The Revival of the Note Issue Paradox: Free Banking in Switzerland between 1872 and 1881

Abstract

This paper uses the unique institutional setting of Swiss cantons from 1872 to 1881 to study the note-issuing behavior of private banks in a free banking system. I find that these banks over-issue notes, in contrast to recent literature on free banking in the United States in the 19th century such Bodenhorn and Haupert (1996). This new conclusion results from measuring two additional determinants of note-issuing that have previously been ignored: the average withdrawals from deposit accounts, and the interest rate paid on those deposit accounts. Controlling for these two variables reveals that the expected return on note-issuing exceeds the returns on deposit creation. Therefore, banks issued too many notes, failing to take into account the negative externality imposed on other issuing banks by the increased transaction costs that result from the larger flow of species and by the effect on the exchange rate volatility.

Keywords: banking, economic history, financial institutions

JEL Classification: G21, N22