ABSTRACT

If free banking theory is the application of market economics to money and banking, then it ought to be able to do more than just explain how a free banking system might work. It ought also to be able to explain how we arrived at the monetary and banking institutions we have today, and the next four chapters attempt to use it towards that end. The first, 'Money and banking: the American experience', was prepared for the Durell Foundation conference on that theme in Washington in May 1990, and provides a very general overview of US monetary and banking history and the main lessons to be drawn from it. The US constitution originally allowed virtually no federal involvement in money and banking, and left the regulation of banking to the individual states. To set up a bank one had to acquire a charter from the local legislature, and the charter normally imposed restrictions on where one could do business. These restrictions severely limited the growth of branch banking and consequently q'lade the American banking system much weaker than it would otherwise have been. The charter system also gave rise to a powerful lobby - the unit bankers - who not only had a vested interest in maintaining the restrictions against branch banking but who lobbied - sometimes successfully - for state protection of the artificially weakened banks in the form of note deposit insurance schemes, and these schemes usually weakened the banks even further by eroding the discipline of the market and encouraging excessive risk-taking. Despite the constitution, the federal government tried early on to charter its own national banks, but opponents of the banks were able to prevent their charters being renewed in each case, and the federal government effectively withdrew from banking after the lapse of the federal charter of the Second Bank of the United States. The following generation saw the banking experimentation of the 'free

Chapter 10 is a review essay, first published in the February 1990 issue of the Scottish Journal of Political Economy, on Charles Goodhart's book The Evolution of Central Banks (1988). The gist of Professor Goodhart's thesis is that central baqking is a 'natural' phenomenon which evolved as a response to the problems caused by market failings, and Goodhart suggests three failings in particular: he claims that free banking would not provide the information necessary for it to work properly; he questions the claims made by free bankers that the clearing system would provide a sufficient check against over-issue; and he argues that free banking would be more likely than central banking to lead to general economic fluctuations. This chapter was my attempt to respond to Goodhart's claim that he had refuted the argument for free banking, and it rejects both his theoretical analysis and his interpretation of history. It argues that information is generally scarce, like most other goods, and, though one can usually choose to describe it as 'imperfect' if one wishes, this 'imperfection' in no way constitutes a market 'failure' that can be corrected with the appropriate

governmental policy response; it also argues that the clearing house argument put forward by free bankers was meant only to show how the clearing house disciplines an individual bank, but it is convertibility that disciplines the system as a whole; Goodhart's third argument, about free banking producing economic fluctuations, presupposes either that banking is a natural monopoly or that competitive banks would expand past the point where they could expect to maximize their profits, and it seems to me that the former is empirically rejected and the latter is unreasonable. As for the historical evidence, the theory that free banking is inherently unsound has a very strong empirical prediction - it predicts that free banking would not work if put into practice - which runs up against the evidence that free banking (or something like it) was tried and apparently did work in countries such as Scotland and Canada (and many others).4 The supporters of central banking have never managed to explain the apparent success of Scottish" free banking (or of other cases, either, as far as I know) which their own theory predicts could not occur. As far as I can see, the case against free banking must therefore be considered empirically refuted.