Free banking

The term "free banking" is generally used to describe a structure of the credit market based on the principle of laissez-faire and characterized by the absence of entry and exit barriers, freedom of monetary issue and the possibility of unrestricted lending and borrowing.

The best-known examples of free banking are those observed in Scotland (from the end of the monopoly of the Scottish Bank to the Peel Act) and in the United States (between 1837 and 1863).

One of the principal supporters of a free banking regime was Mises, whose theories were adopted (and further developed) by the Austrian School. He declared his approval for free banking while recognizing its limitations. In his view, acceptance of a liberalized banking activity did not imply abolition of every form of control over monetary issue: his awareness that banks could issue money without any limit led him to turn his attention to an integral gold monetary system (see Mises, 1949).

A return to free banking was also recommended by Hayek (1976), who suggested giving freedom of issue back to commercial banks. The role of banks would thus be purely that of intermediaries between depositors and borrowers. Although Hayek's analysis, unlike Mises', did not focus on the difference between the monetary function and the credit function of the banking system, it had the merit of underlining the sub- stantially equivalent role of commercial banks and the central bank on the question of monetary issue.

A third approach, New Monetary Economics (see Cowen and Kroszner, 1987), is based on the studies of Black (1970), Fama (1980) and Hall (1982). This identifies elements in the recent economic and financial crisis, and in the evolution of the payments system, to justify the return to a regime of free banking. In light of the global financial crisis that erupted in 2008, Dowd (2009, p. 9) further recommended free banking "anchored on a commodity-based monetary standard". This brought to light the metallist vision often underlying the proposals of those in favour of a free banking system.

Finally, Selgin and White (1994) underlined the view of free banking as a system of free competitive monetary issue by private banks, regulated by clauses to guarantee convertibility. In line with the supporters of the Banking School, they maintained that the law of reflux protected the system from the risk of overissue. They too observed that the information revolution tended inevitably towards a regime of monetary issue free from external control, and that technological development, together with privati- zation in the creation of means of payment, could only result in an advantage for the economic system, reducing the issuing profits of the central banks (see Selgin and White, 2002).

In the debate on free banking, one of the topics under discussion was the possibility that such a regime could lead to situations of instability at a systemic level (see Dow, 1996). But the basic disadvantage of the hypothesis of a return to free banking is that its theoretical reference model, of a monetized exchange economy, enables it to carry out the functions of a barter economy but not of a capitalist economy (see Graziani, 2003). It should be noted that Menger's approach, in line with this hypothesis, does not consider the role of money as a social relation (see Ingham, 2000) or its decisive role in the economic system.

In this respect, monetary circuit theory underlines how the role of the banking system should be defined in light of the workings of a monetary production economy, which characterizes a capitalist system. This would lead to a new financial architecture at both national and international levels, guaranteeing stability and economic growth (see Rochon and Rossi, 2007).

The proposal of the Dijon School in this respect is based on the fundamental dis- tinction between money, income and capital (see Schmitt, 1984). This gives rise to a subdivision of the banking system into three departments (monetary, financial and fixed- capital), their inflows and outflows booked according to the nature of the underlying payment (see Rossi, 2010).

See also:

Banking and Currency Schools; Financial crisis; Financial instability; Hayek, Friedrich Augustus von; Metallism; Monetary circuit; Money and credit; Reflux mechanism; Settlement system.