Free banking is a monetary arrangement where banks are free to issue their own paper currency (banknotes) while also being subject to no special regulations beyond those applicable to most enterprises.
In a free banking system, market forces control the total quantity of banknotes and deposits that can be supported by any given stock of cash reserves, where such reserves consist either of a scarce commodity (such as gold) or of an artificially limited stock of fiat money issued by a central bank.
In the strictest versions of free banking, however, there is either no role at all for a central bank, or the supply of central bank money is supposed to be permanently "frozen". There is, therefore, no government agency acting as a monopoly "lender of last resort", leaving that to the private sector as happened in the US in the panic of 1907. Nor is there any government insurance for banknotes or bank deposit accounts.
Notable supporters include Milton Friedman, Fred Foldvary, David D. Friedman, Friedrich Hayek, George Selgin, Steven Horwitz, and Richard Timberlake.
History
Banking has been more regulated in some times and places than others, and in some times and places it has hardly been regulated at all, giving some experiences of more or less free banking. Free banking systems have existed in more than 60 countries. The first system of competitive issuance of notes began more than 1,000 years ago in China (see below). Free banking was widespread in the 19th and early 20th centuries. lists the most currently known episodes of free banking and discusses in some depth a number of them, including Canada, Colombia, Foochow, France, and Ireland. Monetary arrangements with monopoly issues of notes, including government treasury issues, currency boards, and central banking, replaced all episodes of free banking by the mid-20th century. There were several reasons for the demise of free banking: Economic theories claim the superiority of central banking. Desire to imitate the institutions of more advanced economies, especially Great Britain. The Bank of England was the model for many later central banks, even outside the British Empire. Desire of national governments to collect seigniorage (revenue from issue) from note issues. Financial crises in some free banking systems that created demands to replace free banking with another system that advocates hoped would have fewer problems.
Some prominent 18th and 19th century economists, most notably Adam Smith, defended free banking as opposed to the real bills doctrine. After the mid 19th century, though, economists interested in monetary issues focused their attention elsewhere, and free banking received little attention. Free banking as a subject of renewed debate among economists got its modern start in 1976 with The Denationalization of Money, by economist Friedrich Hayek, who advocated that national governments stop claiming a monopoly on the issuing of currency, and allow private issuers like banks to voluntarily compete to do so.
In the 1980s, this expanded into an increasingly elaborate theory of free market money and banking, with proponents Lawrence White, George Selgin, and Richard Timberlake increasingly centering their writing and research around the concept, either regarding modern theory and application, or researching the history of spontaneously free banking.
Australia
In the late 19th century, banking in Australia was subject to little regulation. There were four large banks with over 100 branches each, that together had about half of the banking business, and branch banking and deposit banking were much more advanced than in other more regulated countries such as the UK and US. Banks accepted each other's notes at par. Interest margins were about 4% p.a. In the 1890s a land price crash caused the failure of many smaller banks and building societies. Bankruptcy legislation put in place at the time gave bank debtors generous terms they could restructure under, and most of the banks used this as a means to restructure their debts in their favor, even though they did not really need to.
Switzerland
In the 19th century, several Swiss cantons deregulated banking, allowing free entry and the issue of notes. Cantons retained jurisdiction over banking until the enactment of the Federal Banking Law of 1881. The centralisation of note issue reduced the problem of the existence of "a bewildering variety of notes of varying qualities ... at fluctuating exchange rates."