Free Banking

Free Banking

Free banking was a trend toward a highly decentralized monetary system that originated in Scotland and in the early nineteenth century, appeared on a modest scale in England, and developed on a wider scale in the United States, beginning in 1838 and ending with the National Banking Act in 1864.

Before the era of free banking, bank charters were granted for political favors, regarded as matters of political patronage. Rising inflation from 1834 to 1837, followed by a money panic and a rash of bank failures, elevated public concern about privilege and political corruption in the banking system. New York acted first with the Free Banking Act of 1838. This act allowed any person or group of persons to obtain a bank charter who could meet capitalization criteria requiring that bank notes be 100 percent backed with mortgages and state bonds, plus an extra 12.5 percent in gold and silver specie. The reserves of gold and silver specie enabled bank customers to count on redemption of bank notes in gold and silver, and when banks failed the state sold the mortgages and state bonds to compensate bank customers.

About 18 states adopted free banking laws similar to the New York act. They usually allowed anyone, without political connections, to deposit suitable financial securities with a state banking authority, receive a bank charter, and make loans and discount bills by issuing their own bank notes.

Free banking was not the only solution to the crisis of confidence in banks. In 1845 the fledgling state of Texas completely outlawed banks in its first constitution, and by 1857 four other states had enacted similar legislation.

The success of the free banking system depended on a delicate balance of state regulation and freedom of enterprise. A certain amount of chaos ensued. Bank notes circulated from defunct banks, and “wildcat” banks established in remote areas issued bank notes that would never be redeemed in specie. Some scholars argue that by the eve of the Civil War state regulation had began to shape the free banking system into a workable and orderly system.

Free banking aroused fears of inflation because there was no one entity regulating money supplies, and the perplexing assortment of bank notes, trading at different discounts, hampered trade between regions. The development of the national banking system during the Civil War ended the free banking era in the United States.

During the 1970s the slow progress of the monetary authorities toward taming inflation brought a renewed interest and attention to the free banking system. Under a properly regulated free banking system, bank notes remain convertible into a precious metal currency, but there is no central bank regulating the total national money supply. In the 1970s and 1980s scholars developed theoretical models of free banking systems that maintained convertibility of bank notes into commodities such as gold and silver. These modes functioned without a central bank and much of current banking regulation. These scholars saw the free banking system as preferable to the so-called stop-and-go policies of the Federal Reserve System. The interest in free banking faded as the Federal Reserve showed more progress combating inflation.