Central Banking , Free Banking , and Financial Crises

Agrowing literature explores the concept of free banking on both a theoretical and an historical basis. George Selgin (1988) sets out the theory of free banking and makes a compelling case that, despite the uniqueness of money, the forces of supply and demand are more conducive to monetary stability, correctly understood, than are the edicts of a central bank. Larry White (1984), focusing on the free-banking episode in nineteenth-century Scotland, and Kevin Dowd (1994), collecting studies of experience with free banking in many countries and time periods, have shown that this alternative to central banking has a respectable history. The aim of this paper is to get a fix on the possible and currently relevant sources of macroeconomic instabilities in the economy and to identify the most promising banking arrangements for dealing with those instabilities. Possible maladies and remedies can be considered in the context of competing schools of macroeconomic and monetary thought. Attention is directed to the issue of whether the perceived problem andlor its solution is inherent in the market economy or lies outside the market process. This formulation immediately gives rise to a two-by-two.matrix with maladies and remedies represented in one dimension, market forces and extramarket forces represented in the other. The fruitfulness of this approach is demonstrated by its ability to sort out competing schools ofthought, put current debate in perspective, and assess the prospects for a stable macroeconomy-with the Federal Reserve as currently constituted and with the alternative institution of free banking. This exercise in comparative-institutions analysis does not deal with the dynamics of the macroeconomy in transition between one set of monetary institutions and another or with the political issues of just how such a transition might be brought about. Nor does i t deal directly