Was There a Note Issue Conundrum in the Free Banking Era?

Abstract

MORE THAN EIGHTY YEARS AGO Spurgeon Bell (1912) uncovered a paradox that has since vexed banking and monetary historians. He found that national banks failed to expand their note issues despite the apparent profitability of doing so. Subsequent writers refined Bell's original profit calculations and most have shown that, if anything, Bell's calculations understated the profits left unexploited by the banks. Explanations of the paradox abound. Bell (1912) and Goodhart (1965) argued that banks failed to increase their note issues fearing revocation of the circulation privilege. James (1976) argued that pronounced regional interest rate differentials during the postbellum era made it more profitable for banks in some regions to focus on lending low-cost deposits rather than high-cost notes. Champ (1990) and Kuehlwein (1992) stressed term-structure and holding-period risks. Cagan and Schwartz (1991) believed that banks simply acted irrationally. Champ, Wallace, and Weber (1992) accounted for costs and risks other writers overlooked and found rates of return to note issue substantially below those previously reported, but it was still profitable for national banks to issue more notes than they did. Despite this outpouring of work, the national bank note paradox remains unsolved, some might say insoluble. Our paper offers a look at note issues of state banks during the Free Banking Era

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