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What Free-Banking Advocates Get Wrong

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Neo-banking authors devote strong efforts to historical studies which they intend to support the thesis that a free-banking system would protect economies from cycles of boom and depression, owing to the “monetary equilibrium” mechanism. Nevertheless the empirical studies produced thus far have not focused on whether free-banking systems have prevented credit expansion, artificial booms and economic recessions. Instead they have centered on whether bank crises and runs have been more or less frequent and severe in this type of system than in a central-banking system (which is obviously quite a different issue).1

In fact, in a recent study, George A. Selgin looks at the occurrence of bank runs in different historical free-banking systems versus certain systems controlled by a central bank and reaches the conclusion that bank crises were more numerous and acute in the second case.2 Moreover the main thesis of the main neo-banking book on free banking in Scotland consists entirely of the argument that the Scottish banking system, which was “freer” than the English one, was more “stable” and subject to fewer financial disturbances.3

However, as Murray N. Rothbard has indicated, the fact that, in relative terms, fewer banks failed in the Scottish freebanking system than in the English system does not necessarily mean the former was superior.4 Indeed bank failures have been practically eliminated from current central-banking systems, and this does not make such systems better than a free-banking system subject to legal principles. It actually makes them worse. For bank failures in no way indicate that a system functions poorly, but rather that a healthy, spontaneous reversion process has begun to operate in response to fractional-reserve banking, which is a legal privilege and an attack on the market. Therefore whenever a fractional-reserve free-banking system is not regularly accompanied by bank failures and suspensions of payments, we must suspect the existence of institutional factors which shield banks from the normal consequences of fractional-reserve banking and fulfill a role similar to the one the central bank currently fulfills as lender of last resort.

In the case of Scotland, banks had so encouraged the use of their notes in economic transactions that practically no one demanded payment of them in gold, and those who occasionally requested specie at the window of their banks met with general disapproval and enormous pressure from their bankers, who accused them of “disloyalty” and threatened to make it difficult for them to obtain loans in the future. Furthermore, as Professor Sidney G. Checkland has shown,5 the Scottish fractional-reserve free-banking system still went through frequent, successive stages of credit expansion and contraction, which gave rise to economic cycles of boom and recession in 1770, 1772, 1778, 1793, 1797, 1802–1803, 1809–1810, 1810–1811, 1818–1819, 1825–1826, 1836–1837, 1839, and 1845–1847. In other words, even though in relative terms fewer bank runs occurred in Scotland than in England, the successive stages of boom and depression were equally severe, and despite its highly praised free-banking system, Scotland was not free from credit expansion, artificial booms and the subsequent stages of serious economic recession.6

The nineteenth-century Chilean financial system provides another historical illustration of the inadequacy of fractional-reserve free-banking systems to prevent artificial expansion and economic recessions. In fact during the first half of the nineteenth century, Chile had no central bank and implemented a 100-percent reserve requirement in banking. For several decades its citizens firmly resisted attempts to introduce a fractional-reserve banking system, and during those years they enjoyed great economic and financial stability.

The situation began to change in 1853, when the Chilean government hired Jean-Gustav Courcelle-Seneuil (1813–1892), one of the most prominent French fractional-reserve free-banking theorists, as professor of economics at the University of Santiago de Chile. Courcelle-Seneuil’s influence in Chile during the ten years he taught there was so great that in 1860 a law permitting the establishment of fractional-reserve free banking (with no central bank) was enacted. At this point the traditional financial stability of the Chilean system gave way to stages of artificial expansion (based on the concession of new loans), followed by bank failures and economic crises. The convertibility of the paper currency was suspended on several occasions (1865, 1867, and 1879), and a period of inflation and serious economic, financial and social maladjustment began. This period resides in the collective memory of Chileans and explains why they continue to mistakenly associate financial disturbances with the doctrinal economic liberalism of Courcelle-Seneuil.7

Moreover the fact that various historical studies appear to indicate that fewer bank runs and crises arose in free-banking systems than in central-banking systems does not mean the former were completely free of such episodes. Selgin himself mentions at least three instances in which acute bank crises devastated free-banking systems: Scotland in 1797, Canada in 1837, and Australia in 1893.8 If Rothbard is correct, and in the rest of the cases institutional restrictions played the role of central bank to at least some extent, then the number of bank crises might have been much larger in the absence of these restrictions.9 At any rate we must not consider the elimination of bank crises to be the definitive criterion for determining which banking system is the best. If this were the case, even the most radical fractional-reserve free-banking theorists would be obliged to admit that the best banking system is that which requires the maintenance of a 100 percent reserve, since by definition this is the only system which in all circumstances prevents bank crises and runs.10

In short, historical experience does not appear to support the thesis of modern fractional-reserve free-banking theorists. Bank credit expansion gave rise to cycles of boom and depression in even the least controlled free-banking systems, which were not free from bank runs and failures. The recognition of this fact has led certain neo-banking authors, such as Stephen Horwitz, to insist that though historical evidence against their views is of some significance, it does not serve to refute the theory that fractional-reserve free banking produces only benign effects, since strictly theoretical procedures must be used to refute this theory.11

Excerpted from Money, Bank Credit, and Economic Cycles
  • 1. 145To date, theorists have carefully examined around sixty free-banking systems from the past. The conclusion they have generally drawn follows:

    Bank failure rates were lower in systems free of restrictions on capital, branching and diversification (e.g., Scotland and Canada) than in systems restricted in these respects (England and the United States).

    However this matter is irrelevant from the standpoint of our thesis, since the above studies do not specify whether cycles of expansion and economic recession were set in motion. See The Experience of Free Banking, Kevin Dowd, ed., pp. 39–46. See also Kurt Schuler and Lawrence H. White, “Free Banking History,” The New Palgrave Dictionary of Money and Finance, Peter Newman, Murray Milgate and John Eatwell, eds. (London: Macmillan, 1992), vol. 2, pp. 198–200. The above excerpt appears on p. 108 of this last article.
  • 2. 6George A. Selgin, “Are Banking Crises a Free-Market Phenomenon?” a manuscript presented at the regional meeting of the Mont Pèlerin Society, Rio de Janeiro, September 5–8, 1993, pp. 26–27.
  • 3. White, Free Banking in Britain
  • 4. Rothbard, “The Myth of Free Banking in Scotland,” Review of Austrian Economics 2 (1988): 229–45, esp. p. 232.
  • 5. Sidney G. Checkland, Scottish Banking: A History, 1695–1973 (Glasgow: Collins, 1975). White himself recognizes in his book that Checkland’s is the definitive work on the history of the Scottish banking system
  • 6. Though much work remains to be done, historical studies on fractional-reserve free-banking systems with very few (if any) legal restrictions and no central bank appear to confirm that these systems were capable of triggering significant credit expansion and provoking economic recessions. This is what took place, for instance, in Italian and Spanish financial markets in the fourteenth and sixteenth centuries (see chapter 2, section 3), as Carlo M. Cipolla and others have revealed, as well as in Scotland and Chile, as we indicate in the text
  • 7. Albert O. Hirschman, in his article, “Courcelle-Seneuil, Jean-Gustav,” The New Palgrave: A Dictionary of Economics, John Eatwell, Murray Milgate, and Peter Newman (London: Macmillan, 1992), vol. 1, pp. 706–07, states that Chileans have even come to demonize Courcelle-Seneuil and to blame him for all the economic and financial evils which befell Chile in the nineteenth century. Murray N. Rothbard believes this demonization is unjust and stems from the fact that the poor functioning of the free-banking system Courcelle-Seneuil introduced in Chile also discredited the deregulating initiatives he launched in other areas (such as mining), when these efforts had a positive effect. See Murray N. Rothbard, “The Other Side of the Coin: Free Banking in Chile,” Austrian Economics Newsletter (Winter, 1989): 1–4. George Selgin responds to Rothbard’s article on free banking in Chile in his paper, “Short-Changed in Chile: The Truth about the Free-Banking Episode,” Austrian Economics Newsletter (Spring–Winter, 1990): 5ff. Selgin himself acknowledges that the period of free banking in Chile from 1866 to 1874 was an “era of remarkable growth and progress,” during which “Chile’s railroad and telegraph systems were developed, the port of Valparaiso was enlarged and improved, and fiscal reserves increased by one-quarter.” According to the Austrian theory, all of these phenomena are actually symptoms of the substantial credit expansion which took place during those years and was ultimately bound to reverse in the form of a recession (as, in fact, occurred). However Selgin attributes the subsequent bank crises (but not the recessions) to the Chilean government’s maintenance of an artificial parity between gold and silver. When gold rose in value, this parity resulted in the massive outflow of gold reserves from the country (see Selgin, “Short-Changed in Chile,” pp. 5, 6 and footnote 3 on p. 7).
  • 8. Selgin, “Are Banking Crises a Free-Market Phenomenon?” Table 1(b), p. 27.
  • 9. Raymond Bogaert appears to confirm Rothbard’s thesis. According to Bogaert, we have documented proof that of 163 banks created in Venice starting at the end of the Middle Ages, at least 93 failed. Raymond Bogaert, Banques et banquiers dans les cités grecques, p. 392 footnote 513.
  • 10. Thus Selgin himself recognizes: “A 100-percent reserve banking crisis is an impossibility.” See George A. Selgin, “Are Banking Crises a Free-Market Phenomenon?” p. 2.
  • 11. With respect to methodology, we fully concur with Horwitz’s position (see his “Misreading the ‘Myth’, p. 167). However it is curious that an entire school which emerged with the analysis of the supposedly beneficial results of the Scottish free-banking system has been forced to stop relying on historical studies of the free-banking system. Stephen Horwitz, commenting on Rothbard’s review of free-banking history, concludes:

    If Rothbard is correct about them, we should look more sceptically at Scotland as an example. But noting the existence of government interference cannot by itself defeat the theoretical argument. The Scottish banks were neither perfectly free nor a conclusive test case. The theory of free banking still stands, and its opponents need to tackle it on both the historical and the theoretical level to refute it. (p. 168)

    This is precisely what we have attempted in this book.

Jesús Huerta de Soto, professor of economics at King Juan Carlos University, is Spain's leading Austrian economist, and a Senior Fellow of the Mises Institute. As an author, translator, publisher, and teacher, he also ranks among the world's most active ambassadors for classical liberalism. He is the author of Money, Bank Credit, and Economic Cycles, as well as Socialism, Economic Calculation and Entrepreneurship (Edward Elgar 2010), The Austrian School (Edward Elgar 2008) and The Theory of Dynamic Efficiency (Routledge 2009).

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