Free Banking and The Limits on Bank Credit Inflation

"Free Banking" is a concept that banks are not required to act as warehouses, merely as debtors to their depositors and note-holders to those who borrow from them (as previously described), but are not subject to government regulation (except that they must redeem the notes they issued).

One check on their power to counterfeit money is the fact that the market is not required to accept it. The bank must establish a reputation of solvency and a history of honoring its notes, or its notes would be rejected (not considered to be worth money, hence not accepted in exchange) in the market.

There is also the threat of a "bank run," in which customers lose confidence and show up, all at once, with their receipts, demanding payment, and the bank runs out of cash. It is therefore in a bank's interest to maintain sufficient reserves to honor its deposits (rather than "creating" an excessive amount of money on an ongoing basis).

Other than this cataclysmic event, there is also the day-to-day restraint imposed by customers in their choice of banks. Depositors would not be inclined to provide funds to the bank unless they have some certainty of being able to later withdraw them. The existence of competing banks would mean that the most reliable one would attract customers. Even in a monopolistic situation, a customer may choose how much to deposit in a bank (even to the point of depositing nothing at all).

It is the author's belief that these natural checks and balances make regulation of the banking industry unnecessary. Some banks will fail, some disaster will occur, but there would be enough firms that acted responsibly, and were inclined to continue to do so, to preserve the existence of the banking industry.

Also, unregulated banking would give rise to a larger number of smaller banks, which would reduce their ability to practice fractional-reserve banking, based on the logic that a bank would wish to redeem the paper of other banks quickly in order to maintain their own assets - hence the money would be in motion constantly, and a higher percentage of funds a bank would maintain in reserve it redeem its own paper.

He also preempts the argument about a cartel or syndicate among banks, who hold rather than redeem one another's notes to enable the banks to maintain a lower fractional reserve (creating more counterfeit funds), as this would require banks to act in theory own detriment in order to allow its partners to cheat, and that by removing the consequences of cheating, the entire cartel would be in danger.

His conclusion is that free banking would inevitably be a regime of hard money and virtually no inflation.