Free Banking in Scotland

The major examples of free banking are supposedly these countries and eras:

(1) Australia (late 19th century);
(2) Switzerland ( –1881);
(3) United States (1837 to 1864);
(4) Canada (1800s–1934);
(5) Sweden (1830–1902), and
(6) Scottish Free Banking (c. 1716–1845).

Australia’s free banking experiment was a disaster, and ended in a massive property and financial asset bubble, whose collapse induced a debt deflationary depression, worse than Australia’s Great Depression in the 1930s.

Moreover, even many libertarians seem to reject the idea that the US had a proper “free banking” period from 1837 to 1864, owing to the restrictions on branch banking and other regulations.

I have not studied Switzerland in great deal, but Goodhart (1987: 131) suggests that Swiss banks had a stability because of their ability to access the Paris financial markets backed by the Banque de France, the central bank of France.

I also remain unconvinced by the claims made by free bankers about Sweden in the late 19th century (see Appendix 1), just as also their claims made for Canada, which also had institutional stability via the large and powerful private Bank of Montreal, and also stability induced by Canada’s banking system becoming a “satellite” (as it were) of the New York money market (Goodhart 1987: 131) (see also Appendix 2).

That leaves us with Scotland. The period of “free banking” in Scotland is usually dated from 1716 and 1845.

The Scottish banking system was divided in this period into four types of banks:

(1) Public banks;
(2) Private banks;
(3) Provincial banks, and
(4) Joint stock banks.

They all had limited liability of shareholders, and the system seems to have had largely free entry and few regulations.

Lawrence H. White (1984) made the case for a successful free banking period in Scotland (see also White 1995, a revised edition).

Goodhart (1987) and Dow and Smithin (1992) provide a critique of White. Rothbard (1988) also attacked White’s thesis, though his article (typically) degenerates into an ignorant rant against fractional reserve banking.

But certain facts suggest that the free banking era in Scotland does not support the views of the free bankers, for these reasons:

(1) The period was marked by a suspension of specie payments from 1797 to 1821.

(2) Scotland was not an independent nation, and in 1707 England and Scotland were formally united as one state, the kingdom of Great Britain. The economic and institutional stability afforded by the existence of the Bank of England cannot be ignored.

For example, in 1793 the British government organised a bailout of Scottish banks after a banking crisis in Scotland when the war with France broke out.

Actual settlement in specie appears to have been restricted in Scottish banks. The Scottish banks often discharged their notes by offering assets that could be directly or indirectly liquidated in the London money markets, which of course were ultimately backed by the Bank of England.

Goodhart (1987: 131) sees Scotland as a mere satellite of the English system, ultimately dependent on the Bank of England.

(3) Even the concentration of banking in Scotland itself produced two “public banks” that also came to fulfil de facto central banking functions.

The three so-called “public banks” were as follows:

(1) the Bank of Scotland (from 1695);
(2) Royal Bank of Scotland (from 1727), and
(3) British Linen Company (from 1746). (Dow and Smithin 1992: 380).

They seem also to have had a de facto limited liability.

By 1752, the Bank of Scotland and Royal Bank of Scotland had formed a cartel and had agreed to accept each other’s notes in settlement and to refuse credit to those who exported specie during times of payments difficulties (Dow and Smithin 1992: 386).

Scotland’s other banks came in time to regard the notes of the Bank of Scotland and Royal Bank of Scotland as money equivalent to reserves, and even treating these banks as lenders of last resort (Dow and Smithin 1992: 387).

So, all in all, it seems difficult to regard Scotland as a true example of a “closed” and independent free banking system (Goodhart 1987: 131). Factor (2) above – the role of the Bank of England – seems sufficient to undermine the idea of such a free banking system.

If free bankers want to claim that their system is superior because the largest private banks in such a system come to exercise de facto central banking functions, this seems like nothing more than a vindication of the position that market stability in banking is achieved by a de facto lender of last resort and expansion of base money over and above the mere stock of gold and silver.

But then why not have a public authority to exercise these functions if the market just develops quasi-central banking by large private banks?

Appendix 1: Banking in Sweden in the 19th Century

Far from being a “free banking” system, it appears to me that Sweden in the 19th century had a number of important banking regulations:

(1) a banking law of 1824, which was revised by royal decree in 1846;

(2) a banking law of 1855 (on minimum number of shareholders, limiting activities banks could undertake);

(3) until 1863, Sweden seems to have had formal ceilings on interest rates;

(4) a banking law decree of 1864 (revised 1874), including a provision by which the so-called “Enskilda Banks” were subject to monthly bank inspections;

(5) new limited liability banks and Enskilda banks were prohibited from owning or lending against shares or real estate. In other words: intrusive government regulation to stop reckless credit flows to speculators (Grossman 2010: 208).

(6) in 1897, all note issue was centralised in the Riksbank. The Riksbank was founded in 1668 as a private bank, was taken over by the state in 1668, and assumed lender of last resort functions in the 1890s.

Appendix 2: Banking in Canada
In the 1800s, Canada had a large private bank called the “Bank of Montreal” that in some ways acted like a de facto central bank (Bordo 2002: 121), by taking over insolvent banks and being committed to the stability of the system. Also, the Canadian banks were able to access the New York money markets, which had a stabilising role.

In both 1907 and 1914, Canadian governments had intervened to stop financial crises in the banking system by providing reserves (Bordo 2002: 121).

Moreover, the Canadian Conservative party (during its tenure from 1911–1917) had implemented the “Finance Act” of 1914, which gave the government the authority to issue its own paper, so that it now had lender of last resort powers (Grossman 2010: 99). An Amendment of 1923 extended this Finance Act, and Canada continued to have a discount window and lender of last resort facility (Bordo 2002: 121), even though there was no formal central bank until 1934.

From 1920–1921, Canada was also ruled by the Conservative party (or the “National Liberal and Conservative Party” as it was called at the time) and credible measures were taken by that government to prevent a serious bank failure by allowing a merger in 1921. In this year, the Conservative Minister of finance Sir Henry Lumley Drayton defended the government’s action and explicitly said of the Merchants Bank that “the interests of the depositors themselves required to be guaranteed” (Kryzanowski and Roberts 1993: 365). This was publicly reported in the press.

Kryzanowski and Roberts conclude:

“… the archival evidence is consistent with our hypothesis that beginning in 1923, an implicit guarantee from the Canadian government (amounting to 100 percent implicit insurance) stood behind all domestic bank deposits. The government actively facilitated mergers during the 1920s to avoid firesale insolvency and successfully created public confidence that no bank would be allowed to fail. This confidence persisted during the 1930s” (Kryzanowski and Roberts 1993: 366).

For more discussion, see here.

BIBLIOGRAPHY

Bordo, M. D. 2002. “The Lender of Last Resort: Alternative Views and Historical Experience,” in Charles Goodhart and Gerhard Illing (eds.). Financial Crises, Contagion, and the Lender of Last Resort: A Reader. Oxford University Press, Oxford. 109–125.

Dow, Sheila and John Smithin. 1992. “Free Banking in Scotland, 1695–1845,” Scottish Journal of Political Economy 39: 374–390.

Goodhart, C. A. E. 1987. Review of Free Banking in Britain: Theory, Experience and Debate, 1800–1845 by L. H. White, Economica n.s. 54.213: 129–131.

Grossman, Richard S. 2010. Unsettled Account: The Evolution of Banking in the Industrialized World since 1800. Princeton University Press, Princeton.

Kryzanowski, Lawrence and Gordon S. Roberts. 1993. “Canadian Banking Solvency, 1922–1940,” Journal of Money, Credit, and Banking 25: 361–376.

Rothbard, Murray N. 1988. “The Myth of Free Banking in Scotland,” Review of Austrian Economics 2: 229–245.

White, Lawrence H. 1984. Free Banking in Britain: Theory, Experience and Debate, 1800–1845. Cambridge University Press, Cambridge.

White, Lawrence H. 1995. Free Banking in Britain: Theory, Experience and Debate, 1800–1845 (2nd rev. edn.). The Institute of Economic Affairs, London.