Why We Should Bank Free

Free banking is seen by many as something that should be left in 18th century Scotland. Free banking is where each bank issues their own note that is redeemable for a certain amount of a commodity, typically gold. The value of the note is determined by the assessed probability that that bank will indeed be able to pay good on their promise.  Each bank lives and dies on its reputation. The most well trusted banks had notes much more stable than the dollar, and they didn’t even need an entire military and coercive system to back up their word.

Free banking is mainly critiqued as creating too much financial friction and allowing for crises to hurt consumers. The friction argument comes from the vast amount of note types employed by free banking. Each bank has their own note and thus users must distinguish between all of them and tie them to the current value of the related bank. This critique seems reasonable to people who have only used state backed currency until you consider that money is a commodity like any other. Distinguished notes merely means that a user can discriminate between the quality of their money like they can any other good. Any consumer would be uncomfortable if there was a state monopoly on bread and it was considered madness to distinguish between bread of different types. Additionally, clearinghouses exchanged various notes for one another, noting their relative worths.

The argument that free banking leaves depositors in constant danger does not hold up historically. The American Banking Crisis of 1907 was under a system different from free banking in several ways. While without a lender of last resort, banks had been more heavily regulated since the departure from true free banking in 1863. Additionally, banks were required to hold federal or state bonds as collateral, damaging the appreciation of their assets and artificially boosting demand for government bonds. While the 1907 crisis was indeed difficult to weather, it actually showed the validity of one of the key tenets of free banking: private incentives will create a lender of last resort. J.P. Morgan personally created a coalition that saved the U.S. banking system. Even in a heavily regulated derivative of free banking firms still took responsibility for the Fed’s job. A less regulated free banking system like Scotland’s embrace of responsibility made crises much rarer and created a strong system of private protection.

Free banking’s first benefit in comparison to state backed banking is that it much more directly rewards good lending. The bank that lends the most to people who will actually pay it back will have a higher note value, as they will have a higher likelihood of making good on their promises. This stratification of the market is a blessing to individuals and industries alike, as people who are sure of their ability to pay back, or the validity of their business plan will gladly submit to the high levels of scrutiny that will come from the most solid banks. Individuals who need some quick cash will take the gamble from a less strong bank. The wide variety of choices will allow financial innovation to come faster, as resources will be put into vetting individuals accurately rather than fulfilling central bank regulation. The system becomes a dynamic competitive market rather than a box-checking exercise that rewards mediocrity with safety. Businesses that would have otherwise received little funding will now receive a more significant look from banks with more resources devoted to scrutiny. Smaller banks seeking to distinguish themselves could embrace novel technology to analyze and lend to unusual innovation.

Historically, free banking died not as a result of inefficiency, but usually as  a result of government desire for control. Most central banks have a monopoly on the issue of notes for precious metals, which typically means that within a few years, no one, not even them will issue notes for Gold. The Fed slowly gave less and less gold for each note until they completely separated their notes from anything but their own manipulation. They shortchanged the American people and used the Gold they took in hundreds of outrageous abuses of trust. Free banking died when governments realized they could hop on a moment of crisis and seize the people’s Gold in return for the illusion of safety. The historically dubious fear of free banking bank runs has been replaced with the reality of constant inflation and involuntary unsound money. Our fear has led us into a perfectly avoidable prison cell of manipulation.