Free Banking
After the central bank was eliminated in the 1830s, the battle for hard money largely shifted to the state governmental arena. During the 1830s, the major thrust was to prohibit the issue of small notes, which was accomplished for notes under five dollars in 10 states by 1832, and subsequently, five others restricted or prohibited such notes.98
The Democratic Party became ardently hard-money in the various states after the shock of the financial crisis of 1837 and 1839. The Democratic drive was toward the outlawry of all fractional reserve bank paper. Battles were fought, also, in the late 1840s, at constitutional conventions of many states, particularly in the West. In some western states the Jacksonians won temporary success, but soon the Whigs would return and repeal the bank prohibition.
The Whigs, trying to find some way to overcome the general revulsion against banks after the crisis of the late 1830s, adopted the concept of "free" banking, which had been enacted by New York and Michigan in the late 1830s. From New York, the idea spread outward to the rest of the country and triumphed in 15 states by the early 1850s. On the eve of the Civil War, 18 out of the 33 states in the Union had adopted "free" banking laws.
It must be realized that "free" banking, as it came to be known in the United States before the Civil War, was unrelated to the philosophic concept of free banking analyzed by economists. Genuine free banking is a system where entry into banking is totally free, the banks are neither subsidized nor regulated, and at the first sign of failure to redeem in specie payments, the bank is forced to declare insolvency and close its doors. "Free" banking before the Civil War, on the other hand, was very different. The government allowed periodic general suspensions of specie payments whenever the banks overexpanded and got into trouble—the latest episode was in the Panic of 1857. It is true that bank incorporation was now more liberal since any bank which met the legal regulations could become incorporated automatically without lobbying for special legislative charters, as had been the case before. The banks were not subject to a myriad of regulations, including edicts by state banking commissioners and high minimum capital requirements which greatly restricted entry into the banking business.
The most pernicious aspect of "free" banking was that the expansion of bank notes and deposits was directly tied to the amount of state government securities which the bank had invested in and posted as bond with the state. In effect, then, state government bonds became the reserve base upon which the banks were allowed to pyramid a multiple expansion of bank notes and deposits.
Not only did this system provide explicitly or implicitly for fractional reserve banking; but the pyramid was tied rigidly to the amount of government bonds purchased by the banks. This provision deliberately tied banks and bank credit expansion to the public debt; it meant that the more public debt the banks purchased, the more they could create and lend out new money. Banks, in short, were encouraged to monetize the public debt, state governments were thereby encouraged to go into debt, and hence, government and bank inflation were intimately linked. In addition to allowing periodic suspension of specie payments, federal and state governments conferred upon the banks the privilege of their notes being accepted in taxes.
The desire of state governments to finance internal improvements was an important factor in subsidizing and propelling expansion of bank credit. The wild-cats lent no money to farmers and served no farmer interest. They arose to meet the credit demands not of farmers (who were too economically astute to accept wildcat money) but of states engaged in public improvements.
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