The Mystery Of Banking

by Murray N. Rothbard

  X = D/MM – 1

  The Fed should buy X, in this case $25 billion, in order to finance a desired deficit of $100 billion. In this case, X equals $100 billion divided by MM (the money multiplier) or 5 minus 1. Or X equals $100 billion/4, or $25 billion. This formula is arrived at as follows: We begin by the Fed wishing to buy whatever amount of old bonds, when multiplied by the money multiplier, will yield the deficit plus X itself. In other words, it wants an X which will serve as the base of the pyramid for the federal deficit plus the amount of demand deposits acquired by government bond dealers. This can be embodied in the following formula:

  MM • X = D + X

  But then: MM • X – X = D

  and, X • MM – 1 = D

  Therefore, X = D/MM – 1

  XII. The Origins of Central Banking

  1 John Carswell, The South Sea Bubble (Stanford, Calif.: Stanford University Press, 1960), pp. 27–28.

  2 Marvin Rosen, “The Dictatorship of the Bourgeoisie: England, 1688–1721,” Science and Society XLV (Spring 1981): 44. This is an illuminating article, though written from a Marxist perspective.

  3 John Clapham, The Bank of England (Cambridge: Cambridge University Press, 1958), pp. 1, 50.

  4 On the South Sea Bubble, see Carswell, The South Sea Bubble. For more on the early history of the Bank of England, in addition to Clapham, see J. Milnes Holden, The History of Negotiable Instruments in English Law (London: The Athlone Press, 1955), pp. 87–94, 191–98.

  5 Estimated total of country bank notes, in 1810, was £22 million.

  6 See Vera C. Smith, The Rationale of Central Banking (London: E.S. King & Son, 1936), p. 13.

  7Lawrence H. White, “Free Banking in Scotland Prior to 1845” (unpublished essay, 1979), p. 1.

  8On the success of the Scottish note-exchange system, see William Graham, The One Pound Note in the History of Banking in Great Britain, 2nd ed. (Edinburgh: James Thin, 1911), p. 59; White, “Free Banking,” pp. 8–19.

  9 Graham, The One Pound Note, pp. 366–67; White, “Free Banking,” p. 41. The Cumberland and Westmoreland experience well supports Professor Klein’s argument that, under free banking, “high confidence monies will drive out low confidence monies.” Klein has stressed the importance of public confidence under free banking; people will only be disposed to accept the money of a fully trustworthy issuer, “so that issuers,” as White sums up Klein’s argument, “must compete to convince the public of their superior reliability.” In a system of private bank notes redeemable in specie, “the primary aspect of reliability is the assurance that convertibility will be maintained by the continued existence of the note-issuing bank.” Benjamin Klein, “The Competitive Supply of Money,” Journal of Money, Credit and Banking 6 (1974): 433; White, “Free Banking,” p. 40.

  10 Walter Bagehot, Lombard Street (Homewood, Ill.: Irwin, 1962), pp. 32–33; White, “Free Banking,” pp. 42–43. Furthermore, Scottish free banking was never plagued by any problem of counterfeiting. Counterfeiting is generally a function of the length of time any given note remains in circulation, and the average Scottish bank note lasted a very brief time until a competing bank would return it to the issuing bank through the clearinghouse for redemption. Emmanual Coppieters, English Bank Note Circulation 1694–1954 (The Hague: Martinus Nijhoff, 1955), pp. 64–65; White, “Free Banking,” pp. 43–44.

  11 Robert Bell, Letter to James W. Gilbart ... (Edinburgh: Bell & Bradfute, 1838), p. 8; White, “Free Banking,” p. 38.

  12 In fact, the maximum limit of Bank of England notes not backed by gold was set at £14 million; circulation of bank notes in 1844 was £21 million, making the restriction on the Bank even more rigorous.

  13 Smith, Rationale of Central Banking, pp. 18–19.

  14As White says,

  The bankers of Scotland did not protest loudly against the Act of 1845, as it bestowed upon them a shared legal monopoly of the note-issue. ... Peel in essence bought the support of all the existing Scottish banks by suppressing new entrants. In freezing the authorized issues at 1844 levels, the Act of 1845 also hampered rivalry for market shares among existing banks. (“Free Banking,” p. 34)

  XIII. Central Banking in the United States I: The Origins

  1 There 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.

  3 On 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.

  4 John 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.

  6 Annals of Congress, 14 Cong., 1 sess., pp. 1066, 1091, 1110ff.

  7 On 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.

  8 Ralph C.H. Catterall, The Second Bank of the United States (Chicago: University of Chicago Press, 1902), p. 36.

  9 The 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.

  10 Figures are adapted from tables, converted pro rata to 100 percent of the banks, in J. Van Fenstermaker, “The Statistics of American Commerc
ial Banking, 1782–1818,” Journal of Economic History (September 1965): 401, 405–06.

  11 William M. Gouge, A Short History of Paper Money and Banking in the United States (New York: Augustus M. Kelley, 1968), p. 110.

  12 Ibid., 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.

  XIV. Central Banking in the United States II: The 1820s to the Civil War

  1 See Philip H. Burch, Elites in American History: The Civil War to the New Deal (Teaneck, N.J.: Holmes and Meier, 1981).

  2 For an excellent survey and critique of historical interpretations of Jackson and the Bank War, see Jeffrey Rogers Hummel, “The Jacksonians, Banking and Economic Theory: A Reinterpretation,” The Journal of Libertarian Studies 2 (Summer 1978): 151–65.

  3 See Jean Alexander Wilburn, Biddle’s Bank: The Crucial Years (New York: Columbia University Press, 1970), pp. 118–19.

  4 See Peter Temin, The Jacksonian Economy (New York: W.W. Norton, 1969).

  5 Mexico was shown to be the source of the specie inflow by Temin, Jacksonian Economy, p. 80, while the cause of the inflow in the minting of debased Mexican copper coins is pinpointed in Hugh Rockoff, “Money, Prices, and Banks in the Jacksonian Era,” in R. Fogel and S. Engerman, eds., The Reinterpretation of American Economic History (New York: Harper & Row, 1971), p. 454.

  6The Floridian, March 14, 1840. Quoted in Reginald C. McGrane, Foreign Bondholders and American State Debts (New York: Macmillan, 1935), pp. 39–40. Americans also pointed out that the banks, including the BUS, who were presuming to take the lead in denouncing repudiation of state debt, had already suspended specie payments and were largely responsible for the contraction.

  Let the bondholders look to the United States Bank and to the other banks for their payment declared the people. Why should the poor be taxed to support the opulent classes in foreign lands who, it was believed, held the bulk of these securities. (p. 48)

  7The four states which repudiated all or part of their debts were Mississippi, Arkansas, Florida, and Michigan; the others were Maryland, Pennsylvania, Louisiana, Illinois, and Indiana.

  8 In a fascinating comparative analysis, Professor Temin contrasts this record with the disastrous contraction a century later, from 1929–33. During the latter four years, the money supply and prices fell by slightly less than in the earlier period, and the number of banks in existence by more. But the impact on the real economy was strikingly different. For in the later deflation, real consumption and GNP fell substantially, while real investment fell catastrophically. Temin properly suggests that the very different impact of the two deflations stemmed from the downward flexibility of wages and prices in the nineteenth century, so that massive monetary contraction lowered prices but did not cripple real production, growth, or living standards. In contrast, the government of the 1930s placed massive roadblocks on the downward fall of prices and particularly wages, bringing about a far greater impact on production and unemployment. Temin, Jacksonian Economy, pp. 155ff.

  9 Hugh Rockoff, The Free Banking Era: A Re-Examination (New York: Arno Press, 1975), pp. 3–4.

  10 Vera C. Smith, The Rationale of Central Banking (London: P.S. King & Son, 1936), p. 36, also ibid., pp. 148–49, Hugh Rockoff, “Varieties of Banking and Regional Economic Development in the United States, 1840–1860,” Journal of Economic History 35 (March 1975): 162, quoted in Hummel, “Jacksonians,” p. 157.

  11 Bray Hammond, Banks and Politics in America: From the Revolution to the Civil War (Princeton, N.J.: Princeton University Press, 1957), p. 627. On the neglected story of the Jacksonians versus their opponents on the state level after 1839, see William G. Shade, Banks or No Banks: The Money Issue in Western Politics, 1832–1865 (Detroit: Wayne State University Press, 1972); Herbert Ershkowitz and William Shade, “Consensus or Conflict? Political Behavior in the State Legislatures During the Jacksonian Era,” Journal of American History 58 (December 1971): 591–621; and James Roger Sharp, The Jacksonians versus the Banks: Politics in the States After the Panic of 1837 (New York: Columbia University Press, 1970).

  12John Jay Knox, historian and former U.S. Comptroller of the Currency, concluded from his study of the Suffolk System that private clearing house service is superior to that of a government central bank:

  the fact is established that private enterprise could be entrusted with the work of redeeming the circulating notes of the banks, and that it could thus be done as safely and much more economically than the same service can be performed by the Government.

  John Jay Knox, A History of Banking in the United States (New York: Bradford Rhodes & Co., 1900), pp. 368–69.

  13 On the Suffolk System, see George Trivoli, The Suffolk Bank: A Study of a Free-Enterprise Clearing System (London: The Adam Smith Institute, 1979).

  XV. Central Banking in the United States III: The National Banking System

  1In Henrietta Larson, Jay Cooke, Private Banker (Cambridge, Mass.: Harvard University Press, 1936), p. 103.

  2 Edward C. Kirkland, Industry Comes of Age: Business, Labor & Public Policy, 1860–1897 (New York: Holt, Rinehart & Winston, 1961), pp. 20–21.

  3 Quoted in Robert P. Sharkey, Money, Class and Party: An Economic Study of Civil War and Reconstruction (Baltimore: Johns Hopkins Press, 1959), p. 245.

  4 See Bray Hammond, Sovereignty and an Empty Purse: Banks and Politics in the Civil War (Princeton, N.J.: Princeton University Press, 1970), pp. 289–90.

  5 Banks generally paid interest on demand deposits until the Federal Government outlawed the practice in 1934.

  6 See Smith, Rationale of Central Banking, p. 48.

  7 See ibid., p. 132.

  8 Actually, Cooke erred, and national bank notes never reached that total. Instead, it was demand deposits that expanded, and reached the billion dollar mark by 1879.

  9 See Sharkey, Money, Class and Party, p. 247.

  10 John J. Klein, Money and the Economy, 2nd ed. (New York: Harcourt, Brace and World, 1970), pp. 145–46.

  11 Irwin Unger, The Greenback Era: A Social and Political History of American Finance, 1865–1879 (Princeton, N.J.: Princeton University Press, 1964), pp. 46–47, 221.

  12On agitation by bankers and others for the substitution of a central bank for the national banking system, see among others, Robert Craig West, Banking Reform and the Federal Reserve, 1863–1923 (Ithaca, N.Y.: Cornell University Press, 1977).

  13 See Gabriel Kolko, The Triumph of Conservatism: A Reinterpretation of American History, 1900–1916 (Glencoe, Ill.: The Free Press, 1963), p. 140.

  14 In addition to Kolko, Triumph of Conservatism, see James Weinstein, The Corporate Ideal in The Liberal State, 1900–1918 (Boston: Beacon Press, 1968). On the new collectivist intellectuals, see James Gilbert, Designing the Industrial State: The Intellectual Pursuit of Collectivism in America, 1880–1940 (Chicago: Quadrangle Books, 1972); and Frank Tariello, Jr., The Reconstruction of American Political Ideology, 1865–1917 (Charlottesville: University Press of Virginia, 1981). On the transformation of the American party system with the Bryan takeover in 1896, see Paul Kleppner, The Cross of Culture: A Social Analysis of Midwestern Politics, 1850–1900 (New York: The Free Press, 1970), and idem., “From Ethnoreligious Conflict to Social Harmony: Coalitional and Party Transformations in the 1890s,” in S. Lipset, ed., Emerging Coalitions in American Politics (San Francisco: Institute for Contemporary Studies, 1978), pp. 41–59.

  15 See Kolko, Triumph of Conservatism, pp. 146–53.

  XVI. Central Banking in the United States IV: The Federal Reserve System

  1 Since the establishment of the Federal Reserve System, the reserve requirement limits on the Fed itself have been progressively weakened, until now there is no statutory limit whatsoever on the Fed’s desire to inflate.

  2C.A. Phillips, T.E. McManus, and R.W.
Nelson, Banking and the Business Cycle (New York: Macmillan, 1937), pp. 26–27. In fact, the inflationary potential of the new centralization was not as great as this, since the previous national banking system was not fully decentralized, but had already been quasi-centralized to pyramid on top of a handful of Wall Street banks.

  3 Phillips, et al., Banking and the Business Cycle, p. 23n.

  4 Quoted in M. Friedman and A. Schwartz, A Monetary History of the United States 1867–1960 (Princeton N.J.: National Bureau of Economic Research, 1963), pp. 276–77. Also ibid., p. 277n. See also Phillips, et al., Banking and the Business Cycle, pp. 29, 95–101.

  5Phillips, et al., Banking and the Business Cycle, p. 99. On time deposits in the 1920s, see also Murray N. Rothbard, America’s Great Depression, 3rd ed. (Sheed and Ward, 1974), pp. 92–94; Benjamin M. Anderson, Economics and the Public Welfare: A Financial and Economic History of the United States, 1914–46, 2nd ed. (Indianapolis: Liberty Press, 1979), pp. 140–42.

  6 Quoted in Rothbard, America’s Great Depression, p. 316n. See also Lin Lin, “Are Time Deposits Money?” American Economic Review (March 1937): 76–86. Lin points out that demand and time deposits were interchangeable at par and in cash, and were so regarded by the public.

  7On the role of the Morgans in pushing the Wilson administration into war, see Charles Callan Tansill, America Goes to War (Boston: Little, Brown and Co., 1938), chaps. II–IV.

  8O. Ernest Moore to Sir Arthur Salter, May 25, 1928. Quoted in Rothbard, America’s Great Depression, p. 143. In the fall of 1926, a leading banker admitted that bad consequences would follow the Strong cheap money policy, but asserted “that cannot be helped. It is the price we must pay for helping Europe.” H. Parker Willis, “The Failure of the Federal Reserve,” North American Review (1929): 553.

  XVII. Conclusion: The Present Banking Situation and What to Do About It

  1 Cordell Hull, Memoirs (New York: Macmillan, 1948), vol. 1, p. 81. See in particular, Murray N. Rothbard, “The New Deal and the International Monetary System,” in L. Liggio and J. Martin, eds., Watershed of Empire: Essays on New Deal Foreign Policy (Colorado Springs, Colo.: Ralph Myles, 1976), pp. 19–64.