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Free Banking and Economic Development, Part 1

(A few years ago I was hired to contribute some articles on free banking and related subjects to an online forum called the Free Market News Network. I wrote several before the checks stopped coming, and then insisted that those already published be taken off the site, which has since ceased to exist.

For a long time I thought the articles were lost for good. But I recently uncovered them on a UGA backup drive, and so have decided to make some of them available again here.)


Some self-styled friends of the free market think the world would be better off without fractional-reserve banks. They believe, among other things, that fractional reserves are inherently fraudulent and that they promote business cycles. Lawrence White and I have addressed these and related criticisms of fractional reserves both in this forum and elsewhere. Here I wish not to refute claims concerning supposed disadvantages of fractional-reserve banking, but to point to one of its crucial advantages—an advantage its opponents studiously ignore.

This advantage has to do with economic development, and industrial development especially. To state the matter baldly: the most tangible achievements of the free market—the vast improvements in technology and productivity, the industrial plant and infrastructure from which these derive, and the extensive retailing networks that deliver industry’s fruits to consumers—would be far more meager were it not for past and present lending financed by fractionally-backed bank liabilities. To condemn fractional-reserve banking in any form is, in other words, to strike a blow, albeit unwittingly, at one of the supporting pillars modern capitalism.

This claim is hardly unique to modern-day champions of free banking. It has, on the contrary, been widely subscribed to by economists since the very beginnings of industrialization. Although The Wealth of Nations (1776) appeared when Great Britain’s Industrial Revolution was just getting started, that didn’t keep Adam Smith from noticing the substantial contribution fractional reserves had made to British, and especially Scottish, industrial development. Smith’s homage to fractional reserves occurs as part of his refutation of Mercantilism, with its naive identification of a nation’s wealth with its stock of coin and bullion. That stock, Smith says,

makes no part of the revenue of the society to which it belongs; and though the metal pieces of which it is composed, in the course of their annual circulation, distribute to every man the revenue which properly belongs to him, they make themselves no part of that revenue.

Indeed, Smith goes on to say, the real resources devoted to producing a nation’s money—to that “great wheel of commerce” that makes efficient exchange possible—are necessarily diverted from the production of other goods and services. Fractional reserves promote real economic growth by reducing the cost of money—what today’s economists might term money’s “opportunity cost”:

The substitution of paper in the room of gold and silver money, replaces a very expensive instrument of commerce with one much less costly, and sometimes equally convenient. Circulation comes to be carried on by a new wheel, which it costs less both to erect and to maintain than the old one….[T]he circulating notes of banks and bankers are … best adapted for this purpose.

Public confidence in Scottish banknotes was already such in Smith’s time as to allow exchanges in that country to be conducted with only a fifth as much gold and silver as would have been needed had coins alone been used. The savings on metallic money translated into a corresponding increase in Scotland’s working capital. “The operation,” Smith says, “resembles that of the undertaker of some great work, who, in consequence of some improvement in mechanics, takes down his old machinery, and adds the difference between its price and that of the new to his circulating capital, to the fund from which he furnishes materials and wages to his workmen.” Scotland, a relatively backward and poverty-stricken country at the onset of the 18th century, was by Smith’s day rapidly catching up with England, the world’s wealthiest country. That Scotland’s fractional-reserve banks had “contributed a good deal to the increase” in Scotland’s wealth was, according to Smith, a matter that “cannot be doubted.” No wonder Smith favored free banking, or something very close to it. He approved of only two special banking regulations—and approved of them, I should add, on rather faulty grounds. The regulations, which dated from 1765, were the outlawing of notes for less than one pound and of “optional clause” notes giving banks the contractual right temporarily to suspend specie payments. That Smith had nothing good to say about permanently irredeemable, “fiat” money should go without saying.

Economic research since Adam Smith’s day has mainly tended to bolster his favorable views on fractional-reserve banking, both by amassing evidence of its beneficial effects and by delving more deeply into the basis for fractional-reserve banks’ unique ability to harness scarce savings and put them to good use. In the second part of this essay, I will briefly review some of these “post-Smithian” findings.