Automatic Stabilizing Mechanisms under Free Banking

Introduction One objective of this paper is to explain the automatic stabilizing mechanisms inherent in a free banking system. Starting from an initial primitive state of society, I will suggest how a banking system would evolve in the absence ofstate intervention. The state is assumed only to enforce contracts freely entered into by private individuals. Government expenses are paid through taxation, but there is no taxation specific to the monetary system. (In other words, there is no seignorage.) The evolutionary process is driven by individuals’ pursuit of their own private interests, and no one consciously attempts to promote any wider “social interest.” At each stage individuals seek to reduce their exchange or operating costs, and these attempts lead to the growth of new institutions that reduce the costs of coordinating economic activity.’ With no state interference to hinder it, this evolutionary process would lead to the development ofa highly sophisticated “free banking system” with several distinctive features, including: (1) multiple note issuers who would guarantee to redeem their notes in a commodity that the community recognizes as valuable; (2) a regular note exchange between these note issuers; and (3) the insertion of “option clauses” into the convertibility con-