by Kevin Dowd, 1993.
Automatic stabilizing mechanisms under free banking
THE EVOLUTION OF A FREE BANKING SYSTEM
The development of coins
In a relatively primitive society in which individuals are just beginning to trade with each other, ‘coincidence of wants’ problems would arise frequently if market participants were restricted to barter. Some goods would be more in demand than others, however, and at some stage individuals would realize that they had a better chance of getting the goods they wanted if they first accepted some popular intermediate good and then swapped it for the good they wanted to consume. This resort to ‘indirect exchange’, which employs a certain class (or classes) of intermediate goods, would allow individuals to avoid the ‘coincidence of wants’ problem, but their transaction costs would remain high. In particular, they would still need to measure the quantity of the goods they were offered and assess their quality. They would therefore prefer intermediate goods whose quantity was easily measured and whose quality was relatively uniform. To minimize transport and storage costs, market participants would also want goods that were sufficiently scarce for small amounts to have a high exchange value. Historically, people have tended to converge on the precious metals as desirable intermediate goods and to abandon alternatives as the advantages of precious metals become more apparent.
The use of precious metals as intermediate goods would still leave individuals with the inconvenience of weighing lumps of metal and assessing their purity. This would create an opportunity for some individuals to act as intermediaries and make their living assessing the purity of the metal brought to them and recasting it into pieces of more convenient size. As such practices spread, the fineness and sizes of metal pieces would gradually become standardized, and the private intermediaries would mark the pieces to show their weight and quality. The profits made by the earliest of these intermediaries would attract others, and they would compete with each other for business. It would not take long for them to realize that they could attract more business by using distinctive marks on the metal pieces they issued. The intermediaries would thus become private mints and their metal pieces privately issued coins.
Each of these private mints would exist primarily to maximize its own profits, which could be generated in several ways. One would be by offering competitive minting fees. Another would be by developing a reputation for probity to reassure prospective customers that they would not be cheated. A third would be by innovation: mints would experiment with coins of new denominations, alternative metals, and so on. Any successful innovations would be imitated by other mints and would become widely adopted. It bears stressing that these mints would have no incentive to cheat by overstating the weight of their coins, because such deception would be easy to detect, and this would harm the mint’s reputation and hence its business. Furthermore, the law would classify such activity as fraud. 
As an aside, it is exactly at this stage that the state historically has intervened in the monetary system. Governments realized they could use their coercive powers to create a legal monopoly that would make the minting business very profitable. Even if the government’s service was inferior to that of private mints, the public could be forced to accept it, as the state would prohibit its subjects from using the coins of other mints.  The government could then impose high minting charges or misrepresent the weight of the coins it issued. Note that it is only the state’s monopoly over the means of legal coercion that enables the state mint to stay in business. A private mint could not provide an inferior service and survive because it would have no way of compelling people to use its services.
Central Banks as Sources of Financial Instability
The “Principle of Adverse Clearings”
To explore the possibility that central banks’ unique privileges may themselves have contributed to financial instability, we must consider precisely how these privileges alter the scope for credit expansion. Doing so requires that we consider the limits to such expansion in a competitive or “free” banking system, meaning one in which numerous banks enjoy equal rights to issue their own distinct brands of circulating notes. (2)
(2). Strictly speaking, a “free” banking system, to use the expression in its European sense, is one in which banks are generally free from restrictive regulations, not simply free to issue their own notes. But the implications of free and competitive note issue in particular concern us here.
Mere Quibbles: Bagus and Howden’s Critique of The Theory of Free Banking
Bagus and Howden find my argument unconvincing because banks, instead of routinely redeeming each other’s notes, might treat those notes as so much extra cash with which to support more of their own lending; because they might cover random (and therefore temporary) reserve losses by borrowing reserves on the interbank market; and because they might reduce their need for precautionary reserves, and thereby extend the limits of coordinated expansion, by lengthening the interval between interbank settlements. But here Bagus and Howden appear to confuse actions that are merely possible with ones that are in banks’ best interest. Would banks capable of issuing their own notes really think it prudent to accumulate rival banks’ notes? Would they really find it more profitable, when faced with larger stochastic reserve gains and losses, to rely more on interbank borrowings than to equip themselves with more precautionary reserves? Would they be inclined, finally, to agree on a lengthening of the period between settlements?
Among the numerous successful episodes of Free Banking, the Hong Kong episode is rarely cited as a relevant one. Not surprisingly, because Kurt Schuler notes that the considered period of free banking (1935-1964) has never been free at all.
Hong Kong ended free banking in 1935 in the wake of China’s unexpected decision to abandon the silver standard, which disrupted the basis of their trade. The government confiscated the banks’ silver, and tied the Hong Kong dollar loosely to the British pound, which itself was no longer convertible into gold at a fixed rate. (The Experience of Free Banking, p. 39)
The anti-free bankers sometimes rehash Hickson and Turner’s paper “Free banking gone awry: the Australian banking crisis of 1893” (2002) as a refutation of the theory of free banking while ignoring the many other successful episodes. In fact, some evidence provided by the paper contradicts their conclusion that the root cause of the 1893 crisis stems from the fact that “Australian banks opportunistically diverted dramatically increased deposits into overly risky assets without corresponding increases in equity capital”. Hickson and Turner ironically support the evidence brought by Selgin that the boom is caused “not by any increase in the bank money multiplier, but by injections of high-powered money from Austra-lian gold mines and from the British capital market”.
Free Banking in Britain – Theory, Experience and Debate 1800-1845, Second Edition, Lawrence H. White.
“There were many competing banks; most of them were well capitalised by a large number of shareholders; no single bank was disproportionately large or dominant; all but a few of the banks were extensively branched. Each bank issued notes for £1 and above; most banks’ notes passed easily throughout the greater part of the country. All the banks of issue participated in an effective note-exchange system. All offered a narrow spread between their deposit and discount (loan) rates of interest.” (p. 32)
“Counterfaiting was not a significant problem in the Scottish experience. Counterfaiting was a problem for the Bank of England, however, especially during the period of the suspension of payments. The explanation is that the likelihood of undetected counterfeiting varies directly with the length of time a note circulates before returning to the issuing bank – where it passes under a teller’s discriminating gaze for deposit or payment. Coppieters (1955, pp. 64-65) points out that Scottish notes had a very brief average period of circulation, as other issuing banks would not hold them as till money, but would return them through the clearinghouse. The same could not be said for Bank of England notes.” (p. 36)
“By one account (Wenley, 1882, p. 142), all failed banks having more than nine partners were able to pay their liabilites to the public in full. The loss to the Scottish banking public from all failures to date was estimated in 1841 at only £32,000. Public losses in London during the previous year alone were estimated at twice that amount (Aytoun, 1844, p. 678).” (p. 37)
While the success of the swedish banking system from 1830 until the end of this century is of no dispute, there is a little dispute regarding the degree of freedom of these swedish banks. First, Erik Lakomaa, in his “Free Banking in Sweden, 1830–1903: Experience and Debate” (2007), provides some evidence that the system was relatively free and that the regulations at that time were not binding. Let’s review some of them :
George A. Selgin, The Theory of Free Banking: Money Supply under Competitive Note Issue 
The U.S. Experience
1837 was, however, also the year in which increased public dissatisfaction with the charter or spoils system of bank establishment led to the adoption of “free banking” laws in Michigan and New York. These laws, later adopted in other states as well, brought banking into the domain of general incorporation procedures, so that a special charter no longer had to be secured in order for a new bank to open. This was an important step toward truly free banking, but it stopped well short of it. State governments, having relied for years on financial assistance they had received from privileged banks, sought to retain such assistance while still allowing free entry into the banking business.
To accomplish this they included “bond-deposit” provisions in their free-banking laws. These provisions required banks to secure their note issues with government bonds, including bonds of the state in which they were incorporated. Typically, a bank desiring to issue 90 dollars in notes would first have to purchase 100 dollars (face value) of specified state bonds, which could then be deposited with the state comptroller in exchange for certified currency.
Though bond-deposit requirements were ostensibly aimed at providing security to note holders, they only served this function if the required bond collateral was more liquid and secure in value than other assets that banks might profitably invest in. In reality, the opposite was often true, particularly in free banking states in the west and midwest. In these places, “banks” emerged whose sole business was to speculate in junk bonds — especially heavily discounted government bonds.
Bond-collateral, purchased on credit, was duly deposited with state officials in exchange for bank notes equal to the better part of the face value of the bonds. The notes were then used to finance further rounds of bond speculation, with any increase in the market value of purchased bonds (which remained the property of their buyers) representing, along with interest earnings, a clear gain to the bankers. The infamous “wildcat” banks were mainly of this species, most of their issues being used to monetize state and local government debt. 
The Other Side of the Coin: Free Banking in Chile, Murray Rothbard
The Law of 1860 created a free bankers’ paradise in Chile. Anyone or any group could set up a bank and issue notes. There were no reserve requirements, no minimum capital or loan requirements, no limits on loans to directors, and no inspection by government agencies. Only two minor restrictions were imposed: a minimum note issue of 150% of the bank’s capital, and a ban on very small denomination notes under 20 pesos. All else was permitted, within, of course, the standard free-banking framework of requiring banks to redeem their notes in gold on demand. [...]
Free-banking revisited: the Chilean experience 1860-1898 (Ignacio Briones) [PDF]
The empirical evidence we report shows that during the free-banking period (period in which Chile experienced two important wars and a civil war), inflation was low and stable most of the time.
Besides the publication of monthly balances and upper issuing limits linked to a fraction of the effective capital they constituted (150%) the Chilean banking system didn’t establish other major limitations for the creation of issue banks. [...] During this period bankruptcies were rare, the number of issue banks increased over time for most part of the 1860-1898 period, while concentration rates reached reasonable levels at some stages. Furthermore, during the free-banking era, economic growth was important and the domestic capital markets strongly expanded in all its branches (Briones 2001).