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Free banking is a financial system where the banks of a nation or other state-like power are not under any special government regulations beyond what would apply to any business. In a free banking system, there is no central bank or government-supported financial body that issues currency or establishes interest rates. Instead, each bank may issue its own currency in the form of banknotes and conduct its business, such as lending money or making other investments, as it sees fit, without government limitations or regulations.
In theory, banks in a free banking system would respond better to market forces than centralized banking systems controlled by governments. In regard to currency, a bank would only issue a certain amount of currency for a given amount of a physical resource, such as dollars per ounce of gold or silver. By varying the amount of currency printed per increment of resource, a bank could vary and control the value of its currency in order to maintain its position in the financial marketplace, providing security for its investors. While the value of bank-issued currency could vary widely early on, in time all of the banks in a free banking system would eventually succumb to market pressures and agree on a set, but not legally enforced, value for all currency.
The creation of currency is also one of the shortcomings of a free banking system. Should a bank overprint currency, the value of the existing currency held by its investors and clients could decrease significantly. Likewise, should a bank make bad investments, or otherwise fail to profit on its expenditures, the value of its resources could decline, taking its currency down in value as well. If the failure is severe enough, the bank could go bankrupt, with its currency losing all value beyond the immediate physical worth of the resources the bank has in its possession.
Without regulation, free banking systems are not required to maintain specific amounts of resources in reserve, as is the case with centralized banking systems. These banks are also not restricted in the number of unsecured loans they can make or that they can obtain from other banks or businesses. These factors, along with the fact that there is no government entity or centralized bank to guarantee a bank’s currency, can leave a bank vulnerable to forces outside their immediate market such as wars or even the reduced productivity that occurs during a drought or other natural disaster.
During the 1700s and 1800s, a number of nations experimented with variations of free banking systems, including Australia, Switzerland, and the United States. By 1902, no nation was still operating a true free banking system. The reasons for the failures varied from unethical banking policies to unexpected depreciation in currency value to simple public confusion over the variety and types of currency being issued.