The Mystery of Banking

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, thus 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.

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 total 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.

• 1There were very few privately-owned banks in colonial America, and they were short-lived.
• 2When he failed to raise the legally required specie capital to launch the Bank of North America, Robert Morris, in an act tantamount to embezzlement, simply appropriated specie loaned to the U.S. by France and invested it on behalf of the government in his own bank. In this way, Morris appropriated the bulk of specie capital for his bank out of government funds. A multiple of these funds was then borrowed back from Morris’s bank by Morris as government financier for the pecuniary benefit of Morris as banker; and finally, Morris channeled most of the money into war contracts for his friends and business associates. See Murray N. Rothbard, Conceived in Liberty, Vol. IV, The Revolutionary War, 1775–1784 (New Rochelle, N.Y.: Arlington House, 1979), p. 392.
• 3On the quasi-Federalists as opposed to the Old Republicans, on banking and on other issues, see Richard E. Ellis, The Jeffersonian Crisis: Courts and Politics in the Young Republic (New York: Oxford University Press, 1971) p. 277 and passim. Ellis perceptively writes: For all their hostility to banks during the 1790’s, the Jeffersonians, once in power, established more state banks than the Federalists had ever thought of creating. Much of this was deliberate on the part of the moderates and bitterly opposed by the radicals. ... The real meaning of Jeffersonian Democracy, it would seem, is to be found in the political triumph of the moderate Republicans and their eventual amalgamation with the moderate wing of the Federalist party. This represented a victory of moderation over the extremism of the ultra-nationalist, neo-mercantile wing of the Federalist party on the one hand, and the particularistic, Anti-Federalist-Old Republican wing of the Democratic party on the other. Very true, although the use of the term “moderate” by Ellis, of course, loads the semantic dice. Ellis notes that one quasi-Federalist hailed the triumph of the center over “Federalism, artfully employed to disguise monarchy” on the one hand, and Democracy, “unworthily employed as a cover for anarchy” on the other. Ibid., pp. 277–78.
• 4John Thom Holdsworth, The First Bank of the United States (Washington, D.C.: National Monetary Commission, 1910), p. 83. Holdsworth, the premier historian of the First BUS, saw this overwhelmingly supported by the state banks, but still inconsistently clung to the myth that the BUS functioned as a restraint on their expansion: “The state banks, though their note issues and discounts had been kept in check by the superior resources and power of the Bank of the United States, favored the extension of the charter, and memorialized Congress to that effect.” Ibid., p. 90. Odd that they would be acting so contrary to their self-interest!
• 5Annals of Congress, 14 Cong., 1 sess., April 1, 1816, p. 267.
• 6Annals of Congress, 14 Cong., 1 sess., pp. 1066, 1091, 1110ff.
• 7On the Girard-Dallas connection, see Bray Hammond, Banks and Politics in America (Princeton, N.J.: Princeton University Press, 1957), pp. 231–46, 252; and Philip H. Burch, Jr., Elites in American History, vol. I, The Federalist Years to the Civil War (New York: Holmes & Meier, 1981), pp. 88, 97, 116–17, 119–21.
• 8Ralph C.H. Catterall, The Second Bank of the United States (Chicago: University of Chicago Press, 1902), p. 36.
• 9The main culprits in the massive BUS fraud were James A. Buchanan, president of the Baltimore branch, his partner Samuel Smith of the leading Baltimore mercantile firm of Smith & Buchanan, and the Baltimore BUS cashier, James W. McCulloch, who was simply an impoverished clerk at the mercantile house. Smith, an ex-Federalist, was a Senator from Maryland and a powerful member of the national quasi-Federalist Democratic-Republican establishment. See ibid., pp. 28–50, 503.
• 10Figures are adapted from tables, converted pro rata to 100 percent of the banks, in J. Van Fenstermaker, “The Statistics of American Commercial Banking, 1782–1818,” Journal of Economic History (September 1965): 401, 405–06.
• 11William M. Gouge, A Short History of Paper Money and Banking in the United States (New York: Augustus M. Kelley, 1968), p. 110.
• 12Ibid., pp. 141–42. Secretary of the Treasury William H. Crawford, a powerful political leader from Georgia, tried in vain to save the Bank of Darien by depositing Treasury funds in the bank. Murray N. Rothbard, The Panic of 1819: Reactions and Policies (New York: Columbia University Press, 1962), p. 62.