Tag Archives: free banking

Technology and Financial Inclusion in North America

Did Railroads Make Antebellum U.S. Banks More Sound?

By Jeremy Atack (Vanderbilt), Matthew Steven Jaremski (Colgate), and Peter Rousseau (Vanderbilt).

Abstract: We investigate the relationships of bank failures and balance sheet conditions with measures of proximity to different forms of transportation in the United States over the period from 1830-1860. A series of hazard models and bank-level regressions indicate a systematic relationship between proximity to railroads (but not to other means of transportation) and “good” banking outcomes. Although railroads improved economic conditions along their routes, we offer evidence of another channel. Specifically, railroads facilitated better information flows about banks that led to modifications in bank asset composition consistent with reductions in the incidence of moral hazard.

URL: http://econpapers.repec.org/paper/nbrnberwo/20032.htm

Review by Bernardo Bátiz-Lazo

Executive briefing

This paper was distributed by NEP-HIS on 2014-04-18. Atack, Jaremski and Rousseau (henceforward AJR) deal with the otherwise thorny issue of causation in the relationship between financial intermediation and economic growth. They focus on bank issued notes rather deposits; and argue for and provide empirical evidence of bi-directional causation based on empirical estimates that combine geography (ie GIS) and financial data. The nature of their reported causation emerges from their approach to railroads as a transport technology that shapes markets while also shaped by its users.

Summary

In this paper AJR study the effect of improved means of communication on market integration and particularly whether banks in previously remote areas of pre-Civil War USA had an incentive to over extend their liabilities. AJR’s paper is an important contribution: first, because they focus on bank issued notes and bills rather than deposits to understand how banks financed themselves. Second, because of the dearth of systematic empirical testing whether the improvements in the means of communication affected the operation of banks.

imgres

In 19th century north America and in the absence of a central bank, notes from local banks were substitutes among themselves and between them and payment in species. Those in the most remote communities (ie with little or no oversight) had an opportunity to misbehave “in ways that compromised the positions of their liability holders” (behaviour which AJR label “quasi-wildcatting”). Railroads, canals and boats connected communities and enabled better trading opportunities. But ease of communication also meant greater potential for oversight.

imgres

ACJ test bank failure rates (banks that didn’t redeem notes at full value), closed banks (ceased operation but redeem at full value), new banks and balance sheet management for 1,818 banks in existence in the US in 5 year increments between 1830 and 1862. Measures of distance between forms of communication (i.e. railroads, canals, steam navegable river, navegable lake and maritime trade) and bank location emerged from overlapping contemporary maps with GIS data. Financial data was collected from annual editions of the “Merchants and Bankers’ Almanac”. They distinguish between states that passed “free banking laws” (from 1837 to the early 1850s) and those that did not. They also considered changes in failure rates and balance sheet variance (applying the so called CAMEL model – to the best of data availability) for locations that had issuing banks before new transport infrastructure and those where banks appear only after new means of communication were deployed:

Improvements in finance over the period also provided a means of payment that promoted increasingly impersonal trade. To the extent that the railroads drew new banks closer to the centers of economic activity and allowed existing banks to participate in the growth opportunities afforded by efficient connections.(p. 2)

imgres

Railroads were the only transport technology that returned statistically significant effects. It suggested that the advent of railroads did indeed pushed bankers to reduce the risk in their portfolios. But regardless of transport variables, “[l]arger banks with more reserves, loans, and deposits and fewer bank notes were less likely to fail.” (p.20). It is thus likely that railroads impact banks’ operation as they brought about greater economic diversity, urbanisation and other measures of economic development which translated in larger volume of deposits but also greater scrutiny and oversight. In this sense railroads (as exogenous variable) made banks less likely to fail.

But ACJ note that means of transportation were not necessarily exogenous to banks. Reasons for the endogeneity of transport infrastructure included bankers promoting and investing in railroads to bring them to their communities. Also railways could find advantages to expand into vigorously active locations (where new banks could establish to capture a growing volume of deposits and serve a growing demand for loans).

Other empirical results include banks decreased the amount of excess reserves, notes in circulation and bond holdings while also increased the volume of loans after the arrival of a railroad. In short, considering railroads an endogenous variable also results in transport technologies lowering bank failure rates by encouraging banks to operate more safely.

Comment

The work of AJR is part of a growing and increasingly fruitful trend which combines GPS data with other more “traditional” sources. But for me the paper could also inform contemporary debates on payments. Specifically their focus is on banks of issue, in itself a novelty in the history of payment systems. For AJR technological change improves means of payment when it reduces transaction costs by increasing trust on the issuer. But as noted above, there are a number of alternative technologies which have, in principle, equal opportunity to succeed. In this regard AJR state:

Here, we describe a mechanism by which railroads not only affected finance on the extensive margin, but also led to efficiency changes that enhanced the intensity of financial intermediation. And, of course, it is the interaction of the intensity of intermediation along with its quantity that seems most important for long-run growth (Rousseau and Wachtel 1998, 2011). This relationship proves to be one that does not generalize to all types of transportation; rather, railroads seem to have been the only transportation methods that affected banks in this way.(p4)

In other words, financial inclusion and improvements in the payment system interact and enhance economic growth when the former take place through specific forms of technological change. It is the interaction with users that which helps railroads to dominate and effectively change the payments system. Moreover, this process involves changes in the portfolio (and overall level of risk) of individual banks.

The idea that users shape technology is not new to those well versed in the social studies of technology. However, AJR’s argument is novel not only for the study of the economic history of Antibellum America but also when considering that in today’s complex payments ecosystem there are a number or alternatives for digital payments, many of which are based on mobile phones. Yet it would seem that there is greater competition between mobile phone apps than between mobile and other payment solutions (cash and coins, Visa/Mastercard issued credit cards, PayPal, Bitcoin and digital currencies, etc.). AJR results would then suggest that, ceteris paribus, the technology with greater chance to succeed is that which has great bi-directional causality (i.e. significant exogenous and endogenous features). So people’s love for smart phones would suggest mobile payments might have greater chance to change the payment ecosystem than digital currencies (such as Bitcoin), but is early days to decide which of the different mobile apps has greater chance to actually do so.

Wall Street (1867)

Wall Street (1867)

Another aspect in which AJR’s has a contemporary slant refers to security and trust. These are key issues in today’s digital payments debate, yet the possibility of fraud is absence from AJR’s narrative. For this I mean not “wildcatting” but ascertaining whether notes of a trust worthy bank could have been forged. I am not clear how to capture this phenomenon empirically. It is also unlikely that the volume of forged notes of any one trusted issuer was significant. But the point is, as Patrice Baubeau (IDHES-Nanterre) has noted, that in the 19th century the technological effort for fraud was rather simple: a small furnace or a printing press. Yet today that effort is n-times more complex.

AJR also make the point that changes in the payments ecosystem are linked to bank stability and the fragility of the financial system. This is an argument that often escapes those discussing the digital payments debate.

Overall it is a short but well put together paper. It does what it says on the can, and thus highly recommended reading.

Does Bank Competition Lead to Higher Growth?

Bank Deregulation, Competition and Economic Growth: The US Free Banking Experience

By Philipp Ager (University of Southern Denmark) and Fabrizio Spargoli (Erasmus University Rotterdam)

Abstract

We exploit the introduction of free banking laws in US states during the 1837-1863 period to examine the impact of removing barriers to bank entry on bank competition and economic
growth. As governments were not concerned about systemic stability in this period, we are
able to isolate the effects of bank competition from those of state implicit guarantees. We find
that the introduction of free banking laws stimulated the creation of new banks and led to
more bank failures. Our empirical evidence indicates that states adopting free banking laws
experienced an increase in output per capita compared to the states that retained state bank
chartering policies. We argue that the fiercer bank competition following the introduction of
free banking laws might have spurred economic growth by (1) increasing the money stock
and the availability of credit; (2) leading to efficiency gains in the banking market. Our
findings suggest that the more frequent bank failures occurring in a competitive banking
market do not harm long-run economic growth in a system without public safety nets.

URL: http://d.repec.org/n?u=RePEc:hes:wpaper:0050&r=his

Circulated by NEP-HIS on: 2013-12-29

Review by Natacha Postel-Vinay

In this paper, Philipp Ager (University of Southern Denmark) and Fabrizio Spargoli (Erasmus University Rotterdam) ask two very topical questions. Does increased bank competition lead to higher economic growth? And, if so, how? Following the recent crisis, many have wondered whether the alternative to “too-big-to-fail” — having many smaller banks competing with each other — would necessarily be a better one. Clouding the debate has been the difficulty of finding appropriate historical settings in which to test the hypothesis that more competition leads to greater growth. In their paper, Ager and Spargoli focus on what they consider the best instance of intense bank competition without any implicit government bail-out guarantee: the American free banking era.

Between 1837 and 1863 new laws were passed in a number of states allowing just about anyone to set up a bank, with very few requirements to fulfill. Until then, banks wanting to open needed a charter from their state, for which they had to meet relatively stringent criteria. As the authors show using a new quantitative analytical framework, the new laws greatly increased the creation of new banks in the states which passed them. As competition increased, however, a higher proportion of banks ended up failing. Could it still be the case that the introduction of free banking laws led to greater growth in those states?

A satire on Andrew Jackson's campaign to destroy the Bank of the United States and its support among state banks, 1836. It was partly to fill this gap that states allowed free banking.

A satire on Andrew Jackson’s campaign to destroy the Bank of the United States and its support among state banks, 1836. It was partly to fill this gap that some states allowed free banking.

The paper’s most important finding is that increasing competition among banks did lead to higher economic growth. Jaremski and Rousseau’s 2012 paper (previously reviewed in NEP-HIS here) found that a new “free” bank, as opposed to a charter bank, did not have a positive effect on the local economy. While this is an important finding in itself, it is also important to look at the effect of the introduction of free banking laws on aggregate bank behaviour, if only because the new entry of free banks may alter the willingness of charter banks to enter the market and their behaviour once in the market. Charter banks’ behaviour may in turn alter free banks’ behaviour, and so on. Interestingly, Ager and Spargoli’s study finds that in the aggregate, the acceleration in bank entry and resulting greater competition among all types of banks had a positive effect on economic growth.

To arrive at this conclusion, the authors are careful to include a number of controls. First, there is the possibility that growth opportunities led some states to adopt free banking laws, in which case the authors would face a reverse-causality problem. Hence they conduct a county-level analysis in which they include time-invariant county characteristics and state-specific linear output trends (although perhaps it would be nice to see these output trends going further back in time than 1830). Second, they also control for other laws that states might have introduced at the same time as the free banking ones, which could potentially bias the results. Finally, they control for unobserved heterogeneity between states by examining contiguous counties lying on the border of states that introduced free banking. Their results are robust to these different specifications.

Private Bank Note, Drover’s Bank, Salt Lake City, Utah, $3, 1856

Private Bank Note, Drover’s Bank, Salt Lake City, Utah, $3, 1856

Ager and Spargoli are of course also interested in where this growth came from. They find a positive relationship between the introduction of free banking laws and lending, and conclude that one of the main channels through which this increase in growth occurred was the increase in the availability of credit that greater competition fostered. This story is consistent with the finance-growth nexus literature, which argues that greater (and safer) access to credit is conducive to economic development.

Although this seems perfectly reasonable, it would perhaps have been interesting to see when most of the failures occurred. If, for instance, they mainly occurred towards the end of the period under study, say around the 1857 panic, then it is possible that the negative effects of such failures on subsequent growth would not have been picked up by this study, since it ends in 1860. This leaves open the possibility that the positive relationship between free banking and increased access to credit was not a beneficial one for the economy in the long run. Loan growth (and asset growth more generally) is not always a good thing, as the recent crisis has tended to show.

Private Bank Note, Mechanics Bank, Tennessee, $10, 1854

Private Bank Note, Mechanics Bank, Tennessee, $10, 1854

Overall however, Ager and Spargoli’s paper asks a very important question and offers a solid analysis. A natural next step would be to include output data on the periods preceding and following the free banking era, although the occurrence of the Civil War is an obvious obstacle to this study.

 

References

Jaremski, M., and P. L. Rousseau (2012): “Banks, Free Banks, and U.S. Economic Growth,” Economic Inquiry, 51(2), 1603–21.

Knowing the Who: Identifying the effect of entrepreneurs on firms

Do entrepreneurs matter?

Sascha O. Becker (s.o.becker@warwick.ac.uk), CAGE University of Warwick

Hans K. Hvide (hans.hvide@econ.uib.no), University of Bergen, CEPR and University of Aberdeen

Abstract

Within the broad literature on firm performance, economists have given little attention to entrepreneurs. We use deaths of more than 500 entrepreneurs as a source of exogenous variation, and ask whether this variation can explain shifts in firm performance. Using longitudinal data, we …find large and sustained effects of entrepreneurs at all levels of the performance distribution. Entrepreneurs strongly affect firm growth patterns of both very young firms and for firms that have begun to mature. We do not find significant differences between small and larger firms, family and non-family firms, nor between firms located in urban and rural areas, but we do find stronger effects for founders with high human capital. Overall, the results suggest that an often overlooked factor –individual entrepreneurs plays a large role in affecting firm performance.

URL: http://d.repec.org/n?u=RePEc:wrk:warwec:1002&r=his
Review by Beatriz Rodriguez-Satizabal

Promoting entrepreneurship has been fashionable since the 1980s and there are no signs of it going away. Messages about the importance of becoming your own boss, giving something back to the society, and be an active agent of the economy are there to be seen everywhere on a daily basis. Governments around the world are constantly discussing new ways to increase the number of entrepreneurs and we also see on a regular basis articles within broadsheet newspapers and the popular media trying to identify and challenge those who see themselves grow by creating firms and markets.

In this paper, distributed by NEP-HIS on 2013-01-28, Hvide and Becker question the outcomes of investments to promote entrepreneurship during the last 20 years: Do the entrepreneurs really deliver technological change? Is it sustainable for an emerging country to allow a growing number of entrepreneurs? Is the longevity of the firm related to the characteristics of the founder? Should entrepreneurs be employees in their firms?

The idea of the entrepreneur as an important agent is not entirely new. But studying the role of the entrepreneur within the firm and its effect over its performance has been neglected. In this regard evidence documented in this paper is a step towards a better understanding of the effect of the entrepreneur over the performance of the firm.

Picture1

Based on the assumption that the death of an entrepreneur has an immediate effect on the firm due to the changes in corporate governance that it implies, Becker and Hvide constructed a database of Norwegian firms consisting of incorporated, limited liability companies for the period 1999 to 2007. The authors identified a total of 500 firms where the founding entrepreneurs died, providing an opportunity to quantify whether entrepreneurs have a causal effect on firm performance or not.

As a result of a thorough statistical analysis, the authors find that the effects are large and strong. The entrepreneur shapes the firm and affects its growth patterns. Entrepreneurs matter because of the loss of human capital (but, interestingly, the effect could be also negative as higher performance takes place after death of the founder). Surprisingly, Becker and Hvide do not find any difference between small and large firms, family and non-family owned, nor between firms located in rural or urban areas. This last result is certainly, in my view, an open call to bring the individual characteristics of the entrepreneur to the study of the firm, which is a unit that needs the human capital factor to success.

This paper is a valuable contribution to those studying entrepreneurship because it positions the role of the individual deep into the nature of firm performance rather than having it as a separate unit. It calls our attention over the widely spread assumption that entrepreneurs also innovate within the organization (Schumpeter) and have effects in and out of it (Baumol). If entrepreneurs matter, then knowing the who, why and how must be part of the discussion on public policy to promote entrepreneurship. Moreover, when in emergent countries the close relationship between the successful entrepreneurs and the government still persists.

Do banks facilitate economic growth? If so, what type?

Banks, free banks, and U.S. economic growth

Matthew Jaremski (Colgate University)
Peter Rousseau (Vanderbilt University)

Abstract

The “Federalist financial revolution” may have jump-started the U.S. economy into modern growth, but the Free Banking System (1837-1862) did not play a direct role in sustaining it. Despite lowering entry barriers and extending banking into developing regions, we find in county-level data that free banks had little or no effect on growth. The result is not just a symptom of the era, as state-chartered banks seem to have strong and positive effects on manufacturing and urbanization.

URL: http://econpapers.repec.org/paper/vanwpaper/vuecon-12-00012.htm
Review by Chris Colvin

Do banks facilitate economic growth, and if so, what type of banks do so best? Matthew Jaremski and Peter Rousseau attempt to answer this question by looking at the economic impact of the entry of “free banks” to the US market for banking services in the mid-nineteenth century.

Free banks, so called because they required no charter, were an early form of financial liberalisation which in the long-run proved to be unsuccessful; by 1863, one third of all the free banks ever created had closed.

The advent of free banking laws lowered entry barriers because any group of individuals could establish a bank, as long as they fulfilled certain requirements set down by the state in which they operated. The incumbent charter banks, by contrast, required significant political lobbying before they were permitted to open.

Jaremski and Rousseau look at a period of US history in which both types of bank operated side-by-side. Using county-level social, financial and economic data, they are able to track the impact, if any, of a bank opening on its locality.

Jaremski and Roussasu find that free banking had little effect on growth

Jaremski and Roussasu find that free banking had little effect on growth

Overall, they find that banks of any kind had a strong effect on local growth, especially in manufacturing. But when differentiating the impact by bank type (charter versus free), charter banks had a positive effect while free banks had little or no effect on growth.

So in conclusion, banks appear to facilitate economic growth, but free banks not so much. Why? The authors reckon it has something to do with: (1) what they were investing in (agriculture rather than manufacture); (2) what backed their note issues (some states required very little stable collateral); and (3) new banking legislation in the 1860s (which saw the advent of national banking).

The Open Access Debate and Economic History

This paper, which was distributed by NEP-HIS 2013-02-03, is an example of an alternative use of working paper series: the distribution of soon-to-be-published journal articles that have already gone through peer review. Jaremski and Rousseau are about to have this article published in Economic Inquiry; it is already available there on Early View.

Why do authors use working paper series for this purpose? Well, probably to improve the access to their work.

Improving access to academic work is a very live political issue here in the UK. There is much talk about ways to make academic research available to the general public. The UK government seems to be in favour of something called Gold Access, where researchers pay to have their work published in journals (see here). This strikes me as a way to prop up the status quo, to support publishers’ existing business models, which in my opinion have come under incredible pressure from digital paper archiving and distribution services like RePEc.

An alternative mooted by others has been dubbed Green Access, and is very much the spirit of what Jaremski and Rousseau do here: in addition to publishing work in the standard way, through an established journal with peer review, academics make a version of their article available free-of-charge through their own website or their institution’s online archive, perhaps after some time delay. Many publishers seem dead against this route, perhaps because it threatens their business model more than Gold Access would. But I think putting pressure on their business is a good idea; I reckon that the likes of Elsevier need this pressure in order to curb their market power.

The Economic History Society has recently sent at letter to the UK government committee tasked with looking into the issue of Open Access (see here). It is written from the perspective of not-for-profit academic publisher, and has a different assessment of the situation than me. I urge economic historians to read it and debate its implications, also those located outside of the UK.