Under “Bagehotian” Free Banking, Numerous Competing Banks Issue Notes Redeemable in “Outside” Money Like Gold

The need for various kinds of legislative interference in banking, and for legislation establishing central banks in particular, has been taken for granted by most monetary writers at least since the passage of the English Bank Act of 1844. Peel’s Act eventually guaranteed the Bank of England a complete monopoly of paper currency in Great Britain, effectively ending the monetary controversies of preceding decades with a verdict in favor of a (rule-bound) central bank. Yet a few stalwarts continued to insist upon the theoretical superiority of free banking, where numerous banks of issue are “regulated” by competitive pressures only. One of them was Walter Bagehot who, while editor of The Economist in 1873, published his highly influential book on Lombard Street. Bagehot viewed free banking as an ideal that was both more stable and more “natural” than central banking. In contrast, he viewed the concentration of legal privileges in the Bank of England of his day as both unnatural and dangerous to economic stability. When it came to offering practical advice, however, Bagehot did not propose taking away the Bank’s special privileges: that, he said, would be like proposing a “revolution,” and just as fruitless. Instead, Bagehot hoped that the Bank could be persuaded to manage its affairs in a manner more conducive to the avoidance of financial crises (and, by implication, less conducive to maximizing the Bank’s profits).

In presenting his case for free banking, Goodhart draws heavily on Bagehot’s particular vision of a free-banking system. Although Goodhart also refers to works by Benjamin Klein and Friedrich Hayek, these have to do with hypothetical arrangements involving competing private issuers of irredeemable fiat money, which are a far cry from free banking in its conventional and traditional (Bagehotian) meaning. In a traditional free-banking system, rival banks issue notes redeemable in some “outside” money, like gold, that none of them can create.

—George Selgin, “The Rationalization of Central Banks,” Critical Review 7, nos. 2-3 (1993): 337.