The Mystery Of Banking

by Murray N. Rothbard

  This healthy deflation brought about speedy recovery by 1838. Unfortunately, public confidence in the banks returned as they resumed specie payment, so that the money supply rose slightly and prices rose by 25 percent. State governments ignited the new boom of 1838 by recklessly spending large Treasury surpluses which President Jackson had distributed pro rata to the states two years earlier. Even more money was borrowed to spend on public works and other forms of boondoggle. The states counted on Britain and other countries purchasing these new bonds, because of the cotton boom of 1838. But the boom collapsed the following year, and the states had to abandon the unsound projects of the boom. Cotton prices fell and severe deflationist pressure was put upon the banks and upon trade. Moreover, the BUS had invested heavily in cotton speculation, and was forced once again to suspend specie payments in the fall of 1839. This touched off a new wave of general bank suspensions in the South and West, although this time the banks of New York and New England continued to redeem in specie. Finally, the BUS, having played its role of precipitating boom and bust for the last time, was forced to close its doors forever in 1841.

  The crisis of 1839 ushered in four years of massive monetary and price deflation. Many unsound banks were finally eliminated, the number of banks declining during these years by 23 percent. The money supply fell from $240 million at the beginning of 1839 to $158 million in 1843, a seemingly cataclysmic drop of 34 percent, or 8.5 percent per annum. Wholesale prices fell even further, from 125 in February 1839 to 67 in March 1843, a tremendous drop of 42 percent, or 10.5 percent per year. The collapse of money and prices after 1839 also brought the swollen state government debts into jeopardy.

  State government debt had totaled a modest $26.5 million in 1830. By 1835 it had reached $66.5 million, and by 1839 it had escalated to $170 million. It was now clear that many states were in danger of default on the debt. At this point, the Whigs, taking a leaf from their Federalist forebears, called for the federal government to issue $200 million worth of bonds in order to assume all the state debt.

  The American people, however, strongly opposed federal aid, including even the citizens of the states in difficulty. The British noted in wonder that the average American seemed far more concerned about the status of his personal debts than about the debts of his state. To the worried question, Suppose foreign capitalists did not lend any further to the states? the Floridian replied, “Well who cares if they don’t. We are now as a community heels over head in debt and can scarcely pay the interest.”6

  The implication was clear: The disappearance of foreign credit to the states would be a good thing; it would have the healthy effect of cutting off their further wasteful spending, as well as avoiding the imposition of a crippling tax burden to pay for the interest and principal. There was in this astute response an awareness by the public that they and their governments were separate and sometimes even hostile entities rather than all part of one and the same organism.

  The advent of the Jacksonian Polk administration in 1845 put an end to the agitation for Federal assumption of the debt, and by 1847, four western and southern states had repudiated all or part of their debts, while six other states had defaulted from three to six years before resuming payment.7

  Evidently, the 1839–43 contraction and deflation was a healthy event for the economy, since it liquidated unsound investments, debts, and banks, including the pernicious Bank of the United States. But didn’t the massive deflation have catastrophic effects—on production, trade, and employment—as we have generally been led to believe? Oddly enough, no. It is true that real investment fell by 23 percent during the four years of deflation, but, in contrast, real consumption increased by 21 percent and real GNP by 16 percent during this period. It seems that only the initial months of the contraction worked a hardship. And most of the deflation period was an era of economic growth.8

  The Jacksonians had no intention of leaving a permanent system of pet banks, and so Jackson’s chosen successor Martin Van Buren fought to establish the Independent Treasury System, in which the federal government conferred no special privilege or inflationary prop on any bank; instead of a central bank or pet banks, the government was to keep its funds solely in specie, in its own Treasury vaults or “subtreasury” branches. Van Buren managed to establish the Independent Treasury in 1840, but the Whig administration repealed it the following year. Finally, however, Democratic President Polk installed the Independent Treasury System in 1846, lasting until the Civil War. At long last, the Jacksonians had achieved their dream of severing the federal government totally from the banking system, and placing its finances on a purely hard money, specie basis. From now on, the battle over money would shift to the arena of the states.

  2. DECENTRALIZED BANKING FROM THE 1830S TO THE CIVIL WAR

  After the financial crises of 1837 and 1839, the Democratic Party became even more Jacksonian, more ardently dedicated to hard money, than ever before. The Democrats strived during the 1840s and 1850s, for the outlawing of all fractional reserve bank paper. Battles were fought during the late 1840s, at constitutional conventions of many western states, in which the Jacksonians would succeed in outlawing such banking, only to find the Whigs repealing the prohibition a few years later. Trying to find some way to overcome the general revulsion against banks, the Whigs adopted the concept of free banking, which had been enacted in New York and Michigan in the late 1830s. Spreading outward from New York, the free banking concept triumphed in 15 states by the early 1850S. On the eve of the Civil War, 18 out of the 33 states in the U.S. had adopted free banking laws.9

  It must be emphasized that free banking before the Civil War was scarcely the same as the economic concept of free banking we have set forth earlier. Genuine free banking, as we have noted, exists where entry into the banking business is totally free, where banks are neither subsidized nor controlled, and where at the first sign of failure to redeem in specie, the bank is forced to declare insolvency and close its doors.

  Free banking before the Civil War, however, was very different. Vera C. Smith has gone so far as to call the banking system before the Civil War, “decentralization without freedom,” and Hugh Rockoff labeled free banking as the “antithesis of laissez-faire banking laws.”10 We have already seen that general suspensions of specie payments were periodically allowed whenever the banks overexpanded and got into trouble; the last such episode before the Civil War being in the Panic of 1857. It is true that under free banking incorporation was more liberal, since any bank meeting the legal regulations could be incorporated automatically without having to lobby for a special legislative charter. But the banks were subject to a myriad of regulations, including edicts by state banking commissioners, along with high minimum capital requirements which greatly restricted entry into the banking business. The most pernicious aspect of free banking was that the expansion of bank notes and deposits was tied directly to the amount of state government bonds which the bank had invested in and posted as security with the state. In effect, then, state government bonds became the reserve base upon which the banks were allowed to pyramid a multiple expansion of bank notes and deposits. This meant that the more public debt the banks purchased, the more they could create and lend out new money. Thus, banks were induced to monetize the public debt, state governments were encouraged to go into debt, and government and bank inflation were intimately linked.

  In addition to allowing periodic suspension of specie payments, federal and state governments conferred upon the banks the highly valuable privilege of having their notes accepted in taxes. And the general prohibition of interstate (and sometimes intrastate) branch banking greatly inhibited the speed by which one bank could demand payment from another in specie. The clearing of notes and deposits, and hence the free market limit on bank credit expansion, was thereby weakened.

  The desire of state governments to finance public works was an important factor in their subsidizing and propelling the expansion of bank credit. Even Bray Hammond, scarcely
a hard money advocate, admits that “the wildcats lent no money to farmers and served no farmer interest. They arose to meet the credit demands not of farmers (who were too economically astute to accept wildcat money) but of states engaged in public improvements.”11

  Despite the flaws and problems in the decentralized nature of the pre-Civil War banking system, the banks were free to experiment on their own to improve the banking system. The most successful such device, which imposed a rapid and efficient clearing system on the banks of New England, was the privately developed Suffolk System.

  In 1824, the Suffolk Bank of Boston, concerned for years about an influx of depreciated notes from various country banks in New England, decided to purchase country bank notes and systematically call on the country banks for redemption. By 1825, country banks began to give in to the pressure to deposit specie with the Suffolk, so as to make redemption of their notes by that bank far easier. By 1838, furthermore, almost every bank in New England was keeping such deposits, and was redeeming its liabilities in specie through the medium of the Suffolk Bank.

  From the beginning to the end of the Suffolk System (1825–58), each country bank was obliged to maintain a permanent specie deposit of at least $2,000 ranging upward for larger sizes of bank. In addition to the permanent minimum deposit, each bank had to keep enough specie at the Suffolk Bank to redeem all the notes that Suffolk received. No interest was paid by the Suffolk Bank on these deposits, but Suffolk performed the invaluable service of accepting at par all the notes received from other New England banks, crediting the depositor banks' accounts the following day.

  As the result of Suffolk acting as a private clearing bank, every New England bank could automatically accept the notes of any other bank at par with specie. In contrast to the general state bank approval of the Bank of the United States (and later of the Federal Reserve System), the banks greatly resented the existence of the Suffolk Bank’s tight enforcement of specie payments. They had to play by the Suffolk rules, however, else their notes would depreciate rapidly and circulate only in a very narrow area. Suffolk, meanwhile, made handsome profits by lending out the permanent, noninterest paying deposits, and by making overdrafts to the member banks.

  Suffolk System members fared very well during general bank crises during this period. In the Panic of 1837, not one Connecticut bank failed, or even suspended specie payments; all were members of the Suffolk System. And in 1857, when specie payment was suspended in Maine, all but three banks (virtually all members of the Suffolk System) continued to pay in specie.12

  The Suffolk System ended in 1858 when a competing clearing bank, the Bank of Mutual Redemption, was organized, and the Suffolk System petulantly refused to honor the notes of any banks keeping deposits with the new bank. The country banks then shifted to the far laxer Bank of Mutual Redemption, and the Suffolk Bank stopped its clearing function in October 1858, becoming just another bank. Whatever the error of management in that year, however, the Suffolk System would have been swept away in any case by the universal suspension of specie payments at the start of the Civil War, by the National Banking System installed during the war, and by the prohibitive federal tax on state bank notes put through during that fateful period.13

  XV.

  CENTRAL BANKING IN THE UNITED STATES III: THE NATIONAL BANKING SYSTEM

  1. THE CIVIL WAR AND THE NATIONAL BANKING SYSTEM

  The Civil War wrought an even more momentous change in the nation’s banking system than had the War of 1812. The early years of the war were financed by printing paper money—greenbacks—and the massive printing of money by the Treasury led to a universal suspension of specie payments by the Treasury itself and by the nation’s banks, at the end of December 1861. For the next two decades, the United States was once again on a depreciating inconvertible fiat standard.

  The money supply of the country totaled $745 million in 1860; by 1863, the money supply had zoomed to $1.44 billion, an increase of 92.5 percent in three years, or 30.8 percent per annum. The result of this large monetary inflation was a severe inflation of prices. Wholesale prices rose from 100 in 1860, to 211 at the end of the war, a rise of 110.9 percent, or 22.2 percent per year.

  After the middle of 1863, the federal government stopped issuing the highly depreciated greenbacks, and began to issue large amounts of public debt. The accumulated deficit during the war totaled $2.61 billion, of which the printing of greenbacks financed only $430 million, almost all in the first half of the war.

  The Civil War public debt brought into prominence in American finance one Jay Cooke, who became known as “The Tycoon.” The Ohio-born Cooke had joined the moderately sized Philadelphia investment banking firm of Clark & Dodge as a clerk at the age of 18. In a few years, Cooke worked himself up to the status of junior partner, and in 1857 he left the firm to go into canal and railroad promotion and other business ventures. Cooke probably would have remained in relative obscurity, except for the lucky fact that he and his brother Henry, editor of the leading Republican newspaper in Ohio, the Ohio State Journal, were good friends of U.S. Senator Salmon P. Chase. Chase, a veteran leader of the antislavery movement, had lost the Republican presidential nomination in 1860 to Abraham Lincoln. The Cookes then determined to feather their nest by lobbying to make Salmon Chase Secretary of the Treasury. After extensive lobbying by the Cookes, the Chase appointment was secured, after which Jay Cooke quickly set up his own investment banking house of Jay Cooke & Co.

  Everything was in place; it now remained to seize the opportunity. As the Cookes' father wrote of Henry: “I took up my pen principally to say that H.D.’s (Henry) plan in getting Chase into the Cabinet and (John) Sherman into the Senate is accomplished, and that now is the time for making money, by honest contracts out of the government.”1

  Now indeed was their time for making money, and Cooke lost no time in seizing the advantage. After wining and dining his old friend, Cooke was able to induce Chase to take an unprecedented step in the fall of 1862: granting the House of Cooke a monopoly on the underwriting of the public debt. Cooke promptly hurled himself into the task of persuading the mass of the public to buy U.S. government bonds. In doing so, Cooke perhaps invented the art of public relations and of mass propaganda; certainly he did so in the realm of selling bonds. As Edward Kirkland, author of Industry Comes of Age: Business Labor & Public Policy 1860–1897, writes:

  With characteristic optimism, he [Cooke] flung himself into a bond crusade. He recruited a small army of 2,500 sub-agents among bankers, insurance men, and community leaders and kept them inspired and informed by mail and telegraph. He taught the American people to buy bonds, using lavish advertising in newspapers, broadsides, and posters. God, destiny, duty, courage, patriotism—all summoned “Farmers, Mechanics, and Capitalists” to invest in loans.2

  Loans which of course they had to purchase from Jay Cooke.

  And purchase the loans they did, for Cooke’s bond sales soon reached the enormous figure of $1 to $2 million a day. Approximately $2 billion in bonds were bought and underwritten by Jay Cooke during the war. Cooke lost his monopoly in 1864, under pressure of rival bankers; but a year later he was reappointed to that highly lucrative post, keeping it until the House of Cooke crashed in the Panic of 1873.

  It is not surprising that Jay Cooke acquired enormous political influence in the Republican administrations of the Civil War and after. Hugh McCulloch, Secretary of the Treasury from 1865 to 1869, was a close friend of Cooke’s, and when McCulloch left office he became head of Cooke’s London office. The Cooke brothers were also good friends of General Grant, and so they wielded great influence during the Grant administration.

  No sooner had Cooke secured the monopoly of government bond underwriting than he teamed up with his associates Secretary of the Treasury Chase and Ohio’s Senator John Sherman to drive through a measure destined to have far more fateful effects than greenbacks on the American monetary system: the National Banking Acts. National banking destroyed the previous decentralized
and fairly successful state banking system, and substituted a new, centralized and far more inflationary banking system under the aegis of Washington and a handful of Wall Street banks. Whereas the greenbacks were finally eliminated by the resumption of specie payments in 1879, the effects of the national banking system are still with us. Not only was this system in place until 1913, but it paved the way for the Federal Reserve System by instituting a quasi-central banking type of monetary system. The “inner contradictions” of the national banking system impelled the U.S. either to go on to a frankly central bank or to scrap centralized banking altogether and go back to decentralized state banking. Given the inner dynamic of state intervention, coupled with the common adoption of a statist ideology after the turn of the twentieth century, the course the nation would take was unfortunately inevitable.

  Chase and Sherman drove the new system through under cover of the war necessity: setting up national banks to purchase large amounts of U.S. government bonds. Patterned after the free banking system, the nation’s banks were tied in a symbiotic relationship with the federal government and the public debt. The Jacksonian independent treasury was de facto swept away, and the Treasury would now keep its deposits in a new series of “pets”: the national banks, chartered directly by the federal government. In this way, the Republican Party was able to use the wartime emergency, marked by the virtual disappearance of Democrats from Congress, to fulfill the long-standing Whig-Republican dream of a permanently centralized banking system, able to inflate the supply of money and credit in a uniform manner. Sherman conceded that a vital object of the national banking system was to eradicate the doctrine of state’s rights, and to nationalize American politics.