Back to the Future
The Free Banking Era (1837-1862) was was one of the few times in industrial society that an economically healthy nation had a decentralized monetary system that wasn’t dominated by its national government. During this period, the only money in the United States was created by banks chartered by the various state governments of the union. These charters were very permissive and easy to obtain, leading to a massive proliferation of banks of all qualities during the era. In 1833, when Andrew Jackson first moved the United States Federal Government's money from the Second Bank of the United States into private banks, there were 517 banks in the United States. By the end of the Free Banking Era in 1862, there were 1562, an increase of over 300%.
The proliferation of banks and banknotes pleased state governments because they had a lot more access to money, even if the quality of the money wasn’t as high or as reliable as it was when the Second Bank of the United States was operating.
During this era, banknotes were used like cash but worked more like gift certificates redeemable for the contents of the issuing bank’s vault. A bank would have, for example, a thousand dollars of value in their vault. (At this time “dollars” were a unit of value denoting 24 grams of silver). When someone got a loan from the bank, they’d be paid not in precious metals, but rather in banknotes that could be redeemed at the bank for their denoted value in hard currency. Since the banknotes had the credibility of the bank behind them, people could use them as a means of exchange to buy things in the area, thereby putting these banknotes into circulation. The banks could safely assume that everyone wouldn’t try to redeem their banknotes at once, allowing them to create more value in banknotes then they had in their vault. This practice of “fractional reserve lending” was one of the ways banks create money “out of thin air” and made banking a very lucrative endeavor. And a confusing one. With hundreds of banks producing hundreds of different banknotes, all of which flowing along trade routes throughout the continent, people had a hard time figuring out whether money was real and whether the banks that produced it were reputable.
What if a note was from a bank that had gone bankrupt? What if the bank was alive and well, but the note was a forgery? What if the bank on the note was fake, but the note itself was made by a printer of legitimate banknotes? What if the bank was in New York and the banknote was being traded in Missouri? What if a banknote looked real, and was coming from a legitimate bank, but the person trying to use it looked and acted like a criminal? The answer to all these questions was always answered in the same way: a discount.
One of the sayings at the time was that it was better to have a bad forgery of a good bank’s note than a good forgery of a bad bank’s note. This meant that, even though a banknote was clearly not worth what it said on the note, it still had a value equivalent to what it was worth to someone else. So, a $5 note that looked potentially fraudulent might be worth $2, or a $20 note from a bank in Ohio might be worth $19 in Missouri and $14 in Connecticut. Every note had a discount rate, and everything was negotiable, including reputations.
The public, in general, viewed many of the new bankers as con-artists, and when a bank failed, the entire profession of bankers were maligned in the media. Meanwhile, counterfeiters became new heroes of folk legend, being celebrated for possessing the talents of a fine artist, the business savvy of an entrepreneur, the daring of an outlaw and the spirit of “Robin Hood”. Coastal elites grew to hate the system not just for the financial ambiguity it brought to transactions, but also for the moral ambiguity. When everyone had to use a potentially illegitimate means of exchange, every transaction was potentially tarnished. But the benefits of a system in which no one was legitimately compelled by government force to accept a particular type of money also had its supporters. The ambiguity created space for small entrepreneurs to get credit and build their own enterprises. Communities without access to banks could start their own and create their own means of exchange. The poor could get counterfeit money from criminal syndicates and use it to build their own enterprises, legitimate or otherwise. It truly was a do-it-yourself monetary system, rewarding bankers and counterfeiters alike. Data from the era suggests it was actually quite effective.'
In 1837, as the Second Bank of the United States was winding down its operations, an economic panic struck that lasted until 1840. After the panic subsided, between 1840 and 1860, one source of economic data claims the US economy’s GDP grew by around 400%. Another source of economic data estimates that during that period the money supply increased 211% and the price level increased 60%, which would support the hypothesis that GDP expand around 400%. If those numbers are remotely accurate, that makes the Free Banking Era one of the most prosperous periods in US economic history. In comparison, GDP in the United Kingdom during the same time period increased 144%, meaning the US was growing more than twice as quickly as the UK. While this increase is certainly attributed to many factors including the political growth of the United States, industrialization, population increase, the exploitation of resources in a pristine environment, and the destitution of indigenous people, it’s still remarkable from an economic perspective. From a political perspective, the nation added seven states to the union during this time. This growth spurt ended as the United States was engulfed by the Civil War, and the Union needed a central bank to fund its war effort. This is when they began printing Greenbacks, which were “Legal Tender” whose value was imposed by the Federal Government. The US hasn’t stopped printing legal tender since.
Last updated
