A Lesson from
the Free Banking Era
Reprinted with the
permission of Adam Zartesky, author of "Will that be Cash, Check,
Charge or Smart Card?" The Regional Economist, April 1996, page
8.
After the demise of
the Second Bank of the United States, which President Andrew Jackson
refused to recharter in 1832, the country entered a period known as
the "Free Banking Era." From 1837 to 1863, states that enacted free
banking laws allowed free entry in the banking industry. This meant
that banks could issue notes on the condition that designated
securities, placed on deposit with state regulatory authorities,
backed them. In general, state authorities directed the printing and
registering of bank notes and issued them to banks in amounts equal
to the securities deposited. Free banks had to redeem their notes at
par (face value) for specie (coins minted by the U.S. Treasury) on
demand, otherwise the state would close the bank.
During this era, many
different bank notes were circulating, making the ability to
determine which notes were valid and sound, and which were risky,
necessary for transactions to occur. As a result, bank note
reportersónewspapers that, like today's financial pages,
listed which bank notes were valid and what their market values
wereówere published and used as guides for bank note
acceptance.
Once a note was
determined to be valid, merchants had to know at what price it was
trading: Was the note trading at par or at some other value? Evidence
suggests that bank notes backed by creditworthy securities circulated
at or near par. Those notes backed by risky securities, however, were
accepted only at a discount, which compensated for the additional
risk.
These bank notes were
not unlike today's currency. Federal Reserve notes (dollar bills) are
printed, registeredóeach has a unique serial numberóand
backed by the full faith and credit of the U.S. government. They are
redeemed at par and can be exchanged for coin. These features make
them, like bank notes during the Free Banking Era, an acceptable
medium of exchange. However, two big differences between the two
currencies exist: Bank notes circulated without a central bank during
the Free Banking Eraóthe Federal Reserve had not yet been
createdóand there was no deposit insurance on them.
Nevertheless, bank notes functioned as "cash" and were used for
transactions even though they had no intrinsic value like
specie.
The analogy to bank
notes can also be applied to stored-value card balances. U.S. dollars
(or some foreign legal tender) are on deposit at the issuing
institution to "back" the stored-value card balances, which
presumably will be accepted for transactions because consumers and
merchants believe they can be exchanged on demand for legal tender.
If consumers and merchants do not have faith that these liabilities
will be honored by the issuing institution, then stored-valued
balances might not circulate as a medium of exchange. In particular,
if a lesser-known firm were to issue the liability, merchants might
be skeptical about accepting this "currency" at par as payment for a
transaction because of the risk of redemption. Skepticism about the
issuer could lead to publications (or on-line databases) similar to
the old bank note reporters to help identify and verify liabilities
issued by lesser-known firms.
Thus, there is a
lesson we can draw from the Free Banking Era: Privately issued bank
notes (or stored-value card balances) can circulate at par as an
accepted medium of exchange if a certain amount of regulation assures
the public that the currency is backed sufficiently, or, at least,
that it is issued through institutions the public feels secure
dealing with. If the public does not have this confidence, the
balances either will not circulate or will not do so at
par.
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