A History of Money and Banking in the United States: The Colonial Era to World War II
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At the end of the Revolutionary War, the contraction of the swollen mass of paper money, combined with the resumption of imports from Great Britain, combined to cut prices by more than half in a few years. Vain attempts by seven state governments, in the mid-1780s, to cure the “shortage of money” and reinflate prices were a complete failure. Part of the reason for the state paper issues was a frantic attempt to pay the wartime public debt, state and pro rata federal, without resorting to crippling burdens of taxation. The increased paper issues merely added to the “shortage” by stimulating the export of specie and the import of commodities from abroad. Once again, Gresham’s Law was at work. State paper issues—despite compulsory par laws—merely depreciated rapidly, and aggravated the shortage of specie. A historian discusses what happened to the paper issues of North Carolina:
In 1787–1788 the specie value of the paper had shrunk by more than fifty percent. Coin vanished, and since the paper had practically no value outside the state, merchants could not use it to pay debts they owed abroad; hence they suffered severe losses when they had to accept it at inflated values in the settlement of local debts. North Carolina’s performance warned merchants anew of the menace of depreciating paper money which they were forced to receive at par from their debtors but which they could not pass on to their creditors.21
Neither was the situation helped by the expansion of banking following the launching of the Bank of North America in 1782. The Bank of New York and the Massachusetts Bank (Boston) followed two years later, with each institution enjoying a monopoly of banking in its region.22 Their expansion of bank notes and deposits helped to drive out specie, and in the following year the expansion was succeeded by a contraction of credit, which aggravated the problems of recession.23
THE UNITED STATES: BIMETALLIC COINAGE
Since the Spanish silver dollar was the major coin circulating in North America during the colonial and Confederation periods, it was generally agreed that the “dollar” would be the basic currency unit of the new United States of America.24 Article I, section 8 of the new Constitution gave to Congress the power “to coin money, regulate the value thereof, and of foreign coin”; the power was exclusive because the state governments were prohibited, in Article I, section 10, from coining money, emitting paper money, or making anything but gold and silver coin legal tender in payment of debts. (Evidently the Founding Fathers were mindful of the bleak record of colonial and Revolutionary paper issues and provincial juggling of the weights and denominations of coin.) In accordance with this power, Congress passed the Coinage Act of 1792 on the recommendation of Secretary of Treasury Alexander Hamilton’s “Report on the Establishment of a Mint” of the year before.25
The Coinage Act established a bimetallic dollar standard for the United States. The dollar was defined as both a weight of 371.25 grains of pure silver and/or a weight of 24.75 grains of pure gold—a fixed ratio of 15 grains of silver to 1 grain of gold.26 Anyone could bring gold and silver bullion to the mint to be coined, and silver and gold coins were both to be legal tender at this fixed ratio of 15-to-1. The basic silver coin was to be the silver dollar, and the basic gold coin the $10 eagle, containing 247.5 grains of pure gold.27
The 15-to-1 fixed bimetallic ratio almost precisely corresponded to the market gold/silver ratio of the early 1790s,28 but of course the tragedy of any bimetallic standard is that the fixed mint ratio must always come a cropper against inevitably changing market ratios, and that Gresham’s Law will then come inexorably into effect. Thus, Hamilton’s express desire to keep both metals in circulation in order to increase the supply of money was doomed to failure.29
Unfortunately for the bimetallic goal, the 1780s saw the beginning of a steady decline in the ratio of the market values of silver to gold, largely due to the massive increases over the next three decades of silver production from the mines of Mexico. The result was that the market ratio fell to 15.5-to-1 by the 1790s, and after 1805 fell to approximately 15.75-to-1. The latter figure was enough of a gap between the market and mint ratios to set Gresham’s Law into operation so that by 1810 gold coins began to disappear from the United States and silver coins began to flood in. The fixed government ratio now significantly overvalued silver and undervalued gold, so it paid people to bring in silver to exchange for gold, melt the gold coins into bullion and ship it abroad. From 1810 until 1834, only silver coin, domestic and foreign, circulated in the United States.30
Originally, Congress provided in 1793 that all foreign coins circulating in the United States be legal tender. Indeed, foreign coins have been estimated to form 80 percent of American domestic specie circulation in 1800. Most of the foreign coins were Spanish silver, and while the legal tender privilege was progressively canceled for various foreign coins by 1827, Spanish silver coins continued as legal tender and to predominate in circulation.31 Spanish dollars, however, soon began to be heavier in weight by 1 to 5 percent over their American equivalents, even though they circulated at face value here, and so the American mint ratio overvalued American more than Spanish dollars. As a result, the Spanish silver dollars were re-exported, leaving American silver dollars in circulation. On the other hand, fractional Spanish silver coins—half-dollars, quarter-dollars, dimes, and half-dimes—were considerably overvalued in the U.S., since they circulated at face value and yet were far lighter weight. Gresham’s Law again came into play, and the result was that American silver fractional coins were exported and disappeared, leaving Spanish silver fractional coins as the major currency. To make matters still more complicated, American silver dollars, though lighter weight than the Spanish, circulated equally by name in the West Indies. As a result, American silver dollars were exported to the Caribbean. Thus, by the complex workings of Gresham’s Law, the United States was left, especially after 1820, with no gold coins and only Spanish fractional silver coin in circulation.32
THE FIRST BANK OF THE UNITED STATES: 1791–1811
A linchpin of the Hamiltonian financial program was a central bank, the First Bank of the United States, replacing the abortive Bank of North America experiment. Hamilton’s “Report on a National Bank” of December 1790 urged such a bank, to be owned privately with the government owning one-fifth of the shares. Hamilton argued that the alleged “scarcity” of specie currency needed to be overcome by infusions of paper and the new bank was to issue such paper, to be invested in the assumed federal debt and in subsidy to manufacturers. The bank notes were to be legally redeemable in specie on demand, and its notes were to be kept at par with specie by the federal government’s accepting its notes in taxes—giving it a quasi–legal tender status. Also, the federal government would confer upon the bank the prestige of being the depository for its public funds.
In accordance with Hamilton’s wishes, Congress quickly established the First Bank of the United States in February 1791. The charter of the bank was for 20 years, and it was assured a monopoly of the privilege of having a national charter during that period. In a significant gesture of continuity with the Bank of North America, the latter’s longtime Bank of North America president and former partner of Robert Morris, Thomas Willing of Philadelphia, was made president of the new Bank of the United States.
The 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 in specie. The Bank of the United States invested heavily in loans to the United States government. In addition to $2 million invested in the assumption of pre-existing long-term debt assumed by the new federal government, the Bank of the United States engaged in massive temporary lending to the government, which reached $6.2 million by 1796.33 The result of the outpouring of credit and paper money by the new Bank of the United States was an inflationary rise in prices. Thus, wholesale prices rose from an index of 85 in 1791 to a peak of 146 in 1796, an increase of 72 percent.34 In addition, speculation boomed in government securities and real estate values were driven upward.35 Pyram
iding on top of the Bank of the United States’s expansion and aggravating the paper money expansion and the inflation was a flood of newly created commercial banks. Whereas there were only three commercial banks before the founding of the United States, and only four by the establishment of the Bank of the United States, eight new banks were founded shortly thereafter, in 1791 and 1792, and 10 more by 1796. Thus, the Bank of the United States and its monetary expansion spurred the creation of 18 new banks in five years.36
The establishment of the Bank of the United States precipitated a grave constitutional argument, the Jeffersonians arguing that the Constitution gave the federal government no power to establish a bank. Hamilton, in turn, paved the way for virtually unlimited expansion of federal power by maintaining that the Constitution “implied” a grant of power for carrying out vague national goals. The Hamiltonian interpretation won out officially in the decision of Supreme Court Justice John Marshall in McCulloch v. Maryland (1819).37
Despite the Jeffersonian hostility to commercial and 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 Bank of the United States before its expiration in 1811 and happily multiplied the number of state banks and bank credit in the next two decades.38 Thus, in 1800 there were 28 state banks; by 1811, the number had escalated to 117, a fourfold increase. In 1804, there were 64 state banks, of which we have data on 13, or 20 percent of the banks. These reporting banks had $0.98 million in specie, as against notes and demand deposits outstanding of $2.82 million, a reserve ratio of 0.35 (or, a notes plus deposits pyramiding on top of specie of 2.88-to-1). By 1811, 26 percent of the 117 banks reported a total of $2.57 million; but the two-and-a-half-fold increase in specie was more than matched by an emission of $10.95 million of notes and deposits, a nearly fourfold increase. This constituted a pyramiding of 4.26-to-1 on top of specie, or a reserve ratio of these banks of 0.23.39
As for the Bank of the United States, which acted in conjunction with the federal government and with the state banks, in January 1811 it had specie assets of $5.01 million, and notes and deposits outstanding of $12.87 million, a pyramid ratio of 2.57-to-1, or a reserve ratio of 0.39.40
Finally, when the time for rechartering the Bank of the United States came in 1811, the recharter bill was defeated by one vote each in the House and Senate. Recharter was fought for by the Madison administration aided by nearly all the Federalists in Congress, but was narrowly defeated by the bulk of the Democratic-Republicans, including 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 upon state or private 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 bank had expended credit at cheap rates and had eased the eternal complaint about a “scarcity of money.” Even more suggestive is the support of the state banks, which hailed the bank as “advantageous” and worried about the contraction of credit if the bank were forced to liquidate. The Bank of New York, which had been founded by Alexander Hamilton, in fact lauded the Bank of the United States 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.”41
THE WAR OF 1812 AND ITS AFTERMATH
War has generally had grave and fateful consequences for the American monetary and financial system. We have seen that the Revolutionary War occasioned a mass of depreciated fiat paper, worthless Continentals, a huge public debt, and the beginnings of central banking in the Bank of North America. The Hamiltonian financial system, and even the Constitution itself, was in large part shaped by the Federalist desire to fund the federal and state public debt via federal taxation, and a major reason for the establishment of the First Bank of the United States was to contribute to the funding of the newly assumed federal debt. The Constitutional prohibition against state paper money, and the implicit rebuff to all fiat paper were certainly influenced by the Revolutionary War experience.
The War of 1812–15 had momentous consequences for the monetary system. An enormous expansion in the number of banks and in bank notes and deposits was spurred by the dictates of war finance. New England banks were more conservative than in other regions, and the region was strongly opposed to the war with England, so little public debt was purchased in New England. Yet imported goods, textile manufactures, and munitions had to be purchased in that region by the federal government. The government therefore encouraged the formation of new and recklessly inflationary banks in the Mid-Atlantic, Southern, and Western states, which printed huge quantities of new notes to purchase government bonds. The federal government thereupon used these notes to purchase manufactured goods in New England.
Thus, from 1811 to 1815 the number of banks in the country increased from 117 to 212; in addition, there had sprung up 35 private unincorporated banks, which were illegal in most states but were allowed to function under war conditions. Specie in the 30 reporting banks, 26 percent of the total number of banks of 1811, amounted to $2.57 million in 1811; this figure had risen to $5.40 million in the 98 reporting banks in 1815, or 40 percent of the total. Notes and deposits, on the other hand, were $10.95 million in 1811 and had increased to $31.6 million in 1815 among the reporting banks.
If we make the heroic assumption that we can estimate the money supply for the country by multiplying by the proportion of unreported banks and we then add in the Bank of the United States’s totals for 1811, specie in all banks would total $14.9 million in 1811 and $13.5 million in 1815, or a 9.4 percent decrease. On the other hand, total bank notes and deposits aggregated to $42.2 million in 1811 and $79 million four years later, so that an increase of 87.2 percent, pyramided on top of a 9.4 percent decline in specie. If we factor in the Bank of the United States, then, the bank pyramid ratio was 3.70-to-1 and the reserve ratio 0.27 in 1811; while the pyramid ratio four years later was 5.85-to-1 and the reserve ratio 0.17.
But the aggregates scarcely tell the whole story since, as we have seen, the expansion took place solely outside of New England, while New England banks continued on their relatively sound basis and did not inflate their credit. The record expansion of the number of banks was in Pennsylvania, which incorporated no less than 41 new banks in the month of March 1814, contrasting to only four banks which had existed in that state—all in Philadelphia—until that date. It is instructive to compare the pyramid ratios of banks in various reporting states in 1815: to only 1.96-to-1 in Massachusetts, 2.7-to-1 in New Hampshire, and 2.42-to-1 in Rhode Island, as contrasted to 19.2-to-1 in Pennsylvania, 18.46-to-1 in South Carolina, and 18.73-to-1 in Virginia.42
This monetary situation meant that the United States government was paying for New England manufactured goods with a mass of inflated bank paper outside the region. Soon, as the New England banks called upon the other banks to redeem their notes in specie, the mass of inflating banks faced imminent insolvency.
It was at this point that a fateful decision was made by the U.S. government and concurred in by the governments of the states outside New England. As the banks all faced failure, the governments, in August 1814, permitted all of them to suspend specie payments—that is, to stop all redemption of notes and deposits in gold or silver—and yet to continue in operation. In short, in one of the most flagrant violations of property rights in American history, the banks were permitted to waive their contractual obligations to pay in specie while they themselves could expand their loans and operations and force their own debtors to repay their loans as usual.
Indeed, the number of banks, and bank credit, expanded rapidly during 1815 as a result of this governmental carte blanche. It was precisely during 1815 when virtually all the private banks sprang up, the number of banks increasing in one year from 208 to 246. Reporting banks increased their pyramid ratios from 3.17-to-1
in 1814 to 5.85-to-1 the following year, a drop of reserve ratios from 0.32 to 0.17. Thus, if we measure bank expansion by pyramiding and reserve ratios, we see that a major inflationary impetus during the War of 1812 came during the year 1815 after specie payments had been suspended throughout the country by government action.
Historians dedicated to the notion that central banks restrain state or private bank inflation have placed the blame for the multiplicity of banks and bank credit inflation during the War of 1812 on the absence of a central bank. But as we have seen, both the number of banks and bank credit grew apace during the period of the First Bank of the United States, pyramiding on top of the latter’s expansion, and would continue to do so under the Second Bank, and, for that matter, the Federal Reserve System in later years. And the federal government, not the state banks themselves, is largely to blame for encouraging new, inflated banks to monetize the war debt. Then, in particular, it allowed them to suspend specie payment in August 1814, and to continue that suspension for two years after the war was over, until February 1817. Thus, for two and a half years banks were permitted to operate and expand while issuing what was tantamount to fiat paper and bank deposits.
Another neglected responsibility of the U.S. government for the wartime inflation was its massive issue of Treasury notes to help finance the war effort. While this Treasury paper was interest-bearing and was redeemable in specie in one year, the cumulative amount outstanding functioned as money, as it was used in transactions among the public and was also employed as reserves or “high-powered money” by the expanding banks. The fact that the government received the Treasury notes for all debts and taxes gave the notes a quasi–legal tender status. Most of the Treasury notes were issued in 1814 and 1815, when their outstanding total reached $10.65 million and $15.46 million, respectively. Not only did the Treasury notes fuel the bank inflation, but their quasi–legal tender status brought Gresham’s Law into operation and specie flowed out of the banks and public circulation outside of New England, and into New England and out of the country.43