Free banking: myth and reality

Dec 21, 2023·Alasdair Macleod

Surely, it is now apparent that central banks are guilty of mismanaging the economy. By slashing interest rates to zero and in some cases to an unnatural minus figure, then flooding financial systems with currency-equivalent credit conjured out of nothing followed by rapidly increasing interest rates in an attempt to stem the consequences, central banks have bankrupted themselves and much of their entire economies. 

Even though hapless economists and money managers are still in thrall to them, central banks have proved themselves to be unfit for purpose. It is time for a new system based on true economic demand for credit without state interference.

The ineptitude of the monetary planners is now sharply focused by events in Argentina, whose new president has vowed to close the central bank and introduce a currency board for the peso backed by the US dollar. Far from being a maverick politician, President Milei is being well advised. Currency boards work, imposing an automatic discipline on government spending.

This article opens up the debate between free banking without central banks under gold standards, and the fiat currency system which gives central banks the power of debasement. Commercial banking without central banks is the historical norm, and the evils of statist currency management is a more recent development.

Those who argue that central banks represent progress from free banking are clearly in the wrong.


The new president of Argentina, Javier Milei, was elected on a platform that included closing down the nation’s central bank. He has been lauded by an eclectic bunch of free marketeers, monetarists, and even the IMF. So far, his monetary reform has included a 54% devaluation of the peso against the US dollar, which probably brings its official value close to the black market exchange rate. It is less of a devaluation and more an acceptance of reality.

Milei has made it plain that Argentina will adopt the US dollar as the nation’s currency through a currency board arrangement. Currency boards were originally the means by which some of Britain’s colonies tied their local currency to the pound. Operating mechanically and beyond the reach of meddling politicians, currency boards worked well. They also allowed free trade and import and export flows making exchange controls unnecessary. They are a quick fix for stabilising currency values, proved in practice to be extremely effective.

Under a currency board, a new peso will circulate backed at least 100% by US dollars. Pesos will be exchangeable for dollars and vice-versa at the holder’s option. It will cover not just banknotes, but sight deposits held at commercial banks. An issuing authority is required to discharge this duty by law, or at least with a clear mandate, precluding political interference. With the possible exception of acting as a lender of last resort, all the other functions of a central bank fall away, so it can be shut down. Where the dollars for Argentina’s currency board will come from is not yet clear, but like any fiat currency presumably the banking system will provide. In any event, dollars already circulate freely in Argentina, pesos being only money for the poor.

When “the establishment” sees its central plank, the fountain of its free financing removed inevitably there will be kickback. But Milei’s tactics are those of a boxer unexpectedly overwhelming his opponent. With the electorate behind him, he is raining rapid blows on the establishment, closing nine ministries, cutting subsidies, and cancelling tenders for public works projects. He appears to have learned the importance of acting quickly to continually keep the establishment off guard, unable to regroup and persuade Argentine’s socialistic media of an adequate response. It must be done early and quickly, while Milei retains the initiative and can always threaten opposition to his plans with a new plebiscite.

Perhaps the greatest danger to Milei is an army coup, which is the Argentine establishment’s normal way of eliminating the democracy problem.

Meanwhile, choosing the US dollar as the backing for a currency board has won him plaudits from foreign economists of various persuasions. The exception, perhaps, has been from the Asian hegemons, China and Russia who accepted Argentina’s membership of an expanded BRICS from next month. But they have kept quiet. From the US’s point of view, Milei’s election must be seen to be a positive development and a chance to throw a spanner into the BRICS works. But it is not so simple, because China recently helped the previous administration with a yuan swap line taken out with the people’s Bank to pay the majority of a dollar debt due to the IMF.

The swap is part of a pre-agreed line of up to 130 billion yuan with free access to the Argentinian central bank of 35 billion yuan of the facility. Abolishing the central bank will simply require the agreement to be novated to the finance ministry, so that shouldn’t be a problem. However, it appears that the delicacy between the previous administration’s ambitions to join BRICS alongside Brazil and Milei’s retrenchment to using US dollars are understood by Milei, because he is reported to being uncharacteristically diplomatic in his relations with China.

Milei will have to tread carefully over this thorny issue. As a free marketeer and said to be a disciple of the great Austrian economist, Friedrich Hayek, he almost certainly understands that the dollar is only a temporary monetary solution. Surely, from his libertarian instincts he observes US budget deficits and the dollar’s own debt trap in the context of its similarities with his own government’s profligacy and its debt traps. 

Apparently, he is a fan of bitcoin, which confirms this understanding. A dollar currency board is only a temporary solution lasting for so long as the dollar doesn’t face its own crisis. Milei would be well advised to assess whether Argentina’s 61.74 tonnes of gold reserves are sufficient insurance for protection against the dollar’s demise, because it is increasingly likely that a Plan B will be required, possibly before the ink is dry on Plan A.

We will watch these developments with great interest, particularly the return to free banking, which we can define as banking without the controlling influence of a central bank.

Central banks are a recent innovation

Given that the Romans invented banking, and that Italian banks adopted the modern form of credit creation through double entry bookkeeping in the fourteenth century, commercial banking without central banking has a far longer history than with central banking. While the Bank of England existed as a central bank following the 1844 Bank Charter Act (it had for a long time previously operated as a commercial bank with the monopoly of the government’s business, which is not the same thing), and America’s Federal Reserve Board came into existence before the First World War, central banking per se spread more widely from then on, coinciding with the end of gold standards, particularly in Europe.

Just as a currency board makes a modern central bank redundant, it also makes them redundant for gold standards, which require a similar and simple function of issue control. The failures of the Bank of England in the years following the 1844 Bank Charter Act were down to its crude attempts at interest rate management. The Act, which was based on currency school precepts, assumed that the separation if the issue department from banking was the solution. It wasn’t, proved when the provisions of the Act with respect to gold cover for the note issue were suspended only three years later in 1847, then in 1857, and in 1866. The legislators and the bank itself did not anticipate that the run on its gold reserves would come not from the public submitting bank notes for sovereigns, but from deposit balances in the banking department being encashed.

The Bank made the further error, which persists to this day, of trying to manage interest rates in an economic context. Besides the real problem of no central banker actually understanding the business of economics, interest rates should have been managed in the context of maintaining gold reserves. At least modern currency board operators have learned this vital distinction.

Modern economists tend to dismiss currency boards, as well as free markets. Their solution to problems, mainly of their own creation, is to double down on regulations increasing their scope and complexity. An entire industry of regulators, policy managers and hangers on has been created to discharge invented functions. 

Naturally, those employed in it support its continual expansion. For this reason, the practical simplicity of a gold standard and currency boards gets short thrift. This ignores the lessons of history, that the world evolved from a feudal state through the industrial revolution to a standard of life for the commoner which would have been the envy of kings only a century ago, all on the back of commercial bank credit. Yes, there have been upsets along the way: but the question to be addressed is whether commercial banks in their relationships with each other can minimise those upsets, or can governments through their central banks achieve a better outcome?

The monopoly over currency provision stems from the 1844 Bank Charter Act in English law, not adopted by the Scottish banks (Scotland has its own legal system) which to this day sees the major banks issuing their own bank notes, admittedly fully backed by their reserves at the Bank of England. While it was gradual, the withdrawal of the facility whereby English banks issued banknotes only served to consolidate the government monopoly over currency. Currency has come to be regarded as national money, and not a credit liability of a bank. The importance of this development tends to be overlooked. Very few are the economists today who understand that a banknote is actually a liability of the central bank, despite it still being evidenced as such in its accounts. They would not so readily take that erroneous view, surely, if commercial banks were still permitted to issue their own banknotes.

When a commercial bank issues banknotes, the notes are bound to have a similar rating to a deposit, the only difference is that a banknote is a promise to its unknown bearer. If the facility was reintroduced, it is certain that a bank would issue banknotes to rank as a substitute for the national currency. It may be that a bank would not take up this facility anyway, bearing in mind that London bankers ceased issuing notes in the 1790s, fifty years before their issue was banned in the 1844 Act. But there is no substantive reason why issuing bank notes should not be permitted, and if demanded by a bank’s customers, a commercial bank’s notes would simply circulate alongside notes issued by the government. Then, perhaps, economists would have a greater understanding of the credit status of banknotes.

The limit of statist involvement in credit should be to provide an updated version of the currency board, an issuing facility for banknotes and deposit balances totally backed by real, legal money, which is gold. The issuer must be charged with the sole responsibility of ensuring gold backing for its liabilities is always there. The issuer’s balance sheet would consist of notes and deposits as credit liabilities, and the assets entirely comprised of gold bars and coin. The profit and loss account would generate sufficient income from seigniorage to cover storage and minting expenses. And the directors of the issuer would be charged with managing interest rates purely with a view to maintaining gold reserves. It must be detached from all other financial activities.

In this way, credit generated through banking operations becomes a purely commercial consideration. Bank credit is a function of commercial banking, referenced to the rate set by the issuer by virtue of bank deposits held with it, but reflecting additional counterparty risks. To satisfy depositors’ likely demands for coin or bullion, a commercial bank can either maintain a deposit at the issuer gained by submitting gold in exchange or buy them in the market. This is sufficient to tie the value of commercial bank credit to that of the national currency, which unquestionably becomes tied to gold.

The error in the 1844 Bank Charter Act was to split the Bank of England into two departments, but under the same management. Its banking department was no less a credit operation than any commercial bank, and it was the inherent conflicts, particularly over the setting of interest rates, which led to the Act’s failures. 

Whether the state maintains a banking presence in the commercial banking system becomes a separate issue. Management of economic outcomes by interest rate manipulation is a dead duck, given that the interest rates objective can only be to maintain gold reserves. But there is still the thorny question of the need for a lender of last resort. In his plans to abolish Argentina’s central bank, this is an important question yet to be addressed by President Milei. 

Free market theory posits that this is unnecessary. In the knowledge that there will be no bail outs, bankers can be expected to pay proper attention to counterparty risk, and the faintest suspicion of impropriety would be immediately reflected in a bank’s credit rating in the interbank markets. And it is not beyond the ability of banks within the commercial network to deal with banking failures, because it is obviously in their collective interest to maintain systemic credibility. This is another lesson from the pre-central banking era.

The violence of Britain’s bank credit cycle abated in the decades following the Napoleonic wars due to improvements in clearing systems, as the chart of wholesale prices below shows: 

A graph showing the price of the uk

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A clearing system for the London banks was set up in the late eighteenth century, when for the first-time daily differences were settled between the banking members on a net basis. The Bullion Report (1810) reported that there were 46 private bankers who cleared a gross value of £4,700,000 daily by a net settlement of $220,000 in bank notes. This was a significant improvement on the earlier system whereby bank clerks walked around London, visiting other banks to settle claims. In 1854, joint stock banks were admitted into the London clearing system, and the Bank of England joined in 1864. By then, the system of settling balances in banknotes was done away with, replaced by bankers’ drafts settled twice daily with a final reconciliation in the late afternoon. Furthermore, over time other cities established similar clearing arrangements as well as intercity arrangements.

Over the time covered by these increasing refinements to interbank settling, wholesale prices became decreasingly volatile. In other words, as commercial banking became increasingly efficient as a system, the impact on prices from the bank credit cycle as credit was alternately expanded and contracted diminished. Given that the objective of a central bank is to ensure price stability, it amounts to evidence that this function is not needed. 

Inflationary considerations

The ending of national gold standards following the First World War led to the wider establishment of central banks, which became the channel for increasing government economic intervention. The rise of socialism in Europe, both Marxist and fascist, led to greater government economic involvement and the need for increasing state revenues. Much of the intervention was ideological, a trend which continued following the Second World War with the development of the welfare state.

Under the cover of the Bretton Woods Agreement, both interest rates and consumer price inflation remained tied to gold through fixed exchange rates to the dollar. The link between currency values and gold was so tenuous that it relied ultimately on public trust, or even general ignorance of the dangers to this new relationship between money and credit. With America’s massive gold reserves, at 20,279 tonnes in 1950 representing 65% of the world’s official holdings, the Bretton Woods arrangement must have seemed unassailable. But the US Government used this advantage to double the quantity of currency in circulation between 1950 and 1970. And as the number of dollars grew, so did their encashment for gold. By the time President Nixon suspended Bretton Woods in 1971, the world’s official holdings had risen to 36,575 tonnes, while US reserves had fallen to 9,070 tonnes, representing only 24.8% of the total. Adjusted for the increase in above-ground gold stocks, US reserves had fallen from a commanding 39% of all mined gold in 1950 to only 12% in 1971.

The only reason that Bretton Woods worked for as long as it did was at the expense of US gold reserves. So long as foreign central banks could encash their dollars, it worked. After Bretton Woods ended, so did the restraint on prices, which under the new fiat regime began to rise uncontrollably.

That is the background against which we must consider the seemingly disruptive bank credit cycle and the new post Bretton Woods environment. It was dominated by the inflationary consequences of fiat currency expansion. The credit cycle was the reason central banks developed their lender of last resort capacity, which led to increasing regulatory intervention aimed at containing systemic risk. 

In this context, it is interesting that from the Bank of England’s Issue Department we learn that its liabilities, being notes in circulation, increased from £20.18 million in 1844 to £29.61 million in December 1913 before the suspension of the gold standard the following year. That was an increase at an average compound rate of about 1% per annum. Using back calculations, consumer prices are estimated to have increased by less than 10% over the entire period. Meanwhile, estimates of M3 broad money increased 446% from £211.34 million to £1,153.77 million.[i]

Broad money supply is overwhelmingly comprised of bank lending. Yet, despite the expansion in bank credit there was virtually no inflation of the general level of prices, illustrated in the chart above of wholesale prices before 1913. From this we can make some important deductions. Inflation of prices is more a currency than bank credit phenomenon. Giving control of the currency to a central bank without a strict adherence to gold convertibility inevitably leads to the debasement of all credit because of the lack of monetary discipline. On its face, bank credit is not inflationary, but that must be qualified.

If, in their credit creation, bank lending policies strictly adhere to the principal that a borrower will be in a position to repay the loan, then by definition it will be constructively deployed. Let us say, for example, that a businessman needs credit in order to expand his production. He will deploy that credit in designing and producing new products or for expanding his output to satisfy anticipated demand. His investment does not lead to higher prices: if anything, increased quality, innovation to reduce production costs, and more competitive products are the result. Therefore, credit expansion for productive purposes is not inflationary.

In an economy where individuals expect to take responsibility for their security by retaining savings, the expansion of bank credit feeds lower demand into immediate consumption by the diversion of credit into savings. The effect on the general level of prices is to reduce immediate consumption relative to production output, leading to a tendency for prices not to rise or perhaps even decline. We see this difference today between, for example, the lesser inflationary consequences of credit expansion in Japan and China, which have high savings rates, compared with the spendthrifts in the US and UK who spend surplus earnings, even borrowing to increase their spending.

Admittedly, there are two problems in commercial bank lending which have inflationary consequences. The obvious one is lending to consumers purely for consumption, described in the paragraph above. This is apparent in credit card debt and borrowing purely for the acquisition of goods and services with little or no intention of repayment. But of particular concern is the cycle of bank lending which destabilises the supply and availability of credit.

In the expansionary phase, bank lending can lead to lending being driven by other than purely productive considerations. Bankers have repeatedly cut lending rates at this stage of the cycle to gain market share and to increase their balance sheet leverage. Inevitably, this excess credit does lead to rising prices. And since interest rates are above all compensation to depositors for time preference, rising prices shifts the general level of interest rates higher, disrupting business plans and imparting additional risk into existing loans. 

Bankers then find that lending risk has increased at a time when their balance sheet exposure is at its maximum through leverage and so they cut back on their lending operations. A shortage of credit ensues, driving interest rates even higher and malinvestments are exposed. This behaviour is the driver of the boom and bust business cycle. In a fiat currency environment, this inevitably leads to fluctuations in the general level of prices for obvious reasons. But under a properly working gold standard, higher local prices lead to an outflow of gold, unless interest rates are increased to stabilise gold reserves. That is why it should be the responsibility of the currency issuer to control interest rates to maintain adequate reserves to cover the note issue and its liabilities to the banking system.

In our fiat currency system, this is no longer how things work, and the business cycle threatens us with currency debasement, either through its expansion by the central bank, or of its value as confidence in credit becomes undermined either on the foreign exchanges or between domestic actors.

These dangers, which I have shown to be greater under a fiat currency system than a system firmly anchored to gold, have provided a poor excuse for central banks to intervene. According to Keynesian theory, it is the failure of free markets which justifies monetary intervention by the state running a budget deficit to stimulate the economy out of its recession. But it should be noted that even though the credit cycle creates instability for business, under a gold standard it is self-correcting in inflationary terms, which cannot be said of statist intervention headed by a central bank creating currency and bank reserves in an attempt to manage outcomes.

Clearly, the experience of interest rate management by central banks is that interest rate volatility has been increased by monetary policy. The underlying bank credit cycle has been made more damaging by statist intervention, as current events illustrate. Having depressed interest rates to zero or even into negative territory, the inflationary consequences for consumer prices have led to rocketing interest rates and an intensified shortage of bank credit. Whole swathes of industry have had their business calculations turned upside down. Commercial property, private equity, and even the banks themselves have been wrongfooted and threatened with bankruptcy.

The current crisis is entirely due to the actions of the central banks.

Funding government deficits

Wrapped up in grandiloquent objectives, arguably the most important objective of a modern central bank is to procure funding for its spendthrift government. Even fiscally conservative governments have an eye towards this requirement. The 1844 Bank Charter Act included government bonds as asset backing for the Issue department, amounting to 43% of total assets. And the Banking Department held further government stock, amounting to 32% of its assets.

Under the discipline of the gold standard, and a general government approach of not getting involved in commercial matters, the UK government’s demand for debt funding led to net repayments, outstanding debt falling from £838 million in 1844 to £709 million in 1913. But this parsimonious approach shared by governments generally changed in the early twentieth century.  In 1930, President Hoover began intervening to try and halt the depression, a baton picked up by President Roosevelt who followed him. 

It was at this time that economists increasingly turned their backs on free markets, wrongly diagnosing the cause of the depression. Keynes published his General Theory in 1936, inventing macroeconomics which was somehow detached from the real world, justifying government management of the business cycle. In practice, the new economics led to increasing government borrowing, notionally funded in credit markets, but without a concomitant increase in savings rates, it became inflationary in nature. It required the issuance of increasing quantities of debt, for which central banks play an important role.

Pursuing its Keynesian policies has given the US Government the excuse to run a total deficit of over $22 trillion since 1950, leading to outstanding debt of $34 trillion today. As the central bank, the Fed has played a pivotal role in this funding, and arguably without the Fed producing the credit — dollars are the Fed’s dollars, not of the government — this funding would have been impossible. To the extent that this is true, the Fed is responsible for the debasement of the dollar, and without the Fed, the US Government would have been forced to take a more responsible line with respect to its own finances.


Since the establishment of central banks was never an issue understood by the public, governments have positioned them to make the most benefit from their fiat currencies. They have been promoted as being better at managing economic outcomes and economic stability than the private sector operating under free market conditions. It is always easier to sell the concept that powerful entities, such as commercial banks, need licencing and regulating, than to argue the case for non-intervention.

This article serves to remind us that normality is no central banks, and that they are a relatively recent innovation. Central bank power has increased immeasurably with the removal of gold from the global monetary system. And as their power has increased, central banks have increased financial instability. This may have been unnoticed by everyone but the keenest observers, but the suppression of interest rates to the zero bound and below, followed by the rapid increase in interest rates to deal with the unexpected (that is by central bankers and their chorus of blind, deaf, and dumb monkeys) surge of price inflation is clearly down to policy failure.

The result of this failure is a debt catastrophe for governments, businesses, and ordinary people. Led by the US as custodian of the world’s reserve currency, G7 nations face economic collapse, and with nothing but rapidly disappearing faith propping up their fiat currencies, the error of putting government agencies in charge of interest rates and credit will shortly become evident even to the dumbest observer.

Following an increasingly inevitable fiat currency crisis brought on by central bank mismanagement, logic states that we should return to free banking, credit backed by gold tying prices to gold, and the abolition of central banks. We have learned a lot since the failures of the 1844 Bank Charter Act about how to implement a cast-iron gold standard through the development of currency boards.

Do not expect this obvious remedy to be rapidly adopted in order to prevent a serious collapse in the value of fiat credit. There is too much institutional and intellectual capital invested in the current fiat currency and central banking system for that. But it is just possible that President Milei in Argentina might lead the way, particularly if Argentina increases its gold reserves for a Plan B.


[i] See the Bank of England’s Millennium of economic data for the UK.