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Trial & Failure: A Monetary Analysis, 1781-1913
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Throughout the colonial period, the states made individual decisions that slowly perfected the current monetary structure the United States has today. The colonial period was marked with macroeconomic divergences between the colonies. The banking eras following the unionization were marked with similar divergences by region and era. The colonies pursued uncoordinated efforts to move towards an improved modern and vigilant banking system. Political, agricultural, and business interest ebbed and flowed the progress and diminishment of the move towards an appropriate modern central bank and fiat currency. The trials that were made from the colonial era through the passage of the Federal Reserve in 1913 allowed for the banks and government to seek out the most suitable system of regulation, crisis mitigation and management, and a uniform currency.
Following the 1780 charter and subsequent debate, the Bank of Pennsylvania ushered in real central banking powers and structures that would continue, in similar fashion, throughout present day banking systems (Moen & Tallman, 2003). The architect of the bank was Alexander Hamilton (Sylla, Wright, & Cowen, 2009). Unfortunately, the institution he founded was not prepared to endure the political onslaught that it experienced from Congress and was forced to close after its 20-year charter expired (Hill, 2015). While the institution laid dormant, never to be awoken again, his ideas laid the groundwork for the Second Bank of the United States and the Federal Reserve in 1913 (Davies, 2007). While the First Bank of the United States did not formalize the concept of centralized monetary controls, its scope foreshadowed the Fed’s stabilizing influence on the nation’s supply of money.
The parallels do not stretch infinitely. For one, the First Bank of the United States had the interest of lending to governments and operating as a commercial bank, both properties the current Fed does not possess (Davies, 2007). Additionally, the modern Fed has dual-functionality as a regulatory body: enforcing reserve requirements and performing stress tests – both elements that the First Bank of the United States did not possess (Hill, 2015; Meltzer & Goodhart, 2005).
The organizational structure and ownership interests align closely with the Fed today. The Fed and the First Bank of the United States shared the quasi-public structure; the banks’ goals were to serve a public purpose with an independence from the political interest (Davies, 2007). Both operated under the direction of private interests, as well as structured utilizing a branch network of banks throughout the country. Thomas Humphrey, a former senior economist with the Federal Reserve Bank of Richmond, asserted that the parallels are extensive. He continued to say that Hamilton’s bank was the uncannily similar ancestor for many of the functions of the modern Fed (Davies, 2007). Hamilton’s bold creation of the First Bank of the United States incorporated, spring-boarded, and foreshadowed the future U.S. economy based on private capital and bank credit of subsequent central banks for two centuries.
After the vetoed renewal of the Second Bank of the United States by Andrew Jackson in 1832, the country endured a period of no formal central banking that became known as the Free Banking Era (Moen & Tallman, 2003). However, in the absence of a government-chartered central bank, New England began forming what some observed as an operational central bank: the Suffolk Banking System (1825-1858) (Moen & Tallman, 2003). This system served as a predecessor to modern banking practices and led to the formation of the Federal Reserve that followed almost 100 years later in its footsteps.
While the system monopolized the brokerage of all paper notes in the U.S., it took charge on stronger banking practices and a uniform currency in the Northeast (Moen & Tallman, 2003). The system began and foreshadowed practices that modern day central banks would inherit. The community of banks began lending reserves to other banks, maintaining a system of payments, and redeeming specie to control note issuance (Moen & Tallman, 2003). Following their practices’ success, the New England area witnessed a decrease in overall counterfeiting and reduced internal risk during economic crisis (Rolnick, Smith, & Weber, 1998). While the country experienced two economic crises during the existence of the Suffolk System, its banking prescriptions minimized the damage to the economy of New England (Moen & Tallman, 2003). Looking back, central banks witnessed the effectiveness of the system in America during a hectic economy and selected its main practices for implementation in the 21st century.
The formation of the New York Clearinghouse in 1853 laid the groundwork for the Federal Reserve’s practices of audits and minimum reserves. In the absence of a formal central bank, the gates were opened to a private crisis management system. Due to the pyramiding of reserves and small geography that the clearinghouse served, the efforts made by the clearinghouse were largely restricted to the New York area (Moen & Tallman, 2003). Thus, monetary adjustments made by the New York Clearinghouse would only be felt regionally.
Upon the recognition of a crisis, the clearinghouse would perform two crucial functions to alleviate or dull the effects of the crisis: 1) merge the balance sheets of the member banks and, 2) issue “payable through the clearing house” IOUs (Moen & Tallman, 2003). The former allowed the general public to believe in the underlying finances of the group of banks and would not allow the analysis of a particular, weaker bank. The latter would arise after a questionable legal practice of suspending convertibility; however, it “performed [a] valuable service [. . .] in moving the crops and keeping business machinery in motion, that the government [. . .] wisely forbore to prosecute” (Hepburn, 1903). The loan certificates proved to be a valuable measure, in the absence of a central bank, to increase liquidity in the short run (Moen & Tallman, 2003). Some historians viewed the clearinghouse’s systems of crisis reduction as a model for the Federal Reserve (Moen & Tallman, 2003). The sponsor of the Federal Reserve bill in the Senate, Robert Owen, said, “This bill, for the most part, is merely putting into legal shape that which hitherto has been illegally done” (Congress, 1913). Further, under the examination of the National Monetary Commission, they observed that the clearinghouses, along with the German Reichsbank, were to be the model for the soon-to-be Federal Reserve (Bordo & Siklos, 2017). The commission’s report suggested that “[the clearing-house system is becoming a definitely recognized power in the financial methods of the United States [. . .] and the powers that the various clearing houses possess are capable of development and expansion to an indefinite degree” (Hepburn, 1903). In the absence of a government chartered central bank, the private sector, specifically clearinghouse associations, was able to formulate features that performed vital functions akin to the modern day Federal Reserve.
As much as the formation of future central reserve practices was vital to the eventual systems that the Federal Reserve would perform, the Free Banking Era proved to be a crucial counterexample to opposition views. Following the veto of the Second Bank’s charter renewal and subsequent charter revocation, the United States was left with a plethora of state-chartered banks (Moen & Tallman, 2003). These banks followed no formal reserve requirements, and their reserves were backed by the bimetallic standard (Moen & Tallman, 2003). Achieving the chartered status became a rubber stamp, sometimes without formal legislative approval (Sanches, 2016). This era must not be interpreted under the lens of how many banks were chartered, but rather by how many banks succeeded throughout the duration of limited regulation. During this period, the lifespan of the banks became exceedingly short, on average five years (Shaffer, 2010). Furthermore, the true colors of the system began to show as the carnage of no formal government banking allowed half of the banks to fail (Shaffer, 2010).
The highest level of failure was likely achieved in Michigan, following its most loosely regulated charter procedures. In 1837, the Michigan legislature passed their state banking laws to encourage the formation of banks throughout the state (Sechrest, 2008). Unfortunately, the desired outcomes of promoting a stable banking system with a safe currency failed. Just two years following the passage of the Michigan Acts, all but four of their free banks closed (Rockoff, 1975). While data is restricted and lost, Rockoff estimated that the loss to Michigan’s noteholders was roughly $4 million (nearly 45 percent of Michigan’s annual income in 1840). While it is essential to observe the properties of the modern Federal Reserve and where they originated, it is arguably just as important to examine the reasons why the United States did not look towards a more free banking system. Due to exceedingly high numbers of bank failures and closures, short bank lifespans, and improper reserve maintenance, the case for the passage of the subsequent reserve banks became more economically logical.
Akin to Articles of Confederation being a period of culminated, learned successes and failures for the Constitution, the trials of central banking proved to be experiences and building blocks for the Federal Reserve. Throughout the late 18th and early 20th centuries, the roles of both public and private banks provided the country with examples of the future role that a central bank should obtain. Bankers and lawmakers alike learned that the ideas and creations of many private institutions should be incorporated in the modern role of the Federal Reserve. Furthermore, they learned that a government-chartered central bank was needed to be a lender of last resort, to set reserve requirements, and to issue a stable currency, among other duties.
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Shaffer, D. S. (2010). Profiting in economic storms: a historic guide to surviving depression, deflation, hyperinflation, and market bubbles: John Wiley & Sons.
Sylla, R., Wright, R. E., & Cowen, D. J. (2009). Alexander Hamilton, central banker: crisis management during the US financial panic of 1792. Business History Review, 83(1), 61-86.
United States Congress (1913). Congressional Record. 63rd Congress, 1st Session, 904.
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