The problem with historical illustrations of Free-Banking Systems: We should welcome banking failures…

Jesús Huerta de Soto, professor of economics at King Juan Carlos University has a nice piece.

He says most of the discussions on free banking are around the fact that there were less banking failures and thus were safer compared to non-free banking era. But that is a wrong way to put things. Bank failures show that the cycle is continuing and should be welcome, The regulated banking systems prevent banking failures which is actually a sign of weakness and not strength:

Neo-banking authors devote strong efforts to historical studies which they intend to support the thesis that a free-banking system would protect economies from cycles of boom and depression, owing to the “monetary equilibrium” mechanism. Nevertheless the empirical studies produced thus far have not focused on whether free-banking systems have prevented credit expansion, artificial booms and economic recessions. Instead they have centered on whether bank crises and runs have been more or less frequent and severe in this type of system than in a central-banking system (which is obviously quite a different issue).1

In fact, in one study George A. Selgin looks at the occurrence of bank runs in different historical free-banking systems versus certain systems controlled by a central bank and reaches the conclusion that bank crises were more numerous and acute in the second case.2 Moreover the main thesis of the main neo-banking book on free banking in Scotland consists entirely of the argument that the Scottish banking system, which was “freer” than the English one, was more “stable” and subject to fewer financial disturbances.3

However, as Murray N. Rothbard has indicated, the fact that, in relative terms, fewer banks failed in the Scottish free-banking system than in the English system does not necessarily mean the former was superior.4 Indeed bank failures have been practically eliminated from current central-banking systems, and this does not make such systems better than a free-banking system subject to legal principles. It actually makes them worse.

For bank failures in no way indicate that a system functions poorly, but rather that a healthy, spontaneous reversion process has begun to operate in response to fractional-reserve banking, which is a legal privilege and an attack on the market.

Therefore whenever a fractional-reserve free-banking system is not regularly accompanied by bank failures and suspensions of payments, we must suspect the existence of institutional factors which shield banks from the normal consequences of fractional-reserve banking and fulfill a role similar to the one the central bank currently fulfills as lender of last resort. In the case of Scotland, banks had so encouraged the use of their notes in economic transactions that practically no one demanded payment of them in gold, and those who occasionally requested specie at the window of their banks met with general disapproval and enormous pressure from their bankers, who accused them of “disloyalty” and threatened to make it difficult for them to obtain loans in the future. 

Hmm..

He also discusses how Chile moved from free banking to fractional reserve banking thanks to a French economist.

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