Central banks are banks that serve as banker’s banks, holding deposits of commercial banks and making loans to commercial banks. Typically, a central bank also acts as the government’s banker, and holds a monopoly on the issuance of paper money. Commercial banks can turn to a central bank as a lender of last resort in financial crises. The Federal Reserve System in the United States, the Bank of England, the Bank of France, and the Bundesbank of Germany rank among the worlds leading central banks.
Monetary systems regulated by a central bank became the preferred form of monetary regulation in the latter part of the nineteenth century. The alternative to central bank regulation is what is called free banking, pioneered by Scotland in the late eighteenth century. In the high tide of nineteenth-century laissez-faire capitalism central banks were not fully evolved and free banking became a trend in England and the United States. The United States abandoned the Second Bank of the United States and turned to a form of free banking. Free banking was a system composed of a multitude of competing commercial banks, each of which issued its own bank notes. Under the free banking system no one bank commanded a monopoly on the issuance of bank notes, which is the position that a central bank enjoys.
Free banking denotes a banking system in which note-issuing banks are established according to the same principles that govern the establishment of any other new business enterprise. The ability to start a new bank requires sufficient financial capital and public confidence to make the new bank notes acceptable to the public and to help the new bank reach a profit-making scale of operation. A new bank need not clear any legal hurdles, such as charters or grants that require a special act of government. Each bank issues its own bank notes that it converts on demand into an acceptable medium of exchange—often, but not necessarily—gold. None of the banks issue notes bearing the legal status of legal tender, or in any way favored by the government. A bank’s refusal to redeem its bank notes into an acceptable medium of exchange is equivalent to a declaration of bankruptcy.
A system of independent commercial banks can cause instability in the economy. In an economic upswing, banks have an incentive to make as many loans as possible, and the loans stand an excellent chance of being repaid. This expansion of loans can turn an economic upswing into an overheated boom and inflationary spiral. In an economic downswing, on the contrary, banks find extending loans more risky, and curtail lending activities accordingly. This restriction on credit and money can push the downswing over the precipice into a depression. Individual banks, driven by the profit motive in a free banking system, add to the severity of cyclical fluctuations.
Central banks seek the public interest rather than strive to maximize profits. In the downswing central banks supply more credit to the system rather than less. In the upswing central banks restrict the supply of credit. The monopoly on the issuance of bank notes and commercial bank reserve deposits gives the central bank control over the money supply, interest rates, and credit conditions. These can be adjusted to counter the cyclical swings in order to smooth out these economic fluctuations.
In the twentieth century the preference for central banking over free banking is dogma. Nearly all the discussion weighing the relative merits of these two systems took place in a 50-year interval in the nineteenth century.