Sunday, April 11, 2021

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

Click here to read the original Cautious Optimism Facebook post with comments

5 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff concludes his series on Scottish free banking, addressing the controversial gold suspension of 1797.

Prime Minister William Pitt the Younger
commands the Bank of England to hoard gold
and shower Britain with irredeemable paper

Scotland's free banking era of 1716-1845 was the most unregulated financial system in modern history. Absent a central bank, deposit insurance, government granted monopolies, bailouts, backstops, and legal restrictions Scottish banks engaged in fierce competition for customers and pioneered a plethora of innovative financial services that are considered commonplace today.

And in contrast to the heavily regulated English system which endured ten banking panics in the same period Scotland was remarkably stable, suffering not a single systemic crisis for 129 years.


More sophisticated critics of the Scottish free banking system argue that it did in fact suffer one banking crisis in 1797, that it was a major and lengthy disruption, and that the alleged stability of free banking is undermined by this event.

Before we examine this accusation more closely, it’s worth noting that even if there was one bona fide crisis in 1797, a single panic during the 1716-1845 free banking era is still vastly superior to the ten that occurred in regulated England during the same period.

Moreover if the price of free banking really is to endure one panic every 129 years, then it’s a very small price to pay indeed. The United States has had ten banking crises in its last 129 years, and twenty crises since its Constitution was ratified. Even with some success in mitigating crises since deposit insurance was introduced in 1933, the U.S. has still experienced two bona fide crises in the 87 years since (1990, 2008).

Most Americans would gladly trade their current banking system’s track record for one that produces just one crisis every 129 years.

But the most pivotal aspect of the 1797 suspension is that it wasn’t even induced by free banking at all but once again by an overt government intervention.

Here's how the story unfolded.

France declared war on Great Britain in 1793 and again in 1797 in what became the Napoleonic Wars, a lengthy series of expensive conflicts that would last until 1815.

Alarmed by a French landing in Wales and runs on several private English banks, Parliament suspended the gold standard and granted the Bank of England and Bank of Ireland the right to refuse gold payment. However this Restriction Act of 1797 did not apply to Scotland.

Perhaps readers can already see the impossible situation this was destined to create. Scotland and England were joined in a pound-standard currency union and banknotes from each country circulated freely within the other. Private Scottish banknotes circulated in England, particularly in the north, and some Bank of England notes circulated in Scotland.

When the Bank of England hoarded gold as was so common at the outbreak of war, it called in every Scottish banknote it could find, draining gold reserves from the Scottish system.

Normally this would not be problematic since Scottish banks were likewise redeeming Bank of England notes for gold leading to offsetting claims and relatively small net gold transfers.

But now with a government intervention annulling the Bank of England’s contractual obligations, redemption became an asymmetric affair. Gold flowed out of Scottish banks rapidly, but Parliament forbade it from flowing back in.

Under this arrangement the Scottish banks would be bankrupted in a matter of months, weeks perhaps.

Imagine if you will Chase bank collecting on deposited checks drawn upon Citibank, but Citibank being restricted by law from collecting on checks drawn upon Chase. Precious reserves would flow unidirectionally, with a constant reserve drain on Citi which would soon be ruined.

Now divide the United States in half down the Mississippi River and apply the same principle: Eastern banks required to make good on their promises and pay up, but Western banks granted the privilege to refuse. Eastern U.S. banks would quickly be bankrupted and a major crisis would ensue in that half of the country—all brought about by a sudden government-bestowed annulment of contracts.

Critics argue Scottish banks could have simply refused to accept Bank of England notes for deposit, but that would not have stopped the redemption of their own notes in the south and they would still have failed—although refusing English notes may have curbed their own customers’ account balances, slowed the pace of local redemption, and at best postponed the inevitable.


Despite being figuratively placed in a Parliamentary straitjacket and thrown into the water, the Scottish system still managed a heroic holdout. In his 1802 classic "An Enquiry Into the Nature and Effects of the Paper Credit of Great Britain," English monetary theorist Henry Thornton records that:

"...the fear of an invasion took place, and it led to the sudden failure of some country banks in the north of England. Other parts felt the influence of the alarm, those in Scotland, in a great measure, excepted, where, through long use, the confidence of the people, even in paper money of a guinea value, is so great (a circumstance to which the peculiar respectability of the Scotch banks has contributed), that the distress for gold was little felt in that part of the island."

Remarkably, Scotland's own citizens didn't feel compelled to withdraw gold coin even under such onerous circumstances.

Nevertheless the English suspension would ultimately persist for twenty-four years and Scottish banks could only brave through the southward gold drain for so long. Eventually the industry appealed to local leaders and the Scottish public for the right to suspend payment themselves, at least until Parliament’s one-sided restrictions were lifted. 

Ironically most everyday Scots supported their own banks’ restriction and were relieved that the entire Scottish banking system would not be brought to ruin by London’s capriciousness. In fact there is no record of a single attempt by any private Scot to sue a Scottish bank for gold payment even as such suits were filed in English courts.

Parliament finally lifted the 1797 Restriction Act in 1821, six years after Napoleon’s final defeat at Waterloo.

So the suspension lasted a very long time—over two decades. Business carried on normally throughout and, unlike in England, without a systemic crisis or wave of failures, but bank customers’ contractual rights to banknote convertibility were undoubtedly violated. To this day it is still not referred to as a systemic crisis or panic by the large consensus of financial historians.

But it can’t be overemphasized that the Scottish suspension did not betray some flaw in the free banking system itself, for its cause was British Parliament’s intervention. Far from what big government academics like to call “market failure,” the 1797 suspension instead serves as yet another indictment of bad bank regulations.

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