Scottish Banking before 1844: A Model for Laissez-Faire?
Cowen, Tyler, Kroszner, Randall, Journal of Money, Credit & Banking
Scottish Banking before 1845: A Model for Laissez-Faire?
ECONOMISTS HAVE BEGUN TO DEVOTE increasing attention to what the banking and financial system would look like if trends toward laissez-faire, through both deliberate deregulation and financial innovation, continue. One group of authors, who may be labeled the modern free banking school (e.g., White 1984a and b, O'Driscoll 1986, Selgin and White 1987), focus upon the experience of eighteenth and early nineteenth century banking in Scotland as the primary illustration of how an unregulated banking system would operate. For these writers, the Scottish system provides the paradigmatic case of the unhampered evolution ofa financial system. In this view, laissez-faire would create a system of banking based upon short-term nominally fixed debt liabilities redeemable in some form of outside (usually commodity) money. There would be a sharply defined money supply. Banks would not be simply pure intermediaries; they would issue non-interest-bearing notes on a fractional reserve basis and provide other transactional services.
The "free banking" perspective contrasts with the analysis of the "legal restrictions theory of money" and the "new monetary economics," (LRT-NME) (Black 1970, Fama 1980, Hall 1982, Greenfield and Yaeger 1983, Wallace 1983, and Cowen and Kroszner 1987a and b, 1988). In this view, our monetary institutions, e.g., the fixed nominal value, debt-based nature of banking claims, have been shaped by legal restrictions affecting private financial intermediation. Under laissez-faire,the money supply would no longer be well defined, and exchange media could assume such forms as equity shares, similar to today's money market mutual funds, and small-denomination interest-bearing assets. Banks would be little more than pure financial intermediaries offering diverse portfolios against which "depositors" would hold claims, much like transferable mutual fund shares (Fama 1980). These asset-claims need not be convertible into an "outside" money such as gold but instead may pay interest or fluctuate in capital value. In this way, it may be possible that the transactions media would not bear a fixed relationship with the unit of account, in contrast with the current system in which Federal Reserve Notes are denominated in dollars (see Cowen and Kroszner 1987b and 1988).
Without legal restrictions, "it is hard to see why anyone would hold non-interest-bearing currency instead of interest-bearing securities" of similar default risk and negotiability (Wallace 1983, p. 1). The demand for portfolio-dominated assets - today, Federal Reserve Notes - arises because legal barriers restrict the use of other assets for transactions and settlement purposes. If entry into the financial intermediation industry were free, then private firms could "break up" large-denomination Treasury securities into small-denomination bearer bonds to suit transactors' wishes. Competition among intermediaries would ensure that the interest rate paid on the small-denomination bonds equals the rate on large-denomination bonds minus the cost of intermediation. Wallace (1983, p. 4) concludes that under laissez-faire either nominal interest rates would be driven down to the costs of denomination arbitrage, thereby eliminating the wedge between the returns on bonds and non-interest-bearing money, or existing government currency would become worthless since interest-bearing media would portfolio-dominate it.
This approach has been criticized for its apparent conflict with the historical record of monetary and financial institutions. White (1984b, p. 707) questions whether a payments system could evolve in which there is no convertibility to an outside money, and equity instruments are used for transactions purposes by citing "the historical fact ... that deposit banking did not naturally grow up upon an equity basis." In addition, White (1987, pp. 450-51) uses the eighteenth and nineteenth century Scottish banking experience to test the predictions of thelegal restrictions theory, arguing that the coexistence of non-interest-yielding paper currency with interest-yielding bearer assets during this "free banking" era cannot be explained by legal restrictions. …