Having considered, in two previous essays, the origins, legality, and adverse consequences of the Scottish bank suspension, we're now ready to ask whether, and in what ways, that episode compels us to reconsider the virtues of free banking, both as practiced in Scotland and in general.

If the Scottish bankers were indeed guilty of "violating the property rights of their depositors and noteholders," as Murray Rothbard and some others charge, does that mean that it's not legitimate to treat the Scottish episode as an example of the advantages of freedom in banking? Does it mean that free banking on a fractional-reserve basis is inherently unsustainable?

The Bank Notes Act of 1765

To answer: yes, the Scottish suspension does suggest that in important respects the Scottish system was not an ideal example of the nature and advantages of freedom in banking. But no, it doesn't follow that fractional-reserve based free banking is inherently flawed.

Why not? Because the Scottish banks' less-than-fully satisfactory response to the Bank Restriction, including both their violation of customer's property rights and the harm that arose from it, might have been avoided altogether had it not been for government meddling. That meddling consisted of two regulatory restrictions imposed upon the Scottish banks by Parliament as components of the Bank Notes Act (Scotland) of 1765, the full title of which is "An Act to prevent the inconveniences arising from the present method of issuing notes and bills by banks, banking companies, and bankers, in that part of Great Britain called Scotland."[1]

Although the 1765 Act recognized the right of both banking corporations ("chartered banks") and private banking partnerships ("provincial banks") in Scotland to issue circulating banknotes, it curtailed their note-issuing abilities in two important ways. It outlawed notes having a face value of less than £1 (or 20 shillings). And it outlawed notes bearing "optional" (or "option") clauses allowing their issuers to defer their redemption for up to six months, with compensation consisting of a 5-percent interest on the unpaid sum, based on the actual length of the delay.

That these two regulatory impositions, rather than any inherent feature of free banking (including the practice of fractional reserve banking) were the ultimate cause of those blemishes that marred the record of Scottish free banking during the Bank Restriction, is readily seen by reviewing the nature of those blemishes. These consisted, once again, of (1) the Scottish bank's own decision to suspend, which contravened their still-standing contractual obligation, as emblazoned upon their notes, to redeem those notes in specie on demand; and (2) the distress borne by Scottish citizens in consequence of no longer being able to convert banknotes into equal nominal sums of gold and silver coin.

The Small Note Ban

Regarding the second item, the distress in question was, as I noted in my previous post, almost entirely due to a sudden want of small change. The point is made especially clear in Andrew Kerr's (1884) History of Banking in Scotland (pp. 106-7). "One of the most distressing features of the situation," he writes concerning the state of things in Scotland at the onset of March 1797,

was the want of small currency. For sums of £1 and upward the bank notes were still available, but for smaller sums there was no medium of payment. The commonality, and indeed the whole community, were thereby placed in a most painful situation. Tradesmen could not pay wages, and small purchases could not be made. People resorted to the expedient of tearing £1 notes into halves and quarters, a practice which appears to have been tacitly recognized by the banks.

The situation improved dramatically after Parliament passed an Act that month again allowing Scottish banks to issue notes of less than 20s, albeit for a limited period only, whilst indemnifying any bank that had resorted to issuing small notes before the emergency measure became law. Although this temporary relaxation of the Scottish small-note ban was originally supposed to expire on May 15th, 1797, a subsequent Act continued it until the 5th of July, 1799, after which the Scottish public's needs were met by a combination of new British copper coin and silver Bank of England tokens.

Suspension by Contract

If much of the harm done by the Scottish bank suspension could have been avoided had it not been for the 1765 Act's ban on small notes, the violation of property rights that the suspension itself entailed might itself have been unnecessary had Scottish banks still had recourse to notes bearing option clauses. In that case, the Scottish banks might have responded to the Bank Restriction simply by exercising their right to invoke those clauses. Indeed, as Tyler Goodspeed explains in his fine Harvard University Press book, Legislating Instability: Adam Smith, Free Banking, and the Financial Crisis of 1772 (p. 34), although certain Scottish banks first began including option clauses on their notes as means for protecting themselves against note redemption "raids" staged by rival banks, in practice the main purpose such clauses served before they were outlawed was that of protecting Scottish banks against English and other arbitrageurs "seeking to profit from the price differential between English and Scottish Bills of exchange."

A distinct advantage of the option clause was that bankers could employ it with discretion against arbitrageurs whilst continuing to meet other note holders' requests for specie. "Far from providing an easy means for suspending payment," Goodspeed observes, the option clause "was conceived precisely to avoid the necessity of suspending payment by allowing for the threat of discriminate and orderly suspension" (ibid., p. 35). Because invoking the clause meant marking specific notes and then having to pay interest to their holders at 5 percent, which was also the maximum rate allowed by British usury laws, solvent banks had no incentive to resort to the clause except when faced with a genuine emergency. An insolvent bank, on the other hand, would be better-off closing its doors than invoking a clause that would only add to its total losses. In short, to employ modern jargon, notes bearing optional clauses embodied "incentive-compatible" contracts — contracts that were in the interest of banks and their ordinary customers alike.[2]

Had option clauses remained in use in Scotland at the time of the Bank Restriction, the presence of those clauses alone would have done much to avert runs on Scottish banks, together with the panic that ensued once those banks announced their decision to altogether cease paying out silver and gold. Note holders with ordinary requests for specie might then have had their needs accommodated, while others would have to decide whether it was worth waiting up to six months to have their marked notes redeemed. The delay would, in the meantime, have given Scottish bankers all the time they needed to acquire gold on the London market.

Blame the Bankers, Not Freedom in Banking

So it seems that the Scottish banks, far from having abused their freedom to victimize the Scottish public, were themselves innocent victims of Parliamentary encroachments upon that freedom.

Alas, the truth isn't quite so simple. For it was Scottish bankers themselves who lobbied for, and got, the restrictions included in the 1765 Bank Act. The bankers were themselves to blame, in other words, for the fact that they were inadequately prepared to meet the crisis of February 1797, or were prepared to meet it only by both breaking the law and having the Scottish public go begging for small change.

The story of the politics leading to the Bank Notes (Scotland) Act of 1765 is one I can't go into in any detail here. Instead, I'll once again refer my readers to Goodspeed, whose book tells the whole, sordid tale. In brief, to quote from that work, "though the stated intent of the Bank Act was to prevent excessive issuance of paper currency, in reality its underlying purpose was to achieve precisely what it did achieve, namely, to raise barriers to entry and limit competition in the Scottish banking sector." Far from addressing any genuine causes of instability residing in the Scottish system in the years leading to its passage, the Act "substantially amplified the level of systemic risk in Scottish credit markets" (p. 61). We've seen the damage done by the Act's provisions during the course of the Bank Restriction. Goodspeed, for his part, argues, convincingly, that the same provisions also contributed to the severity of the Ayr Bank crisis of 1772.

So we must, after all, place a "black mark" on the record of Scottish bankers. But the mark belongs, not among entries for the year 1797, but among those for 1765. More importantly, although it is a black mark for the Scottish bankers, it is not one for the principle of freedom in banking, which remains, so far as the events we've been considering are concerned, unsullied.

Nor ought it to surprise us, finally, that Scottish bankers should themselves have conspired to adulterate what was in most other respects a shining example of the benefits of free trade in currency and banking. "People of the same trade," Adam Smith famously observed, "seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public." It's the responsibility of government, rather than of businessmen, to keep trade free, and competition open, and to keep them so whether businessmen like it or not.

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[1] Although most of its provisions had long since become inactive, this Act remained among the statutes until 1993, when it was finally repealed.

[2] For more on incentive-compatible contracts allowing banks to suspend payment in emergencies see Gary Gorton, "Bank Suspension of Convertibility" and George Selgin, "In Defense of Bank Suspension."