Central Bank in the United States

History

Introduction

The history of central banking in the United States does not begin with the Federal Reserve. The Bank of the United States received its charter in 1791 from the U.S. Congress and was signed by President Washington. The Bank’s charter was designed by Secretary of the Treasury Alexander Hamilton, modeling it after the Bank of England, the British central bank.

The Bank met with considerable controversy. Agrarian interests were opposed to the Bank on the grounds that they feared it would favor commercial and industrial interests over their own, and that it would promote the use of paper currency at the expense of gold and silver specie (Kidwell, 54). Ownership of the Bank was also an issue. By the time the Bank’s charter was up for renewal in 1811, about 70 percent of its stock was owned by foreigners. Although foreign stock had no voting power to influence the Bank’s operations, outstanding shares carried an 8.4 percent dividend. Another twenty year charter, it was argued, would result in about $12 million in already scarce gold and silver being exported to the bank’s foreign owners (Hixson, 115).

Secretary of State Thomas Jefferson believed the Bank was unconstitutional because it was an unauthorized extension of federal power. Congress, Jefferson argued, possessed only delegated powers which were specifically enumerated in the constitution. The only possible source of authority to charter the Bank, Jefferson believed, was in the necessary and proper clause (Art. I, Sec. 8, Cl. 18). However, he cautioned that if the clause could be interpreted so broadly in this case, then there was no real limit to what Congress could do. Then, curiously, in the memorandum in which he articulated his thoughts on this matter, Jefferson advised that if the President felt that the pros and cons of constitutionality seemed about equal, then out of respect to the Congress which passed the legislation the President could sign it (Dunne, 17-19). James Madison said the Bank was “condemned by the silence of the constitution” (Symons, 14).

Hamilton conceeded that the constitution was silent on banking. He asserted, however, that Congress clearly had the power to tax, to borrow money, and to regulate interstate and foreign commerce. Would it be reasonable for Congress to charter a corporation to assist in carrying out these powers? He argued that the necessary and proper clause gave Congress the power to enact any law which was necessary to execute its powers. A “necessary” law in this context Hamilton did not take to mean one that was absolutely indispensable. Instead, he argued that it meant a law that was “needful, requisite, incidental, useful, or conducive to.” Then Hamilton offered a proposed rule of discretion: “Does the proposed measure abridge a pre-existing right of any State or of any individual?” (Dunne, 19). Hamilton’s arguments carried the day and convinced President Washington.

The Bank of the United States had both public and private functions. Its most important public function was to control the money supply by regulating the amount of notes state banks could issue, and by transferring reserves to different parts of the country. It was also the depository of the Treasury’s funds. This was an important function because, as later experience would prove, without a central bank, the Treasury’s deposits were placed in private commercial banks on the basis of political favoritism. The Bank of the U.S. was also a privately owned, profit-seeking institution. It competed with state banks for deposits and loan customers. Because the Bank was both setting the rules and competing in the marketplace especially irritated state banks, and they joined with agrarian interests and Jeffersonians in opposition to the Bank.

The Bank was supervised by the Secretary of the Treasury who could inspect all the Bank’s transactions and accounts, except those of private individuals, and order audits on demand (Ibid, 11-13). The Bank’s ownership was set by $10 million in capital, divided into 25,000 shares of voting stock with a par value of $400 each. About 80 percent of the stock was sold to the public with the remainder capitalized by the federal government. No individual could own more than 30 shares. Shares were also sold to foreigners, although the Bank’s charter did not grant them voting rights (Phalle, 43). [1]

The First Bank of the United States (1791-1811)

The First Bank of the United States is considered a success by economic historians. (read more on the entry).

Second Bank of the United States (1816-1836)

The Second Bank of the U.S. was chartered in 1816 with the same responsibilities and powers as the First Bank. However, the Second Bank would not even enjoy the limited success of the First Bank. Although foreign ownership was not a problem (foreigners owned about 20% of the Bank’s stock), the Second Bank was plagued with poor management and outright fraud (Galbraith). The Bank was supposed to maintain a “currency principle” — to keep its specie/deposit ratio stable at about 20 percent. Instead the ratio bounced around between 12% and 65 percent. It also quickly alienated state banks by returning to the sudden banknote redemption practices of the First Bank. Various elements were so enraged with the Second Bank that there were two attempts to have it struck down as unconstitutional. In McCulloch v. Maryland (1819) the Supreme Court voted 9-0 to uphold the Second Bank as constitutional. Chief Justice Marshall wrote “After the most deliberate consideration, it is the unanimous and decided opinion of this court that the act to incorporate the Bank of the United States is a law made in pursuance of the Constitution, and is part of the supreme law of the land” (Hixson, 117). The Court reaffirmed this opinion in a 1824 case Osborn v. Bank of the United States (Ibid, 14).

Not until Nicholas Biddle became the Bank’s president in 1823 did it begin to function as hoped. By the time the Bank had regained some control of the money supply and had restored some financial stability in 1828, Andrew Jackson, an anti-Bank candidate, had been elected President. Although the Second Bank was not a campaign issue (Biddle actually voted for Jackson), by 1832, four years before the Bank’s charter was to expire, political divisions over the Bank had already formed (Ibid). Pro-Bank members of Congress produced a renewal bill for the Bank’s charter, but Jackson vetoed it. In his veto message Jackson wrote,

A bank of the United States is in many respects convenient for the Government and for the people. Entertaining this opinion, and deeply impressed with the belief that some of the powers and privileges possessed by the existing bank are unauthorized by the Constitution, subversive of the rights of the States, and dangerous to the liberties of the people, I felt it my duty…to call to the attention of Congress to the practicability of organizing an institution combining its advantages and obviating these objections. I sincerely regret that in the act before me I can perceive none of those modifications of the bank charter which are necessary, in my opinion, to make it compatible with justice, with sound policy, or with the Constitution of our country (Ibid, 14-15).

Jackson was not opposed to central banking, per se, but to the Second Bank in particular. No other bill to renew the Bank’s charter was presented to Jackson, and so the Second Bank of the United States expired in 1836. The U.S. would be without an official central bank until 1913 when the Federal Reserve System was formed.

Jackson believed that the nation’s money supply should consist only of gold or silver coin minted by the Treasury and any foreign coin the Congress chose to accept. This view was fully impractical. The gold and silver stocks of the U.S. were terribly inadequate to provide a sufficient money supply of Jackson’s preference. The U.S. at that time had no substantial mines of its own and regularly had a trade deficit, so there was no dependable method to increase the money supply under what Jackson perceived to be the only Constitutional monetary system.

However, few others shared Jackson’s opinions on this matter. Even the so-called “Jacksonian” Supreme Court ruled in 1837 in Briscoe v. Bank of Kentucky that state-chartered banks, state-owned banks, and the banknotes they created were fully Constitutional (Hixson, 119). Combined with the unanimous 1819 McCulloch ruling, the legal environment of the U.S. had clearly established that central banking, state banking, and paper currency issued by both entities were Constitutional. That the U.S. chose to proceed through the balance of the nineteenth century without a central bank would lead to interesting and creative measures to construct a financial system. [2]

States in Charge

Following the demise of the Second Bank of the United States in 1836, the American financial system entered a period frequently termed by economic historians as the “free banking era.” These were the years 1837-1862: the time between the Second Bank and the first of the National Banking acts. The only banks in the U.S. were those chartered by the states. The federal government neither chartered banks nor regulated the existing state banks.

Under a chartered bank system, a bank could only begin operations by a specific act of a state’s legislature. The charter issued by the legislature would specify in what activities the bank could and could not engage, the interest rates that could be charged for loans and paid on deposits, the reserve ratio, the necessary capital ratio and so forth. The issuing state was also responsible for regulating the activities of the banks it created.

The first bank licensed in this manner was the Bank of North America in 1782 and which operated in Philadelphia. It was designed by Alexander Hamilton and modelled after the Bank of England. Although bank-like institutions existed in the colonial period, the Bank of North America was the first bank in the modern sense of the word. The bank was permitted to accept gold and silver coin, also called specie, for deposit and to issue banknotes in exchange. Banknotes were paper bills of credit that promised to pay the bearer the note’s face value in specie on demand. The public accepted the banknotes as money because it had faith that the notes would in fact be redeemed by the bank in specie. The banknotes that augmented the money supply proved effective in stimulating economic activity. Its success inspired similar banks to be chartered in New York and Boston a few years later. By the end of Washington’s administration, twenty four state banks were in operation along with the Bank of the United States. The number tripled within the next dozen years despite the well-known opposition to banking of the next two Presidents, Adams and Jefferson (Hammond, 144-45). [3]

Money and the Constitution

The ability of banks to issue money raises some interesting questions about the nature of money and about the legal aspects of its issuance (see the entry) in the United States.

Michigan Act (1837)

In the early and mid nineteenth century the supply of gold and silver coins was insufficient to serve as the only form on money as is prescribed by a literal interpretation of the Constitution. For this reason and despite its inherent risks, state banking thrived (see the entry) as a means of augmenting the money supply.

Depository Safety and Economic Safety

How did the free banking system perform in terms of depositor safety and promoting economic stability? Overall, about 16 percent of the free banks in those states could not redeem their banknotes. Find out more in the above link.

State and Private Attempts at Reform

During the free banking era of 1837-1863 the federal government divorced itself from almost all attempts to regulate the banking system. Following the demise of the Second Bank of the United States in 1836, the nation was left with state banks as its only supplier of banking services. States were left in charge of regulating the banks they chartered, and in the states that adopted the free banking laws, this meant little or no regular supervision.

National Banking Acts of 1863 and 1864

Despite these private or state-sponsored efforts at reform, the state banking system still exhibited the undesirable properties enumerated earlier. The National Banking Acts of 1863 and 1864 were attempts to assert some degree of federal control over the banking system without the formation of another central bank.

Two Remaining Major Defects

There were two major defects remaining in the banking system in the post-Civil War era despite the mild success of the National Banking Acts. The first was the inelastic currency problem. The amount of currency which a national bank could have circulating was based on the market value of the Treasury securities it had deposited with the Comptroller of the Currency, not the par value of the bonds. If prices in the Treasury bond market declined substantially, then the national banks had to reduce the amount of currency they had in circulation. This could be done be refusing new loans or, in a more draconian way, by calling-in loans already outstanding. In either case, the effect on the money supply is a restrictive one. Consequently, the size of the money supply was tied more closely to the performance of the bond market rather than needs of the economy.

Another closely related defect was the liquidity problem. Small rural banks often kept deposits at larger urban banks. The liquidity needs of the rural banks were driven by the liquidity demands of its primary customer, the farmers. In the planting season the was a high demand for currency by farmers so they could make their purchases of farming implements, whereas in harvest season there was an increase in cash deposits as farmers sold their crops. Consequently, the rural banks would take deposits from the urban banks in the spring to meet farmers’ withdrawal demands and deposit the additional liquidity in the autumn. Larger urban banks could anticipate this seasonal demand and prepare for it most of the time. However, in 1873, 1884, 1893, and 1907 this reserve pyramid precipitated a financial crisis.

When national banks experienced a drain on their reserves as rural banks made deposit withdrawals, reserves had to be replaced in accordance with the federal law. A national bank could do this by selling bonds and stocks, by borrowing from a clearinghouse, or by calling-in a few loans. As long as only a few national banks at a time tried to do this, liquidity was easily supplied to the needy banks. However, a mass attempt to sell bonds or stocks caused a market crash, which in turn forced national banks to call-in loans to comply with the currency- Treasury bond regulation, and only a small portion of banks met the requirements to be members of the private clearinghouses. Many businesses, farmers, or households who had these loans were unable to pay on demand and were forced into bankruptcy. The recessionary vortex became apparent. Frightened by the specter of losing their deposits, in each episode the public stormed any bank rumored, true or not, to be in financial straights. Anyone unable to withdraw their deposits before the bank’s till ran dry lost their savings all together. Private deposit insurance was scant and unreliable. Federal deposit insurance was non- existent.

The 1907 crisis, also called the Wall Street Panic, was especially severe. The Panic caused what was at that time the worst economic depression in the country’s history. It appears to have begun with a market crash brought about by both a modest speculative bubble and the liquidity problem and reserve pyramiding just discussed. Centered on New York City, the scale of the crisis reached a proportion so great that banks across the country nearly suspended all withdrawals — a kind of self- imposed bank holiday. Several long-standing New York banks fell. The unemployment rate reached 20 percent in the fall of 1907. Millions lost their deposits as thousands of banks collapsed. The crisis was terminated when J.P. Morgan, a man of unscrupulous business tactics and phenomenal wealth, personally made temporary loans to key New York banks and other financial institutions to help them weather the storm. He also made an appeal to the clergy of New York to employ their Sunday sermons to calm the public’s fears.

Morgan’s emergency injection of liquidity into the banking system undoubtedly prevented an already bad situation from getting still worse. Although private clearinghouses were able to supply adequate temporary liquidity for their members, only a small portion of banks were members of such organizations. What would happen if there were no J.P. Morgan around during the next financial crisis? Just how bad could things really get? There began to emerge both on Wall Street and in Washington a consensus for a institutionalized J.P. Morgan, that is, an institution that could provide emergency liquidity to the banking system to prevent such panics from starting. The final result of the Panic of 1907 would be the Federal Reserve Act of 1913.[4]

Aldrich Plan (1910)

Following the near catastrophic financial disaster of 1907, the movement for banking reform picked up steam among Wall Street bankers, Republicans, and a few eastern Democrats. However, much of the country was still distrustful of bankers and of banking in general, especially after 1907. See more about the Aldrich Plan and the Federal Reserve Act here.

Federal Reserve Act (1913)

What eventually emerged was the Federal Reserve Act, also known at the time as the Currency Bill, or the Owen-Glass Act. The bill called for a system of eight to twelve mostly autonomous regional Reserve Banks that would be owned by commerical banks and whose actions would be coordinated by a committee appointed by the President. The Federal Reserve System would then become a privately owned banking system that was operated in the public interest. For information on the Federal Reserve Act (1913), please click here.

Louvre Accord in the International Business Landscape

Definition of Louvre Accord in the context of U.S. international business and public trade policy: Agreement made in 1987 among central bankers to stabilize the value of the U.S. dollar.

Resources

Notes

Edward Flaherty, A Brief History of Central Banking in the United States.
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Central Banking