FIGURES

  1.   Microeffects of an Increase in k

  2.   Macroeffects of an Increase in k

  3.   Microeffects of a Decrease in Goods’ Production Costs

  4.   Macroeffects of a Decrease in Goods’ Production Costs

  5.   Microeffects of an Increase in Specie Reserves

  6.   Macroeffects of an Increase in Specie Reserves

After the first edition of this book appeared in 1993, I turned away from many of the banking issues explored herein. Anarchocapitalism, taxation, and public goods in maritime history occupied most of my professional attention, while at the same time there was an ongoing personal project, a 1300-page manuscript analyzing merchant sailing ship performances, on which I have been working for some 20 years. I continued to think and write about business cycles, but largely left free banking behind.

Free banking is—or at least ought to be—one of the key economic issues of our time. There is mounting evidence that the monetary instability created by the Federal Reserve—persistent and often erratic inflation, the unpredictable shifts of Federal Reserve monetary policy, and the gyrating interest rates that accompany both inflation and the monetary policy that creates it—have inflicted colossal damage on the U.S. economy and on the fabric of American society more generally. Furthermore, much as the United States has suffered, less fortunate countries have suffered far more.

The debate over free banking is one of the most important in economics today. It is perhaps the penultimate debate between those who advocate free markets and those who embrace (at least partial) central planning. Macroeconomic monetary policy conducted by a central bank is the last bastion of both methodological holism and the “constructivist rationalism” such holism often spawns. To advocate free banking is to mount an assault upon that citadel.

It is no longer possible to deny that there exist widespread academic concern for and dissatisfaction with the American financial system. In particular, various regulatory agencies have been singled out for criticism. The FDIC, the now-defunct FSLIC, and the Federal Reserve have all come under fire in the recent past.

The purpose of this chapter is to offer a formal interpretation of the most detailed verbal treatment of free banking extant: George Selgin’s explanation of such a system structured around a specie-convertible currency (1988a, 1988b, 1990). The key points in Selgin’s argument, as well as the relevant features of the present work, will be identified. A mathematical model will be constructed from which comparative static equilibrium conclusions will be drawn. Also, graphical illustrations of the various parametric effects will be offered.

The question of which monetary regime is optimal has several facets. Ethically, the question may be about which regime is consistent with a “rule of law,” procedural justice, and individual rights. Socio-politically, one may ask which regime minimizes rent-seeking behavior on the part of special interest groups. In a technical economic sense, one may inquire as to which institutional structure minimizes the destructive effects of business cycles. This chapter will examine the relationships between free banking and cyclical stability.

At one level, the collapse of socialism seems, indeed, to be all around us. The Soviet Union and East Germany no longer exist. Poland and Romania have overthrown their Socialist hierarchies. The Berlin Wall is in pieces; the Iron Curtain seems irreparably torn. In many parts of the world, the rhetoric—if not the action—is that of the free market.

The three previous chapters have presented a number of theoretical arguments for free banking. One must turn now to the historical side of this issue. This chapter is devoted to a look at Scottish free banking. Chapter 6 will examine the American experiment with multiple issuers of notes. These are probably the best-known and best-documented cases of free banking. However, the reader should be aware of a problem that persists with any review of these periods.

The previous chapter presented reasons why one should question Lawrence H. White’s popular portrait of Scottish free banking. Scottish banking seems to have been both less free and less successful than White’s work would lead one to believe. Here free banking in the United States will be examined. Once again, reasons will be given for rejecting the popular view, but in the other direction. American free banking will be shown to have been significantly safer and more stable than is usually believed to have been the case.