Central banks. Nobody asked for them, everyone got them. Take the Fed for example. The Fed was officially founded in 1913, but certain people had been trying to establish a “fed” since at least 1781. If your idea takes 200 years to catch on, you have to wonder if it’s good. It took an impressive amount of deception, a bunch of tries and a national crisis for that thing to finally settle in.
This is pretty much a compressed version of the second half of Rothbard’s book The Mystery of Banking, with some extra notes.
The Zeroeth “Fed”
The Bank of North America was where it all began. It was headed by Robert Morris, a wealthy merchant from Philadelphia. Morris made his millions as a war contractor during the Revolutionary War, siphoning off millions from the public treasury to his and associates’ firms. Morris used his connections to obtain a charter for starting the Bank of North America. The bank obtained the monopoly privilege of its notes being legal tender. Moreover, no other banks were allowed to operate in the country. In return, the bank promised to lend most of its newly created money to the federal government. The first “Fed” was born. The federal government did not park its funds at the Bank of North America, so we can’t call this bank a federal reserve just yet.
Being the people they are, the Americans had little trust in this federal scheme. The market’s lack of confidence was reflected in the value of the bank’s notes. Receivers of notes quickly went to the teller to convert them to gold. With such a pressure on its gold reserves, the bank could hardly operate like the Fed does now. It could not hold a fractional reserve if nobody held reserves at the bank. Morris’s political power slipped and he moved quickly from trying to play Fed back to playing commercial bank. By the end of 1783, the federal government had sold its stock in the bank and repaid its debt. The first Fed had failed.
The First “Fed”
The First Fed bears the appropriate name First Bank of the United States. The charter was obtained by Alexander Hamilton. The First Bank was to be a privately owned central bank, with the federal government owning a fifth of its shares. Hamilton produced the then new, now common, argument that there was a scarcity of gold and silver. That scarcity had to be overcome by printing a bunch of paper money. This is roughly the same argument central banks still use today. One wonders, if 200 years of printing paper money didn’t solve this scarcity problem, will it ever?
Anyway, the First real Fed was born as it received the privilege of holding the federal government’s funds. This would alleviate at least one problem that killed the zeroeth Fed, namely, a lack of reserves. Former president of the first Fed and Morris’s longtime business partner Thomas Willing was made the First Fed’s president. This further showed that the First Fed really was a second try.
No sooner was the First Fed created than it turned on the press. Rothbard writes:
Pyramiding on top of $2 million in [federal reserves,] the BUS invested heavily in $8.2 million of loans to the US government by 1796. As a result, wholesale prices rose from an index of 85 in 1791 to a peak of 146 in 1796, an increase of 72 percent.
The Democratic-Republicans, officially hostile to commercial and central banking, made no move to end the First Fed’s charter before its expiration date. They also made no move to stop the rapid multiplication and spread of state chartered banks during the period. One can hazard a good guess why.
The First Fed failed to renew its charter when it expired. The people didn’t want it. Who did want it? Government and merchants, mostly. Merchants were happy with the bank as they were able to get loans cheaper than ever. The Bank of New York, founded by Alexander Hamilton, said that the First Fed was great, because it could step forward and lend to merchants “in case of any sudden pressure” and “in a degree which the state institutions were unable to do”. This resonates the “Lender of Last Resort” characterization of the Bank of England by Sir Francis Baring. If one needed further convincing that there was a plot to establish England style central banking in the US, this was it.
A Small Break
While the First Fed fell, the number of state banks multiplied. The federal government was at war with England, and it needed cash.
From 1811 to 1815, the number of banks in the country increased from 117 to 246. The estimated total specie in all banks fell from $14.9 million to $13.5 million, whereas the aggregate of bank notes rose from $42.2 million to $79 million.
More cash, less gold. In four years, banks collectively went from a 35 percent reserve ratio to a 17 percent one. Double the banks, half the ratio.
In the war of 1812, many banks got in trouble. By 1814 it became clear that many banks were insolvent. They did not have the reserves required to pay their debts. If it weren’t for the federal government stepping in, they would have to close up shop. The government did step in, however, and decided to let banks stay in business while refusing to redeem their obligations in specie. In other words, banks were allowed to write IOUs indefinitely. Ofcourse as a debtor to the bank you still had to pay your debts.
Has anyone ever asked you: “What would you do if you knew you couldn’t fail?”. The possibility of failure is a very potent natural regulator of human behaviour, and that regulator was removed by the federal government. The precedent set by the intervening government told banks that, as long as they all failed together, the government would bail them out. It told banks that if they were to fall, they had to make sure their fall would make the biggest crash possible. From there, banks started erring on the dangerous side. Four more times would species payments be suspended in the next fifty years.
The Second “Fed”
Banking after the War of 1812 was a mess of independent, fiat issuers. It was clear that this could not last. There were two ways out of this disaster. The first was a return to hard money. This one would be painful, as so often the right choice is. The federal government would have to command all banks to redeem in specie. Many banks would not have been able to, and they would have to liquidate. Most likely this would have resulted in an economic depression as things went back into order. Many people didn’t like that idea.
The second was to try the central banking thing again. Many liked that idea. Big smart people told them we could get out of this mess without any more pain. The Second Bank of the United States was established in the image of the First Bank: privately owned, a fifth of its stock by the government, and able to create national paper currency. Also it held the federal government’s reserves, making it a proper federal reserve.
That the Second Fed was a true successor to the first was shown in 1817. While working on the charter for the Second Fed in 1816, congress also passed a resolution that required the US to accept tax payments only in specie, treasury notes, bus notes or state bank notes redeemable in specie. No irredeemable state bank notes were to be accepted. This move would have devalued irredeemable bank notes, and state banks would have been forced to redeem and take a big hit. The Second Fed had a trick up its sleeve. In exchange for future cooperation of these banks, it provided $6 million of credit to these banks to reduce the impact of making their notes redeemable.
The charter for the Second Fed didn’t get through congress without a fight. Wealthy men had to throw tons of political weight around to make it so. There was vocal opposition to this. In the words of John Randolph:
Every man you meet in this House or out of it, with some rare exceptions, which only served to prove the rule, was either a stockholder, president, cashier, clerk or doorkeeper, runner, engraver, paper-maker, or mechanic in some other way to a bank…
…There were very few who dared to speak truth to this mammoth; the banks were so linked together with the business of the world, that there were very few men exempt from their influence. The true secret is, the banks are creditors as well as debtors.
In fact, the appointment of Secretary of the Treasury Alexander J. Dallas seemed to be engineered precisely for the purpose of getting the charter for the Second Fed passed. Engineered by Stephen Girard, one of the wealthiest men in the country, and his close friend John Jacob Astor.
The Second Fed started up its printer in 1816 and by 1818 had increased the money supply by over 40 percent. On the back of this over a hundred new state banks were opened all across the US. By 1818, the Second Fed realized it may have overstretched. It came very close to failing species payments. The next year came the inevitable monetary contractions that always follow a printing press powered boom. This bust became the first big one of its nature for the US.
This contraction was BIG. The supply of bank notes fell from $21 million to $11 million in a year. Almost 80 banks were forced to close their doors. Many businesses went bankrupt, exports and prices fell. The Second Fed was supposed to solve the chaos left by the war of 1812, but instead it brought on more.
Andrew Jackson ends the Fed
The economic fallout of this big boom-bust woke people up. The Democratic Party was founded by Martin Van Buren, who rallied politicians from various states behind the 1812 War hero Andrew Jackson. They wanted free markets and they wanted the Fed gone. The charter for the Second Fed was up for renewal by 1836, but by that time, Andrew Jackson would be president. Nicholas Biddle, head of the Second Fed at the time, decided to press the issue early and try to file for renewal in 1831, when Andrew had only been in office for two years. President Andrew Jackson vetoed the renewal, the Second Bank of the United States turned into the United States Bank of Pennsylvania, and that was that.
The early bit of the Civil War was funded by Treasury printed “greenbacks”. The treasury printed so many of these that it had to suspend specie payment, lets it go bankrupt. Between 1860 and 1863, the total money supply in the country near doubled. This much printing, combined with the effect of the war on goods, caused prices to more-than-double. The greenbacks quickly lost value, and after they had lost nearly all their value, the government started issuing debt instead. At the end of the war, the total debt was over $2.5 billion, of which less than a fifth consisted of those greenbacks.
This huge debt now needed to be serviced. The usual way states do this is by perpetually rolling it over by issuing new debt. The problem was finding people willing to buy that debt. That’s where Jay Cooke comes in. He and his brother were friends with US senator Salmon P. Chase. The Cookes successfully lobbied to get Chase appointed as Secretary of the Treasury. Chase rewarded the Cookes with the monopoly privilege to underwrite new bonds. As soon as this privilege was granted, the Cookes launched a massive campaign to sell bonds. Between $1 million to $2 million of new bonds would be sold each day. Approximately $2 billion in bonds were underwritten by the Cookes during the war period.
But the Cookes weren’t done. They used their wealth and political influence to change the US banking system forever. They conceived of and drove through the National Banking Acts. The system defined by these acts would remain in the US untill 1913 and paved the way for the Fed as we know it today. The new system was pushed through during the war and replaced the Jacksonian quasi-free banking system. In the new system, a group of federally chartered National Banks were picked to hold the treasury’s reserves.
What did Cooke get out of this? In the new system, the national banks could expand their issued notes on top of US government bonds, thus ensuring a market for those bonds. In this way, the Government was assured a market for its debt. Cooke was assured a fat paycheck. That still wasn’t enough. Cooke established a few national banks of his own. One of these, the Fourth National Bank of New York, was the largest bank in New York from the day its doors opened. Cooke exited the war period a powerful and wealthy man.
His fortune did not last long, however. By 1869, Cooke went big into railroad bonds and overextended. The House of Cooke went bankrupt and ignited the financial crisis known as the Panic of 1873.
The Lender of Last Resort
The Panic of 1873 wouldn’t be the last. Panic after panic happened in 1884, 1893 and 1907. Instead of critically examining the National Bank Act and the resulting centralized banking system, national banks concluded that the current system wasn’t centralized enough. They concluded that a big central bank was necessary to function as a lender of last resort. During panics, the blame was laid on the money supply. It wasn’t that too much credit was extended. No, the problem was that too little money was available. The national banking system was found to be too inelastic, since its issue of notes was dependent on the amount of government bonds deposited at the treasury.
The real reason the national banks seeked more control may be that these banks saw their control slowly slipping away. Just before the 1900s, the fraction of national banks had decreased greatly, down to 30% from over 40% after the Civil War. Wall Street lost power.
Economic winds were blowing in a different direction at the end of the 19th century than at the start. The dominant philosophy used to be hard money and laissez-faire, but now it shifted to big government and economic nationalism. Businessmen and Politicians enjoyed this intellectual shift. It gave businessmen a taste of power and politicians a taste of wealth. The Panic of 1907 put the desire for a central bank into high gear, and the Federal Reserve Act was passed in 1913 with a large majority.
The Return of the Fed
Thus, after over 200 years of political powerstruggles, the Fed as we know it was born. In this new Federal Reserve System, all banks held accounts at member banks, who in turn held accounts at the Fed. Gold reserves from previously national banks were henceforth held at the Fed. This structure was designed as an inflationary measure. The Fed could expand its deposits on top of its gold reserves, and member banks could expand their deposits in turn on the Fed’s expanded deposits.
Did this put an end to those panics that plagued US banking? The two big post-war depressions in the 20th century can hardly be blamed entirely on the Fed, although the Fed did enable the US to join those wars. But besides those, during the interwar periods, there were plenty of booms and busts to be seen. This continues all the way into the present day, where booms and busts have become a fact of life. Hell, we’re in some bubble or another every year. These days, bubbles are even acknowledged by established economists and sometimes viewed as positive. Nobel Memorial Prize winner and New York Times economic writer Paul Krugman called for a housing bubble in 2002 to replace the recently burst dotcom bubble.
When the Zeroeth Fed was proposed, central banking only plagued the English. Now it plagues us all. With all banks big, no crash is allowed to be local. It used to be that small overextended banks crashed, went out of business and made the lives miserable of an unhappy few. Now no single bank can crash without bringing along misery for all.
I guess there is an upside. Economics has been turned from a dull affair into an exciting game with big players. I can only hope the next big loser doesn’t take me down too.