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Econ Focus

First Quarter 2018

Economic History

When Banking Was 'Free'

From 1837 until the Civil War, currency issuance and banking were left to the states. Can this era offer lessons for today's cryptocurrency boom?

Article by: Helen Fessenden
Bank note issued around 1854 by the Quassaick Bank of Newburgh, N.Y
A $100 bank note issued around 1854 by the Quassaick Bank of Newburgh, N.Y., a free-banking state.

Few assets were hotter in 2017 than cryptocurrencies, including bitcoin. The surge was dramatic enough that New York Fed then-President William Dudley disclosed in November that the Fed was "starting to think about" offering a digital currency — although he quickly downplayed the chance of this materializing soon.

What's behind this boom? A central feature of cryp­tocurrencies is that they rely on "blockchain" technology, which, advocates claim, enables them to take on the functions of money and ultimately compete with conventional currency. Thanks to blockchain's open-source nature, anyone can design his or her own version of cryptocurrency and cater to market demand through "initial coin offerings" (IPOs for cryptocurrencies); today, there are more than 1,600 cryptocurrencies available. Based on a decentralized global network of computers, blockchain enables speedy, transparent, and cheap financial transactions that anyone, anywhere, can access with an Internet connection, without going through banks. It also allows its users complete anonymity — which means it's become a favored conduit for illegal transactions. The black market stigma is one reason why this market has cooled a bit in 2018; Bitcoin's trading price is now around $9,000, after spiking to $20,000 last year, amid rising regulatory pressure in Asia and elsewhere. Other concerns have emerged as well, including vulnerability to hackers and heightened scrutiny of coin offerings in regards to violation of investor-protection laws.

But many skeptics cite volatility as a chief hurdle preventing cryptocurrencies from fulfilling the functions of money — specifically, as a store of value, unit of account, and medium of exchange (see "Interview: Jesús Fernández-Villaverde" in this issue). What does this mean in practical terms? Investors can make or lose money on cryp­tocurrencies as a speculative asset, but this also means they serve poorly as a common and stable measure of the value of goods and services. Money's function as legal tender — to be liquid enough to be accepted widely — is also difficult. Cryptocurrency issuance is finite in that it's determined by how many computers and programmers are mining it rather than the macroeconomic goals of a central bank's monetary policy, and payments are accepted by only a fraction of vendors.

The idea of an "unregulated" currency, however, isn't new. Before the Civil War, the United States ran a vast natural experiment by leaving "free banking" to the states, even while other major economies were adopting central banking. From the demise of the Second Bank of the United States in 1836 until the passage of National Banking Acts of 1863 and 1864, the United States lacked a federal authority to issue and redeem banknotes, act as a fiscal agent for the federal government, or keep banknote issuance in check. Instead, banking was run by the states, and "free banks" could issue their own banknotes. But just how much did this amount to the kind of free-entry, highly decentralized currency competition that some cryptocurrency backers advocate today?

Back to the Future

Under the traditional narrative of this era, free banking had a poor reputation. The absence of national regulation was seen as one reason for the extreme booms and busts of the pre-Civil War years, as well as the high frequency of bank failures. Free banking is also often conflated with the term "wildcat" banking, which refers to short-lived (and sometimes fraudulent) banks in more remote regions where banknotes couldn't easily be redeemed. More recent scholarship, however, has suggested that true wildcat banking was in fact quite rare and that there were often multiple drivers behind banking and economic turmoil. Moreover, free banking wasn't one uniform model; rather, it was established in only 18 out of 32 states, with considerable variation. In general, free banking was less developed in the South, and in some cases, states formally adopted free banking but saw very few such banks established.

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