Stateless Money: Lessons from the Free-Banking Era and Wildcat Bankers

Historical lessons on decentralized banking should guide our approaches to Web3 protocols and tokenomics design, but they’re helpful only if we remember and examine them appropriately.

The Tower of Babel is a biblical narrative which tells of a world in which all people spoke the same language, and could therefore focus all of their efforts on a singular goal. King Nimrod decided to build a tower reaching up to “the heavens” in order to unify humanity and demonstrate its greatness. Ironically, we have not given up our ambitions for centralized institutions to decide the direction for all of humanity. 

As the narrative goes, God decided to confuse the peoples’ languages so they couldn’t understand each other anymore, which forced them to scatter across the world and abandon their tower. More recently, J. R. R. Tolkien wrote of an all-powerful ring which essentially warned of the same danger in the Lord of the Rings. There’s a valuable underlying lesson to be learned here: Too much centralization is arguably against human nature. It seems that our ancestors may have understood the importance of decentralization before Satoshi Nakamoto’s divine Bitcoin intervention shook the financial world and made the first crack in our own tower appear to those who were watching. 

Many civilizations build their own version of the Towers of Babel, do they not? We imagine our contributions to be greater and more durable than those that came before us. Our inflated ambitions and sense of greatness become our greatest weakness once a world power becomes too dominant for too long, throwing civilizations into crisis. Yet even as a crisis can expose weakness, it eventually forces us to take sober introspective assessments of our collective productivity and available resources.

Although civilizations rise and fall through the generations like fractal patterns in financial markets, the goal should be to make progress by effectively regrouping and recovering the best from these Towers of Babel. Just as cryptocurrency traders use Elliott Waves for technical analysis, we can also look back in history to draw parallels, and assess likely outcomes moving forward. 

This begs the question: are we experiencing a Tower of Babel event play out in global financial markets? Perhaps the scalability of fiat money has reached its limits, and we are in the midst of a great paradigm shift as we form new networks and build up our strength with decentralization embedded into the core of it all. The world needs a global currency, but it may not have to be centrally issued or issued by a sovereign government at all. The financial world operating without sovereign-issued money is a world full of experimentation and opportunity, but is stability important enough to simply cling to our centralized institutions?

Cryptography & Decentralized Finance: A Trustless Network of Decentralized Towers

What underpins global reserve currencies and assets is shared trust amongst all parties involved. At the macro level, this means central and sovereign governments. Additionally, this trickles all the way down to the individual citizen — looking to preserve the wealth they’ve acquired — and deploying it efficiently towards endeavors which will bring returns to them. Ideally, these returns are based upon their endeavors bringing value to others, but it is no secret that the current financial system is facing structural issues, not to mention the most necessary component, trust. 

We trust so many of our institutions that it’s easy to forget just how many layers of trust our financial system relies upon. Blockchain and Web3 protocols make it possible to create financial institutions based on verification and mathematical proof instead of trust. This results from a variety of advancements in cryptography and interoperability, not to mention the composability and modularity of Web3 in general. 

By creating a world with fewer trust assumptions, we can reduce systemic risk, and ultimately create healthier and more productive economies and societies. Trust is earned, however, and not given easily. This will not be a quick and painless transition, but will have to be built from the ground up, brick by brick. Therefore, learning from the past will be the most efficient way to press forward, in many senses.

A Brief History of Free-Banking and Wildcat Bankers

From 1837 to 1864, banks in the US issued currency with little to no oversight by the federal government. Various schemes had been tried, but perhaps the most controversial came to be known as free-banking. The so-called “free-banking era” was a colorful and dynamic time characterized by decentralization and a strong demand for hard money. The past certainly rhymes with the present when examined properly, and may help guide our decisions today. 

Free-banking was a collection of early, local efforts overseen by the states attempting to address trust issues following The Panic of 1837, caused by extreme investor pessimism and subsequent bank runs. After witnessing New York banks fail to convert fiat to gold, free-bankers meant to avert the corruption they felt had caused monetary inflation, but nevertheless witnessed a great many bank failures in those states that tried free-banking schemes.

The term refers specifically to a banking system with free entry and federal bond-secured note issuance. Free entry meant that a potential bank which could raise a minimum threshold of capital could start a bank without any special grant from their state’s legislature, which had been common practice under the older chartered banking system. 

The other provision of this new free-banking system meant that banks were allowed to issue paper currency redeemable in gold or silver, but they were required to deposit the designated government bonds with their state authority as a security measure. These bonds were to act as collateral for the circulating notes issued by the ‘free bank’ and would earn interest so long as the bank remained solvent. However, should it fail to honor its notes, the state authority would then sell the defunct bank’s bonds, using the proceeds to reimburse note holders.

Though historians have traditionally judged the experiment a failure, the proliferation and continuation of free-bank laws in the US leading up to and even during the Civil War suggest that they were quite popular in many localities. In fact, the first free-bank laws were passed in Michigan in 1837 and in both New York and Georgia the following year. By 1861, over half the states had free-bank laws. Pennsylvania adopted free-banking 23 years after Michigan in 1860, indicating that problems encountered by early adopters did not dissuade adoption of free banking, but rather led to more rigorous oversight and regulatory protections.

The failure of free-banking is often attributed to wildcat banks, but it is much more complex in reality. Broadly speaking, wildcat banks issued notes far in excess of what they could or intended to redeem for gold, located their redemption offices in remote areas, and then disappeared. Of course, being out in the wilderness, it is not uncommon to encounter predators like Bobcats or mountain lions, or “wildcats.” This was most profitable when bankers were able to take advantage of interest rate arbitrages, incentivizing this sort of pump-and-dump scheme that left many people holding bags of worthless paper and a non-existent bank to redeem it at. 

Again, the consensus view is that Michigan’s early experiences with free-banking were largely failures, and that New York’s experience was mostly successful. Investors in Michigan’s free-banks and those holding their issued bank notes suffered large losses in 1837–1838 resulting from unsound lending practices and inadequate specie reserves when called upon for redemption. Of course, note-holders had no reason to redeem notes for specie so long as they viewed the bank as healthy.

As such, a bank’s gold and silver reserves were typically small compared with the amount of its notes in circulation, often resulting from loans like mortgages for homes. Since their gold and silver reserves paid no interest, banks kept only enough specie in their vaults to meet that day’s expected redemptions. 

However, if note holders suddenly suspected that the bank was issuing bad loans or was at risk for insolvency, a surge of specie redemptions, often called bank runs, could result in a liquidity crisis, a refusal to redeem their notes for specie, and finally the bank’s collapse. Interestingly, even if the bank were not at risk, if note holders feared a run on the bank, it often created what we now call FOMO, increasing the pressure on banks to redeem more notes than they had anticipated.

In contrast, free-banking in New York rarely saw failures over the span of their free-banking period despite being one of the earliest adopters. Historical data coming out of the other states which adopted free-banking suggests varying degrees of success in terms of the stability of their banks.

Of course, free-banking ended in 1864 when Congress passed The National Bank Act to incentivize banks to obtain a national charter. During the debates over the National Banking Act, proponents cited the large number of failures of banks with state charters in the free-banking states and the need to establish a uniform, nationwide currency system. However, was that really necessary — and does history have lessons to teach us? 

The notion that free-banking encouraged risk-taking and wildcat banking remains a widely held view among historians, though it will be disputed in subsequent paragraphs. Essentially, the main hypothesis is that the threat of losing future profit streams and reputational harm generally puts a significant damper on risk-taking, whereas excessive competition of those times reduced the value of a bank’s franchise value by creating unhealthy short-term incentives.

That is, if longer term incentives for stability and franchise value become too small as a consequence of fierce competition, the likelihood of wildcat banking and other risk-taking for short-term gains are greatly increased. The same sorts of security considerations are carefully calculated by Web3 developers and DeFi protocols which need to mitigate their platform’s incentive structures. 

Other evidence suggests that the market value of those state bonds which were required as collateral for free-bank note issuance suffered prolonged periods of decline was the main culprit for the bank runs. Fortunately, this was demonstrated by Rolnick and Weber by comparing the falling state bond prices of four states and found that 79 percent of bank failures were consistent with the falling bond price hypothesis.

The same pair of researchers further demonstrated that bank failures in these four states were actually inconsistent with periods of time in which wildcat banking would have been most profitable. Therefore, falling state bond prices created distress in the free-banks’ treasury portfolios, which created panic and subsequent bank runs. The free-banking failures can then, at least in part, be attributed to the collateral restrictions imposed by the states on free-banks to hold their state bonds. 

Essentially, risky state bonds were treated by banking regulators as if they were essentially riskless, which is still a problem in modern banking and politics. An important takeaway is that tying bank safety to the presumed recklessness of a particular asset class is quite risky itself, even if the assets are backed by governments. Those paying attention will adjust their portfolios to protect themselves from counterparty risk without mandates from bureaucratic institutions.

It is difficult to miss the parallels between the past and present, with a number of treasuries and financial institutions mandated to hold minimum ratios of certain assets, like sovereign bonds for example. This caused headaches for many in recent years who witnessed sovereign debt explosions which outpaced the yields of the bonds they were mandated to hold for their clients. 

Another key issue to take note of was a general lack of transparency coupled with a weariness amongst people from their lack of trust that banks were not simply printing money unrestrained. Of course, this was not isolated to the US, as free-banking came and went in several countries around the world, like Australia, Switzerland, Colombia, France, and Britain, among others.

Global, Stateless Money:  A Trustless World Order

Issues experienced in the Free-Banking Era could be more adequately addressed in the modern era by blockchains and oracles, meaning people can verify instead of trust the issuers of their currencies. Likewise, inflation rates and token burning mechanisms are written into a Web3 protocol’s code, allowing users a window into the workings of their modern day crypto free-banks. 

Fiat currency is fundamentally limited by scaling problems, making it difficult to scale trust in financial institutions. This is particularly important given how the global economy has become so interconnected. There is presently an opportunity for the world to adopt trust-minimized money in the form of cryptocurrency issued by software instead of sovereign governments. Some have proposed Bitcoin as the next global reserve currency, but mandating just one underlying collateral asset poses its own risks, as we have already learned from the past.

Running fully on crypto rails, assets can in fact be bound if not by physics then by sheer mathematics rather than human institutions. Furthermore, regulations by governments need to be carefully vetted and met with healthy skepticism to avoid mistakes made in the past, whether intentions were good or not. In other words, mandating the use of just one reserve asset or base collateral asset within a banking system could pose systemic risks. 

This is not to argue for a laissez-faire adoption of digital per se, but rather that it is not entirely clear that central banks and centralization in general is more stable in the long run. Perhaps it was just easier to scale our financial systems using central banks. However, recent developments should encourage us to remain untethered from the reins of central banks and run our own free-banking experiments as long as we can. The National Bank Act cut the last experiment short, but that doesn’t mean we should give up so easily this time.

Conclusion

As mentioned, mandating the use of one or another asset class to act as baseline collateral is unsustainable, though that does not mean that over time a single victor won’t emerge as best in class reserve asset. That is, the free market should decide if a single reserve asset is needed, or perhaps a basket of assets. 

Just as water flows from higher to lower elevations, so will hard assets flow into the portfolios of those looking for liquid markets and to preserve their wealth. Therefore, soundness, liquidity, and transparency will play key roles in the competition for the hardest and most universally accepted currencies and collateral assets. 

Of course, political interference and warfare are wildcard variables which inevitably divert even the most carefully laid plans. The course forward, however, is to lobby for free markets and the chance that one of many decentralized projects is successful rather than placing all of our eggs into the central bank basket, with only one chance of success. If we go that route, we may as well start building another tower, just like the biblical narrative we began with, but we know how that turned out.

References

1. Briones, I., & Rockoff, H. (2005). Do economists reach a conclusion on free‐​banking episodes? Econ Journal Watch 2(2), 279–324.
2. Campbell, S. (2020, 12 Nov.). Panic of 1837. The Economic Historian. 
3. De Filippi, P., Mannan, M., & Reijers, W. (2020). Blockchain as a confidence machine: The problem of trust & challenges of governance. Technology in Society, 62, 101284.
4. Markowitz, M. (2017, 13 Feb.). The origin of specie: How gold and silver became money. CoinWeek. 
5. Rockoff, H. (1974). The free banking era: A reexamination. Journal of Money, Credit and Banking, 6(2), 141. 
6. Rolnick, A., & Weber W. (1984). The causes of free bank failures: A detailed examination. Journal of Monetary Economics, 14(3), 267-291.
7. Samani, K. (2019, 24 Apr.). Crypto mega theses. Multicoin Capital. 
8. Sanchez, D. (2016, Q3). The free-banking era: A lesson for today? Federal Reserve Bank of Philadelphia Economic Insights.
9. White, L. H. (2015, 28 Apr.). What you should know about free banking history. Cato Institute.

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