Rothbard, M. N. (1989). The Other Side of the Coin: Free Banking in Chile. Austrian Economics Newsletter (Winter), 1-4.
The Law of 1860 created a free bankers’ paradise in Chile. Anyone or any group could set up a bank and issue notes. There were no reserve requirements, no minimum capital or loan requirements, no limits on loans to directors, and no inspection by government agencies. Only two minor restrictions were imposed: a minimum note issue of 150% of the bank’s capital, and a ban on very small denomination notes under 20 pesos. All else was permitted, within, of course, the standard free-banking framework of requiring banks to redeem their notes in gold on demand. […]
It took less than five years for the brave new free banking system to collapse. In 1864, Spain and Peru went to war over the Guano Islands off the coast of South America, and Chile went to the aid of Peru, declaring war on Spain on September 24, 1865. By the outbreak of war, the free banks had inflated to such an extent that they were vulnerable to insolvency in a major crisis. Hence, the war scare of 1865 led to massive withdrawals of bank deposits and the cashing of notes from the fractional reserve banks. At the point of insolvency, the banks were promptly saved by the Chilean government, which now embarked on a path of inconvertible bank paper. First, five days after the declaration of war, it authorized the new Banco Nacional de Chile to issue a mass of inconvertible bank notes, stipulating (a) that the inconvertibility would last only for 90 days and (b) that the maximum note issue would be 1.5 million pesos. The fiat notes would not be legal tender, but would be receivable in taxes or other payments to the government. Second, the government induced four of the leading banks to agree to receive the Banco Nacional notes at par, and also to turn over to the government all coin taken in to help eventually redeem the bank notes received by the government. Third, the government agreed to issue 1 million pesos worth of bonds to be kept as a guarantee for any of the inconvertible bank notes received by the government.
Another law was passed at the end of December, delaying specie convertibility until six months after the war with Spain was over, or, at the latest, by the end of June 1867. In addition, more inconvertible bank notes were made receivable in taxes. […]
The next step in the acceleration of inflation came in July 1866. The government borrowed massively from banks to help pay the foreign debt; in return, the government bestowed a host of special privileges on the banks. The law of the previous December was repealed. From now on, there were to be no restrictions on the amount of loans or note issue by the banks; all bank notes would be inconvertible until six months after the war, or June 1867 at the latest. All banks lending money to the government would agree to receive each others’ notes at par for twenty-two years, to the extent of 4.5 million pesos. For this massive set of privileges, the banks agreed to pay the government a fee of 2 percent per annum on any inconvertible notes outstanding.
Fortunately, the war was shortly over, and convertibility into specie was soon resumed. But the signal had been given to the banks that the government would bail them out in times of real financial trouble, and so an inflationary boom soon began, fueled by bank credit expansion and ensuing speculation. The bank credit boom after 1866 led to a speculative boom in mining, as well as an increase in wheat and copper prices. […]
Booms always give way to busts, and a depression set in by 1874. Farmers and landlords went even more heavily into debt, and total agricultural debt in arrears rose to 11.7% in 1877 and to a staggering 33.6% in 1879. There was a heavy depression in the mining industries. The Chilean government incurred heavy deficits from 1874 on. Having exhausted private nonbank credit sources after several years, the government in June of 1878 finally turned to the already overextended banks, borrowing 2.5 million pesos per year for two years. In turn, the Treasury allowed the lending banks to issue 10.1 million pesos in bank notes, to be receivable in taxes.
Just before the suspension, on June 30, 1878, demand liabilities of the Chilean commercial banks totalled 46.8 million pesos; specie reserves of the banks totalled only 3.45 millions pesos, a reserve ratio of 7.4%. Even during prosperity at the end of 1869, total reserves had constituted only 8% of demand liabilities.
Selgin, G. A. (1990). Short-Changed in Chile: The Truth about the Free-Banking Episode,”. Austrian Economics Newsletter, 11(1), 5-7.
Chile’s free-banking system was undermined by (1) its bimetallic legislation of 1851 and (2) its sanctioning of inconvertible currency to ease the government’s fiscal burdens in connection with its war with Spain and again in 1878.
Chile’s wartime suspension of specie payment in 1865-66 was due entirely to the government’s desire for fiscal support and not … to any general banking crisis stemming from overissue of bank notes. Indeed, prior to the outbreak of the war the banking law of 1860 had led to only a minor expansion in note issues. The government’s sanctioning of irredeemable issues – first by the new Banco Nacional de Chile and then restored on August 31, 1866. In fact, despite the government’s irresponsible behavior the entire war episode passed without any serious depreciation of the currency. The period from 1866 to 1874 was exceptional in that the government refrained from interfering with the free-banking law or with the principle of convertibility. The consequence was an era of remarkable growth and prosperity, free of monetary crises. [Footnote 3 : Fetter, p.16. During this era Chile’s railroad and telegraph systems were developed, the port of Valparaiso was enlarged and improved, and fiscal revenues increased by one-quarter.]
… the events leading to the suspension of specie payments in 1878 were largely a consequence of Chile’s bimetallic legislation of 1851 fixing the legal rate of exchange of silver to gold at 16.39:1. This legal restriction alone accounts for the crisis of 1874 […]
Here is what Rothbard himself has to say elsewhere on this subject:
“… Thus, suppose that … the government set the ratio between [gold and silver] at 16 ounces of silver:1 ounce of gold. The market price, perhaps 16:1 at the time of the price control, then changes to 15:1. What is the result? Silver is now being arbitrarily undervalued by the government and gold arbitrarily overvalued… . The same consequences now follow as from any effective price control… . Gold goes begging for silver in unsold surplus, while silver becomes scarce and disappears from circulation. Silver disappears to another country … and gold, in turn, flows into the country.”
… whereas prior to 1874 the market value of silver was above the official rate of 16.39:1; it fell early in 1874 to 17.623:1. The official rate, which had previously overvalued gold, now overvalued silver – almost all of which had been melted down and exported in the preceding decades. All of a sudden there emerged a vast demand for gold to export: holders of bank notes rushed to redeem them in the newly undervalued metal. The banks, having little silver to offer in place of gold to meet these exceptional demands for redemption, were left with no alternative but to watch their specie reserves dwindle while taking steps to reduce their liabilities as quickly as possible. […]
Furthermore … average figures disguise the fact that many banks kept much higher reserve ratios: the averages reflect to a large extent the irresponsible policies of a few “bad apples.”
In the early 1870s the government ran small budget deficits. But the situation changed dramatically after 1874 when gold began to leave the country, provoking a severe shortage of credit and causing fiscal revenues to plummet. In June 1878 the government once again sought financial support from the banks. Nine banks in all agreed to purchase over 2.5 million pesos of two-year, 9% Treasury notes in return for their notes (up to four times the value of their individual loans) being declared publically receivable until 1888. Thus a privilege previously limited to the National Bank and the Banco de Agustin Edward y Cia was extended to seven others. In turn the two previously favored banks were given a small annual side payment as a consolation prize.
The inequity of these arrangements did not pass without notice. At least one member of the Chamber of Deputies attacked the loan, saying it would pave the way to suspension “because the government would authorize inconvertibility before it would allow the banks to fail.” It was not long before this prophecy was borne out. By early July three of the nine banks which had participated in the June loan saw their reserves fall to exceptionally low levels … Rather than contract their obligations as other banks had done, the imperiled three continued recklessly to extend credit. […] Finally a committee of representatives from the troubled banks … approached the government to request permission to suspend payment. To rescue these ill-managed banks … the government authorized a suspension for the nine banks that were a party to the June loan only. […]
The favored banks had lent generously to the government to rescue it from its own bimetallic legislation, knowing full well that this would lead them to insolvency. They relied upon the government to support them by sanctioning the suspenson of payments, and were not disappointed. Had the government abided by a policy of true free banking these ill-managed banks would have been allowed to fail and suspension would have been avoided; with such a policy in place the banks might never have dared to undertake the excessive lending that caused their reserves to be depleted.