Click here to read the original Cautious Optimism Facebook post with comments
7 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff examines U.S. banking in the quarter-century before the Civil War, a chapter when the federal government withdrew from regulating banks but state governments filled in the gap. Accordingly, the period has been misnamed the “free banking era” by many economists who present it as proof that “laissez-faire” and “deregulation” in American banking has already been tried and failed.
|The Panic of 1857|
After the Second Bank of the United States was shuttered and the Panic of 1837 passed, the federal government backed away from intervening in the American monetary system. For the next 25 years its only contribution to money and banking was at the U.S. Treasury which accepted newly mined gold and silver from the public and minted it into coins.
For this reason, the quarter century from 1837 to 1862 has been misnamed the “free banking era” by many economists and historians.
But even without federal intervention the period was hardly free from government interference.
Washington might have temporarily bowed out, but the states still played a disruptive role in the regulation of banks and in fact increased their interventions. Legislatures ratcheted up their control over the industry with a slew of new, also misnamed “free banking” laws.
Unfortunately, the free banking misnomer has stuck with the mainstream economics and journalism communities—in the Correspondent’s opinion deliberately—and the problems that sprang from the era’s regulations have been blamed on a nonexistent “deregulation” and “laissez-faire” of the time.
(to read some examples see the comments section of this article)
Why wasn’t the free banking era all that free?
First, state unit banking regulations hadn’t gone anywhere. The lion’s share of U.S. banks were still made artificially weak and fragile by anti-branching regulations dating back to the nation’s founding. No bank anywhere in the USA was permitted to branch outside its home state. Many states restricted intrastate banking to just one or a few counties while others forbade branching entirely, mandating that a bank could literally be only one building (ie. a "unit bank").
Unable to branch, banks couldn’t diversity their loan portfolios or depositors, couldn't shift capital from healthy branches to distressed ones experiencing elevated customer withdrawals, and endured a host of other regulation-induced problems.
The Economics Correspondent has previously written in detail on the problems of branch banking restrictions and you can revisit the topic at:
Adding atop old problems were new and widespread state “free banking” laws that added more mechanisms for failure.
Prior to 1837 it took a lot for a prospective banker to get a charter from his state legislature. To open a new bank one often had to lend to state governments so that legislatures could in turn buy ownership stakes in the bank itself, using dividend payments as a revenue source.
Banks also had to pay hefty fees to secure a charter and the charters had rapid expiration dates, meaning banks had to return only a few years later and pay another “fee” to renew licenses. Often “fees” implicitly meant flat out paying bribes to state officials which was sometimes euphemistically called a “bonus.”
When the federal government backed away from bank regulation in 1837 there was an outcry in many states against these onerous and sometimes downright corrupt charter provisions—both from the public and the bankers themselves. Many states responded by altering the rules to make it easier—more “free,” if you will—to open a bank.
And one of the first problems with the characterization of “free banking” is that free banking states required banks applying for new charters to operate as unit banks (Surro, Calomiris).
Yes, “free banking” meant that operating branch offices was against the law.
Already the historical fable of laissez-faire under this system is undermined. But we’re just getting started.
YOU MUST BUY OUR BONDS
Yet free banking laws went much further with their regulatory interventions. For they not only expanded the onerous unit banking mandate but built another giant problem upon it: the bond deposit requirement for issuing currency.
It's important to remember that in 1837 there was no monopoly central bank issuing paper currency. Instead private banks, which accepted gold and silver deposits from customers, issued banknotes which were payable on demand in the dollar’s defined weight of specie (24.75 grains of pure gold or 371.25 grains of silver).
Like nearly every other country at the time, America relied on private banks to provide paper currency. But unhappy to leave well enough alone, the free banking states placed a new condition on the private issuance of currency: banknote issuances had to be 100% backed by bonds.
And just what kind of bonds? The state government’s itself of course.
What was the reason and how did this regulation breed financial instability?
The political rationale advertised to the public was “If your bank fails what better asset to back your banknote than a government bond that is repaid with the power of the state’s taxing authority?”
But the real impetus was that state legislatures wanted a generous source of revenue for “infrastructure” spending.
In the 1830’s, 40’s, and 50’s the U.S. was engulfed in an infrastructure craze. Steamboats, canals, railroads, bridges, and turnpikes were all the rage and being built up everywhere.
While building an advanced infrastructure for a country is generally a good thing, state governments weren’t content letting private industry handle the work. Many states decided to get in on the party themselves and borrowed heavily to do so.
And if you want to borrow a lot of money quickly and easily, what better place to get it than from banks? Banks are concentrated money centers, and it’s far easier to borrow from a handful of banks than it is to solicit thousands of private households or wealthy widows to loan you money in small, disparate pieces.
Hence the state bond mandate. If banks wanted to issue paper currency, they were forced by free banking laws to lend the same amount to their state governments and hold their bonds.
BAD BONDS = BAD BUSINESS
Even given the misnomer of “free banking,” one can already see how this state/bank arrangement provided opportunities for waste and corruption, or what many call crony capitalism today. Unfortunately, it also led to unnecessary bank failures and one significant financial crisis in 1857.
For most “free banking” state governments proved to be incompetent, if not completely corrupt, when it came to building infrastructure.
Their borrowed funds were often wasted or simply disappeared. States commonly ran out of funds before projects had even begun, the coffers running dry before the first bridge girder was installed, the first mile of turnpike was paved, or the first foot of railroad track was laid.
On a side note: Does any of this sound familiar today? Like the hundreds of billions of dollars in federal “stimulus” money from 2009 that promised to fix America’s infrastructure but mostly evaporated?
Unsurprisingly most free banking states had difficulty servicing their bonds and many of them defaulted.
And as the value of their bonds plummeted, often reaching zero, banks found themselves unable to issue paper currency since the value of notes outstanding had to equal the value of their state bonds, many of which were now worthless.
Prohibited from issuing cash, banks were faced with angry customers who demanded something they could use to conduct hand-to-hand business transactions, so they withdrew the only remaining option: gold or silver coin. The loss of gold and silver reserves forced banks to contract credit and a monetary crunch then ensued.
Worsening the strain was the impact of lousy bonds on bank balance sheets. State bonds were added to the assets side of bank ledgers, but when the bonds depreciated or became worthless the bank’s adjusted assets took a huge haircut. When word got out a bank was now technically insolvent its depositors rushed for the exits, lining up to withdraw their gold and silver coin in a classic bank run and failure.
And all because state governments forced banks to serve as a tool of fiscal policy, mandating they lend heavily to legislatures which in turn squandered the proceeds.
As monetary economist George Selgin points out “Careful economic historians have shown that [depreciating state government bonds] was the main cause of free bank failures in the antebellum United States.”
THE FINAL TALLY
At its peak how prevalent was free banking in the United States?
Selgin places the number of states at “a great many,” at least thirteen states with Michigan starting in 1837, followed by New York and Georgia in 1838.
Chris Surro (UCLA, 2015) numbers free banking states at eighteen by 1860 when there were thirty-three states (55%).
And prolific economic historian Hugh Rockoff (Rutgers, 1975) provides the most comprehensive list so far, confirming eighteen states in 1860 including their dates of adoption.
Michigan (1837, again in 1857)
New York (1838)
New Jersey (1850)
Three more states—Virginia, Kentucky, and Missouri—forced the state bondholding requirement on their banks without passing comprehensive free banking laws, bringing the total number of states requiring bond purchases to twenty-one of thirty-three (64%).
Yet despite eighteen of thirty-three states forcing their banks to become non-branching unit banks and twenty-one states compelling banks to buy their mostly lousy government securities, the absence of the additional layer of federal regulation still made the so-called “free banking” era one of the quieter periods in terms of America’s banking panics.
Only one substantial crisis, the Panic of 1857, struck during the quarter century and the country was able to rebound fairly quickly from the ensuing recession. This stands in contrast to the two panics of the First Bank of the United States era (1791-1811) and the highly destructive Panic of 1819 under stewardship of the Second Bank of the United States (1816-1836).
But that doesn’t stop many academics and the press from depicting free banking era disruptions as a failure of “deregulation” and “laissez-faire.”
The free banking era ended in 1862, but only because the Civil War Union government returned to regulating banks with a vengeance.
In our next column we’ll visit the 52-year long “National Banking System” era (1862-1914) which produced the worst run of banking crises in the nation’s history.
Post a Comment
Note: Only a member of this blog may post a comment.