Bringing gold and silver back as America's Constitutional money

Joakim Book's Sound Money Scholarship Essay

Free Banking and the Bagehot Defence

Even the best-informed government department cannot be trusted to judge wisely and impartially when more money is wanted. Currency must be supplied, like all other commodities, according to the free action of the laws of supply and demand.' Jevons (1898: 231-322)

It is well known that the vast majority of economists, even those generally favourable to free markets, make an exception in the production of money. The analysis of money and monetary regimes differ from other markets, they say, and invoke different principles for the economics of money than the economics of goods.1 

This essay first outlines how money does differ from other goods and points out that the differences are not enough to justice central banking on welfare-enhancing grounds. Since objections to free banking are also defences of central banking, I then discuss three common criticisms of free banking and the historical and theoretical mistakes that fuel them, before suggesting that the apparent cognitive dissonance among the economics profession may be an understandable outcome of Bagehot-inspired pragmatism.


In a rather obvious way, money is different from all other goods; it is the unit of account, the most common medium of exchange and the good that is present on one side in almost all economic or financial transactions. All other goods and services are acquired with production or consumption in mind, whereas money is acquired with the sole purpose of giving it away in future exchanges (Mises 2009: 267-68). This would seem to support the notion that money is a special good subject to special treatment. Additionally, money has at least two different attributes and peculiarities that are brought up in the justification for government control over monetary matters. First, the attribute of network externalities implies that a good’s usefulness increases as others use it too. Well-known examples are telephones, organisation memberships, social networks like Facebook or Twitter – and money. The more people use and accept a certain kind of money, the better that money performs monetary functions to other people; one essential quality of money is the extent to which others use it, how ‘saleable’ and liquid its market is (Menger 1892; Bagus 2009: 28-33). Banking historian Stefano Ugolini (2017: 25-29, 89-90), recently discussed network externalities in the payment system and pointed to their indispensability for all economic activities. Combining network externalities with increasing return to scale and finality of payment, he concluded that publicly provided money is superior to private money. Echoing state theories of money, he maintains that the state’s sheer size will cause a public medium of exchange to be adopted as money even between private parties (Ugolini 2017: 175).2

The second attribute of money justifying government production is the ‘information acquisition’ point. Obtaining information on which private bank notes are safe, makes publicly provided money, backed by the full power of the state, “socially optimal” (King 1983: 128; Brunner & Meltzer 1971: 801-2).3

There are thus several important differences between money and other goods. However, in no way does it follow that governments must monopolistically produce money; the main hurdle advocates of government-controlled money have to overcome is showing that privately- produced money is sufficiently or even markedly inferior to government-money such that it justifies the intervention on public good or welfare-enhancing grounds (either through these attributes or other alleged shortcomings of private money). The problem is a perennial one in economics (Hausman 1994: 190, 207, 253): we lack controlled experiments to demonstrate the effects under different scenarios, especially when some of those scenarios are outlawed. In particular, since privately produced money is replaced by government monopoly and legal tender laws, critics of government-money are at an empirical disadvantage. Luckily enough, we may draw on a large historical and theoretical literature to indicate that government money may in fact not be superior to privately produced money, undermining the rationale to treat money differently than other goods.


A brief overview of the main arguments provided by sceptics of privately produced money is provided below. Rebuttals using historical facts are provided throughout.

Natural monopoly:

Insofar as production of money has increasing returns to scale, particularly in reserve holding, (Sechrest 1993: 163) or enjoys network externalities, the industry tends towards a single provider (Goodhart 1988; Tobin 1980: 86-87; King 1983: 133). Like all monopolies, the argument goes, it will inefficiently provide less-than-equilibrium amount of money. Sechrest (1993: 163) points out that the only way to know that, is to find out by allowing the market to prevail. Even more bluntly, Vaubel (1986: 936) argues that:

The only operational proof that a common more is more efficient than currency competition and that the government is the most efficient provider of the common money would be to permit free currency competition.

Most economists rely on the presumption of increased returns to scale to conclude that the industry will tend towards a monopoly concentration, with prohibitively high costs to entry. The conjectures are at odds with the historical episodes in which versions of free banking have been tried: free banks did not converge into one dominant monopoly (Selgin 1988: 45-46) and barriers to entry were not prohibitively high (White 1991: 42-44). Moreover, it is an awkward, perhaps internally inconsistent, position to take, since theories of natural monopoly usually suggest as a solution government regulation of that industry's excess profits or price ceilings towards consumers – not outright centralisation (Tirole 2014).

In a different version of this criticism it is sometimes asserted, like Mervyn King, the former Governor of the Bank of England, that money is a public good (King 2016: 87). The meaning of such statements is quite unclear, since money exerts none of the attributes of public goods (non-excludability and non-rivalrousness).4  One interpretation is that the adoption of money enlarges a society's set of feasible exchanges and so makes everyone better off (Nosal & Rocheteau 2011: 4, 47)5, or its production or quality has substantial positive benefits for others (positive externalities), making private production under-supply the amount and quality demanded. It is hard to see how private profit-seeking free banks would undersupply notes when competition and the profit motive continuously shove them toward consumers’ demand for notes (Selgin 1988: 102-3).

Externalities from bank failures and inflation

This objection combines financial stability concerns from unregulated private banks with a belief in (unlimited) note issuing, causing runaway inflation. Gorton (2017: 569) recently pointed out at the main rationale for bank regulation is the negative externalities of their actions and failures.6  The concern is based the historical observation that mid-nineteenth century U.S. banks often refused to honour their liabilities (King 1983: 136-37).7  However, this idea of rampaging wildcat bankers seems much exaggerated; rather, it was “episodic and not typical” (Hammond 1948: 24)8. In truth, experience with note-issuing banks varied remarkably across states9 and the wide-spread recurrent nineteenth century panics in no small amount stemmed from ill-advised government regulations.10 Moreover, the free-banking eras of Scotland (Goodspeed 2016; White 1991: 37, 59; White 1992), Sweden (Jonung 1988; Briones and Rockoff 2005: 304-307)11  and Canada (Calomiris and Haber 2014: ch. 9) suggests that free banking system may be both stable and refrain from overexpansion of the money supply. The reason, as convincingly outlined by Selgin (1988: 40-48) and White (1999: 58-63) is that decentralised note-issuing more closely corresponds to consumer demands, has lower ‘time lag’ (Friedman 1961) than central banking, and more reliably prevents overexpansion of credit through adverse clearing mechanisms and note-brand discrimination. Historical experience aligns more closely with this explanation than with notions that dominant banks evolved into central banks (Goodhart 1988; Redish 1993:783).12

Lender of Last Resort (LOLR)

A banking system without a central bank, it is argued, lacks the essential role of a LOLR (Ugolini 2017: 4-7, 111-118, 141; Goodhart 2017: 22-24; Humphrey 2010: 333-343). In an apt description of conventional beliefs about the indispensability of the LOLR function, Edvinsson, Jacobson & Waldenström (2018: 10) emphasised the ‘unlimitedness’ of central banking provision of last resort-loans:

[P]rivate note issuing banks during the free banking period were unable to perform central bank functions, since they did not control the monetary base. Their ability to perform the role of lender of last resort and government’s bank in times of emergency was limited, since they could not issue a theoretically unlimited amount of notes that would be generally accepted, and backed by a state authority. (emphasis added)

Lacking a central bank to backstop market panics (Humphrey and Keleher 1984), banking crises in free banking systems are recurrent, severe and unavoidable – more so than under central banking.

The argument is not only historically inaccurate, since many different institutions can and have provided emergency lending during panics (White 1999: 70-87; Dowd 2015: 223; Timberlake 1984), but logically unfeasible since it hinges on unlimited money creation. As every hyperinflation has shown, a central bank that issued ‘unlimited’ amounts of cash to support banks would quickly see the demise of its currency and the LOLR support effectively nullified.

On its own terms, the LOLR function in a free banking system requires that some agent be able to mobilise enough funds for a) the illiquid bank to meet its short-term obligation and b) the financial system to believe that the illiquid bank will (Calomiris et al. 2016: 52). Scottish free banking provides us with at least two private features through which free banks performed LOLR functions: unlimited owner liability (Goodspeed 2016: 26, 92-102; Turner 2014: chs.1, 5) through which all landed wealth of owners of banks could be called on to settle liabilities of troubled bank13; and the Options Clause (Selgin and White 1997; Dowd 1988: 323-25) through which banks could legally postpone withdrawal demands for six months (against interest) and so alleviate bank runs. Other discussions in the economic literature include clearinghouses (Timberlake 1984), illiquidity insurance (Solow 1982; Holmström & Tirole 2001: 1862) or pre-arranged credit lines (Goodfriend and Lacker 1999: 4).


Despite free banking arguments or convincing critiques of central banking, even persuaded economists may invoke the ultimate trump card to support their actions: The Bagehot Defence.

In his 1873 book, Lombard Street14, Bagehot prescribes the correct behaviour of a central bank during a financial panic. But his work is one of compromise. Admitting that his preferred system is “the natural system” (Bagehot 1873: 67) of freely competing note issuing banks rather than a Bank of England with monopoly over the money supply, he nevertheless concedes that abolishing the Bank's monopoly is unfeasible and so he outlined the best behaviour possible within an inferior system (Bagehot 1873: 20, 67-68, 111, 197). 

As seen above, objections to free banking and positions defending central banking are commonly based on historically inaccurate beliefs or lack of insights into the theoretical and historical mechanisms of free banking systems. Since free banking scholars for decades have attempted to correct those beliefs (White 1984; White 1999; Selgin 1988; Sechrest 1993; Glasner 1989), a plausible explanation for why the dissonance among the economics profession persist may simply be – like Bagehot – intellectual pragmatism. The defence of the status quo follows from the political unfeasibility of adopting a free banking system. By working within a flawed system and upholding its rationale, their writings may be mistakenly interpreted by outsiders as believing that money production is subject to different economic laws than other kinds of production.


1  White (1992: 114-15) makes the same observation.
2  Remarkably, there are no calls for public provisions of other industries subject to network externalities (railways, phones, shopping malls).
3  The same dissonance as in fn. 3 applies, since the same ‘information overload’ argument is not applied to other goods markets – or even different financial products offered by financial intermediaries (White 1992: 118).
4  The point is developed in Vaubel (1986: 934). See also White (1999: 90-92).
5  Perhaps allowing an escape from some Nash equilibrium.
6  Note how negative externalities of failures are used as an objection against free banks, while positive externalities are used to support central bank provision of money. Opposite instances are conveniently not considered.
7  In Gorton’s (1985: 267) words, “The American free banking experience […] is generally viewed as a failure”. For a countervailing position, see Rockoff (1974, 1985).
8  See also Schwartz (1993: 362).
9  See the accounts in Hammond (1948: 5-9) or Calomiris and Schweikart (1991).
10  See for instance Calomiris and Haber (2014: chs 6-9); Calomiris & Gorton 81991; Selgin, White and Lastrapes (2012: 573-83).
11  See Ögren (2003:4-9) for a moderating view.
12  Notice how this objection relies on the opposite assumption of how free banks work; now, note issuing under free banking is so lucrative that its issuance will be unlimited, causing large-scale bank failures, inflation and monetary, financial and economic instability, as opposed to the objection above, where their note-issuance was suboptimal.
13  A suggestion even Goodhart (2017: 25) has recently accepted as feasible.
14  Commonly held to be the foundational text for central banking practice (Bernanke 2015:45).


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