The Rationale of Central Banking and the Free Banking Alternative
By Vera C. Smith
The Rationale of Central Banking invites us to reassess our monetary institutions and give reform proposals due consideration. The decades since it first appeared in 1936 have restored its themes to relevance. Government-dominated monetary systems have continued to perform poorly. Other experience, as well as the work of James Buchanan and the Public Choice School, has heightened skepticism about government generally. People are now willing to discuss what Vera Smith set out to examine: “the relative merits of a centralized monopolistic banking system and a system of competitive banks all possessing equal rights to trade” (p. 3)…. [From the Preface, by Leland B. Yeager]
First Pub. Date
Indianapolis, IN: Liberty Fund, Inc. Liberty Press
The text of this edition is under copyright.
The Scottish System
But for the fact that the Act of Union was just over a decade too late, the Bank of England might have been the Bank of England and Scotland. As it was, however, Scottish banking developed along independent lines. At the beginning, the practice of giving concessions by charter was followed. The Bank of Scotland, founded by a group of Scottish merchants in 1695, only a year after the establishment of the Bank of England, received under Charter from the Scottish Parliament a monopoly for twenty-one years. This Bank experimented almost immediately with a policy of setting up branches, and it also issued notes for denominations as low as £1. When in 1716 the Bank’s monopoly expired, it protested strongly against threats of competition, but without success, and in 1727 a second charter was granted to the Royal Bank of Scotland.
The primary object of forming under special charter was that the Bank obtained thereby the right to limited liability, but there was no restriction in Scotland on the liberty of joint stock companies to set up in the banking business so long as the shareholders were willing to accept unlimited liability for the debts of the association, and not much time elapsed before unchartered banks of this kind were starting up all over the country.
Only one further charter was granted: this was to the British Linen Company in 1746. All the other banks formed under the ordinary law. There was no restriction on the number of partners and, after a short period of abuses in the experimental stage, banking came into the hands of a number of substantial joint stock companies of considerable size and financial strength. The collapse of the Ayr Bank in 1772 after an over-issue of notes did a great deal of damage to the credit of the smaller banks; most of the little private banks went out of business and their place was taken by joint stock banks or private banks with larger capital resources.
The Scottish system developed certain characteristics which early distinguished it from the systems in other countries. There was keen competition between the banks and they kept very strictly to the practice of regularly clearing each other’s notes; exchanges were made twice a week and the balances immediately settled. They adopted branch organisation almost from the beginning, and there was, as compared with other countries, a much more rapid growth of deposit banking and development of loan technique.
In 1826 there were, besides the three chartered banks (with twenty-four branches), twenty-two joint stock banks (with ninety-seven branches) and eleven private banks, whereas in England legislation was only just being passed to permit joint stock banks to establish, and not even the Bank of England had yet set up any branches. Right up to that time there had only been one serious failure in the history of Scotch banking—the Ayr disaster—and it was computed that the total loss sustained by the public had not exceeded a figure of £36,000.
The Scottish network of solid institutions, free from legislative interference, with an already highly developed deposit business—its marked success and its freedom from the excesses which lead to suspensions—could not help but impress English eyes at a time when large numbers of the small country banks in England were foundering. Still more, perhaps, did it impress the protagonists of free banking on the Continent.
The investigations by Committees of both Houses of Parliament in 1825 into the supposedly evil practice of the issue of £1 notes and the suggestion that it should be prohibited alike in Scotland as in England aroused bitter indignation in Scotland. The Scottish community had become, by long use, accustomed to handling £1 notes instead of gold in their daily transactions, and it was consequently not from the banking interests alone that the protests derived. Notable among the antagonists was Sir Walter Scott. It was, indeed, difficult for the promoters of the 1826 legislation to claim on the experiences of Scotch banking that the issue of £1 notes had had any catastrophic results.
Scotland escaped the censure of its £1 notes, but had to submit to the Peel regulations of 1845. These conferred a monopoly of the note issue on the then existing Scotch banks. The fiduciary issue of each bank was limited to a maximum fixed on the basis of an average taken over the previous year, but, unlike the English banks, the Scotch ones could issue notes above this fixed limit so long as they backed the extra notes a 100 percent by gold, and also if two banks fused they might retain a fiduciary issue equal to the combined issues of both.
The regulation imposed by the Act was regarded with dissatisfaction for many years afterwards. In 1864 complaints were coming from Scottish quarters that owing to bank extinctions Scottish note issues had diminished and Bank of England notes were not fitted to fill the gaps because they were not issued below the denomination of £5. And for the comfort of the opponents of Peel’s legislation the next thirty years witnessed two of the worst failures the Scottish banking system had ever experienced, comparable only with that of the Ayr Bank a century before. These were the collapse of the Western Bank in 1857 and of the Glasgow Bank in 1878.