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Free banking and classical liberalism: a potted history

Free banking as a policy ideal is the result of applying the norms of classical liberalism to money and banking.  Classical liberalism upholds individual liberty and private property rights, including freedom of contract, under the rule of law.  It opposes rule by unconstrained authorities. 

Skipping over ancient thinkers, early modern expressions of classical liberal thought on money may be found in the writings of Nicholas Oresme and other Scholastics who denounced the sovereign’s debasement of the coinage as a dishonest and tyrannical, a violation of the sanctity of contract that a just sovereign must respect.  David Hume in the 1750s refuted the Mercantilist fear that unless the sovereign interfered with freedom of trade and payments the nation’s economy would retain too little silver and gold.  Adam Smith in 1776, and later defenders of free banking in Britain, on the Continent, and in the Americas (my favorite being William Leggett), applied free-trade doctrines to banking and bank-issued currency.  Thomas Hodgskin and Herbert Spencer even dared to defend private coinage.  Walter Bagehot defended the principles of free banking, though he thought it a lost cause politically.  In the twentieth century the Austrian economist Ludwig von Mises gave new subtlety and rigor to the case for free banking.  Friedrich Hayek made somewhat ambivalent cases for gold and free banking earlier in his career, but in the 1970s forcefully called for Choice in Currency and The Denationalisation of Money.

Many leading classical liberals over the centuries, however, have failed to apply their free-trade principles consistently to money.  David Ricardo favored nationalization of coinage and banknote issue, and the forced substitution of redeemable paper notes for coins in all but the largest payments.  John Cobden, the free trader, supported the nationalization of banknotes.  After the Second World War, most of the German Ordoliberals and the Monetarists, led respectively by Walter Eucken and Milton Friedman, made peace with central banking and fiat money.   (Although Friedman, it should be noted, reconsidered his position in the 1980s and began favoring free banking and the abolition of the central bank .)   The otherwise radically free-market theorist Murray Rothbard favored a 100% reserve requirement, with no allowance for capitalist acts among mutually consenting adults who want to contract around that rule. Alternatives to fiat money, central banking,  and deposit insurance were not on the program of the Mont Pelerin Society, a leading international society of classical liberal intellectuals, at its special meeting to discuss the financial crisis in 2009. 

A century ago, before the First World War, economic classical liberals almost unanimously supported the ideals of the international gold standard.  The “classical” period of the gold standard is usually dated from the United States’ resumption of gold payments in 1879 until the suspensions of payments in the First World War.  The gold standard was fatally wounded in the First World War and never fully recovered.  In practice it had not been a completely market-regulated system even before the war.  National governments had long banned market competition in coining by giving themselves a monopoly in the minting of coins.  Many similarly banned market competition in the issue of gold-backed banknotes and gave a monopoly to a government-sponsored central bank.  National central banks violated the “rules of the game” by interfering with, overriding, or suspending the automatic operation of international gold flows.  The centralization of gold reserves, a characteristic feature of central banking, altered the operation of the international gold standard for the worse.

Nonetheless the classical gold standard more nearly approached a self-regulating international monetary system than anything that has followed.  Monetary nationalism and monetary statism since the First World War has brought us to our present system of national fiat monies, central banking, and extensive government interference in financial markets everywhere in the world (with the exception of offshore banking havens).  The global financial crisis that begain in 2007 has exposed the weakness and non-self-regulating character of the present system for all to see. 

Our challenges for the present day, and for this blog, are to discover how we might reform the system in manner consistent with the ideals of freedom. How might we restore healthy self-regulation to our local and international monetary and banking systems? 

Here are some references for the above history, which may also begin to answer Brad Jansen's request for recommendations of classic readings.

Nicholas Oresme, De Moneta (Of Currency) [c. 1355], translated by Charles Johnson, in Lawrence H. White, ed., The History of Gold and Silver (London:  Pickering and Chatto, 2000), vol. 1;  David Hume, “Of the Balance of Trade,” in Essays, Moral, Political, and Literary, ed. Eugene F. Miller (Indianapolis:  Liberty Fund, 1987); Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, ed. R. H. Campbell, A. S. Skinner, and W. B. Todd. (Oxford: Oxford University Press, 1976); Vera Smith, The Rationale of Central Banking [1936] (Indianapolis: Liberty Fund, 1990); William Leggett, Democratick Editorials (Indianapolis: Liberty Fund, 1984); Thomas Hodgskin, Popular Political Economy (London: Charles Tait, 1827); Herbert Spencer, “State-Tamperings with Money and Banks,” in Essays Scientific, Political and Speculative, vol. 3 (London:  Williams and Norgate, 1891); Ludwig von Mises, The Theory of Money and Credit [1912] (Indianapolis:  Liberty Fund, 1980); Mises, Human Action, 3rd ed. (Chicago: Henry Regnery, 1966); F. A. Hayek, Choice in Currency (London: Institute of Economic Affairs, 1976); Hayek, Denationalisation of Money, 2nd ed. (London:  Institute of Economic Affairs, 1978).  David Ricardo, Plan for the Establishment of a National Bank [1824] in The Works and Correspondence of David Ricardo, ed. Piero Sraffa with the Collaboration of M.H. Dobb (Indianapolis: Liberty Fund, 2005), vol. 4, Pamphlets and Papers 1815-1823;  Richard Cobden in 1840 Parliamentary testimony cited by Lawrence H. White, Free Banking in Britain, 2nd. ed (London: Institute of Economic Affairs, 1995), p. 84; Walter Eucken, Grundsätze der Wirtschaftspolitik (Tübingen:  J. C. B. Mohr, 1952); Milton Friedman, A Program for Monetary Stability (New York:  Fordham University Press, 1960); Friedman,  “Monetary Policy for the 1980s” in John H. Moore, ed., To Promote Prosperity (Stanford: Hoover Institution Press, 1984); Murray N. Rothbard, “The Case for a 100 Percent Gold Dollar” in Leland Yeager, ed., In Search of a Monetary Constitution (Cambridge, MA: Harvard University Press, 1962).


  1. Quantity theorists like Ricardo, Cobden, Rothbard, etc. violated their own free trade principles because they thought that fractional reserve banking expanded the money supply and thereby caused inflation. Rothbard, for example, thought every fractional reserve bank was a counterfeiter and the central bank was the head counterfeiter.

    What they failed to see is that when a bank or government issues new money, they normally get new assets of equal value. Assets rise in step with the quantity of money, so the issuance of new money does not cause inflation, and banks and governments are not counterfeiters. If quantity theorists understood this, they would favor free banking. But not only do fail to understand it, they fight against it.

    1. Mike,

      For the sake of simplicity, let's say that the price of goods on the market is equal to the quantity of money in circulation divided by total goods in an economy(M/TG). To illustrate, let's say TG = 1,000 and M = 1,000, so that M/TG = 1. The price of each good is equal to 1 monetary unit.

      Now, a central bank increases the quantity of money in circulation to 2M. It's now 2,000/1,000 = 2 monetary units.

      Whatever "assets" were purchased to make this monetary expansion possible represent either an already existent asset or a new imaginary asset that corresponds only to fiduciary media. For instance, the Federal Reserve may gain an asset by opening a bank account.

      That an asset was gained, in other words, does not necessarily mean that there will be no inflation. As my simplified example clearly suggests, there will be inflation.

      But, let's not pretend that the disagreement is in the concept of gaining an asset in exchange for credit expansion. The disagreement is in the quantity theory of money.

      1. Jon:

        My point is that the price level will NOT equal the quantity of money divided by total goods, and yet that is your starting assumption. If some bank accepts 100 oz of silver on deposit, and issues 100 paper receipts ("dollars") in exchange, then the value of each dollar is 1 oz. By your M/TG example, the value of a dollar would be 100/1000. The trouble is the unspoken assertion that the 100 dollars are somehow a claim to the 1000 units of goods produced in the economy. They are not. The 100 dollars issued by the bank are a claim to the assets of the issuing bank, and nothing else.

        If the bank accepted another 200 oz on deposit and issued another 200 dollars, then the value of each dollar will still be 1 oz., even though the quantity theory would lead people to think that the tripling of the quantity of dollars would cut their value by 2/3.

        If the bank then accepted a deposit of miscellaneous goods worth 300 oz. (accompanied, let us suppose, by a promise to deposit more land if the deposited land should fall in value relative to silver) then there are $600 laying claim to 600 oz. worth of assets, and the dollar is still worth 1 oz., in spite of what the quantity theory says.

        1. But the monetary value of a good is a factor of how much money is being bid towards it. I'm not talking about the price of paper receipts; I'm talking about the price of goods in demand, denominated in your currency of choice.

          1. If each paper receipt (dollar) is worth 1 oz of silver, and if a basket of groceries costs 1 oz of silver, then the price of that basket will be $1. It's the amount of silver being bid for groceries that determines the price of groceries. That price then determines how many paper dollars it will take to buy those groceries.

  2. Your second paragraph sounds like support of the real bill doctrine. If assets and the prices of those assets rise in step with the quantity of money, then as more money is issued the prices of those assets would rise. Which in the next round of higher asset prices would cause an even greater quantity of money to be issued causing asset prices to rise further. On and on it would go with asset prices rising and the quantity of money backing those assets rising further and further. So far from asset prices rising in step with the quantity of money not causing inflation, the exact opposite would happen and would lead to an explosion of inflation.

    Or the other situation could happen with a falling price level. Falling asset price would require a smaller money supply, causing asset prices to fall farther. The next round of money issue would be even smaller with falling asset prices leading to a deflationary spiral. An article by Thomas Humphrey spells this out in an article called “The Real Bills Doctrine”.

    I have found this to be a very persuasive article against the real bills doctrine.

    1. This whole for and against thing concerning the real bills doctrine seems pointless.

      In an economy with unregulated banking you couldn't put a stop to it even if it was inflationary. However it is unlikely to be inflationary due to the fact that as seen in the Scottish free-banking era banks are very restrained in how much currency they can produce. If they produce too much then when the clearing takes place that bank will end up owing the other banks more gold and risk insolvency if they have to pay out too much.

      Also what is inflationary about purchasing the rights to an income stream? That's all the RBD is. The producer of goods has an invoice and he has to wait 30-60-90 days for it to pay off but wants the money now and is willing to sell* the bill at a discount to get that cash, some other firm has money and is willing to wait for the goods to be sold and when they are sold (provided things went correctly) they will get the value of the invoice. And their profit being whatever the discount was (minus costs of course.)

      So where is the inflation? If it was gold coins that were used it would be obvious that there was no inflation because you just can't print up gold on demand. The bank drew down it's gold stores to buy the invoice and that money went into circulation via the producer and then that hole in the bank's account was totally refilled plus the extra from the discount by the purchase of the product.

      No new money was created. Nor did it need to be created.

      Now if the bank paid with notes or tokens or some other fiduciary media and created that money for that purpose it might look inflationary because there are a bunch of new notes out there but they are still I.O.U.s on the bank and will make their way back and any overage owed to other banks will have to be redeemed in gold.

      So if the bank has paid out 1000 units in it's own token currency and in 60 days gets paid 1020 worth of their currency in gold those outstanding notes will be fully redeemed and extinguished leaving the firm up 20 units worth of gold. If they got paid in tokens or notes then they will have to undertake to convert it. But that's just an extra step and doesn't change anything for the example.

      It doesn't matter if it's one firm buying invoices or 100 or 10000 in a given area the flow of gold into the area will cover all the notes (again provided sales go well and assuming competence on the part of the banks.)

      The pro side on RBD seems to view it as some near mystical thing that will solve all our problems while the anti side is skeptical and views it as crank economics. But all it is is one liquidity tool in the toolbox of capitalism. One of many things that makes commerce easier on everybody.

      A falling price level is not always a bad thing. If prices are falling because production has become more efficient then that is a happy time! If one year your income is X and the bundle of things you need is X and then the next year your income is still X but your bundle of needs is X -3% then you're better off by 3%. You can either save the excess for future consumption or buy more or better stuff now. Either way your standard of living will increase.

      If prices are falling because of incompetence by monetary authorities than yeah, that sucks. However as Selgin has shown there was but one tiny crisis in Scotland and none at all in Canada during their free-banking eras so it's difficult to imagine such systemic government-level incompetence in the unregulated private production of currency that would cause a problem in an economy using real bills.

      *If I were the producer I would not be interested in a loan. I would want to sell that invoice and end my part in this chain straight away. A loan I have to pay back and I'm still tied into the process but if I sell I'm done. And I can concentrate on more production rather than on making sure I get paid by the wholesaler and then making sure I repay that loan. Those are multiple functions that I need not do or have staff to do which would save me time, effort, and money. But that's just me.

      1. Warren:

        I agree, except that the discussion is not pointless.

        Free banks will naturally follow real-bills policies if the government will just leave them alone. The problem is that the government will not leave them alone, and the reason it won't leave them alone is that the government is dominated by quantity theorists, who believe that all fractional reserve banks are no better than counterfeiters.

        Educating the public about the real bills doctrine (aka the backing theory of money) could possibly reduce this source of hostility to free banking.

        1. One of the things I don't understand about the RBD is why it's called "the real bills doctrine" isn't "factoring" a good enough word? Or even "forfaiting" if that is closer to the concept?

          What's the difference between the RBD and these currently in use concepts that it needs a whole new phrase to describe it? Why do we need the RBD if we have access to factoring?

          I was not aware of just how widespread factoring is and has been in history (thanks Google! If I'd done a search first I could have saved some words in my previous post!) I thought the RBD folks were trying to revive some long dead business tactic that had been purposefully driven out or rendered moot by government interference.

          1. Warren:

            The RBD (aka backing theory) encompasses more forms of money issuance than factoring. For example, if a bank lends 100 newly-issued dollars to someone who offers a lien on his house, then the bank has followed the real-bills rule of only issuing new money in exchange for assets of adequate value, but that action would not be considered "factoring".

    2. Tom:

      If you google 'real bills doctrine', you'll find my real-bills website at about the second link. Once at my website, click on "Three False Critiques of the Real Bills Doctrine", which spends a page or two answering Lloyd Mints' critique of the real bills doctrine, which you and Humphrey have summarized pretty well.

      Briefly, the problem with the refutation of the real bills doctrine is in this sentence:

      "If assets and the prices of those assets rise in step with the quantity of money, then as more money is issued the prices of those assets would rise."

      Now, the real bills doctrine says that if new money is issued in exchange for equal-valued assets, then the money will hold its value and Mints' "self-perpetuating cycle of more loans, more money, and higher prices" will never get started. But that sentence of yours assumes that the initial issue of new money, even if adequately backed by new assets, will cause inflation. In other words, your sentence assumes what it is trying to prove. It assumes the incorrectness of the real bills doctrine on its way to trying to prove the incorrectness of the real bills doctrine.

      By the way, everyone recognizes that a firm can issue new stock, and as long as it gets new assets of adequate value, the value of the stock will not change.

      1. Mike,

        I would only direct your attention to footnote 2 in Thomas Humphrey's article, which I linked to above. At the end of footnote 2 he says, "Its [the Real Bills Doctrine] error lies in treating prices as exogenous when in fact they are determined by the money stock itself".

        By the way, I don't think there is anything wrong with the quantity theory of money nor am I aware that the contributors to this blog who are promoting Free Banking would deny the value of the quantity theory of money. Perhaps you could say why you think Free Banking and the quantity theory of money are incompatible. And what you feel is the relationship between Free Banking and the Real Bills Doctrine. Or perhaps you don't want to and that's fine. It's just that I don't see the connections.

        1. Tom and George:

          I'll start by saying that the I prefer "backing theory" to "real bills doctrine", since the popular understanding of the real bills doctrine has become corrupted over 3 or 4 centuries. But if the two theories are properly understood (and they usually aren't) they are identical.

          That said, take my example of 100 oz. of silver backing 100 paper receipts called dollars. If things change so that there are now 300 oz. backing $300, then each dollar remains worth 1 oz. If things change again and there are $600 backed by 300 oz of silver plus miscellaneous goods worth 300 oz., then each dollar is still worth 1 oz. If dollars sold for .99 oz or for 1.01 oz., arbitragers would have a money machine.

          Of course the price level is exogenous. $1 must always be worth 1 oz., no matter how many dollars are issued. Humphrey is mistaken when he says that prices are determined by the money stock. Prices are determined by the amount of backing per dollar.

          A backing theorist would have no objection to banks issuing as much or as little money as they choose, as long as those banks acquired new assets of adequate value as they issued the new money. A quantity theorist, on the other hand, thinks that the increase in the money supply will cause inflation, thus robbing the holders of existing dollars. It is on these grounds that they (wrongly) oppose free banking.

          I don't think much of statements like "it is not regarded as sound by any competent monetary economists today", as if to say "Truth is what the majority believes, as long as the majority agrees with me." But you will find that the fiscal theory of the price level (another incarnation of the backing theory) is supported by Cochrane, Woodford, Sims, etc., each of whom might inspire the proper reverence among people who prefer not to think for themselves.

  3. For the record, Larry and I (I feel I speak for him on this) both utterly reject the real-bills doctrine, and regret the tendency for it to be treated as part of our own understanding of how free banking systems work. It is not a sound doctrine; it does not supply either a sufficient or a necessary basis for limiting the supply of bank money to the "needs of trade"; and it is not regarded as sound by any competent monetary economists today–at least not as traditionally understood. It has been subjected to withering refutations by Henry Thornton; by Knut Wicksell; and by Loyd Mints, among others. Finally, despite common claims to the contrary, it plays no crucial part in Adam Smith's (generally very sound) understanding of money and banks.

    Please, everyone: if you want to link free banking theory to the real-bills doctrine, please take care not to suggest that you are presenting the theory as understood by Larry and myself and by the other more prominent free bankers. It can of course be part of your own theory if you like; but it's no part of ours!

    1. I certainly agree with George. To clarify, if I may speak for him, "needs of trade" in his statement denotes the demand to hold bank-issued money, while "the real-bills doctrine" denotes the false view that if the central bank (or the banking system as a whole) limits its money-issuing to transactions in which it acquires the right sort of assets, it can't create an excess supply of money. See my critical discussion of the RBD in Free Banking in Britain, 2nd ed., ch. 5 (pdf at; see Selgin, George A.. 1989. The Analytical Framework of the Real-Bills Doctrine. Journal of Institutional and Theoretical Economics 145.3 (September):489-507; see also David Glasner's piece which finds a small germ of truth in a version the RBD limited to a single bank, namely that a bank issuing redeemable liabilities should stay liquid, at

      1. Larry:

        You have stated the real bills doctrine in what I have called its "corrupted" form, which is loosely based on the idea "that so long as a bank issues its notes only in the discount of good bills, at not more than sixty days’ date, it cannot go wrong in issuing as many as the public will receive from it." (Fullarton, 1845). A "good bill" is understood to mean one that is
        1. of adequate value
        2. based on productive activity (ok to lend to a carpenter or farmer, but not to a tourist or gambler)
        3. short term

        In my view, (2) and (3) are irrelevant. For example, if a bank issues $100, while getting assets worth 100 oz. in exchange, then each dollar remains worth 1 oz., regardless of whether it financed short term, productive activity. Adequacy of backing is all that matters.

        The popular view, which you seem to advocate, focuses only on (2) to the exclusion of (1) and (3). The idea is that if money is only issued for productive purposes, then the money supply will move in step with the quantity of goods produced. In the equation of exchange, MV=Py, the claim is that issuing money for productive purposes causes M to move in step with y, and thus maintain a stable price level. This version of the real bills doctrine is full of holes, and that's what real bills critics have always attacked.

        So just like economists have done for centuries, we are talking at cross purposes, with me defending the "backing theory" version of the real bills doctrine, and you attacking the "productive loan" version.

        1. Mike, in my comment on George I deliberately characterized the RBD as broadly as possible ("acquires the right sort of assets") so as to cover what you call the "backing theory," in which "right sort" means (as you put it) "of adequate value." It might help avoid confusion if you were to stop calling what you defend "the real bills doctrine" and simply call it "the backing theory of money." I don't believe that "adequacy of backing" is all that matters. Even if a central bank issuing gold-redeemable notes and account balances retains the same net worth as it expands its balance sheet, it can still create an excess supply of money.

          In any case, criticizing the RBD wasn't the point of my blog entry, so let's move on.

          1. Larry:

            I do call it the backing theory most of the time, but of course we have 4 centuries worth of entanglement between the two ideas to deal with.

            If a central bank issues notes redeemable for 1 oz of gold, and if its net worth stays the same as it expands its note issue (or, more correctly, if net worth stays at a level that always allows the bank to buy back its notes at par), then each note remains worth 1 oz. of gold and any excess notes will reflux to the bank as fast as they are issued. Such a bank cannot create an excess supply of money.

            You asked "how we might reform the system in manner consistent with the ideals of freedom. How might we restore healthy self-regulation to our local and international monetary and banking systems?" I answered that we could do it by explaining the backing theory to quantity theorists, in order to convince them that unregulated banks are not like counterfeiters. That's not a point to move on from. It's a point that should be central to the discussion.

  4. Gentlemen,

    I have some questions on this issue.

    The 2% or so reserves that the Scottish banks carried were like their buffer against having the shareholders have to sell off personal property to redeem notes, yes? So a bank need not go out of business if this capital is used up as long as enough personal property could be sold to make up the difference?

    What would cause a bank to call it's loans? If there was a problem and a bank had to call some or all of it's loans how did that help as it's loans were made in it's own currency, the currency that in this hypothetical example, no one wants anymore?

    How much gold was deposited with these banks? Did the banks add this gold to their reserves? And if the banks did not use it as reserves what did they do with it or where did it go?

    Why was branch banking in the U.S. so restricted? And did people get around this by opening multiple but allied banks? Because that's what I would do: The banks might all have different names but their notes would be surprisingly similar and redeemable at any allied bank.

    Speaking of notes will there still be a need for them and coins in the future considering the rise in the use of debit cards? I would hate to see debit cards eliminate notes as I, and I suspect many others, like notes and coins for various reasons.

    Thank you.

    1. Also, I forgot to ask if you have any plans for a links page so that easy access to all the articles you all have written that are scattered about the web can be managed from this one site?
      I see many listings in the bios but I'm thinking of something indexed by subject.

  5. Larry White,

    Interesting post. Do you know where Bagehot defends free banking principles?

    1. In his famous Lombard Street. I should have added that work to my list of references. I particularly had in mind this passage, ch. 2, para. 63:

      But it will be said—What would be better? What other system could there be? We are so accustomed to a system of banking, dependent for its cardinal function on a single bank, that we can hardly conceive of any other. But the natural system—that which would have sprung up if Government had let banking alone—is that of many banks of equal or not altogether unequal size. In all other trades competition brings the traders to a rough approximate equality. In cotton spinning, no single firm far and permanently outstrips the others. There is no tendency to a monarchy in the cotton world; nor, where banking has been left free, is there any tendency to a monarchy in banking either. In Manchester, in Liverpool, and all through England, we have a great number of banks, each with a business more or less good, but we have no single bank with any sort of predominance; nor is there any such bank in Scotland. In the new world of Joint Stock Banks outside the Bank of England, we see much the same phenomenon. One or more get for a time a better business than the others, but no single bank permanently obtains an unquestioned predominance. None of them gets so much before the others that the others voluntarily place their reserves in its keeping. A republic with many competitors of a size or sizes suitable to the business, is the constitution of every trade if left to itself, and of banking as much as any other. A monarchy in any trade is a sign of some anomalous advantage, and of some intervention from without.

      1. Larry, somewhat related to your comment above "if Government had let banking alone," I was reading your "Free Banking in Britain" and was astonished to read in Chapter 2 that the chartering of free banks could mean unlimited liability for bank shareholders in the event of a bank failure.

        I was under the impression that chartering always meant limited liability. Why isn't this feature of 18th century Scottish banking front and center here? It's one thing to talk about fractional reserve banking backed by bank shareholders and quite another where courts limit bank liability under the vague Business Judgment Rule. If government would "let banking alone" in the sense that it would stop limiting the liability of banks who engage in reckless fractional reserve practices, we'd have a banking system that was largely self-regulating, despite whatever barriers to entry unlimited liability may create.

        On page 29 you refer to unlimited liability as "one of the most remarkable features of Scottish free banking," and on page 38 you raise a huge legal issue by noting that the enforcement of liability against the shareholders of a failed bank "was facilitated by Scottish bankruptcy law, which was stricter than English law. In England only the personal estate of an insolvent debtor could be attached. A Scottish creditor was legally entitled to the debtor's real and heritable estate as well." Again, the possibility that banking corporations can be denied government-supported limited liability sheds a whole new light on fractional reserve banking.

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