Only Free Banking Would Have Rendered the Market Economy Secure Against Crises and Depressions

Mises blamed unwarranted credit expansion on political pressures for cheap money that the central bank failed to resist. As an institutional reform to avoid the problem he favored free banking, a monetary system without a  central bank, although he acknowledged that the spread of central banking throughout Europe in previous decades had made the choice between free banking and central banking one of those “questions that have long been regarded as closed.” Exemplified by Scotland, Sweden, Canada, Switzerland, and other countries in the periods before their central banks were created, free banking meant a system in which decentralized and competitive commercial banks issue the paper currency, tied down by a contractual obligation to redeem their notes for gold or silver coin.

Advocates of free banking argued that competition would prevent all the banks from colluding to expand in concert, and interbank redemption of excess notes or deposits would restrain any smaller set of banks from overexpanding. International redemption would restrain the system as a whole. In his later treatise Human Action Mises wrote along these lines:

Free banking is the only method for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all the information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular — one is tempted to say normal — feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions.

—Lawrence H. White, The Clash of Economic Ideas: The Great Policy Debates and Experiments of the Last Hundred Years (New York: Cambridge University Press, 2012), 74-75.