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A classic study of free banking in Scotland before 1845

Those good people at the Institute of Economic Affairs have put this fine study of free banking, as it existed in Scotland until the middle of the 19th Century, back into print. It is examined in great detail, with lots of figures and examples of how these banks operated, how many bank failures there were, and so forth. There are a few equations but nothing that should faze all but the most mathematically challenged. Historical scholarship of this detail and depth is vital. It is as vital, in fact, as those studies that showed that in Victorian Britain, before the Welfare State came along, Britain already had an extensive network of mutual aid societies. Without this historical memory, it becomes easier for politicians to sell the lie that the solution to X or Y lies in ever bigger government.

Readers can either read the pdf for free or, if it is tough on the eyesight, as it is for me, readers can get a publication-on-demand sorted out for just £10.

I do not suggest that free banking is necessarily the panacea for the current troubles. But it seems to me that a point lost on the anti-globalistas as well as many of the other critics of the current financial system is that they fail to grasp how banking, as it is practised in most instances today, has deviated from a genuine example of laissez faire capitalism. What we need is sound money, administered by banks operating under the constant blast of competition in proving the soundness of that money. When you think about it, it is not very hard to grasp the idea, is it?

30 comments to A classic study of free banking in Scotland before 1845

  • Johnathan

    Thanks. I’m hoping this will answer my question here: http://www.brianmicklethwait.com/index.php/weblog/comments/my_confusion_about_free_banking/

    You’re absolutely right about getting this meme out there, that banking was free (much less regulated) and is now not free (much more regulated). The lie that the latest round of turmoil is a failure of unregulated capitalism has to be challenged again and again.

  • Was free in Scotland before 1845, I should have said.

  • This essay was the subject of a scathing review by Murray Rothbard. I would dearly like to know who was telling the truth. Anybody know?

  • Richard Garner

    The Rothbard paper on this book is here.

  • Relevant to this discussion is the work by Larry Sechrest, Free Banking, which I believe contains a reconsideration of the Scottish case. It also considers the era of relatively free banking in the United States.

    It’s quite good.

    Worth recalling when reading Rothbard is that he is, on principle, opposed to issuing notes not fully backed up with specie. Sechrest argues that there are serious problems with 100% specie systems, which can be mitigated with truly free-market fractional-reserve banking.

    Whether or not you support free-market fractional-reserve, considering the monstrosity we have now Rothbard’s objections are a case of the perfect being the enemy of the good.

  • Ian B

    Rothbard’s argument seems to be that the Scottish banks weren’t even good. If as he claims, anyone attempting to redeem their “specie backed” notes at the counter would be greeted by a swift kicking and little or no specie, then indeed the case in favour of the Scots banks rather falls apart.

  • Ian B

    Also, just a thought that just occurred to me here, but there seem to be two distinct argument conflated regarding fiat. The first is that fractional reserve inflates credit; the second is that central banks destroy crucial information in the market by manipulating interest rates centrally.

    Imagining if we abolished central banks but allowed private fiat; would there be sufficient information in the marketplace now to prevent credit over-expansion?

  • Isn’t “private fiat” an oxymoron?

  • Ian B

    Not at all Alisa. Imagine a system (absence of a “system”) without central banks or nationalised money. Anyone can set up a bank, and anyone can issue money- promisory notes or tokens- on whatever basis they like. That would include offering promisory notes without specie backing, if you so desire. You could have a whole bunch of private currencies circulating for instance, with the banks just holding enough of other currencies for exchange purposes.

  • Ian: I understand that. I was rather referring to the actual meaning of the word “fiat“, to emphasize the notion that in such a “non-system” an average Joe of a customer will not be forced to accept an IOU that is not backed by specie. This was my way of addressing your question above, but to put it another way:

    fractional reserve inflates credit

    Not in itself it doesn’t, but only in the presence of fiat money (which, as I am trying to argue, is by definition issued by a government). As to the question of information, the only information you’d need is on the kind of backing (or lack thereof) of the IOUs the private institutions are issuing. In other words, as long as there is transparency, the “non-system” should work.

  • Ian B

    That’s not quite the question I was asking though Alisa. I was basically asking: if private fractional reserve banks were not manipulated by central bank interest rate setting, would there still be booms or would the marketplace regulate them adequately? In other words, what is to blame: the central banks or the fractional reserve system? We know that fractional reserve (which is merely the lending of demand deposits) would exist under free banking unless you specifically prohibited it- which as a form of interventionist regulation would presumably be against libertarian principles.

  • I thought that was the question I was addressing. So, to clarify my view: I think that there still would be booms and busts, but they would be much more mild and short lived. The system would correct itself by letting people who shouldn’t be in business for various reasons to actually go out of business, and be replaced by others who hopefully would learn the lessons of the dropouts. So it’s not as if there would be no suffering, but it would be mostly on the part of those who should have known better. That’s what I meant by “it should work”.

  • lukas

    promissory notes without backing? Why would anyone accept those? They are no more convenient or useful than those who are backed by insert favorite commodity here. If Walmart started issuing Wallars, would anyone use them unless they actually allowed you to, y’know, buy stuff at Walmart?

  • Ian B

    promissory notes without backing? Why would anyone accept those?

    Well, maybe they’re backed by a Big Name Brand- see Ebay/PayPal. Or maybe Bank Of IanB started off as a good honest 100% reserve currency, became a market leader, then became a 99% reserve currency, then a 98% reserve currency…

    It’s a very small step from fractional reserve to no reserve, isn’t it?

  • Well then the BoIB would have to make that change in policy known to its customers. And note that such disclosure need not to be mandatory: if you are not disclosing, I am not buying. The state though would have to enforce the contract where such disclosure is included, just like it would have to enforce any other contract.

  • lukas

    PayPal keeps a tight fist on the use of its virtual money by imposing high transaction costs and other regulations… as far as I know, there is no PayPal currency/official currency exchange market (or is there?). For a currency to become viable and gain more than a marginal market share, it needs to be convertible. But if it is convertible, the exchange markets will watch very closely what happens to it… and the traders will definitely track reserve ratios.

  • James Tyler

    My speech to the Policy Exchange http://www.hedgehedge.com

  • Nuke Gray!

    Is this an April Fools’ joke?
    The two words ‘free’ and ‘Scotland’ just won’t occupy the same space in my mind. I keep thinking- Where’s the catch?

  • Midwesterner

    Something that needs to be clear to casual readers -

    ‘Fractional reserve’ and ‘money multiplier’ are not synonyms. The money multiplier effect that occurs under contracted deposit based lending and fractional reserve lending is indistinguishable in its consequences. The difference is in how and why it appears and how it is restrained (or not).

    All loans cause a money multiplier effect, you lend 10 dollars to somebody, that person ‘has’ ten dollars and so do you. But with contract deposit lending you can’t ask for it back before the end of the term you contracted for. With fractional reserve lending you can. When you can’t get your deposit back until its term expires, you will play an active role in monitoring the institutions where you deposit. When all banks are by law permitted to lend your money whether you agree or not (fractional reserve), you don’t have that option. That severance of action and consequence is the single biggest factor in reckless banking. Fractional reserve is a time bomb even in a hard money system. On the other hand, a fiat system will work if the controller of the currency doesn’t inflate the currency. I would say that has never happened but some reader can probably name some brief period of time when . . .

    If the lender, either directly or through a proxy (Fed system) has the ability to print or issue new money, a 0% fractional reserve is possible. The banks lend new money at whatever rate the central bank dictates.

    Regular debaters here are aware of these more obscure differences but for casual readers hopefully this helped a bit.

  • Ian B

    So here’s a thing. If you outlaw FRB (lending of demand deposits), then to all intents and purposes that’s a banking regulation. Customers agree to their money being loaned out when they open an interest bearing account. FRB is no secret, even if it’s not well publicised. Caveat emptor…

    So, the only way to stop FRB is to make a specific law (regulation) prohibiting it. Are we not being inconsistent to say that the market makes the best choices, then have government impose a regulation against a market practise on it? If we can’t trust the market on this one, how can we claim to trust it on everything else?

    Are we saying that FRB is a direct consequence of central banks, loan deposit schemes etc, and without those government interventions it simply wouldn’t exist? Or are we saying that having set up our “true free market” banking scheme, we would pass a law banning the lending of demand deposits, even if the depositors agree to it? If so, why don’t we trust depositors to make the correct decision in the marketplace, if we want to trust them with every other decision in the marketplace?

  • What I want to know is how much free hobbit porn I’ll get for opening my account at the Bank of Ian B.

  • Ian B

    Consider this article for instance.

  • RRS

    How come no one has mentioned those magic words:


    With which Martin Wolf “corrected” me on views as to what exactly ultimately stands behind “money” to give it value.

    Those words may indeed be the “Fiat.”

    Which is indeed a different concept from “Credere.”

    The resources to publications via IEA, Mises.org, and especially Liberty Fund are just amazing. would that there were now “more time.”

  • Nuke Gray!

    We had a discussion like this at the Australian Libertarian Society blog months ago, and the anti-factionalist couldn’t answer one basic objection.
    How do you stop individuals from inventing it for themselves?
    I could have $100 dollars in the Holistic Bank, which promises to never engage in anything other than fully-backed notes. I write a note to Alisa, promising her $50. She could use my written promise to pay her debts to her friends. I promise the same to Perry, and I also give IanB. an identical letter, which he can use amongst his samizdata friends. My friends trust me enough to keep the notes instead of the money (we could call my notes Personal Cheques). Haven’t I invented one-person fractional banking?

  • Ian B

    So far as I can see indeed you have, Nuke Gray!, and this brings us to another point. Once you denationalise money, you’ve abolished it. Money ceases to exist. Currently, the word “money” refers to specific government authorised tokens. Once you denationalise, you just have people trading stuff, which might be lumps of metal, little blue bags of salt, promisory notes, futures contracts, or anything else. There’s no way to even define what “money” is any more. So it’s hard to see how anyone can outlaw fractional reserve without restricting freedom of trade and contract.

    If I want to trade a bag of carrots to Alisa for an IOU from Nude Gray! for a bag of spuds, that’s my business, not the State’s. Isn’t it?

  • Midwesterner

    I don’t recommend outlawing fractional reserve banking. I think it should be legal. Assuming full disclosure, of course. In a multiple currencies environment I can choose one that either permits or does not permit it based on what I want from it.

    It is the monopoly nature of present banking where I am prevented by law from using any currency other than the one for which fractional reserve is mandated. There is no option in the US (and most other places) for me to use anything other than the one politically managed, deliberately inflated, fractionally reserved (or in the UK not reserved at all?) currency issued by the Fed. It is that mandatory mono-currency that I oppose. I am prevented by inflation from holding the money myself, I am prevented by law from finding a full service bank that doesn’t engage in fractional reserve lending. I am prevented by the nature of our modern economy (ever tried to rent a car for cash?) from not using full service banks and credit cards.

    I’m glad to see Johnathan revving up the multiple currencies debate.

  • Laird

    I find it amusing that every thread here which touches on banking or money seems inevitably to turn into a debate over fractional reserve banking. I’ve posted my own feelings on that topic quite enough recently that I have no interest in repeating them here. It is good, though, to see a few more voices here defending the practice (even with stipulations about full disclosure, etc.). Ian, thank you for the link to that article; Hultberg makes the case very well.

  • Midwesterner

    There is only one reason for having mandatory single currency. That is the furtherance of a totalitarian state. A mandatory government controlled currency is essential for collecting confiscatory personal taxes and for redistributing wealth ‘fairly’.

    Fractional reserve is merely the way in which they steal control of what money they allow you to keep (or redistribute to you). If you want to interpret my (libertarian) belief that the practice should be permitted as “defending the practice”, you have missed my point entirely.

    My belief is that in a free market, multiple currency environment, fractional reserve would take its place alongside of any other “trust me” confidence schemes. But that is for the participants in the market to decide, I do not advocate experts deciding for them.

  • Exactly.


    If you outlaw FRB (lending of demand deposits), then to all intents and purposes that’s a banking regulation.

    You don’t outlaw it, you stop it from being mandatory the way it is now.


    LEGAL TENDER … Those words may indeed be the “Fiat.”

    They indeed are “Fiat”.

  • Thanks, Jonathan, for the plug!

    In chapter 3 of the 2nd edition (which is the edition now freely downloadable from the IEA), I respond to the criticisms Rothbard and some others made of the book’s 1st edition. Read both and decide.