The key to a stable financial system: set banks free

Free banking offers a radical take on banking: banks should be treated like any other business. Free banks would be free to print their own money and lend it as they pleased. There'd be no central banks (so no Bank of England), no deposit insurance (so no £85,000 savings protection), and no banking regulations (not that the ones we have today worked especially well).

The central idea of free banking is that private banks would be free to issue as much currency as they liked. Your cash would carry the insignia of HSBC, say, rather than Charles Darwin or the Queen. That money would be a claim on some fundamental unit of money, which would form the bank's reserves. This might be gold, or it could even be fiat money. But whatever it was, the unit of reserve would - crucially - be fixed, and the entire money system would be overlaid upon it.

Getting rid of central banks sounds extreme to most modern ears - we've known nothing but central banks. We have them for three main reasons: firstly, to keep inflation in check; secondly, to stabilise the banking system in a crisis (this is their lender of last resort' function); and thirdly, to keep overall spending in the economy stable.

Free bankers say that central banks not only fail to perform these three functions, but in fact have the exact opposite effect. Indeed, they reckon that the best way to achieve these three goals is to dismantle the central banks. Here's why.

Who'd watch inflation?

Inflation happens when money in circulation grows faster than the economy's ability to produce. To put it simply, the amount of money being spent rises faster than the amount of stuff', so the amount of money you have to pay per item of stuff' goes up.

Under free banking, however, a bank that printed too much money relative to its reserves would quickly go out of business. The bank's notes would circulate through the system and end up at other banks, who'd call in the profligate bank's underlying reserves. When the reserves ran out, the bank would be finished and its shareholders and creditors would be wiped out.

Fixed reserves throughout the system would provide the discipline. That simple constraint would prevent the money supply from outstripping the economy's ability to produce. Next question!

Who'd act as the lender of last resort?

A system of unregulated private banks printing money and collapsing willy-nilly sounds like trouble. So what would prevent financial crises in a free banking system?

Free bankers argue that you wouldn't need anyone to do so. The lender of last resort function is a next-best solution which is only made necessary because our current system is so flawed. They argue that a free banking system would be far less prone to crashes and panics.

How? Because ordinary depositors would be putting their savings at risk - without deposit insurance, you could lose all your cash if a bank went bust. This possibility of small-scale bank failure, and depositors being forced to eat the losses, would, they say, prevent large-scale bank failures, which end up with taxpayers eating the losses.

Our banking regulation is currently geared around protecting the creditor in the name of stability. If you deposit money at a bank, the state insures it, in the name of stability. If a bank wobbles, the central bank will buy its dodgy assets and lend freely as needed, in the name of stability. If a bank collapses, taxpayers take the hit and recoup creditors in full, all in the name of stability.

So the stability' of our current system is predicated on creditors never having to take a loss. That sounds like a sensible idea. But this is where moral hazard' - that much derided concept - comes in.

Because the ordinary depositor knows he won't lose money, he pays scant attention to the quality of his bank (you only need to look at what happened with Icesave, the Icelandic bank, for proof of this).

In turn, because his banker realises the institution is backstopped by the government and the central bank, he has little incentive to lend prudently. He chases business quantity at the cost of business quality.

So the risk of a small individual default is passed along the chain to the very top of the financial system, and it is amplified by moral hazard at every stage.

This moral hazard means that the government is forced to regulate the banks, because they have no interest in restraining themselves. The trouble here is that ultimately, the banks capture their regulators, and get away with running wild. Again, for proof here, you just need to consider Hank Paulson (who later became US Treasury Secretary) and his successful lobbying efforts to have investment banks' capital ratios lowered in 2005.

Free bankers argue that to prevent this, everybody in the financial system must face some chance of losing their money. Attempts to insulate us from losses for stability's sake may seem admirable, but in fact it's these attempts that make the system unstable.

The resulting losses snowball, becoming big, systemic and public instead of small, localised and private. Free bankers argue that the existence of a central bank backstop inevitably creates moral hazard and that moral hazard ultimately sinks the system.

Nothing precludes healthy private banks from rescuing solvent but illiquid banks under a free banking system, acting as a sort of private lender of last resort. Indeed, the experience of free banking - which operated in the Scotland of Adam Smith's time for a period of roughly 150 years - was of overall financial stability, with small isolated failures and private losses.

Who'd keep the economy stable?

Under free banking, money would be a claim on a fixed amount of reserves. The key word here is claim'.

Banks would be free to create as many claims as they like on the underlying reserves, so the money supply would expand or shrink with banks' promises. In a sense the money supply wouldn't be based on reserves; it would be based on the trustworthiness of private banks.

Money today is also based on trust, albeit trust in one group - central bankers. Instead of a gold standard, you could call it a PhD standard. Only central bankers may issue currency in our system. If that group messes up, the whole system suffers from recession or inflation.

Free banking advocates argue that since trust is the foundation of every money system, it makes more sense to put our faith in the diffuse wisdom of lots of people with skin in the game' than one all-powerful and politically selected committee.

The goal of monetary policy - of the PhD standard - is to stabilise spending in the economy in such a way that there is low, predictable inflation and low unemployment (in theory, the Bank of England only targets inflation but in practice, the last three years at least suggest that inflation is not its only goal). A central banker's job is to nudge interest rates around in such a way as to balance these two objectives.

Under free banking, no group would attempt to stabilise the economy using interest rates, or monetary policy generally. So would the result be an unstable economy, prone to deep prolonged busts and inflationary booms?

History shows that demand for money and goods bounces around quite a lot. During periods of confidence, money flows through the system quickly. But that velocity' of spending can drop off suddenly if expectations change, leading people to hold more cash as a precaution. When the velocity of money slows, it usually leads to recession. That's the spending that central bankers try to stabilise using monetary policy.

Free banking advocates including George Selgin, professor of economics at the University of Georgia, say that free banking automatically stabilises spending through the system. When spending slows, the public draws fewer claims on the free banks' reserves. That leaves banks free to issue more loans and print more currency.

So the slower the velocity of money through the system, the more money banks can safely print to compensate for it. Through the simple mechanism of fractional reserve banking and private money, Selgin claims that free banking would lead to stable spending and a stable macroeconomy.

The uses and limits of free banking

Clearly, free banking raises more questions than I've addressed here. Would the isolated experience of 19th century Scotland really be replicated in a modern economy? Would the extra transaction costs that go with private monies slow the economy's growth? Would special interests and politics distort a free banking system? How would the man and woman in the street react to the idea that all of their hard-earned savings would be at risk if their bank went bust?

Free banking is banking from first principles, and perhaps its main use is to encourage thinking from first principles. The financial system is complex, perplexing and very real; whereas free banking is simple, elegant and theoretical. But perhaps simplifying and clarifying our thinking might, ultimately, lead to simpler and better banking.