The American Free-Banking Experience, 1836-1860

Part II: The American Free-Banking Experience, 1836-1860

...Banks were also required to redeem their notes on demand in
gold or silver coin. Failure to do so resulted in the bank being closed by
the state, and the bank's assets being liquidated. The state's bank
examiners were in charge of enforcing this specie reserve requirement,, but
the banks were always one step ahead. Consider this account given by
Galbraith:

At the outer extreme of compliance, a group of Michigan banks
joined to cooperate in the ownership of reserves. These were
transferred from one institution to the next in advance of the
examiner as he made his rounds. And on this or other occasions,
there was further economy; the top layer of gold coins in the
container was given a more impressive height by a larger layer of
ten-penny nails below. But not all of the excesses of leverage
were in the West. In the same years, in the more conservative
precincts of New England, a bank was closed up with $500,000 in
notes outstanding and a specie reserve of $86.48 in hand
(Galbraith, 63-64)...

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)...full chapter