The Mystery Of Banking

by Murray N. Rothbard

  Several of the Congressional opponents delivered trenchant critiques of the establishment of the BUS. Senator William H. Wells, Federalist from Delaware, noted in some surprise that:

  This bill came out of the hands of the Administration ostensibly for the purpose of correcting the diseased state of our paper currency, by restraining and curtailing the over issue of banking paper; and yet it came prepared to inflict upon us the same evil; being itself nothing more than simply a paper-making machine. ... The disease, it is said, under which the people labor, is the banking fever of the States; and this is to be cured by giving them the banking fever of the United States.5

  In the House of Representatives, Artemas Ward, Jr., Federalist from Massachusetts, pointed out that the remedy for the evil of inflated and depreciated paper was simple: “refusing to receive the notes of those banks, which do not pay specie, in dues to the Government.” This would naturally be done, Ward pointed out, but for an alliance, which he considered “disgraceful to the country and unjust to individuals,” between the Secretary of the Treasury and the banks, without which the evil never would have existed. The leader in the battle against the Bank, Daniel Webster, Federalist of New Hampshire, pointed out that “there was no remedy for the state of depreciation of the paper currency, but the resumption of specie payments,” which the government should force the banks to undertake.

  But the most eloquent attack on the new BUS was that of the fiery Old Republican from Virginia, John Randolph of Roanoke. After pointing out that only specie can soundly function as money, Randolph prophetically warned that a central bank

  would be an engine of irresistible power in the hands of any administration; that it would be in politics and finance what the celebrated proposition of Archimedes was in physics—a place, the fulcrum from which, at the will of the Executive, the whole nation could be huffed to destruction, or managed in any way, at his will and discretion.

  The Bank, Randolph charged, would serve “as a crutch,” and, as far as he understood it, it was a broken one: “it would tend, instead of remedying the evil, to aggravate it.”

  “We do not move forthrightly against the insolvent banks,” Randolph warned, because of fear and greed:

  Every man you meet in this House or out of it, with some rare exceptions, which only served to prove the rule, was either a stockholder, president, cashier, clerk or doorkeeper, runner, engraver, paper-maker, or mechanic in some other way to a bank ...

  However great the evil of their conduct might be ... who was to bell the cat—who was to take the bull by the horns? ... There were very few, he said, who dared to speak truth to this mammoth; the banks were so linked together with the business of the world, that there were very few men exempt from their influence. The true secret is, said he, the banks are creditors as well as debtors

  and so their debtors fear to tackle the banks.

  Randolph went on to pinpoint the fraudulent nature of fractional reserve banking:

  ... [i]t was as much swindling to issue notes with intent not to pay, as it was burglary to break open a house. If they were unable to pay, the banks were bankrupts ...6

  The BUS was driven through Congress by the Madison administration and particularly by Secretary of the Treasury Alexander J. Dallas, whose appointment had been pushed for that purpose. Dallas, a wealthy Philadelphia lawyer, was a close friend, counsel, and financial associate of Philadelphia merchant and banker, Stephen Girard, reputedly one of the two wealthiest men in the country. Girard had been the largest single stockholder of the First BUS, and during the War of 1812, he became a very heavy investor in the war debt of the federal government. As a prospective large stockholder of the BUS and as a way of creating a buyer for his public debt, Girard began to urge a new Central Bank. Dallas’s appointment as Secretary of Treasury in 1814 was successfully engineered by Girard and his close friend, wealthy New York merchant and fur trader, John Jacob Astor, also a heavy investor in the war debt.7

  As a result of the deal between the BUS and the state banks, the resumption of specie payments by the latter after 1817 was more nominal than real, thereby setting the stage for continued inflation, and for renewed widespread suspensions of specie payment during the 1819–21 panic and depression. A mark of this failure of redemption was that varying discounts on bank notes against specie continued from 1817 on.

  The problem was aggravated by the fact that the BUS lacked the courage to insist on payment of notes from the state banks. As a result, the BUS piled up large balances against the state banks, reaching over $2.4 million during 1817 and 1818. As the major historian of the BUS writes: “So many influential people were interested in the [state banks] as stockholders that it was not advisable to give offense by demanding payment in specie, and borrowers were anxious to keep the banks in the humor to lend.”8

  From its inception, the Second BUS launched a massive inflation of money and credit. Lax about insisting on the required payments of its capital in specie, the Bank failed to raise the $7 million legally required to be subscribed in specie. During 1817 and 1818, its specie never rose above $2.5 million and at the peak of its initial expansion, BUS specie was $21.8 million. Thus, in a scant year and a half of operation, the BUS added a net of $19.2 million to the money supply.

  Outright fraud abounded at the BUS, especially at the Philadelphia and Baltimore branches, which made 3/5 of all BUS loans.9 Furthermore, the BUS attempt to provide a uniform national currency foundered on the fact that the western and southern branches could inflate credit and bank notes, and that the inflated notes would then come into the more conservative branches in New York and Boston, which would be obligated to redeem the inflated notes at par. In this way, the conservative branches were stripped of specie while the western branches continued to inflate unchecked.

  The expansionary operations of the BUS impelled an inflationary expansion of state banks on top of the enlargement of the central bank. The number of incorporated state banks rose from 232 in 1816 to 338 in 1818, with Kentucky alone chartering 40 new banks in the 1817–18 legislative session. The estimated total money supply in the nation rose from $67.3 million in 1816 to $94.7 million in 1818, a rise of 40.7 percent in two years. Most of this increase was supplied by the BUS.10 This enormous expansion of money and credit impelled a full-scale inflationary boom throughout the country.

  Starting in July 1818, the government and the BUS began to see what dire straits they were in; the enormous inflation of money and credit, aggravated by the massive fraud, had put the BUS in danger of going under and illegally failing to maintain specie payments. Over the next year, the BUS began a series of enormous contractions, forced curtailment of loans, contractions of credit in the south and west, refusal to provide uniform national currency by redeeming its shaky branch notes at par, and at last, seriously enforcing the requirement that its debtor banks redeem in specie. These heroic actions, along with the ouster of President William Jones, managed to save the BUS, but the contraction of money and credit swiftly brought to the United States its first widespread economic and financial depression. The first nationwide “boom-bust” cycle had arrived in the United States, ignited by rapid and massive inflation and quickly succeeded by contraction of money and credit. Banks failed, and private banks curtailed their credits and liabilities and suspended specie payments in most parts of the country.

  Contraction of money and credit by the BUS was almost incredible, notes and deposits falling from $21.8 million in June 1818 to $11.5 only a year later. The money supply contributed by the BUS was thereby contracted by no less than 47.2 percent in one year. The number of incorporated banks at first remained the same, and then fell rapidly from 1819 to 1822, dropping from 341 in mid-1819 to 267 three years later. Total notes and deposits of state banks fell from an estimated $72 million in mid-1818 to $62.7 million a year later, a drop of 14 percent in one year. If we add in the fact that the U.S. Treasury contracted total treasury notes from $8.81 million to zero during this period, we get a tota
l money supply of $103.5 million in 1818, and $74.2 million in 1819, a contraction in one year of 28.3 percent.

  The result of the contraction was a rash of defaults, bankruptcies of business and manufacturers, and a liquidation of unsound investments during the boom. Prices in general plummeted: the index of export staples fell from 158 in November 1818 to 77 in June 1819, an annualized drop of 87.9 percent in seven months.

  In the famous charge of the Jacksonian hard money economist and historian William M. Gouge, by its precipitate and dramatic contraction “the Bank was saved, and the people were ruined.”11

  The Bank of the United States was supposed to bring the blessings of a uniform paper currency to the United States. Yet from the time of the chaotic 1814–17 experience, the notes of the state banks had circulated at varying rates of depreciation, depending on how long the public believed they could keep redeeming their obligations in specie.

  During the panic of 1819, obstacles and intimidation were often the lot of those who attempted to press the banks to fulfill their contractual obligations to pay in specie. Thus, Maryland and Pennsylvania engaged in almost bizarre inconsistency. Maryland, on February 15, 1819, enacted a law “to compel ... banks to pay specie for their notes, or forfeit their charters.” Yet, two days after this seemingly tough action, it passed another law relieving banks of any obligation to redeem notes held by professional money brokers, the major force ensuring such redemption. The latter act was supposed “to relieve the people of this state ... from the evil arising from the demands made on the banks of this state for gold and silver by brokers.” Pennsylvania followed suit a month later. In this way, these states could claim to be enforcing contract and property rights while trying to prevent the most effective means of such enforcement.

  Banks south of Virginia largely went off specie payment during the Panic of 1819, and in Georgia at least general suspension continued almost continuously down to the 1830s. One customer complained during 1819 that in order to collect in specie from the largely state-owned Bank of Darien in Georgia, he was forced to swear before a justice of the peace, five bank directors, and the bank cashier, that each and every note he presented to the bank was his own and that he was not a “money broker” or an agent for anyone else. Furthermore, he was forced to pay a fee of $1.36 on each note in order to obtain the specie to which he was entitled.12

  In North Carolina, furthermore, banks were not penalized by the legislature for suspending specie payments to brokers, though they were for suspending payments to other depositors. Thus encouraged, the three leading banks of North Carolina met in June 1819 and agreed not to pay specie to brokers or their agents. Their notes, however, immediately fell to a 15 percent discount outside the state. In the course of this partial default, of course, the banks continued to require their own debtors to pay them at par in specie.

  Many states permitted banks to suspend specie payments during the Panic of 1819, and four Western states—Tennessee, Kentucky, Missouri, and Illinois—established state-owned banks to try to combat the depression by issuing large amounts of inconvertible paper money. In all states trying to prop up bank paper, a quasi-legal tender status was conferred on it by agreeing to receive the notes in taxes or debts due to the state. All the inconvertible paper schemes led to massive depreciation and disappearance of specie, succeeded by rapid liquidation of the new state-owned banks.

  XIV.

  CENTRAL BANKING IN THE UNITED STATES II: THE 1820S TO THE CIVIL WAR

  1. THE JACKSONIAN MOVEMENT AND THE BANK WAR

  Out of the debacle of the Panic of 1819 emerged the beginnings of the Jacksonian movement dedicated to laissez-faire, hard money, and the separation of money and banking from the State. During the 1820S, the new Democratic Party was established by Martin Van Buren and Andrew Jackson to take back America for the old Republican program. The first step on the agenda was to abolish the Bank of the United States, which was up for renewal in 1836. The imperious Nicholas Biddle, head of the BUS who was continuing the chain of control over the Bank by the Philadelphia financial elite,1 decided to force the issue early, filing for renewal in 1831. Jackson, in a dramatic message, vetoed renewal of the Bank charter, and Congress failed to pass it over his veto.

  Triumphantly reelected on the Bank issue in 1832, President Jackson disestablished the BUS as a central bank by removing Treasury deposits from the BUS in 1833, placing them in a number of state banks (soon called “pet banks”) throughout the country. At first, the total number of pet banks was seven, but the Jacksonians, eager to avoid a tight-knit oligarchy of privileged banks, increased the number to 91 by the end of 1836. In that year, as its federal charter ran out, Biddle managed to get a Pennsylvania charter for the Bank, and the new United States Bank of Pennsylvania managed to function as a regular state bank for a few years thereafter.

  Historians long maintained that Andrew Jackson, by his reckless act of eliminating the BUS and shifting government funds to pet banks, freed the state banks from the restraints imposed upon them by a central bank. In that way, the banks allegedly were allowed to pyramid money on top of specie, precipitating an unruly inflation later succeeded by two bank panics and a disastrous inflation.

  Recent historians, however, have demonstrated that the correct picture was precisely the reverse.2 First, under the regime of Nicholas Biddle, BUS notes and deposits had risen, from January 1823 to January 1832, from $12 million to $42.1 million, an annual increase of 27.9 percent. This sharp inflation of the base of the banking pyramid led to a large increase in the total money supply, from $81 million to $155 million, or an annual increase of 10.2 percent. Clearly, the driving force of this monetary expansion of the 1820S was the BUS, which acted as an inflationary spur rather than as a restraint on the state banks.

  The fact that wholesale prices remained about the same over this period does not mean that the monetary inflation had no ill effects. As “Austrian” business cycle theory points out, any bank credit inflation creates a boom-and-bust cycle; there is no need for prices actually to rise. Prices did not rise because an increased product of goods and services offset the monetary expansion. Similar conditions precipitated the great crash of 1929. Prices need not rise for an inflationary boom, followed by a bust, to be created. All that is needed is for prices to be kept up by the artificial boom, and be higher than they would have been without the monetary expansion. Without the credit expansion, prices would have fallen during the 1820S, as they would have a century later, thereby spreading the benefits of a great boom in investments and production to everyone in the country.

  Recent historians have also demonstrated that most of the state banks warmly supported recharter of the Bank of the United States. With the exception of the banks in New York, Connecticut, Massachusetts, and Georgia, the state banks overwhelmingly backed the BUS.3 But if the BUS was a restraining influence on their expansion, why did they endorse it?

  In short, the BUS had a poor inflationary record in the 1820S, and the state banks, recognizing its role as a spur to their own credit expansion, largely fought on its behalf in the recharter struggle of the early 1830S.

  Furthermore, the inflationary boom of the 1830S began, not with Jackson’s removal of the deposits in 1833, but three years earlier, as an expansion fueled by the central bank. Thus, the total money supply rose from $109 million in 1830 to $155 million at the end of 1831, a spectacular expansion of 35 percent in one year. This monetary inflation was sparked by the central bank, which increased its notes and deposits from January 1830 to January 1832 by 45.2 percent.4

  There is no question, however, that the money supply and the price level rose spectacularly from 1833 to 1837. Total money supply rose from $150 million at the beginning of 1833 to $276 million four years later, an astonishing rise of 84 percent, or 21 percent per annum. Wholesale prices, in turn, rose from 84 in the spring of 1834 to 131 in early 1837, a rise of 52 percent in a little less than three years—or an annual rise of 19.8 percent.

  The monetar
y expansion, however, was not caused by state banks going hog wild. The spark that ignited the inflation was an unusual and spectacular inflow of Mexican silver coins into the United States—brought about by the minting of debased Mexican copper coins which the Mexican government tried to keep at par value with silver. The system of fractional reserve banking, however, fundamentally was to blame for magnifying the influx of specie and pyramiding notes and deposits upon the specie base. In 1837, the boom came to an end, followed by the inevitable bust, as Mexico was forced to discontinue its copper coin issue by the outflow of silver, and the Bank of England, worried about inflation at home, tightened its own money supply and raised interest rates.5 The English credit contraction in late 1836 caused a bust in the American cotton export trade in London, followed by contractionist pressure on American trade and banks.

  In response to this contractionist pressure—demands for specie—the banks throughout the United States (including the old BUS) promptly suspended specie payments in May 1837. The governments allowed them to do so, and continued to receive the notes in taxes. The notes began to depreciate at varying rates, and interregional trade within the United States was crippled.

  The banks, however, could not hope to be allowed to continue on a fiat basis indefinitely, so they reluctantly began contracting their credit in order to go back eventually on specie. Finally, the New York banks were compelled by law to resume paying in specie, and other banks followed in 1838. During the year 1837, the money supply fell from $276 million to $232 million, a large drop of 15.6 percent in one year. Specie continued to flow into the country, but increased public distrust in the banks and demands to redeem in specie put enough pressure on the banks to force the contraction. In response, wholesale prices fell precipitately, by over 30 percent in seven months, declining from 131 in February 1837 to 98 in September of that year.