Free Banking vs Banking Panics

“Panics” are not an inherent aspect of free banking

by CARL SVANBERG 

In the 19th century America experienced one banking “panic” after another: 1819, 1837, 1857, 1873 and 1893. These recurring “panics” allegedly proved what happens in a completely unregulated banking system, a banking system free from the enlightened supervision of the government. To bring order and stability, the government had to step in and regulate the banks. With time, it would also have to establish a government run central bank, the Federal Reserve, as the “lender of last resort”. You have probably heard some version of this story before. This is, after all, the “conventional wisdom”. It is also complete fiction.

It’s true that America suffered from “panics” in the 19th century. But why? Because various government regulations made it difficult for bankers to act as rational businessmen. For one thing, interstate branch banking was illegal. This made banks dependent on the local business, making it virtually impossible to diversify risks. As a consequence banks became under-diversified and undercapitalized. Banks were, furthermore, forced to back up their money stock with state bonds. And since states had a tendency to go bankrupt, there was a justified fear that these bonds would eventually lose their value. When the bonds were losing their value banks quickly became insolvent and they had to declare bankruptcy. The “panics” were, in other words, caused by regulations. Indeed, it’s been estimated that 80% of the bank failures were caused by such destabilizing regulations. (Fribanksskolan, Per Hortlund, p. 50; pp. 134-136.)

It’s worth noting that the Swedish, Scottish and Canadian bankers didn’t have to submit to such irrational regulations; they were free to act on their rational judgment. As expected they didn’t suffer, to the same extent, from any recurring “panics”. Indeed, during Sweden’s 70 years (1830-1900) of free banking not a single bank failed. In Scotland some banks failed, but the losses were very small (between 1695-1841 the total loss for bank customers amounted to £32,000, which is half of the total losses in a single year, 1840, in London). During the Great Depression not a single bank went bankrupt in Canada. By comparison more than 9.000 banks went bankrupt in the US. (Ibid.)

The Federal Reserve wasn’t introduced to bring order and stability to the panic ridden, “unregulated” banking industry of the 19th century. No, the banking industry of the 19th century was destabilized by destructive government interventions, which were forcing and/or encouraging the bankers to act irrationally. The introduction of the Federal Reserve is, therefore, an example of the principle that controls breed controls.

In the absence of the Federal Reserve, functioning as the “lender of last resort”, banks will be less willing to make risky and irresponsible loans, since there will be no Alan Greenspan or Ben Bernanke around to bail them out. It’s, therefore, no wonder that the “panics” of 1800s were, in addition, shorter and milder than the booms and busts of the 20th century, not to mention the 21th century.

Consequently, economist Charles W. Calomiris observes in a paper that “[n]one of the U.S. banking panics of the pre-World War I era saw nationwide banking distress (measured by the negative net worth of failed banks relative to annual GDP) greater than the 0.1% loss of 1893″. During The Great Depression, on the other hand, “[b]ank failures resulted in losses to depositors in the 1930s in excess of 3% of GDP”. (“Banking Crisis,” Charles W. Calomiris, pp. 2-5.)

What accounts for the difference? “Market discipline (the fear that depositors would withdraw their funds) provided incentives for banks to behave prudently”, writes Calomiris. “The picture of small depositors lining up around the block to withdraw funds has received much attention, but perhaps the more important source of market discipline was the threat of an informed (often ‘silent’) run by large depositors (often other banks). Banks maintained relationships with each other through interbank deposits and the clearing of public deposits, notes, and bankers’ bills. Banks often belonged to clearing houses that set regulations and monitored members’ behavior. A bank that lost the trust of its fellow bankers could not long survive”. (Ibid.)

The historical record in Sweden, Scotland and Canada does, indeed, show that “panics” are not an inherent aspect of free banking. Quite the contrary. Thus, if we want to avoid panics in the future, then the lesson is that we should liberate the bankers; we should leave the bankers free to act rationally. What we should embrace is, in other words, real free banking: laissez-faire banking.