Financial Update (January-March 1997)

Free Banking Era Provides Lessons for Today

T he prospect of "virtual money" exchanged electronically on the Internet has prompted some analysts to make comparisons between electronic computer transactions and the "free banking" system of the mid-1800s. Some historians have concluded that free banking was very risky and problematic, sometimes calling it "wildcat banking."

In an article in the Atlanta Fed's Economic Review, visiting scholar Gerald P. Dwyer Jr. explores various historical instances of free banking to determine if, in fact, so-called "wildcat banks" were imprudent and reckless.

He concludes that "free banking in the United States was not the disaster portrayed by some, but it was also not problem-free." To understand what factors contributed to the success or failure of free banks, Dwyer examines the case of Michigan, where free banks were disappointing, and the case of New York, where free banking evolved quite successfully. Dwyer also looks in detail at the experience with later free banking in states that experienced major difficulties—namely Indiana, Illinois, and Wisconsin during the period from 1853 to 1863.

He observes that while there were certainly some abuses present among free banks, the banks were not generally characterized by fraudulent activity. The success or failure of free banking was more often affected by events external to banking. Dwyer's research found that while the earliest free bank experiments experienced a variety of troubles, the climate for free banking improved with time. This improvement, says Dwyer, can probably be traced to adjustments in laws as various problems arose. He proposes that major problems, such as bank "panics," were episodic and often related to outside circumstances rather than being endemic to the structure of free banking.

Free banking was taxed out of existence by the federal government in 1865. This action was apparently not in response to the dissatisfaction of clients in the free-banking states. Whether people would have been better off with some other kind of banking system during the period of free banking remains an open question, Dwyer concludes.

Aside from its intrinsic historical interest, Dwyer's study sheds light on current discussions about the impact of "electronic money," which seems likely to become an attractive choice for some consumers in the near future. Dwyer says that "there may be some similarities between electronic money and free banks' notes. Like free banks' notes, electronic money is likely to consist of uninsured liabilities of private individuals or companies." As with free banks, consumers must be cautious, Dwyer says; they should pay particular attention to the assets backing the electronic money and to the issuer's reputation for converting the electronic money as promised.

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