The History of US National Banking
Before the Federal Reserve
Note that this is part 1 of a 3 part series about US Banking history. See part 2 and part 3.
The US has gone through several influential and sometimes tumultuous eras of banking. In order to better understand why the Federal Reserve was created and what we can compare it to, this article will go over the history of banking prior to The Fed. The following posts will be a short series about The Fed.
Many of the founding fathers of the United States were strongly opposed to the formation of a national bank and continued to oppose it when the First Bank of the United States was chartered in 1791. While this was a national bank, it wasn’t a central bank. Only about half of the currency supply at the time came from bank notes, the rest being mostly Spanish silver dollar coins. And only about half of the bank notes came from this national bank, the rest coming from state banks. The bank’s charter expired after 20 years and was not renewed by congress. The Second Bank of the United States went the same way, being created in 1816 and expiring after 20 years when Andrew Jackson refused to sign a renewal of its charter.
The Free Banking Era
The 25 year era of “Free Banking” in the US (from 1837 to 1864) was less “free” than the term suggests. Banks generally had to ask permission of a state’s congress to be chartered and were subject to various regulations often structured to the benefit of the state government rather than the stability of the banking system. This requirement often led to corruption in the form of using charters as political favors, granting government-protected regional monopolies, like in Pennsylvania. Only 18 of 32 states eventually established free banking laws that allowed banks to be established via a bureaucratic process that didn’t require approval of state congress. This was the case in many frontier states.
While these places still had mostly honest banks, the few dishonest or reckless banks become infamous as the wildcat banks. The Bank of Singapore in Singapore, Michigan was one such example (a bank note pictured above). The state dissolved the bank in 1838 when they failed to prove enough gold reserves to back the required 1/3rd of their note issuance, a mere 8 years before the town burned down and was abandoned. The bank, along with the ruins of the town, is now buried under the sand dunes of Lake Michigan.
Often states required or heavily incentivized banks to purchase bonds of state debt. When a state defaulted on its debt, the bonds were substantially devalued which caused many banks to become insolvent. And this was not an irregular occurrence. In the aftermath of the Panic of 1837 alone, 8 states defaulted on their debt and others delayed payments. A study by Rolnick and Weber showed that about 80% of bank failures in the free banking states of Indiana, New York, Minnesota, and Wisconsin were likely caused by state bond value crashes. It seems likely that poorly structured regulations that tied banks to the finances of reckless state governments were the real causes of the bad reputation of banks during this era.
Free banking in the state of New York was a relative success where about 65% banks survived the era and losses were negligible during that time even for depositors of banks that closed. The Suffolk Bank System in New England was also a notable success, with very low bank failure rates even during panics. Notes from the Suffolk banks were so trusted they traded at a premium to their nominal value rather than the usual discount.
“A close analysis of the free-banking era does not support the view that egregious risk-taking and fraud were the primary cause of bank failures.” – Daniel Sanches, Federal Reserve of Philadelphia
The free banking era presided over the longest uninterrupted economic expansion in the history of the United States, with no recession happening between 1841 and 1856. In 1865, the federal government began taxing bank notes issued by state banks, forcing the free banking era to end not because it collapsed, but because Congress merely decided to end it. The decision to end it was not about creating a better financial system but rather about eliminating the ability for state banks to compete with the new national currency designed to create a steady demand for federal debt.
In fact, a handful of countries also had free banking eras, like in Scotland, Canada, and Sweden. Most of them were quite successful, considered more successful than the US example, tho several were worse, like in Australia. In all cases, the eras ended because a central or national bank wanted to monopolize money issuance.
The Era of National Banking Acts
In 1846 during the free banking era, congress created the Independent Treasury (after a false start in 1840). The Independent Treasury (not to be confused with the US Department of the Treasury) was created to hold government funds in the form of coinage instead of the prior practice of depositing government funds at the national banks or at a patchwork of state banks.
When the Civil War broke out in 1861, the federal government was strapped for cash and created the infamous greenback. Originally issued as a demand note redeemable in coin, the government defaulted on that promise within months and reissued greenbacks known as United States Notes which did not promise to pay “on demand” but only at some unspecified future time (which ended up being in 1879). These were the first issuances of paper currency in the US, and also the first issuance of fiat currency. While the US Treasury had issued Treasury Notes backed by coinage before this, unlike the greenbacks, these treasury notes were not legal tender and not generally used as a medium of exchange.
The National Banking Act of 1863 (aka the National Currency Act) was the act that brought the free banking era to a close. While still technically not central banks, these national banks did create a unified standard currency and a federally regulated banking system, but there was no unified monetary policy. They did this to create a national mechanism to create paper money that both simplified transactions and created a steady artificial demand for federal bonds. The National Bank notes created were redeemable for gold but banks were required to keep government bonds as collateral for these notes. Banks in fact had to own *more* federal bonds than issued currency.
This was all despite the fact that the constitution intentionally does not give congress the power to create money other than in the form of coins, as found in the Hepburn v. Griswold supreme court case in 1870. This ruling was reversed in 1871 and 1884 supreme court cases (Knox v Lee & Parker v Davis and Juilliard v Greenman), clear and obvious miscarriages of constitutional jurisprudence, in my opinion, violating both the 10th amendment and the prohibition of ex post facto laws.
Regardless, the National Banking Acts ushered in an era of national paper money and the system, in the words of Carter Glass, became a “breeder of panics”. Seven bank panics happened during the 50 year Greenback era (1869, 1873, 1884, 1893, 1896, 1901, and 1907). By contrast, only one real bank panic happened during the 25 years of the free banking era in 1857 (excluding the panic of 1839 which was was linked with the 1837 panic caused by bad federal policy), less than 1/3rd the frequency. Many modern economists believe this was in part caused by the inflexible currency supply as an unintended consequence of the National Banking Acts of 1863 and 1864 that required all currency to be backed by holdings of US government bonds, which meant that the money supply was essentially equal to the amount of government debt. Seasonal demand, panics, and other economic shocks could quickly change the demand for money to exceed the available reserves of banks. Banks were generally required to keep 25% of their deposits in reserve, but often this wasn’t enough.
However, it was not simply inflexibility of the money supply that caused the problem, but rather how that interacted with other artificial constraints of the banking system. A Federal Reserve study on the US National Banking System of the late 1800s shows convincingly that the prohibition of banks from creating multiple branches in other states (and often even other cities) in that era and the practice of “pyramiding” bank reserves both contributed to a system that was very prone to bank panics.
“Pyramiding” reserves meant when one bank kept its reserves deposited at another bank. Smaller banks would often keep most of their reserves at larger banks that paid greater interest than they could attain. This interconnected these banks in a way where issues with the larger city banks spread to all banks that pyramided their reserves there, and also meant that when there was unexpected liquidity demands at the smaller banks, they didn’t actually have reserves on site to meet demand, which could trigger or exacerbate bank runs.
The Federal Reserve study mentioned above also argues that Great Britain and Canada during the same time period had no system-wide bank runs because they allowed banks to create branches in different regions, allowing these institutions to hedge risk against local fluctuations. It argues that these attributes make an institution like the FDIC unnecessary.
Conclusion
The Free Banking Era and the Era of the National Banking Acts were very different banking eras that experimented with diametrically opposite monetary policies. One era allowed any bank to issue currency however their state allows and the other standardized currency at the national level with unified requirements for issuing bank notes. The National Banking Acts is widely considered to have been a failed system that needed to be replaced. By contrast the Free Banking era was a relative success, although misrepresentations about the era continue to abound in historical accounts and collective memory.
Next post, I’ll go over the storied history of the Federal Reserve.