Depository Safety and Economic Safety

How did the free banking system perform in terms of depositor safety and promoting economic stability? Rolnick and Weber (1982) studied four free banking states (New York, Indiana, Minnesota, and Wisconsin) for which they found data on 709 free banks during the period 1838-1863. They found that about half of those banks failed with about a third of those unable to redeem their banknotes for specie. Overall, about 16 percent of the free banks in those states could not redeem their banknotes. In addition, free banks were short-lived relative to modern banks. About 16 percent of free banks existed for less than one year, with the overall average about five years (Sechrest, 99). In the four states they studies, Rolnick and Weber estimate depositor losses ranged from $1.6 million and $2.1 million per state.

Nearly all of the free bank failures, Rolnick and Weber argue, were due to sharp declines in the market value of the bonds the banks held rather than being caused by fraud, as seems to be the popular perception. They were caused mostly by the legal requirement to tie note issues to the market value of the bank's bond-holdings. When the market value declined substantially, the bank was required by law to withdraw some of its currency from circulation. It did this by calling in loans, an act which frequently put a tight credit vice on businesses and which shrank the money supply.

In terms of economic stability, the free banking era was characterized by considerable swings in the money supply and the price level, as is shown in the table below.

Period      % Chng in Money Supply        % Chng in Price Level


1834-37             + 61                          + 28

1837-43             - 58                          - 35

1843-48            + 102                          +  9

1848-49             - 11                             0

1849-54            + 109                          + 32

1854-55             - 12                          +  2

1855-57             + 18                          +  1

1857-58             - 23                          - 16

1858-61             + 35                          -  4
(Sources: John Knox, A History of Banking in the United States, New York: Bradford Rhodes, 1903; and Historical Statistics, 1960, series E 1-12.)

Kidwell and some other economists blame the state banking system for contributing to the volatility in the economy, even if it did not directly cause it. In the initial expansionary phase of the business cycle, overly optimistic banks would issue too many banknotes which would accelerate the growth of the economy. However, this would eventually lead to inflation and an over-extension of credit. A random downturn in key commodity markets would then sharply reduce the market value of many bonds and loans, and banks would be forced to call in loans and contract the money supply. Sometimes this led to cases of depositor panic and further reductions in the money supply, which brought the next contraction of economic activity (Kidwell, 56).

Most economists regard the free banking era as on balance being a de-stabilizing influence on the developing U.S. economy. Edward Symons writes "In some states, particularly Michigan where more than forty banks failed before the system was declared unconstitutional, the system is better characterized as a fiasco than a failure" (Symons, 22). However, free-banking advocates claim that this period is not a true test of their theory (Rolnick and Weber, 19-20). In particular, the legal requirement in most free banking states that note issues be tied to the market value of bonds limited the management to sub-optimal choices in terms of their note issues. In current free banking theory banks would have the incentive to issue a profit- maximizing volume of notes which would be based on economic factors, not exogenous regulations, and that this quantity of notes would not, in theory, cause monetary instability (Sechrest, 16-17).

Regardless of its merits or its problems, the free banking era ended in 1863 with the passage of the first of the National Banking Acts. These laws reasserted federal influence in the functioning of the nation's financial system.