How Did Financial Innovation Shape Early America?

Before the outbreak of the Civil War, an empowered American electorate was voting in policies built around the embrace of innovation and opportunity, and voting out of existence any policies that encouraged control of resources by a small elite or that favored stability and tradition over change. The United States, for example, had a very open banking system. Most banks were chartered by states, and most states put in place “free banking” laws. Anyone could get a charter to open a bank just by applying. Before, each bank had to be approved individually by the legislature, a slow and cumbersome, and potentially corrupt process. In addition, there were many private banks that did not get state charters but merely operated on their reputation with the public. This was a risky but also very lucrative financial system, and access to finance is typically crucial to moving innovative efforts out of the idea or model stage into the market.

By 1840 or so the number of banks and new corporate startups exploded. The U.S. had only 28 state-chartered banks in 1800 but had nearly 700 forty years later, plus an additional 200 private banks. America had more banks per person and as a percentage of GDP than any other country. The contrast with other capital-poor developing countries such as Brazil, Mexico, or Argentina is striking. The U.S. had more banks in 1800 than Brazil did in 1888 or Mexico in 1900. In Latin American nations, which were far less equal and had much less democratic political systems, financial institutions were fewer in number, hard to open, and mainly served the plantation and land-owning elite, an elite that had concentrated political power to prevent any move in the direction of democratic financing. In North America, a proliferation of banks, located in places of almost any size, provided easy access to financing for entrepreneurs.

What is interesting to note is that this openness to finance in America was encouraged even though it was not always the most efficient system. State charters and laws prevented branch banking in many places—policies that in some states would not be rescinded until the 1970s. The fear was that with branches, bigger city banks would soon dominate the financial landscape. Many local banks, on the other hand, would better serve local firms and entrepreneurs, and also offer opportunities for ambitious business people to start their own banks to mobilize capital for projects that would benefit their towns. Branching, however, can be more efficient, as it allows one bank to consolidate and centralize back-office operations and thus lower the cost of making loans. But it wasn’t efficiency Americans sought in finance, it was opportunity. And the very structure of the American political system encouraged this sort of financial and organizational innovation. Since states made the bank and corporate charters, states also competed with each other for business. This competitive federalism led to easier and easier chartering of banks and other businesses with fewer and fewer regulations and restrictions, much like today where state competition had led some states, notably South Dakota, to ease or erase restrictions on credit cards and interest rates, so that many, indeed most credit cards set up operations there.

America’s open banking system encouraged a raucous approach to financing, to be sure. The nineteenth century was filled with bank failures, fraudulent corporations, worthless stock, and counterfeit bank notes. There was no central bank to regulate the money supply, once Andrew Jackson killed off the Bank of the United States. It seems a deep part of American culture to move between openness and speculation, and then take away the punch bowl to reign in the excesses. When the Republican Party took over the White House and Congress after the Civil War, it cut back on the open financial policies of the previous generation, passing laws that ended free banking and replaced loose state charters with tighter federal ones. To encourage bankers to get federal charters, the new laws put a tax on notes issued by state banks. At this time there was no Federal Reserve, so the money supply was created by individual banks issuing their own notes. For a time state banks went into decline, but in a decade or so they had bounced back. American financiers are apparently irrepressible innovators. The state bankers stopped depending on the heavily taxed paper currency and began using something new, the check. With this innovation, they came roaring back. For better or worse America will likely remain a land of financial innovation, which will mean booms and busts and bubbles (not to mention fraud), but also a land of easy financing for innovators to bring ideas to market.