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U.S. Banking Before the Civil War: Wildcat or Restricted? (Part 2)

This takes us to the Second Bank of the United States. With banks freed from their obligations to redeem paper money in specie, the numbers of banks were rapidly expanding. The solution to the dizzying expansion appeared to be either a strictly hard-money path or the creation of a second central bank and further inflation. The hard-money path would have forced inflationary banks to either promptly redeem obligations in specie or liquidate, thus ending the rapid monetary expansion and the perverse effects thereof.

Instead, the Second Bank was established with the premise of eliminating the inflationary tendencies of local banks. Unfortunately, this was not the case. As argued by one Senator from Delaware, the Second Bank was created “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.”

Under the lax requirements of the Second Bank, an enormous expansion of paper money and credit fueled an inflationary boom through 1818. Amazingly, those in charge were able to foresee the great potential of failure and began a program to contract the money supply. This policy most certainly saved the bank from failure, but had the result of creating the first widespread economic depression in the United States. Within the span of a year, total notes and deposits dropped from $22 million to only $11.5 million. The result was a massive amount of default and liquidation of malinvestment caused by the previous inflation.

This event led to the creation of the Jacksonian Movement. In essence, they firmly placed the blame for boom-bust cycles on inflationary expansions followed by a contraction of the money supply. Their goal was to abolish central banking and ultimately fractional reserve banking. Thus, when Andrew Jackson was re-elected in 1832, he quickly removed Treasury deposits from the Second Bank and refused to renew the charter which eventually failed in 1841.
Therefore, the period of interest is from 1836 with the lapse of the charter for the Second Bank until 1913 when the Federal Reserve Act was passed. Was this period actually “75 years worth of near-uninterupted private banking failure” characterized by “some of the rudest and most unstable years in our financial history”? Let us do some exploring.

Under the regime of the Second Bank, the money supply roughly doubled. Curiously enough, the money supply continued to increase and nearly doubled in the span from 1833 to 1837. However, this bout of inflation was not caused by a sudden lack of control by the newly neutered Second Bank, but a rapid expansion of specie. Specie within the nation had remained relatively constant for ten years at around $32 million, but rapidly jumped to $73 million by 1837. With banks continuing to issue notes at constant ratios, the ensuing monetary inflation was solely the result of increased specie and not unrestrained “free” banking as some would have you believe.

As one would expect, a credit expansion of this magnitude is quickly followed by an equally impressive contraction. With the expansion of bank credit, prices begin to rise which has the effect of increasing demands for specie. This increased demand for specie promptly curtails the expansionary tendencies and establishes an end to the boom and potentially the beginning of a bust. Once again, banks suspended specie payment until forced to do so late in 1838.

Meanwhile, upon discovering a large budget surplus after paying off the federal debt (for the only time in U.S. history), President Jackson distributed the surplus to the states. The state governments, suddenly finding themselves awash in cash, subsequently lavishly spent money on various “public works” projects. Virtually every project was established on typical government shortsightedness and optimism of continued budget surpluses. Thus, the various states abandoned their projects throughout 1839 as the realities of limited revenue caught up with them.

The ensuing four years of massive monetary and price deflation allowed for the liquidation of unsound investments, the bankruptcy of unsound banks, and a general reallocation of capital. By 1847, four states had repudiated all or a portion of their debt and six others had defaulted for multiple years. As shown in “The Jacksonian Economy” by Peter Temin, the percentage of deflation from 1839 to 1843 was almost the same as the infamous period from 1929 to 1933. However, the effects of this deflation were drastically different between these two periods.

As described in “A History of Money and Banking in the United States Before the Twentieth Century” by Murray Rothbard:

Whereas in 1929–1933, real gross investment fell catastrophically by 91 percent, real consumption by 19 percent, and real GNP by 30 percent; in 1839–1843, investment fell by 23 percent, but real consumption increased by 21 percent and real GNP by 16 percent.

Temin suggests the difference lies in the “massive roadblocks” placed by the government in the 1930s on the ability of prices and wage rates to naturally fall as they did during the 1840s. The downward flexibility of prices during the 19th century allowed prices to drop without crippling production as occurred in the 20th century.

In 1853, the effects of the recent gold discoveries caught up with the enforced silver-gold ratio which quickly removed silver coins from circulation. Therefore, rather than remove the arbitrary ratio and allow for a monometallic standard, the government deliberately overvalued silver coins, but restricted issuance to small-denominations. Furthering the restrictions, Congress prohibited foreign coins from exercising legal tender status as previously mentioned in 1857.

At this point, the expansion of bank notes and credit was tied directly to state activity. In effect, state government bonds were allowed to be used as the reserve base upon which to expand the money supply. This, in turn, meant that the more public debt the banks purchased, the more money they could create and lend out. Obviously this arrangement had the effect of encouraging banks to monetize debt and states to go into debt. Also during this time, the federal government prohibited interstate branch banking and continued to allow the periodic suspension of specie payment.

During this period of alleged “private banking failure”, the Suffolk Bank emerged as a de facto private central bank. Since many banks would not accept the notes issued by certain other banks and the ability to redeem notes from far-away banks could take quite some time, the Suffolk Bank created an orderly and efficient system without the heavy hand of government. From 1825 to 1858, nearly every bank in New England became a member of the Suffolk System.

History of Money and Banking said:
With the Suffolk acting as a “clearing bank,” accepting, sorting, and crediting bank notes, it was now possible for any New England bank to accept the notes of any other bank, however far away, and at face value. This drastically cut down on the time and inconvenience of applying to each bank separately for specie redemption. Moreover, the certainty spread that the notes of the Suffolk member banks would be valued at par: It spread at first among other bankers and then to the general public.

Obviously, inflationary banks did not appreciate the Suffolk System because it forced them to stay honest. The power came from the ability of the Suffolk Bank to allow or deny membership into the system. While it could not prevent other banks from inflating, it could deny membership to the system, thus greatly inhibiting the circulation of notes issued by that particular bank.

John Knox, U.S. comptroller of the currency, compared the Suffolk System to the national banking system (later established in 1863) in his “A History of Banking in the United States”:

In 1857 the redemption of notes by the Suffolk Bank was almost $400,000,000 as against $137,697,696, in 1875, the highest amount ever reported under the National banking system. The redemptions in 1898 were only $66,683,476, at a cost of $1.29 per thousand. The cost of redemption under the Suffolk system was ten cents per $1,000 ... the fact is established that private enterprise could be entrusted with the work of redeeming the circulating notes of the banks, and it could thus be done as safely and much more economically than the same service can be performed by the Government.

Finally in 1861, the Civil War set the United States firmly on the path towards fiat money and ever-increasing levels of public debt. From the Suffolk System, we can draw the conclusion that, given the freedom to do so, similar systems would highly likely have developed in other regions and/or expanded beyond state borders. For a very brief time, banks were allowed a little bit of freedom to experiment with various business models in the search for an efficient and safe monetary system. Unfortunately, the governments at both state and federal levels prevented this from fully developing.
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