The issue I want to raise here is this: what is the empirical evidence about systems that approximate the free banking ideal? I use the word “approximate” because obviously there is no real world example of a system that is a perfect example of the free bankers’ utopia. There are some approximations, and Australia in the late 19th century is one of them.
Although Australian banking supervision was originally done by the British Treasury, from 1846 all the Australian colonies (except Western Australia) received banking autonomy, and then from 1862 the British Treasury no longer exercised this responsibility, which passed to each colonial government. These colonial governments (or state governments as they are called in Australia) did very little to regulate banks. Under the Colonial Bank Regulations of 1840, Australian banks already had limited liability. But, unless one wants to argue that limited liability is anti-market, this was no anti-market measure.
And even the basic earlier regulations were not even followed to any great degree: the restriction on banks with regard to advances on real estate was circumvented by the 1850s by legal tricks, and in Victoria the regulation was abolished in 1888 (Hickson and Turner 2002: 154).
By the 1860s, the Australian banking system had these characteristics:
(1) a gold standard (usually dated from 1852 [Bordo 1999: 327] with a branch of the British mint established in Sydney in 1855);
(2) no central bank;
(3) no capital controls;
(4) few legal barriers to entry;
(5) no branching restrictions;
(6) no credible restrictions on assets, liabilities or bank capital;
(7) no legally established price controls;
(8) no government-provided deposit guarantees.
What happened?
One obvious factor that a free banking system will never control is the speculative inflows and outflows of capital that any country experiences: by this factor alone there will always be the possibility of rapid inflation of the commodity money base, which will allow a surge in credit. This happened in Australia’s case: there was a surge of capital inflows in 1881–1885 and a flood in 1886–1890 (Hickson and Turner 2002: 149).
There is a real paradox here: the free bankers, much like the Austrians, make a fetish of free markets. For them only unrestricted capital movements are consistent with economic freedom, but it is this very trait that means that any free banking system will be subject to exogenous factors that cause its capital inflows and outflows to fluctuate. This is the Achilles’s heel, so to speak.
There is no reason in theory why a free banking system overflowing with foreign capital could not experience a credit boom.
Secondly, with no prudential regulation there is nothing to stop banks from
(1) lowering lending standards (leaving the bank with loans that default), and
(2) buying the latest trendy, poor quality assets which will be held on their books, only to collapse in value later.
And why would a free banking system not get caught up in the speculative frenzies when people and banks think they can make money quickly on rising asset prices?
This is precisely what happened in the case of Australia: banks started directing credit to property speculators and to those purchasing what were called “pastoral securities” (Hickson and Turner 2002: 159). A new class of companies appeared that specialised in property and stock market speculation, as well as building societies and land development companies, and they obtained credit from the banks for this purpose (Hickson and Turner 2002: 159).
The speculative boom in the prices of real estate and stocks of land, land finance and mining companies reached its apogee in 1888, but terminated in October of that year (Hickson and Turner 2002: 148).
From 1891 to March 1892, 41 deposit-taking building or land finance companies failed in Melbourne and Sydney (Hickson and Turner 2002: 148). The full force of the banking crisis did not hit until after 30 January 1893 when the Federal Bank failed. From April, when the Commercial Bank of Australia was hit by the crisis, there was a major panic, and by 17 May some 11 commercial banks had been suspended, with runs on many others (Hickson and Turner 2002: 149).
There existed an organisation of private banks called “The Associated Banks of Victoria” that supposedly existed partly to co-ordinate the activities of banks. Free bankers think such associations will engage in self-regulation and provide a lender of last resort function in times of panic.
This is not what happened in the Australian case: in January 1893 the Federal Bank failed and it was a member of the Associated Banks association, and then the Commercial Bank of Australia failed without any help forthcoming.
What is ridiculous here are the excuses offered by free market apologists: they contend that the Victorian Treasurer’s attempts to force the Associated Banks to provide assistance to smaller bankers and the bank holiday introduced by the Victorian government in early 1893 exacerbated the crisis. Yet the full scale panic had already begun in April 1893, before these actions. None of these actions had anything to do with the creation of the asset bubbles in the first place, which had occurred in the previous decade of the 1880s. There had already been a credit boom in the decade before 1893.
From April 1893, there were a number of limited interventions some colonial governments undertook: some banks that suspended were allowed to engage in reconstruction (conversion of deposits into preference shares, changing short-term deposits into long-term fixed deposits and the issuing of new shares to obtain capital).
In Victoria, the state government declared a 5 day bank holiday on Monday, 1 May 1893, which is adduced by some as a move that made matters worse. However, what is not said is that history ran an experiment for us in 1893: the Victorian government did very little to stop the crisis in the way of interventions to save the financial system in addition to its bank holiday. In contrast, the New South Wales government took quite different action.
In New South Wales, the government made the bank notes of the major banks – the Bank of Australasia, Bank of New South Wales, City Bank of Sydney and Union Bank – legal tender, and announced that it was willing to act as a lender of last resort (on 21 April 1893). This restored confidence to the financial sector in New South Wales to such an extent that the crisis ended in a couple of days here (Hickson and Turner 2002: 165).
The government of Victoria failed to intervene in the way the New South Wales government did, and the result was clear: in Victoria there was a deep crisis and in New South Wales the crisis was largely avoided.
Victoria was a large part of the Australian economy, so it was only natural that the financial crisis exacerbated a recession in these years. In fact, the familiar pattern of debt deflationary disaster had already hit the Australian economy in 1890, after the asset bubble collapse and deleveraging of the over-indebted private sector:
“In Australia, GDP fell for four years running, from 1890 through 1893 ... Unemployment rose sharply. Immigration slowed and tentatively reversed direction. Social disorder spread, led by protesting sheep shearers, dock workers, and miners. Post-1893 recovery, if it may be called that, was slow and uneven” (Adalet and Eichengreen 2007: 233).
As always, when we are dealing with 19th century GDP, we can only ever have estimates.
One estimate is that real GDP fell by around 10% in 1892 (Kent 2011), and by 7% in 1893, and deflation occurred from 1891 to 1897. Angus Maddison has made the following estimates:
Year | GDP
1888 | $14,685
1889 | $15,953 | 8.64%
1890 | $15,402 | -3.45%
1891 | $16,586 | 7.69%
1892 | $14,547 | -12.29%
1893 | $13,748 | -5.49%
(Maddison 2006: 452).
On these figures, a moderate recession began in 1890, a recovery occurred in 1891, but this did not last and a real, technical depression (that is, a period of real GNP/GDP contraction of 10% or more) hit Australia in 1892, which continued into 1893.
After 1893, there was uneven growth, with actual recessions in 1895 and 1897, and the economy was mired in what we can call a chronic underemployment disequilibrium, just as many countries were in the 1930s.
APPENDIX: ESTIMATES OF AUSTRALIAN GDP IN THE 1890s
There exist three modern estimates of Australian GDP in the 19th century, as follows:
(1) The figures of Noel G. Butlin, Australian Domestic Product, Investment and Foreign Borrowing 1861–1938/39 (Cambridge University Press, Cambridge, 1962), p. 460ff., with some amendments in Noel G. Butlin, Investment in Australian Economic Development, 1861–1900 (Cambridge University Press, Cambridge, 1964), p. 453.
(2) the revised lower estimates of Bryan Haig, “New Estimates of Australian GDP: 1861-1948/49,” Australian Economic History Review 41.1 (March, 2001): 1–34.
(3) adjusted figures for both (1) and (2) by Angus Maddison, The World Economy, Volumes 1–2 (OECD, 2006), p. 452, but using the estimates of Butlin (1962) and Haig (2001).
The data from Angus Maddison are below:
I. Angus Maddison’s Estimates of Australian Real GDP from Butlin (millions of 1990 international Geary-Khamis dollars)
Year | GDP | Growth Rate
1888 | $14,685
1889 | $15,953 | 8.64%
1890 | $15,402 | -3.45%
1891 | $16,586 | 7.69%
1892 | $14,547 | -12.29%
1893 | $13,748 | -5.49%
1894 | $14,217 | 3.41%
1895 | $13,418 | -5.62%
1896 | $14,437 | 7.59%
1897 | $13,638 | -5.53%
1898 | $15,760 | 15.56%
1899 | $15,760 | 0%
1900 | $16,697 | 5.95%
(Maddison 2006: 452).
It is interesting how these show further moderately bad recessions in 1895 and 1897 with stagnation (no growth) in 1899.
II. Angus Maddison’s Estimates of Australian Real GDP from Haig (millions of 1990 international Geary-Khamis dollars)
Year | GDP | Growth Rate
1888 | $12,546
1889 | $13,702 | 9.21%
1890 | $13,772 | 0.511%
1891 | $13,890 | 0.857%
1892 | $13,640 | -1.8%
1893 | $13,663 | 0.17%
1894 | $13,819 | 1.14%
1895 | $14,015 | 1.42%
1896 | $14,288 | 1.95%
1897 | $15,147 | 6.01%
1898 | $15,749 | 3.97%
1899 | $16,592 | 5.35%
1900 | $17,186 | 3.58%
(Maddison 2006: 452).
For comparison, here are the figures directly from Haig (2001) in millions of pounds in 1891 prices:
Year | GDP | Growth Rate
1889 | 175.4
1890 | 176.3 | 0.51%
1891 | 177.8 | 0.85%
1892 | 174.6 | -1.79%
1893 | 174.9 | 0.17%
(Haig 2001: 29).
We have agreement here on the growth rates calculated from Angus Maddison’s adjusted citation of them.
On Bryan Haig’s revised figures, there was
(1) very low growth in 1890–1891,
(2) a mild recession in 1892, and
(3) essentially stagnation in 1893 (with a growth rate of 0.17%).
Even these figures confirm that something had gone wrong in the Australian economy in these years, even if they are quite different from Butlin (1962).
Moreover, there are problems with Haig’s estimates. Angus Maddison’s assessment of Bryan Haig’s revised figures for 1860–1911 demonstrates to me that they are not necessarily better than those of Butlin at all. Angus Maddison points out the following:
(1) for 1860–1911 Haig has no quantitative measure of 70% of GDP (Maddison 2006: 453);
(2) Haig described the estimating procedure he used in but five pages, but Butlin provided his in 200 pages (Maddison 2006: 453);
(3) Butlin provided data for more states than Haig did: Haig used data from Victoria and New South Wales to fill in gaps for overall Australian estimates (Maddison 2006: 453).
(4) one of Haig’s fundamental objections to Butlin’s estimates was that they conflicted with traditional interpretations of Australian economic history: but this is just an unreasonable a priori objection. As Maddison says in reply to this, “it is up to those who disagree with Butlin to prove him wrong” (Maddison 2006: 451).
All in all, I do not see any reason to think Haig’s estimates are to be preferred.
BIBLIOGRAPHY
Adalet, M. and B. Eichengreen. 2007. “Current Account Reversals: Always a Problem?,” in R. H. Clarida (ed.), G7 Current Account Imbalances: Sustainability and Adjustment, University of Chicago Press, Chicago. 205–246.
Bordo, Michael D. 1999. The Gold Standard and Related Regimes, Cambridge University Press, Cambridge.
Butlin, Noel G. 1962. Australian Domestic Product, Investment and Foreign Borrowing 1861–1938/39, Cambridge University Press, Cambridge.
Butlin, Noel G. 1964. Investment in Australian Economic Development, 1861-1900, Cambridge University Press, Cambridge.
Dowd, Kevin. 1992. “Free Banking in Australia,” in K. Dowd (ed.), The Experience of Free Banking, Routledge, London.
Haig, Bryan. 2001. “New Estimates of Australian GDP: 1861-1948/49,” Australian Economic History Review 41.1 (March): 1-34.
Hickson, C. R. and J. D. Turner. 2002. “Free Banking Gone Awry: The Australian Banking Crisis of 1893,” Financial History Review 9: 147–167.
Kent, C. J. 2011. “Two Depressions, One Banking Collapse: Lessons from Australia,” Journal of Financial Stability 7.3: 126–137.
Maddison, Angus. 2006. The World Economy: Volume 1: A Millennial Perspective and Volume 2: Historical Statistics, OECD Publishing, Paris.
Merrett, David T. 1989. “Australian Banking Practice and the Crisis of 1893,” Australian Economic History Review 29.1: 60–85.
Merrett, David T. 1993. “Preventing Bank Failure: Could the Commercial Bank of Australia have been saved by its Peers in 1893?,” Victorian Historical Journal 64.2: 122–142.
Pope, D. 1989. “Free Banking in Australia Before World War I,” Australian National University, Working Papers in Economic History, Working Paper No. 129.
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