it, bubbles like the one we have just experienced would be starved of air.

There are some more extreme proponents of laissez-faire banking who even rule out fractional reserve banking as not in line with private property rights and as inherently bubble-blowing. And toward the other end of the spectrum people who care deeply about social justice could fear that a banking system in which the total number of notes issued by the banks was strictly determined by the market would give no leeway in which to issue credit to the poor.

Yet even with all this in mind, it is clear that the Scottish example and the work of the contemporary proponents of laissez-faire banking systems inspired by it could be of immense value to those wishing to plan or realise a more stable banking system, or at least get to grips with what might be the weaknesses of the present one.

Would free banking improve access to finance?

Proponents of laissez-faire banking argue that its mechanisms would drain the reserves of banks that overissued notes, thereby forcing them to reduce their issues. Meanwhile banks that underissued notes would miss out on profit opportunities and thereby face competitive pressure to increases their issues. Free banking advocates believe that these two forces would automatically keep the money supply equal to the demand to hold it, leading to extreme monetary stability.

But the suggested economic strengths of free banking are also its major political weaknesses. For while interest rates and levels of credit determined entirely by market forces would produce stability, they would rule out any form of, say, government monetary policy to support employment through low interest rates or social policy to make loans available to the financially insecure. Even after the subprime fiasco, these are still issues that would impede the acceptance of a monetary system not controlled by the government.

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