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The Free Banking Era
Abstract
The period from 1837 to 1863 is known as the free banking period in the history of American banking. After two attempts at establishing a central bank for the country (the First Bank of the United States and the Second Bank of the United States), the federalists lost the power struggle to the advocates of states’ rights, and all banks began to be chartered by the states. The result was a proliferation of banks. Each of these banks issued their own banknotes against their deposits of gold and silver. These notes did not trade one for one, and their value mostly depended on the size of the issuing bank. Issuing paper currency wasn’t just limited to banks; even drugstores and railroad and insurance companies sometimes issued their own notes. The notes were also of varying size and color, and forgers had a field day: approximately a third of all paper currency during this period was counterfeit. Benchmarks like the reserve ratio, the capital adequacy ratio, and interest rates were set by the states. About half of these banks failed, and their average lifespan was five years.
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Banks in the United States issued currency with no oversight of any kind by the federal goverment from 1837 to 1865. Many of these banks were part of "free banking" systems with no discretionary approval of entry into banking, and these banks issued notes that were used for payments in transactions just as Federal Reserve notes are today. There was no central bank or goverment insurance, and the ultimate guarantee of the value of a bank's notes was the value of the bank's assets. As the author indicates, these banknotes have similarities to some forms of electronic money. ; Free banking in the United States sometimes has been equated with wildcat banking, a name that suggests that opening a bank has much in common with drilling an oil well. The author examines notorious instances of supposed wilcat banking and finds little evidence that free banks were imprudent, let alone financially reckless. Instead, episodic difficulties faced by free banks occurred because of developments outside the banking systems.
Thesis (Ph. D.)--University of Chicago, Department of Economics. Includes bibliographical references.
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The U.S. Constitution, by taking away the power of the states to issue paper money, removed a major source of flexibility in state public finance. In their search for new sources of revenue and fiscal flexibility, the states discovered that the banks they chartered could fill the gap. Investment earnings and tax revenues derived from banks soon became major elements of state public finance. We discuss the nature of these early business-government relationships and provide the first systematic assessment of their relative importance in state finance.
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JEL classification : F 15; F 33; N 13