Financial stability without central banks

In the late eighteenth and early nineteenth century, Scotland had a stable financial system. Its stability arose from the pressure that private banks, which had the right to issue bank notes, placed on each other to behave prudently. Unlike in England, the Scottish banking system had no central bank. If one bank within the system overstretched, it would quickly find its reserves leaking away to other banks and the less prudent bank would have to restrain its behaviour or face failure. In one well-known case, that of the Ayr Bank, a problem did arise in relation to its solvency. It failed and brought down some smaller banks. However, it did not bring the system as a whole down because most banks were able to anticipate its failure and ensure that they were not over-exposed. This failure ushered in a century of financial stability in Scotland. The fears of those who believe that a central bank has to stand behind a banking system to prevent systemic failure are not borne out in practice. A free banking system without a central bank provides incentives for banks to act with restraint. Their lending policies are, in effect, tied to each other. If one over-reaches, it will be pulled back as others present notes to and demand reserves from the bank that is lending recklessly. This ensures not only the stability of the system, but also stability of overall spending in the economy. Such stability of overall spending does not lead to price stability as many understand it, that is, inflation at or close to zero in each and every year. For example, if the total level of reserves in the banking system is relatively fixed, prices may well drift down as productivity and total output rise. However, there will be no systematic bias towards inflation or instability in total spending. A banking system that is backed by a central bank has a tendency towards instability. This is because the creation of money by the central bank can inflate money and credit creation in the banking system as a whole. The mechanism of banks restraining the behaviour of each other is blunted. Financial instability and price instability are likely results. The banking system in Scotland was more stable than that in England in the late 1700s and early 1800s. Furthermore, the banking system in Canada was stable relative to that in the US. Canada’s banking system evolved in a similar way to that in Scotland. The US system did not have a central bank (the Federal Reserve) until the early twentieth century. However, regulation and the control and distortion of the banking system by government, especially during and after the Civil War, was disastrous and led to acute instability. Instead of copying the deregulated Canadian model, in the early twentieth century, the US decided to create a central bank. Since the creation of the Federal Reserve, financial stability has worsened. The pre-Federal Reserve model was itself problematic. However, the history of other countries’ banking systems suggests that, whatever the problem was, the solution was not a central bank. Financial stability is more likely in a system without central banks and that is not distorted by misguided regulation.

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