Free vs Regulated Banking: Scotland’s Free Banking Era (Part 2 of 4)

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6 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff gets to the heart of financial stability under Scotland’s free-market banking system of 1716-1845, when regulated England suffered from ten crises and unregulated Scotland experienced none.

Contemporary account of the English and Scottish
experiences during the Great Financial Crisis of 1825

III. OVERISSUANCE, RISK, AND ECONOMIC DEVELOPMENT

From 1716-1845, Scottish banking operated in the closest to a laissez-faire environment the industrialized world has ever seen.

There was no central bank. There were no government privileges, protections, or barriers to entry. Banks were free to issue their own notes and lend any share of their reserves they chose. There was no deposit insurance, there were no bailouts, and failed banks that could not pay off depositors made up the difference from their owners’ pockets (ie. full liability).

Critics of capitalism contend that under such a system unregulated banks, left free to their own devices, will leverage themselves to the hilt, issue too many risky loans through notes and deposits, and their recklessness will bring the entire banking system down in crisis.

Yet Scottish bank failures—especially due to overleverage—were rare and credit quality was excellent.

The reason once again was unfettered market competition, unmarred by government-granted privileges, monopolies, backstops, and restrictions that are later called “the free market” by politicians after they’ve created full-blown crises.

Unlike in England there was no monopoly central bank to overextend or rapidly contract credit for the entire system, and any private Scottish bank that issued too many banknotes had to worry about large quantities of its notes returning for redemption and depleting its specie reserves. 

The private clearinghouse networks also settled mutual banknote obligations daily, so any bank felt the consequence of overissuance very quickly. Once again, absent bailouts from central banks and central governments, it was precisely market competition that kept the banks prudent.

Adam Smith, himself a Scottish resident of Edinburgh, marveled in “The Wealth of Nations” (1776) how effectively the threat of redemption and workings of the private clearinghouse systems kept banks honest. 

Clearinghouses even set standards of financial soundness for banks to become and remain members, and they established accounts for member banks to maintain a minimum balance so that in the unexpected event of failure their liabilities to other banks would not go fully unpaid. This reserve account mechanism was quite effective at stemming the contagion of panic if a large bank failed since other banks it owed to were protected with what were effectively escrow accounts.

Unlike in England Scottish banks were free to widely branch and diversify their depositor bases and lending portfolios.

Also given that there was no central bank standing by to make emergency loans, no government bailouts, and no deposit insurance, banks had great incentive to lend to only the most creditworthy clients and promising enterprises. 

Furthermore most Scottish banks operated in a full liability environment. If enough of a bank’s loans went bad and depositors were not fully paid off, the difference came out of the owners’ personal estates.

The Economics Correspondent is no expert on liability and imagines there are many advantages to our present system of limited liability that promote economic growth. However there can be no doubt that having their own assets at stake proved very effective at focusing the banks’ owners like a laser on sound lending.

Finally, while the Bank of England dominated English finance and diverted funds to the Crown for war, leaving small English country banks to scrape up what little capital they could muster, larger Scottish banks were concerned with the needs of commerce and contributed greatly to the nation’s economic development. 

In 1745 Scotland’s per-capita GDP was only half that of England’s. 

A century later it was equal to that of England’s.

Considering England itself was undergoing the first Industrial Revolution and an unprecedented expansion at the time, the pace of Scotland’s economic growth must be considered all the more impressive as Adam Smith also noted and credited largely to the free banking system.

IV. STABILITY IN SCOTTISH BANKING

But undisciplined by the omniscient wisdom of government regulators, didn’t Scottish banks still lower credit standards, lend recklessly, and spawn constant banking panics like the 2008 financial crisis? After all, we’re told by politicians, regulators, academics, and the media that a private, competitive system left to its own devices is a recipe for disaster and collapse.

As we’ve mentioned in previous columns, not a single systemic banking crisis struck Scotland during its 129 years of free banking. 

By contrast England, dominated by a monopoly central bank and hobbled by Six Partner Rule regulations that kept private banks small, weak, and undiversified, suffered from at least ten banking panics during Scotland’s free banking period: in 1721, 1745, 1772, 1783, 1793, 1797, 1810, 1815, 1825, and 1837.

During the tumultuous period of wars with Revolutionary and Napoleonic France, 300 English banks failed in the thirty years between 1791 and 1821. 

Scotland was tranquil by comparison. Of the joint-stock banks that dominated the market, not a single one failed in the even wider forty-year span of 1786-1826. What few failures did occur were limited to a handful of small private non-issuing banks—on average one per decade (versus one hundred per decade in England).

During the English Crisis of 1825, the largest banking panic in British history before 2008, 80 banks failed in England and 700-800 more appealed to the Bank of England for assistance which was effectively every bank in the country. In Scotland only four banks were even impacted, all smaller houses. One was acquired by a larger bank, two paid their liabilities in full in 1825 and 1826, and only one outright failed in 1829.

J.R McCulloch, heir to the Ricardian school after David Ricardo’s death, wrote in 1826 of Scotland’s “comparative exemption of this part of the empire from the revulsions that have made so much havoc in England.”

And as we’ve noted in previous chapters on England, conservative Prime Minister Lord Liverpool and future Prime Minister Sir Robert Peel urged their parliamentary colleagues in 1826 to consider the free banking system in Scotland as a model for England’s post-1825 crisis reform. Peel even noted in House of Commons debate that 300 English banks had failed in the previous thirty-three years while he could only find a single Scottish bank failure on record in the same period.

Another large panic struck England in 1837 and even spread to the United States which, with its own perversely regulated system (more on that in a future column), suffered the American Panic of 1837. Yet Scotland, even sitting on England’s border with a tightly integrated economy and common currency union, was again unaffected and its resilience once more did not go unnoticed.

Economist Robert Bell recorded in 1838 “While England, during the last year, has suffered in almost every branch of her national industry, Scotland has passed paratively uninjured through the late monetary crisis.”

And economic historian William Graham noted in 1911 that “In the heavy losses and banking failures [of 1837] which ensued, Scotland had little share.”

Scotland’s crisis-free record is particularly impressive considering its close economic ties to its much larger neighbor. A major banking crisis in England could more easily spread to the north than a Scottish crisis could destabilize the south, yet the Scottish system was so durable that it was practically immune to English dysfunction with a sole exception (the 1797 suspension) that we’ll examine in a future installment.

So the British experience completely contradicts the conventional wisdom that unregulated banking leads to industry recklessness and crisis while government regulation promotes stability.

Scotland’s zero crises during its 129 years of free banking stands in stark contrast to regulated England’s ten crises during the same period. And the reasons aren’t hard to understand once the history is unveiled.

In Part 3 we’ll talk about what few regulations did exist in Scotland, its few isolated bank failures, and the end of the free banking era.