A History of Money and Banking in the United States: The Colonial Era to World War II
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The expansion of bank money and Treasury notes during the war drove up prices in the United States. Wholesale price increases from 1811 to 1815 averaged 35 percent, with different cities experiencing a price inflation ranging from 28 percent to 55 percent. Since foreign trade was cut off by the war, prices of imported commodities rose far more, averaging 70 percent.44 But more important than this inflation, and at least as important as the wreckage of the monetary system during and after the war, was the precedent that the two-and-a-half-year-long suspension of specie payment set for the banking system for the future. From then on, every time there was a banking crisis brought on by inflationary expansion and demands for redemption in specie, state and federal governments looked the other way and permitted general suspension of specie payments while bank operations continued to flourish. It thus became clear to the banks that in a general crisis they would not be required to meet the ordinary obligations of contract law or of respect for property rights, so their inflationary expansion was permanently encouraged by this massive failure of government to fulfill its obligation to enforce contracts and defend the rights of property.
Suspensions of specie payments informally or officially permeated the economy outside of New England during the panic of 1819, occurred everywhere outside of New England in 1837, and in all states south and west of New Jersey in 1839. A general suspension of specie payments occurred throughout the country once again in the panic of 1857.45
It is important to realize, then, in evaluating the American banking system before the Civil War, that even in the later years when there was no central bank, the system was not “free” in any proper economic sense. “Free” banking can only refer to a system in which banks are treated as any other business, and that therefore failure to obey contractual obligations—in this case, prompt redemption of notes and deposits in specie—must incur immediate insolvency and liquidation. Burdened by the tradition of allowing general suspensions that arose in the United States in 1814, the pre–Civil War banking system, despite strong elements of competition when not saddled with a central bank, must rather be termed in the phrase of one economist, as “Decentralization without Freedom.”46
From the 1814–1817 experience on, the notes of state banks circulated at varying rates of depreciation, depending on public expectations of how long they would be able to keep redeeming their obligations in specie. These expectations, in turn, were heavily influenced by the amount of notes and deposits issued by the bank as compared with the amount of specie held in its vaults.
In that era of poor communications and high transportation costs, the tendency for a bank note was to depreciate in proportion to its distance from the home office. One effective, if time-consuming, method of enforcing redemption on nominally specie-paying banks was the emergence of a class of professional “money brokers.” These brokers would buy up a mass of depreciated notes of nominally specie-paying banks, and then travel to the home office of the bank to demand redemption in specie. Merchants, money brokers, bankers, and the general public were aided in evaluating the various state bank notes by the development of monthly journals known as “bank note detectors.” These “detectors” were published by money brokers and periodically evaluated the market rate of various bank notes in relation to specie.47
“Wildcat” banks were so named because in that age of poor transportation, banks hoping to inflate and not worry about redemption attempted to locate in “wildcat” country where money brokers would find it difficult to travel. It should be noted that if it were not for periodic suspension, there would have been no room for wildcat banks or for varying degrees of lack of confidence in the genuineness of specie redemption at any given time.
It can be imagined that the advent of the money broker was not precisely welcomed in the town of an errant bank, and it was easy for the townspeople to blame the resulting collapse of bank credit on the sinister stranger rather than on the friendly neighborhood banker. During the panic of 1819, when banks collapsed after an inflationary boom lasting until 1817, obstacles and intimidation were often the lot of those who attempted to press the banks to fulfill their contractual obligation to pay in specie.
Thus, Maryland and Pennsylvania, during the panic of 1819, engaged in almost bizarre inconsistency in this area. 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 money brokers, “the major force ensuring 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 maintain the virtue of enforcing contract and property rights while moving to prevent the most effective method of ensuring such enforcement.
During the 1814–1817 general suspension, noteholders who sued for specie payment seldom gained satisfaction in the courts. Thus, Isaac Bronson, a prominent Connecticut banker in a specie-paying region, sued various New York banks for payment of notes in specie. He failed to get satisfaction, and for his pains received only abuse in the New York press as an agent of “misery and ruin.”48
The banks south of Virginia largely went off specie payment during the panic of 1819, and in Georgia at least general suspension continued almost continuously to the 1830s. One customer complained during 1819 that in order to collect in specie from the largely state-owned Bank of Darien, Georgia, he was forced to swear before a justice of the peace in the bank 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; he was forced to swear to the oath in the presence of at least five bank directors and the bank’s cashier; and he was forced to pay a fee of $1.36 on each note in order to acquire specie on demand. Two years later, when a noteholder demanded $30,000 in specie at the Planters’ Bank of Georgia, he was told he would be paid in pennies only, while another customer was forced to accept pennies handed out to him at the rate of $60 a day.49
During the panic, North Carolina and Maryland in particular moved against the money brokers in a vain attempt to prop up the depreciated notes of their states’ banks. In North Carolina, banks were not penalized by the legislature for suspending specie payments to “brokers,” while maintaining them to others. Backed by government, the three leading banks of the state met and agreed, in June 1819, not to pay specie to brokers or their agents. Their notes immediately fell to a 15-percent discount outside the state. However, the banks continued to require—ignoring the inconsistency—that their own debtors pay them at par in specie. Maryland, during the same year, moved to require a license of $500 per year for money brokers, in addition to an enormous $20,000 bond to establish the business.
Maryland tried to bolster the defense of banks and the attack on brokers by passing a compulsory par law in 1819, prohibiting the exchange of specie for Maryland bank notes at less than par. The law was readily evaded, however, with the penalty merely adding to the discount as compensation for the added risk. Specie furthermore was driven out of the state by the operation of Gresham’s Law.50
In Kentucky, Tennessee, and Missouri, stay laws were passed requiring creditors to accept depreciated and inconvertible bank paper in payment of debts, else suffer a stay of execution of the debt. In this way, quasi–legal tender status was conferred on the paper.51 Many states permitted banks to suspend specie payment, and four western states—Tennessee, Kentucky, Missouri, and Illinois—established state-owned banks to try to overcome the depression by issuing large issues of inconvertible paper money. In all states trying to prop up inconvertible bank paper, a quasi-legal status was also conferred on the paper by agreeing to receive the notes in taxes or debts due to the state. The result of all the inconvertible paper schemes was rapid and massive depreciation, disappearance of specie, succeeded by speedy liquidation of the new state-owned banks.52
An
amusing footnote on the problem of banks being protected against their contractual obligations to pay in specie occurred in the course of correspondence between one of the earliest economists in America, the young Philadelphia state Senator Condy Raguet, and the eminent English economist David Ricardo. Ricardo had evidently been bewildered by Raguet’s statement that banks technically required to pay in specie often were not called upon to do so. On April 18, 1821, Raguet replied, explaining the power of banks in the United States:
You state in your letter that you find it difficult to comprehend, why persons who had a right to demand coin from the Banks in payment of their notes, so long forebore to exercise it. This no doubt appears paradoxical to one who resides in a country where an act of parliament was necessary to protect a bank, but the difficulty is easily solved. The whole of our population are either stockholders of banks or in debt to them. It is not the interest of the first to press the banks and the rest are afraid. This is the whole secret. An independent man, who was neither a stockholder or debtor, who would have ventured to compel the banks to do justice, would have been persecuted as an enemy of society.53
THE SECOND BANK OF THE UNITED STATES, 1816–1833
The United States emerged from the War of 1812 in a chaotic monetary state, with banks multiplying and inflating ad lib, checked only by the varying rates of depreciation of their notes. With banks freed from redeeming their obligations in specie, the number of incorporated banks increased during 1816, from 212 to 232.54 Clearly, the nation could not continue indefinitely with the issue of fiat money in the hands of discordant sets of individual banks. It was apparent that there were two ways out of the problem: one was the hard-money path, which was advocated by the Old Republicans and, for their own purposes, the Federalists. The federal and state governments would have sternly compelled the rollicking banks to redeem promptly in specie, and, when most of the banks outside of New England could not, to force them to liquidate. In that way, the mass of depreciated and inflated notes and deposits would have been swiftly liquidated, and specie would have poured back out of hoards and into the country to supply a circulating medium. The inflationary experience would have been over.
Instead, the Democratic-Republican establishment in 1816 turned to the old Federalist path: a new central bank, a Second Bank of the United States. Modeled closely after the First Bank, the Second Bank, a private corporation with one-fifth of the shares owned by the federal government, was to create a national paper currency, purchase a large chunk of the public debt, and receive deposits of Treasury funds. The Second Bank of the United States’s 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 Second Bank of the United States was to support the state banks in their inflationary course rather than crack down on them is seen by the shameful deal that the Second Bank made with the state banks as soon as it opened its doors in January 1817. At the same time that it was establishing the new bank 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 United States should accept as payments for debts or taxes only specie, Treasury notes, Bank of the United States 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 the opportunity to compel the banks to redeem, however, the Second Bank of the United States, in a meeting with representatives from the leading urban banks, excluding Boston, agreed to issue $6 million worth of credit in New York, Philadelphia, Baltimore, and Virginia before insisting on specie payments from debts due to it from the state banks. In return for that agreed-upon massive inflation, the state banks graciously consented to resume specie payments.55 Moreover, the Second Bank and the state banks agreed to mutually support each other in any emergency, which of course meant in practice that the far stronger Bank of the United States was committed to the propping up of the weaker state banks.
The Second Bank of the United States was pushed through Congress by the Madison administration and particularly by Secretary of the Treasury Alexander J. Dallas, whose appointment was lobbied for, 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. Toward the end of its term, Girard was the largest stockholder of the First Bank of the United States, and during the War of 1812 Girard became a very heavy investor in the war debt of the federal government. Both as a prospective large stockholder and as a way to unload his public debt, Girard began to agitate for a new Bank of the United States. Dallas’s appointment as secretary of Treasury in 1814 was successfully engineered by Dallas and his close friend, wealthy New York merchant and fur trader John Jacob Astor, also a heavy investor in the war debt. When the Second Bank of the United States was established, Stephen Girard purchased the $3 million of the $28 million that remained unsubscribed, and he and Dallas managed to secure for the post of president of the new bank their good friend William Jones, former Philadelphia merchant.56
Much of the opposition to the founding of the Bank of the United States seems keenly prophetic. Thus, Senator William H. Wells, Federalist from Delaware, in arguing against the bank bill, said that it was
ostensibly for the purpose of correcting the diseased state of our paper currency by restraining and curtailing the overissue of bank paper, and yet it came prepared to inflict upon us the same evil, being itself nothing more than simply a paper-making machine.57
In fact, the result of the deal with the state banks was that their resumption of specie payments after 1817 was more nominal than real, thereby setting the stage for the widespread suspensions of the 1819–21 depression. As Bray Hammond writes:
[S]pecie payments were resumed, with substantial shortcomings. Apparently the situation was better than it had been, and a pretense was maintained of its being better than it was. But redemption was not certain and universal; there was still a premium on specie and still a discount on bank notes, with considerable variation in both from place to place. Three years later, February 1820, Secretary [of the Treasury] Crawford reported to Congress that during the greater part of the time that had elapsed since the resumption of specie payments, the convertibility of bank notes into specie had been nominal rather than real in the largest portion of the Union.58
One problem is that the Bank of the United States lacked the courage to insist on payment of its notes from the state banks. As a result, state banks had large balances piled up against them at the Bank of the United States, totaling over $2.4 million during 1817 and 1818, remaining on the books as virtual interest-free loans. As Catterall points out, “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.” When the Bank of the United States did try to collect on state bank notes in specie, bank President Jones reported, “the banks, our debtors, plead inability, require unreasonable indulgence, or treat our reiterated claims and expostulations with settled indifference.”59
From its inception, the Second Bank launched a spectacular inflation of money and credit. Lax about insisting on the required payment of its capital in specie, the bank failed to raise the $7 million legally supposed to have been subscribed in specie; instead, during 1817 and 1818, its specie held never rose above $2.5 million. At the peak of its initial expansion, in July 1818, the Bank of the United States’s specie totaled $2.36 million, and its aggregate notes and deposits totaled $21.8 million. Thus, in a scant year and a half of operation, the Second Bank of the United States had added a net of $19.2 million to the nation’s money supply, for a pyramid ratio of 9.24, or a reserve ratio of 0.11.
Outright fraud abounded at the Second Bank of the Un
ited States, especially at the Philadelphia and Baltimore branches, particularly the latter. It is no accident that three-fifths of all of the bank’s loans were made at these two branches.60 Also, the bank’s attempt to provide a uniform currency throughout the nation floundered on the fact that the western and southern branches could inflate credit and bank notes and that the inflated notes would wend their way to 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 could continue to inflate unchecked.61
The expansionary operations of the Second Bank of the United States, coupled with its laxity toward insisting on specie payment by the state banks, impelled a further inflationary expansion of state banks on top of the spectacular enlargement of the central bank. Thus, the number of incorporated state banks rose from 232 in 1816 to 338 in 1818. Kentucky alone chartered 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 Bank of the United States.62