The Mystery Of Banking
Page 17
The result of this tragic error on bank deposits meant that fractional reserve banking did not end in England after 1844, but simply changed to focusing on demand deposits instead of notes. In fact, the pernicious modern system now came into full flower. Both the Bank of England and the country banks, deprived of the right to issue notes at will, began to issue deposits to a fare-thee-well. And since only the Bank of England could now issue notes, the country banks relied on the Central Bank to issue notes, which remained as legal tender, while they themselves pyramided demand deposits on top of them.
As a result, inflationary booms of bank credit continued immediately after 1844, leading to the final collapse of the Currency School. For as crises arose when domestic and foreign citizens called upon the banks for redemption of their notes, the Bank of England was able to get Parliament to “suspend” Peel’s Act, allowing the Bank to issue enough fractional reserve legal tender notes to get the entire banking system out of trouble. Peel’s Act requiring 100 percent issue of new Bank of England notes was suspended periodically: in 1847, 1857, 1866, and finally, in 1914, when the old gold standard system went into the discard. How seriously the government and the Bank of England kept to the spirit of noninflationary banking may be seen by the fact that when the last vestiges of Peel’s Act were scrapped in 1928, the authorized maximum of the Bank of England was permanently raised from the traditional, but now unfortunately obsolete, £14 million to the now realistic £260 million, while any further issues could simply be authorized by the British government without an act of Parliament. Vera C. Smith justly writes that:
The 1847, 1857 and 1866 crises showed the Government always ready, on the only occasions when it was necessary, to exempt the Bank from the provisions of the Bank Act (Peel’s Act), and the opinion was necessarily expressed in some quarters that the clause of the Act, limiting the fiduciary issue of the Bank, was a mere paper provision having no practical application, since the Bank of England could always rely on the Government to legalise a breach of it every time it got into a difficult position. The relations between the Bank and the Government were, in fact, a tradition too long established for either the Bank, or the public, or the Government, to envisage anything other than full Government support to the Bank in time of stress. It had always been a privileged and protected institution.13
If the political flaw of trusting a monopoly Bank of England combined with the economic flaw of overlooking deposits to make the English banking system worse than before, the effect on Scotland was far worse. For the Currency School theorists were totally ignorant of the beneficial workings of the Scottish free banking system, and in their haste to impose a uniform monetary scheme on the entire United Kingdom, they proceeded to destroy Scottish free banking as well.
Peel’s Act to Regulate the Issue of Bank Notes was imposed on Scotland in July 1845. No new banks of issue were allowed in Scotland any longer; and the note issue of each existing bank could only increase if backed 100 percent by specie in the bank’s vault. In effect, then, the Scottish banks were prevented from further note issue (though not absolutely so as in the case of England), and they, too, shifted to deposits and were brought under the Bank of England’s note issue suzerainty.
One interesting point is the lack of any protests by the Scottish banks at this abrogation of their prerogatives. The reason is that Peel’s 1845 Act suppressed all new entrants into Scottish note banking, thereby cartelizing the Scottish banking system, and winning the applause of the existing banks who would no longer have to battle new competitors for market shares.14
XIII.
CENTRAL BANKING IN THE UNITED STATES I: THE ORIGINS
1. THE BANK OF NORTH AMERICA AND THE FIRST BANK OF THE UNITED STATES
The first commercial bank in the United States was also designed to be the first central bank.1 The charter of the Bank of North America was driven through the Continental Congress by Robert Morris in the spring of 1781. Morris, a wealthy Philadelphia merchant and Congressman, had assumed virtually total economic and financial power during the Revolutionary War. As a war contractor, Morris siphoned off millions from the public treasury into contracts to his own mercantile and shipping firm and to those of his associates. Morris was also leader of the powerful Nationalist forces in the embattled new country whose aim was to reimpose in the new United States a system of mercantilism and big government similar to that in Great Britain, against which the colonists had rebelled. The object was to have a strong central government, particularly a strong president or king as chief executive, built up by high taxes and heavy public debt. The strong central government was to impose high tariffs to subsidize domestic manufacturers, develop a big navy to open up and subsidize foreign markets for American exports, and launch a massive system of internal public works. In short, the United States was to have a British system without Great Britain.
Part of the Morris scheme was to organize and head a central bank, to provide cheap credit and expanded money for himself and his allies. The new privately owned Bank of North America was deliberately modeled after the Bank of England. Its money liabilities were to be grounded upon specie, with a controlled monetary inflation pyramiding credit upon a reserve of specie.
The Bank of North America received a federal charter very quickly in a Congress dominated by its founder and major owner. Like the Bank of England, the Bank of North America was granted the monopoly privilege of its notes being receivable in all duties and taxes to state and federal governments, and at par with specie. Furthermore, no other banks were allowed to operate in the country. In return for this monopoly license to issue paper money, the Bank graciously agreed to lend most of its newly created money to the federal government. In return for this agreement, of course, the hapless taxpayers would have to pay the Bank principal and interest.2
Despite the monopoly privileges conferred upon the Bank of North America and its nominal redeemability in specie, the market’s lack of confidence in the inflated notes led to their depreciation outside the Bank’s home base in Philadelphia. The Bank even tried to bolster the value of its notes by hiring people to urge redeemers of its notes not to insist on specie—a move scarcely calculated to improve long-run confidence in the Bank.
After a year of operation, Morris’s political power slipped, and he moved quickly to shift the Bank of North America from a central bank to a purely commercial bank chartered by the state of Pennsylvania. By the end of 1783, all the federal government’s stock in the Bank, amounting to 5/8 of its capital, had been sold into private hands, and all U.S. government debt to the Bank repaid. The first experiment with a central bank in the United States had ended.
But the U.S. was not to be allowed to be without a central bank for very long. In 1787–88, the Nationalist forces pushed through a new Constitution replacing the decentralist Articles of Confederation. The Nationalists were on their way to re-establishing the mercantilist and statist British model, even though they were grudgingly forced to accept the libertarian Bill of Rights as the price for the Anti-Federalists—who commanded the support of the majority of Americans—not insisting on a second constitutional convention to return to something very like the decentralized Articles.
The successful Federalists (the term the Nationalists called themselves) proceeded to put through their cherished program: high tariffs, domestic taxes, public works, and a high public debt. A crucial part of their program was put through in 1791 by their leader, Secretary of the Treasury, Alexander Hamilton, a disciple of Robert Morris. Hamilton put through Congress the First Bank of the United States, a privately owned central bank, with the federal government owning 1/5 of the shares. Hamilton argued that an alleged “scarcity” of specie had to be overcome by infusions of paper money, to be issued by the new Bank and invested in the public debt and in subsidies of cheap credit to manufacturers. The Bank notes were to be legally redeemable in specie on demand, and they were to be kept at par with specie by the federal government’s accepting its notes in taxes, thu
s giving it a quasi-legal tender status. The federal government would also confer upon the Bank the privileges of being the depository for its funds. Furthermore, for the 20-year period of its charter, the First Bank of the United States was to be the only bank with the privilege of having a national charter.
The First Bank of the United States was modeled after the old Bank of North America, and in a significant gesture of continuity the latter’s longtime president and former partner of Robert Morris, Thomas Willing of Philadelphia, was made president of the new Bank.
The First Bank of the United States promptly fulfilled its inflationary potential by issuing millions of dollars in paper money and demand deposits, pyramiding on top of $2 million of specie. The BUS invested heavily in $8.2 million of loans to the U.S. government by 1796. As a result, wholesale prices rose from an index of 85 in 1791 to a peak of 146 in 1796, an increase of 72 percent. In addition, speculation mounted in government securities and real estate. Pyramiding on top of BUS expansion, and aggravating the paper money expansion and the inflation, was a flood of newly created commercial banks. Only three commercial banks had existed at the inception of the Constitution, and only four by the time of the establishment of the BUS. But eight new banks were founded shortly thereafter, in 1791 and 1792, and 10 more by 1796. Thus, the BUS and its monetary expansion spurred the creation of 18 new banks in five years, on top of the original four.
Despite the official hostility of the Jeffersonians to commercial as well as central banks, the Democratic-Republicans, under the control of quasi-Federalist moderates rather than militant Old Republicans, made no move to repeal the charter of the BUS before its expiration in 1811. Moreover, they happily multiplied the number of state chartered banks and bank credit during the two decades of the BUS existence. Thus in 1800, there were 28 state banks; by 1811, the number had grown to 117, a fourfold increase.3
When the time came for rechartering the BUS in 1811, the recharter bill was defeated by one vote each in the House and Senate. Recharter was fought for by the quasi-Federalist Madison administration, aided by nearly all the Federalists in Congress, but was narrowly defeated by the bulk of the Democratic-Republicans, led by the hard money Old Republican forces. In view of the widely held misconception among historians that central banks serve, and are looked upon, as restraints on state bank inflation, it is instructive to note that the major forces in favor of recharter were merchants, Chambers of Commerce, and most of the state banks. Merchants found that the BUS had expanded credit at cheap interest rates, and eased the eternal complaints about a “scarcity of money.” Even more suggestive is the support of the state banks, which hailed the BUS as “advantageous” and worried about a contraction of credit should the Bank be forced to liquidate. The Bank of New York, which had been founded by Alexander Hamilton, even lauded the BUS because it had been able “in case of any sudden pressure upon the merchants to step forward to their aid in a degree which the state institutions were unable to do.”4
But free banking was not to have much of a chance. The very next year, the United States launched an unsuccessful war against Great Britain. Most of the industry and most of the capital was in New England, a pro-British region highly unsympathetic to the War of 1812. New England capital and the conservative New England banks were not about to invest heavily in debt to finance the war. Therefore, the U.S. government encouraged an enormous expansion in the number of banks and in bank notes and deposits to purchase the growing war debt. These new and recklessly inflationary banks in the Middle Atlantic, Southern, and Western states, printed enormous quantities of new notes to purchase government bonds. The federal government then used these notes to purchase arms and manufactured goods in New England.
Thus, from 1811 to 1815, the number of banks in the country increased from 117 to 246. The estimated total of specie in all banks fell from $14.9 million in 1811 to $13.5 million in 1815, whereas the aggregate of bank notes and deposits rose from $42.2 million in 1811 to $79 million four years later, an increase of 87.2 percent, pyramiding on top of a 9.4 percent decline in specie.
What happened next provides a fateful clue to the problem of why free banking did not work as well before the Civil War as in our theoretical model. It didn’t work well (although its record was not nearly as bad as that of central banking) because it wasn’t really tried. Remember that a crucial aspect of the free banking model is that the moment a bank cannot pay its notes or deposits in specie, it must declare bankruptcy and close up shop. But the federal and state governments did not allow this crucial process of insolvency—fundamental to the capitalist system—to work itself out.
Specifically, in the War of 1812, as the federal government spent the new inflated notes in New England, the conservative New England banks called on the banks of the other regions for redemption in specie. By August 1814, it became clear that the banks of the nation apart from New England could not pay, that they were insolvent. Rather than allow the banks of the nation to fail, the governments, state and federal, decided in August 1814 to allow the banks to continue in business while refusing to redeem their obligations in specie. In other words, the banks were allowed to refuse to pay their solemn contractual obligations, while they could continue to issue notes and deposits and force their debtors to fulfill their contractual obligations. This was unfair and unjust, as well as a special privilege of mammoth proportions to the banking system; not only that, it provided carte blanche, an open sesame, for bank credit inflation.
Free banking did not work well in the U.S. because it was never fully tried. The banks were allowed to continue to “suspend specie payments” while remaining in business for 21/2 years, even though the war was over by early 1815. This general suspension was not only highly inflationary at the time; it set a precedent for all financial crises from then on. Whether the U.S. had a central bank or not, the banks were assured that if they inflated together and then got in trouble, government would bail them out and permit them to suspend specie payments for years. Such general suspensions of specie payments occurred in 1819, 1837, 1839, and 1857, the last three during an era generally considered to be that of “free banking.”
2. THE SECOND BANK OF THE UNITED STATES
The United States emerged from the War of 1812 in a chaotic monetary state, its monetary system at a fateful crossroads. The banks, checked only by the varying rates of depreciation of their notes, multiplied and expanded wildly, freed from the obligation of redeeming their notes and deposits in specie. Clearly, the nation could not continue indefinitely with discordant sets of individual banks issuing fiat money. It was apparent that there were only two ways out of this pressing problem. One was the hard money path, advocated by the Old Republicans, and, for their own purposes, the Federalists. The federal and state governments would then have sternly compelled the recklessly inflating banks to redeem promptly in specie and, when most of the banks outside of New England failed to do so, force them to liquidate. In that way, the mass of depreciated and inflated notes would have been liquidated quickly, and specie would have poured back out of hoards and into the country to supply a circulating medium. America’s inflationary experience would have been ended, perhaps forever.
Instead, the centrist Democrat-Republican establishment in 1816 turned to the second way: the old Federalist path of a new inflationary central bank, the Second Bank of the United States. Modeled closely after the First Bank, the Second Bank, a private corporation with 1/5 of its stock owned by the federal government, was to create a uniform national paper currency, purchase a large part of the public debt, and receive deposits of Treasury funds. The BUS notes and deposits were to be redeemable in specie, and they were given quasi-legal tender status by the federal government’s receiving them in payment of taxes.
That the purpose of establishing the BUS was to support rather than restrain the state banks in their inflationary course is shown by the shameful deal that the BUS made with the state banks as soon as it opened its doors in January 1817. While it
was enacting the BUS charter in April 1816, Congress passed a resolution of Daniel Webster, at that time a Federalist champion of hard money, requiring that after February 20, 1817, the U.S. would accept in payments for taxes only specie, Treasury notes, BUS notes, or state bank notes redeemable in specie on demand. In short, no irredeemable state bank notes would be accepted after that date. Instead of using this opportunity to compel the banks to redeem, however, the BUS, meeting with representatives from the leading urban banks outside Boston, agreed to issue $6 million worth of credit in New York, Philadelphia, Baltimore, and Virginia before insisting on specie payments on debts due from the state banks. In return for that massive inflation, the state banks graciously consented to resume specie payments. Moreover, the BUS and the state banks agreed to mutually support each other in any emergency, which, of course, meant in practice that the far stronger BUS was committed to the propping up of the weaker state banks.