Inherent instability in banking: the free banking experience

Historically, even some of the staunchest proponents of laissezfaire have viewed banking as inherently unstable and so requiring government intervention. According to this view, left to unfettered market forces, banks are prone to periodic runs and failures simply because of unpredictable private decisions about the form in which individuals hold their money. This view arose not from any explicit theory that points to an inherent problem with a laissez-faire banking system, but from experience with U.S. banking that goes back at least 150 years. In particular, the Free Banking Era (1837—63) is often cited as an example of what would happen if banking were unregulated. It was a period when banks were subject to few restrictions, fewer than any other period in U.S. banking history. And it has often been characterized as chaotic, with many differentkinds ofpaper money, with numerous bank runs and failures, and withsubstantial losses andinconvenience to holders of bank notes. Some even claim that the U.S. economy would not have grown as robustly as it did late in the 19th century if the free banking system had been left in place (Cagan 1963). In this paper we reexamine the view that banking is inherently unstable by taking a closer look at the free banking experience. Based on rather extensive empirical evidence recently accumulated on this experience, we find that the problems with free banking were not caused by anything inherent in banking. Rather, we find that the