The Case for Financial Laissez-Faire

Abstract

The argument for financial laissez-faire (or free banking) is essentially very simple: if free trade is generally desirable, then what is wrong with free trade in the financial services sector? If nothing is wrong with it, the whole panoply of government intervention into the financial sector the central bank, government-sponsored deposit insurance and government regulation of the financial system should presumably all be abolished. If there is something wrong with laissez-faire, on the other hand, then what exactly is the problem with it? Why does this problem justify intervention? And why does it justify the particular interventions we have, such as a central bank? Most economists take a patently untenable position on these issues. For the most part, they accept the general principle of free trade, but they deny that it applies to financial services. Yet relatively few could give a coherent defence of this position or have even thought that much about it. They oppose free banking more or less instinctively, as if its failings are obvious. The response, of course, is that what is obvious is not necessarily true the history of science is full of cases where the 'obvious' turned out to be wrong. It therefore behoves us, as academic economists, to explore these issues more carefully and beware of assuming we already know the answers before we start. Before getting into detail, I would like to make three general points. First, if free trade is good, as most of us agree, there must be at least a primafacie case in favour of free banking. If the principle of free trade applies in general, we must presume it to apply to any specific individual case, unless we have clear reason to believe the contrary. The onus of proof is on those who oppose free banking to demonstrate its undesirability. Most professional economists have the wrong priors on this issue. Secondly, while I accept that free banking seems strange at first sight, I believe this reaction mainly reflects the way we have been conditioned to think. Our education leads us to take certain things for granted, and the need for central banking is one of them. After all, why else do we initially react so strongly to what is no more than the application of the generally accepted doctrine of free trade to financial services? Finally, there is a great deal of empirical evidence on the free banking issue, and this evidence is supportive of the predictions of free banking theory, and, in particular, of its claim that unregulated banking is stable. Economists cannot therefore maintain that free banking has never been tried, nor that it has been tried and 'failed'. The evidence also supports the predictions made by free banking theory that intervention generally weakens the financial system and causes the very problems it is ostensibly meant to cure. By contrast, the evidence is also inconsistent with opposing theories that have been suggested as providing justifications for central banking.