A Smithian Reading of Chilean Free Banking

Abstract

In the second half of the nineteenth century, the Chilean free banking system worked similarly to how Adam Smith describes the eighteenth-century free banking system in Scotland. The characteristics of free banking that Smith identifies as conductive of successful outcomes—free entry, unlimited liability, and convertibility on demand—are present in both Scotland and Chile. And the Chilean system failed for similar reasons to the worries Smith had about the Scottish system: inconvertibility, legal tender, involvement with government borrowing, and lobbying. The Chilean experience of free banking appears to follow Smith's account of free banking.

The Chilean 1860 Ley General de Bancos, formally abolished in 1898, prescribed a system of free banking that, in its successes and problems, allows for parallels between the successes of free banking as well as the problems free banking may face that Smith describes in The Wealth of Nations ([1776] 1981).

A free banking system may not necessarily be a completely unregulated banking system, just as a so-called free market may not be a completely laissez-faire market. Ignacio Briones and Hugh Rockoff (2005: 279) would prefer calling free banking “lightly regulated banking,” because of the practical impossibility of a complete absence of a government presence in the system (see also Cowen and Kroszner 1989: 222). Regardless of the appropriateness of the name, what is generally called free banking is a system characterized by (relative) freedom to issue banknotes, (relative) freedom to enter, (relative) freedom to lend, and (relative) light regulation (Briones and Rockoff 2005: 283).

The aspects of free banking that Adam Smith analyzes and that are considered here as among the strengths of a successful system of competitive banks of issue, even if not without some controversies, include free entry, unlimited liability, and convertibility on demand. They are to be found in Chile in the first period—the first two decades—of the existence of free banking laws. Inconvertibility, legal tender, and involvement with government borrowing are among the causes of instability and failure that Smith identifies and that are to be found in the second and more troublesome part of the Chilean experience of free banking—the last two decades of the formal existence of free banking laws.

That the almost forty years in which free banking legislation existed in Chile was not an example of the inherent failures of free banking has been discussed by René Millar (1994) and César Ross (2003), in the unpublished dissertations of Ignacio Muñoz (1996) and Ignacio Briones (2002), and more thoroughly in the papers included in the volume edited by Juan Pablo Couyoumdjian (2016; see also the debate in Rothbard 1989 and Selgin 1990). Briones and Rockoff (2005) analyze the Chilean experience alongside the ones of Scotland, the United States, Canada, Switzerland, and Sweden; but, rather than compare them, they limit themselves to an independent analysis of each.

What has yet to be shown, and what I propose to show here, are the links and similarities with the Scottish free banking experience as described by the most renowned Scottish economist of that time, Adam Smith, as well as the links and similarities between the worries Smith describes and the troubles of the Chilean experience. Adam Smith's analysis highlights the strengths and threats to free banking in Scotland, and the Chilean experience seems to fit the predictable pattern that Smith highlights.

The parallels may not be accidental, though. The alleged drafter of the 1860 banking law (Correa 1997) was the French economist Jean Gustave Courcelle-Seneuil (1813–92). The Chilean government hired Courcelle-Seneuil in 1855 as finance minister adviser and professor of political economy of the Universidad de Chile (Couyoumdjian 2015; Edwards 2018; Smith 1957). And Courcelle-Seneuil was part of a “liberal” intellectual elite who, according to Pedro Urzúa (1884: 11; as cited in Couyoumdjian [Juan Pablo] 2016: 34), worked in the tradition of Adam Smith, Jean-Baptiste Say, and Frédéric Bastiat. He eventually, in 1888, edited an abridged edition of Smith's Wealth of Nations in French.

As far as I am aware, nobody so far has shown how close the Chilean experience of free banking was to Smith's account of free banking in Scotland. The direct influence of Smith on Courcelle-Seneuil on banking, and on the banking system of Chile in particular, will be the subject of future studies. Here the scope is limited to show how the Chilean free banking system parallels Smith's account of free banking, with its strengths and its threats.

The analysis of successful competitive systems of banks of issue is increasingly relevant in a world where the possibility of choosing different moneys is more and more common, and in a world where the intermediation between borrowers and lenders can occur not only at the local, but also at a global, level.

The Success Stories

Adam Smith wrote in a time of economic boom. With the union of the parliament of Scotland and England in 1707, Scotland gained access to a larger market and in particular to the very large colonial market. And as he describes in his Wealth of Nations ([1776] 1981), the division of labor is at the base of the wealth of a nation, and it depends on the extent of the market. The larger the market, the more it is possible to specialize, and the more it is possible for wealth (i.e., real income) to increase (WN I.i–iii).¹

And indeed, gaining access to the colonial market allowed Scotland to grow. The total tonnage of oceanic vessels passing through Scotland's ports went from 54,407 in 1759 to 109,895 tons in 1771, and of costal vessels from 150,995 to 257,494. Glasgow became the largest port in the world for the tobacco trade. Scottish linen manufacturing increased significantly. Iron manufacturing and coal output increased by more than a factor of ten. Sugar refining, rope and sailcloth manufacturing, tanning, kelp and soap production, and fishery all experienced very rapid growth (Hamilton 1956: 405–6; Goodspeed 2016: 129–31). Agricultural production improved too (Bonnyman 2014).

Smith also recognizes that the extent of the market depends on the infrastructure that connects different markets. And indeed, Scotland experienced a vast increase in infrastructure. Dikes were built, fens drained, roads laid, harbors dredged, bridges built, and canals dug. The canals included the Forth and Clyde Canal, connecting the two coasts of Scotland, and the Monkland Canal, linking Glasgow to the coalfields of Coatbridge. The capital for these long-term investments generally came from public subscriptions (see, e.g., Priestley [1831] 1968; Prebble 1968; Dowds 2004).

Such economic growth caused and was supported by an extremely competitive and sophisticated banking system that offered short-term funds and provided the financial stability needed to support this rapid growth (Cameron 1967). As Smith himself tells us, “That the trade and industry of Scotland . . . have increased considerably during this period, and that the banks have contributed a good deal to this increase, cannot be doubted” (WN II.ii.41).

About a century later, Chile also experienced a significant economic expansion. The Chilean economy was less diversified and more peripheral than the Scottish one, but the independence from Spain in 1818 allowed Chile to open its markets, thus creating that extension of the market that in Smith's framework allows for economic growth. Foreign demand fueled mineral extraction as well as agricultural production (Collier and Sater 2004: 73–103). Mineral extraction also demanded a modernization of the country, the construction of an extended railway system, an expansion of infrastructure in general, and an increased urbanization. Manufactures increased with the extension of the railroads. Most of these major works in Chile were financed with foreign direct investments. And as the real economy grew, so did the financial sector (Carrasco 2009: 20).

And so, in eighteenth-century Scotland, as in many other countries experiencing economic growth, the problem of a lack of small change was a constant presence in monetary discourses (Sargent and Velde 2003). Thus, as in Scotland, in nineteenth-century Chile the demand for short-term credit to support the economic expansion emerged and was fulfilled by private issuers of notes (Muñoz 2016: 72–76).

In Scotland, a 1695 act of Parliament created the first official bank, the Bank of Scotland. The legal monopoly on banking and issuing notes expired in 1716 and was not renewed. This allowed for a slow but steady entry of other banking institutions so that by 1769, one could count thirty-two banks (Checkland 1975: 320–21; White 1994: 22–34).

In Chile, the 1860 banking law officially recognized and formalized the preexisting banking environment (Briones 2016: 115; Muñoz 2016: 73). Opening a bank was considered as easy as opening a bakery (Muñoz 2016: 74). There were no prescribed restrictions on the sort of assets a bank could hold or on the volume and composition of its loans and deposits. By the end of the 1880s, even foreign banks—British and German—would enter the Chilean banking market. As in Scotland, the start was slow. In the 1860s three banks, Banco Nacional de Chile, Banco de Valparaiso, and Banco de A. Edwards, had about 80 percent of the operations (Briones 2016: 212). But in the 1870s there were seven banks, and by 1900 there were twenty-eight of them, without counting their branches (Carrasco 2009: 26–27). Between 1878 and 1898, the year in which free banking laws were formally abolished, in real terms, banking deposits rose by more than 300 percent—nearly 15 percent of GDP (Briones and Rockoff 2005: 313).

Chilean banking law contained some of the characteristics that Smith praised in the Scottish system: free entry and full and immediate convertibility. The law also included unlimited liability, which Smith does not mention explicitly but implicitly recognizes as a prudential mechanism against the temptation to overissue, since bankers would face the costs of their erroneous decisions. Unlike Scottish banks, Chilean banks were legally required to limit note issue to the equivalent of 150 percent of their capital and to regularly publish their books (Jeftanovic and Lüders 2016: 51). In Scotland, publishing a bank's asset and liability status was adopted for the first time only in 1836, voluntarily, by the Union Bank. In Scotland, the Union Bank used it as a form of product differentiation, as a competitive practice (White 1994: 34).

Furthermore, in Chile, as in Scotland, there was regulation regarding the value of banknotes, forbidding the issuing of small-denomination notes, as well as usury laws, both regulations Smith favored.

Free Entry and Stability

Both systems proved to be stable and well equipped to absorb changes in demand for credit. This should not come as a surprise, if one follows Smith's analysis.

According to Smith, a competitive decentralized system is better able to face problems. Competition is the most effective instrument to discipline banks, and decentralization keeps possible negative shocks local.

Smith saw and described, for example, the catastrophic failure of Douglas, Heron & Co., most commonly known as the Ayr Bank, from the town in which it was based. Its losses in 1775 were estimated to reach two-thirds of a million pounds (Hamilton 1956: 415). And yet, all creditors and noteholders were paid in full, and the repercussions on other banks were short-lived (Checkland 1975: 133).

Similarly, the first banking crisis in Chile, in 1865–66, even if it was initiated from war financing as we will see below, proved the stability of the system: it posed only few major problems to banks and customers, and the banking system retained the trust of the people. In the 1860s and 1870s, several banks closed their doors for a variety of reasons, but all their obligations were always honored (Jeftanovic and Lüders 2016: 43). Even between 1880 and 1898, a more unstable time in the Chilean banking system, the cumulative losses for depositors was just 2.5 percent of total deposits (Briones and Rockoff 2005: 313–14). As a comparison, in New York State, where free banking was generally considered a success, the aggregate losses a few decades earlier were around 4 percent (King 1983: 147). And even during the Chilean civil war of 1891, in which the government of President Jose Manuel Balmaceda monopolized the issuing of inconvertible paper money to cover the expense of his government (as discussed below), the parliamentary revolutionary government in exile in Iquique maintained free competitive issuing. In the account of a contemporary of the events, Ramón Santelices (1893), as reported by Jeftanovic and Lüders (2016: 45), the municipality of Iquique was not able to keep up with the money demand. The foreign Banco de Tarapaca, a few big businesses, and small businesses such as hotels, restaurants, and even barbershops were all authorized to issue notes. And at the end of the revolution, all bills were rigorously redeemed.

In both countries, exogenous shocks were thus absorbed via local bankruptcies and mergers (White 1994; Muñoz 2016). And in both countries, the qualities of banknotes remained high over time, limiting the possibilities of counterfeiting (Chen 1987).

Unlimited Liability

Unlimited liability, in which bank shareholders are fully and personally responsible for all the liabilities of the bank, may be interpreted as a barrier to entry (Carr, Glied, and Mathewson 1989; Cowen and Kroszner 1989: 225–27; cf. White 1990: 528–31). But unlimited liability may not only insure the creditors against possible bad decisions of the banks, thus increasing trust in the bank and decreasing the fears of bank runs, but may also incentivize more responsibility from the banks than a limited liability, in which shareholders are responsible only for their shares of capital. When bankers face the full cost of their actions, banks are, in Smith's language, more prudent and more responsible (White 1990).

In Scotland, banks had unlimited liability, with the exception only of the three chartered banks—the Bank of Scotland, chartered in 1695; the Royal Bank of Scotland, chartered in 1727; and the British Linen Bank, chartered in 1746. In Chile, two of the three largest banks, the Banco National de Chile and the Banco de Valparaiso, had limited liability. In Ignacio Briones's account, it may not be an accident that during the banking crisis of 1878 (more on it below) there was a bank run on these limited liability banks, but not on Banco Edwards and Banco Ossa Y Matte, which had unlimited liability instead (Briones 2016: 127).

Convertibility

A competitive system of issuing institutions is able to avoid an upward pressure on monetary prices due to overissuing. Overissuing of notes is not in the interest of banks. Smith acknowledged that banks did do it, but mostly through a process of trial and error. For Smith, inexperienced bankers may think that overissuing would bring them more profits from the interest on the additional notes in circulation. And if banks discount bills of exchange with promissory notes rather than with gold and silver, they could make even more profit. Borrowers may be tempted to ask for overissuing of credit, and banks may be tempted to overissue credit (WN II.ii.43).

But if a bank issues more notes than demanded, the holders of notes would redeem them, as it is costly to hold notes. The bank would be obligated to convert notes on demand into gold and silver; and, if it failed to do so, it would face the risk of a run and thus the risk of bankruptcy (WN II.ii.48). Liquidity might be maintained, but at a very high price, by borrowing specie from other banks at an interest rate often higher than the rate the bank would earn on its assets. Add insurance and transportation costs, and one sees how overissuing is unsustainable for long periods (WN II.27–86). So, once banks understand how the adverse clearing process works, they understand that excess notes come back for redemption. If the notes are convertible on demand, sizable and prolonged overissuing would challenge the bank's ability to redeem its notes and might initiate the possibly compromising perception of illiquidity or insolvency of the bank, potentially triggering a run (Checkland 1975; Munn 1981; Curott 2017).

Ignacio Briones (2016: 134) describes the awareness of Chilean bankers of the same mechanism, especially before the 1878 crisis, offering a detailed explanation for the lack of overissuing during the first part of the Chilean free banking history. Problems would emerge when banks in Chile departed from the Smithian principles of free entry and full and immediate convertibility.

Smith's recommendation for Scottish banks was to offer only short-term loans, as long-term loans would potentially cause liquidity problems. Chilean banks, in the first decade of their free banking period, offered over 80 percent of their credit in loans of less than a year, of which more than two-thirds were under six months (Ross 2003: 47). Banks in Chile started to extend credit for long-term loans only in the last two decades of the free banking period, when the government offered them more privileges in exchange (111).

But while they stuck to the principles that Smith identified as conducive of successful free banking, it was no accident that prices were remarkably stable both in Smith's time and in Chile (Jeftanovic and Lüders 2016: 65–66). The history of inflation in Chile starts with the fall of the metallic standard in 1878, when the free banking practices started to crack (Fetter 1931; Hirschman 1963). But according to Albert Hirschman (1963: 173), inflation in Chile actually went unchecked only after 1904. And similarly, to the criticism of price inflation in the 1740s and 1750s, Smith answered that the higher prices were due to “the badness of the seasons, and not to the multiplication of paper money” (WN II.ii.96).

The Unsuccessful Worries

Inconvertibility

The way to maintain price and institutional stability is, according to Smith, a full convertibility of notes on demand.

In Scotland, the Bank of Scotland at first would not accept competitors' notes. But soon banks started not only to accept competitors' notes, but also to collect them. The idea was that one bank would show up at a rival's door with a large amount of notes asking to redeem them all at once, thus forcing the rival into scrambling to find the needed liquidity. To avoid this potentially troublesome situation, banks started to offer an “option clause,” that is, a bank would offer to customers an “option” to convert the notes at a later date, paying interest for the time until its redemption (Checkland 1975; Munn 1981).

Adam Smith was against the option or optional clause and called for it to be banned (WN II.ii.98). His reasoning was that the suspension of convertibility would decrease the incentives not to overissue. The possibility of rivals asking to convert a large amount of notes all at once would induce the bank to make sure to issue only the amount of notes that is profitable to issue, and no more. Removing that constraint, or simply the threat of that constraint, would, according to Smith, create instability owing to the now-increased incentives to overissue notes.

In practice, the option clause was seldom used. And for some later commentators, it had its benefits, if it was used. Banks' assets were quite illiquid, even for solvent banks. Gaining time to get liquidity was an effective way to avoid more dangerous runs and thus decrease instability (Dowd 1988; Cowen and Kroszner 1989: 223–24; West 1997). It also avoided generalized suspensions of convertibility (Goodspeed 2016: 50–59).

Nevertheless, the option clause was never a possibility in Chile. Individual banks were not allowed to temporarily suspend convertibility of their own notes. Whenever there was a problem in Chile, the whole system would become inconvertible by law.

Another difference between the two countries was that Scotland did not have to face bills such the ones for national defense alone. After the 1707 Act of Union, expenses such as national defense were covered by the British Treasury. The independent Chile, on the other hand, had to face the full bill of its national defense (Zelmanovitz 2013) and of the variations in international prices of gold and silver, given its fixed bimetallic standard (Hirschman 1963). Adam Smith does not explicitly analyze the problems of exchange rates for bank stability, but he seems to have understood the problem of war financing. He criticized the use of public debt to finance wars because, even if necessary at the end, it would incentivize frequent and prolonged wars by hiding their real costs from taxpayers (Paganelli and Schumacher 2018). Chile faced the need to finance wars.

So Chile ended up relatively frequently using one of the most dangerous practices that Smith saw in banking: inconvertibility. Making notes inconvertible creates incentives to overissue and thus causes inflation, destabilizing the entire system. That is, not surprisingly, what happened in Chile.

In Chile, inconvertibility involved lending to the government. Scottish chartered banks, unlike the Bank of England, were explicitly forbidden to lend to the government (Checkland 1975: 119–20). A similar provision was on the table in the early drafts of the banking law in Chile too (Jeftanovic and Lüders 2016: 49). But it did not make it to the final version. And so, when the Chilean government faced strong pressure due to its increased expenses linked to military engagements, or decreased revenue caused by changes in the value of taxable exports (the main revenue source in Chile), notes would be made inconvertible, and banks overissued notes purchasing government debt.

War between Chile and Spain over Peruvian territories in 1865–66 occasioned the first of these episodes. Spanish ships bombed Valparaíso, the main port of Chile. Ports closed, disrupting trade. Banks in Valparaíso and Santiago were no longer able to answer the demands of convertibility. Convertibility was thus suspended.

In September 1865, under pressure to finance the war, the government gave the Banco National de Chile the legal privilege of being the sole issuer of new inconvertible notes, backed with government bonds, not to exceed 50 percent of the bank's capital (Carrasco 2009: 27). A bond-collateral system, which required banks to hold specific bonds as a precondition for issuing notes, is one of the most regulated “free banking” systems, similar to the one present in the United States when the United States had free banking (Schuler 1992). In Chile, by the end of 1865, the privileges were also extended to other note-issuing banks, as long as they would offer non-interest-bearing loans to the government. These banknotes would not be convertible until early 1866, and the Public Treasury would accept them at face value for twenty-two years, even if they were not legal tender (Carrasco 2009: 27). The government on this occasion also authorized the issuing of small-denomination notes (Ross 2003: 49).

Not surprisingly, the government continued to need funding. In 1866 private banks started to lend directly to the government, under the agreement that their notes maintained inconvertibility for six months after the end of the war.

In Chile, as in England, banking problems may not have been endogenous to the “free banking” system. The privilege of issuing notes in exchange for direct loans to the government was granted to the Bank of England, but not to the Scottish banks. As Larry White (1994: 21) noted, “The root of England's monetary difficulties was not too little central banking, . . . but too much.” Briones (2016: 114) offers the same judgment with respect to the Chilean banking crises. At the same time, however, the exigencies of war were regarded as offering few alternatives.

Legal Tender and Government Borrowing

For Smith, the imposition of legal tender could aggravate the mistake of inconvertibility.

Legal tender, for Smith, is the most serious problem of paper money. He strongly condemned the practice adopted in some North American colonies. Declaring paper money legal tender is denounced as “a scheme of fraudulent debtors to cheat their creditors”:

This is exactly what happened in Chile. Banking in the North American colonies was able to function without additional problems, in Smith's account, because the motherland forbade the colonies from issuing notes with legal tender status (WN II.ii.101). Chile did not have that imposed restriction.

The first inconvertibility episode, as we saw above, happened in consequence of the war with Spain in 1865. The second inconvertibility episode, and the first establishment of legal tender, happened in 1878, in response to another crisis.

The Chilean government's revenue depended on mineral export taxes, thus varying with fluctuations in international trade (Sater 1979; Carrasco 2009: 27–29). Given these revenue fluctuations, the government found itself forced to borrow from abroad in 1870, 1873, and 1875. But when foreign credit dried up, the government again offered privileges to private banks in exchange for loans (Briones 2016: 125–30). By 1873 the Banco National de Chile's privileges included managing the government's international finance (Jeftanovic and Lüders 2016: 53).

With a worldwide depreciation of silver that caused a rapid outflow of gold, by July of 1878, the Banco Nacional de Chile found itself with about 3 percent of reserves. It asked for government help, and it received it. Notes were yet again declared inconvertible, until May 1880, but this time they were also made legal tender (Carrasco 2009: 28).

The situation worsened in April 1879, when Chile engaged in the War of the Pacific, against Peru and Bolivia. In Camillo Carrasco's account, the minister of finance, Julio Zegers, in a secret meeting of the government, declared that, if no agreements with banks could be made, the government would directly issue notes. No agreement was reached. And since there was no time to physically issue them, given their traditional high quality,² the government directly issued 6 million pesos in debt instead for five-year terms and with no interest (Jeftanovic and Lüders 2016: 55), which would circulate as legal tender. In less than two years, paper money in circulation tripled. By 1882 the total amount of notes was around 26 million pesos—16 million in government notes and 10 million in banknotes (Carrasco 2009: 28).

Returning to gold convertibility became impossible until the retirement of the government's notes because the banks simply converted their notes into the government's depreciated legal tender paper (Briones and Rockoff 2005: 312).

Notes that are forced to be accepted at nominal value for the payment of any debts undermine the clearing mechanism. If customers can choose between sound money and overissued money, they would choose sound money, giving incentives to banks not to overissue. But when that choice is no longer present, the incentive not to overissue is also no longer present.

Cronyism?

The problem that Adam Smith highlights was present in Chile. While inflation stayed practically at 0 percent between 1860 and 1878, after 1879 it started to increase (Jeftanovic and Lüders 2016: 66). And the people who benefited the most from this, aside from the government, were debtors.

Smith warned his readers that big merchants and manufacturers can be powerful interest groups and lobbyists. For Smith, we should carefully scrutinize any law or regulatory proposal coming from them because their interest is not the interest of society (WN I.xi.p.8–10). Through their influence on the government, they can benefit themselves at the expense of society. And if we take Roberto Espinoza (1909) seriously, in Jeftanovic and Lüders's (2016: 46, 67) account, many members of Chile's executive and legislative powers were indebted owners of mines and lands who would benefit from inflation. They were in favor of a nonconvertible monetary regime (see also Ross 2003: 95–126).

The play of interests may have been more complicated, though. Landlords were generally seen in a negative way, and their negative reputation was used for political gains. Aside from instabilities in the exchange rate due to international variations in the price of gold (Hirschman 1963), duties and subsidies for agricultural products, supported by the powerful Agricultural Society, may also have had an effect on prices (Wright 1973; on the interconnections between businesses and banks that led to a higher probability of long-term survival, and higher market evaluation of firms in Chile, see Braun, Briones, and Islas 2019).

Yet, the idea of going back to full convertibility remained for some time. The government implemented a program of monthly retirements of notes. But the civil war of 1891 halted it. The government of Jose Manuel Balmaceda found itself forced to issue an additional 20 million pesos (the rebel government in the north of the country declared it illegal). The conversion program resumed in November 1892. The goal was to return to full convertibility by the end of 1895 (Carrasco 2009: 29).

But the full return to the gold standard was eventually postponed to 1897. A severe monetary contraction due to errors in setting the conversion rate of pesos into gold and to an international crisis in Chilean exports, combined with poor agricultural outcomes, forced the government to intervene again. On July 5 and 6, 1898, yet another bank run was made on the Banco de Chile. The government returned to inconvertibility and legal tender. It forbade private issuance of notes and replaced bank notes with government notes. The Chilean free banking era formally ended in 1898 (Couyoumdjian [Ricardo] 2016).

The debate between the “papeleros,” who favored a fiat money regime, and the “oreros,” who favored a return to the gold standard, continued even after the abolition of the free banking law. The papeleros claimed in their favor an increasing growth and stability even if brought about by better international conditions (on the debate between oreros and papeleros in Chile and in Latin America in general, see in particular Alcouffe and Boianovsky 2013). Convertibility was postponed again to 1910. In 1907 the minister of finance, Guillermo Subercaseaux, hoped to create a currency board, the first centralized institution of issue in Chile, with a 100 percent gold backing. He failed. Paper money in circulation instead ended up doubling between 1905 and 1910. Other institutional experiments included a Conversion Office before the First World War, a proposal for a Privileged Central Bank after the war, and a first proposal for a Banco Central de Chile in 1921, followed by several others (Carrasco 2009: 33–34). The Central Bank of Chile was eventually created in 1925, after the visit of the Kemmerer mission (Millar 1994: 419–33).

Conclusions

Kurt Schuler (1992) suggests that the economic models of bank runs in the absence of central banks are historically unsupported (see also Calomiris and Gorton 1991). Rather than to their inherent instability, suppression of free banking may be more reasonably linked to the governments' desire to extract seigniorage from their own note issues (Schuler 1992: 30). The papers in Kevin Dowd's (1992) edited volume are evidence of this. And it is pretty much the history of the Chilean experience of free banking as well.

Often enough the free banking experience of Chile is presented as an example of the failure of free banking due to its in-built instability (Espinoza 1913; Fetter 1931; Ross 2003). Others link the crisis to a de facto concentration of banks, where three major banks played the lion's share (Subercaseaux 1921: 154).

But the problem may not have been any of the above. Scotland too had very liberal banking laws and only three major banks, as well as a myriad of more or less small banks.

Looking at the Smithian analysis of free banking in Scotland and comparing it with the Chilean experience, it is possible to see that the problem may not have been one of inherent instability of free banking, but rather of the inherent destabilizing effects of government interference with free banking, as Briones (2016: 114) suggested.

If we take Adam Smith seriously, we can see that a system of competitive banks of issue works well if banks are subject to the checks of free entry, convertibility, and unlimited liability, while it would start experiencing problems with the introduction of inconvertibility of notes, legal tender, the government borrowing directly from the banks, and special interest groups affecting the legislation. The lessons that Smith teaches from Scotland and the Chilean experience may be valuable lessons whenever competitors try to enter the market for means of payment.

A special thanks to Fulbright Chile, Universidad Del Desarrollo, and Trinity University for supporting this research. Thanks also to Camilo Carrasco, Juan Pablo Couyoumdjian, and José de la Cruz Garrido, as well as to Tyler Cowen, Andrew Farrant, Leonidas Montes, Craig Smith, and Leonidas Zelmanovitz, for comments and feedback on earlier drafts of this article. Thanks also to two anonymous referees and the editor of this journal for their detailed comments and encouragement. All mistakes are mine.

Notes

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