In order to address the claims made by typical mainstream layman and economist alike, we must first briefly outline how the modern American monetary system came about.
Prior to the establishment of the United States, this geographic area was settled by scattered groups of primarily English and Spaniards. As will occur in any location, the choice medium of exchange arises as a function of scarcity and demand. For the early colonials, this ranged from beaver pelts and corn in the northern areas to fish and tobacco in the south. As the region began to grow, gold and silver coins were imported and used frequently in the cities and for foreign trade.
I must stress that many different foreign coins were freely circulating in early America. Although it seems patently obvious to some, the fact that a mass of gold or silver is equivalent without regard to the minting stamp seems to escape many of those who are insistent upon government control of money. In point of fact, foreign coins were readily accepted throughout all of America until Congress outlawed the use of foreign coins in 1857.
With exception to ancient China (see the great book “Paper Money – A Cycle in Cathay” by Gordon Tullock), the first government issued fiat paper money originated in Massachusetts. The reason was due, of all things, to a failed raid on Canada. For many years, Massachusetts had been sending soldiers into Quebec to plunder as much riches as they could carry and then sell off all the booty in Boston, with a portion of the proceeds used to pay the soldiers (or pirates, if you prefer). Quebec eventually garnered enough defenses to repel the raid and the soldiers returned to Boston in an obviously foul mood demanding payment for their services. Ill-content soldiers are prime victims of mutiny and discord, so Massachusetts attempted to borrow money to pay them off, but their credit rating was apparently too low for the available creditors. Therefore, the government printed £7,000 in paper notes. Along with the paper, the government promised to redeem them in the future in either gold or silver from tax revenue and that not another single paper note would be issued.
As is typical of government promises, both quickly went the way of the dodo. Within a few short months the paper money supply increased another £40,000 while ultimately taking some 40 years to redeem the paper.
Following in lock-step with the laws of economics, the risk and lack in quality of the paper money led to depreciation. The Massachusetts government attempted to force the acceptance of the fiat money on par with specie, but ultimately effected the disappearance of specie. Additionally, the rapid expansion of paper money had the result of price inflation and dramatically reduced exports. Thus, while many modern economists claim that the so-called “money shortage” is reason enough for the introduction of fiat paper money, it was actually the introduction of fiat paper money which created the money shortage to begin with.
By the late 1750s, every colony in America had begun issuing fiat paper money and the price of silver had increased tenfold. In every case, after new paper money was released into the economy, an inflationary boom eventually followed by a deflationary depression resulted.
Finally, King George prohibited the further issuance of paper money in the colonies and required the redemption of all outstanding obligations. As is typical of today’s naysayers, opponents of specie money predicted that foreign trade would come to a standstill, prices would skyrocket, and a “shortage of money” would result. In reality, after a brief adjustment period, the resumption of specie money resulted in an increase in trade and lower prices.
Here was a silver standard … in the absence of institutions of the central government intervening in the silver market, and in the absence of either a public or private central bank adjusting domestic credit or managing a reserve of specie or foreign exchange with which to stabilize exchange rates. The market … kept exchange rates remarkably close to the legislated par. … What is most remarkable in this context is the continuity of the specie system through the seventeenth and eighteenth centuries. – Roger W. Weiss, Economic History Review
The next period of paper money was during the Revolutionary War. While not accompanied by a promise of specie redemption, the infamous Continental was supposed to be retired in seven years and replaced through future taxation. Of course, politicians being what they are, this apparently limitless new form of revenue expanded rapidly. Beginning with a paltry $6 million in 1775, the Congress eventually issued more than $225 million of the next five years. As a consequence, by 1781 the Continentals were trading on the market at a virtually worthless ratio of 168:1. As will likely occur with modern U.S. Dollars, the Continental was allowed to sink into worthlessness without burdening the economy with redemption.
Thus emerges the first central bank in 1782, the Bank of North America. This bank was the first fractional reserve bank in the United States as well as being a privately owned and monopolistic bank. The federal charter allowed it to issue notes receivable for all taxes and duties owed to the government at par with specie. Lack of confidence likely due to the previous bad experiences with paper money resulted in failure by the end of the following year.
The Coinage Act of 1792 made the mistake of establishing a bimetallic standard for the U.S. Dollar. This Act defined the dollar as both 371.25 grains of pure silver and 24.75 grains of pure gold; thus, a fixed ratio of 15:1. Gresham’s Law tells us that when competing monies are artificially fixed at legal ratios, the overvalued money will drive out the undervalued money. Or in other words, the least valuable money will remain in circulation while the more valuable money will remain in “hoarding”. By 1810, gold coins all but disappeared from circulation.
Simultaneously, the First Bank of the United States was established at Hamilton’s urging in order to combat the alleged “scarcity” of specie. The ensuing rapid increase in credit and paper money promptly resulted in price inflation. Within the twenty-year span of the First Bank, 113 new banks were formed which collectively increased the supply of money and credit by more than fourfold.
The First Bank’s charter expired in 1811, but the War of 1812 had a devastating effect on the money supply. The number of banks nearly doubled by the end of the war, piling new paper money and credit upon specie to the point of a nearly 6:1 ratio across the nation. However, this ratio was only around 2:1 in New England banks which generally refrained from inflating credit while Virginia and South Carolina approached a ratio of 19:1. This had the effect of subsidizing northern manufactured goods with inflated paper in the south and was likely a contributing factor to the Civil War.
Most alarmingly, the federal government allowed banks to suspend payment of specie (i.e. refuse redemption of paper money for gold or silver) for over two years beginning in 1814. Further suspensions occurred in 1819, 1837, 1839, and 1857. These blatant violations of property rights represented the golden key for bankers and planted the seed which eventually resulted in our modern monetary system.
The importance of everything explained to this point is the refutation of the common claim of a “failure of free banking”. Free banking can only occur in an environment in which banks are treated no differently than any other business. That is, a failure to conform to contractual obligations results in insolvency and the liquidation of assets to pay for debts incurred. For an excellent explanation of free banking, refer to “The Rationale of Central Banking” by Vera Smith:
“Free banking” is a regime where note-issuing banks are allowed to set up in the same way as any other type of business enterprise, so long as they comply with the general company law. The requirement for their establishment is not special conditional authorization from a government authority, but the ability to raise sufficient capital, and public confidence, to gain acceptance for their notes and ensure the profitability of the undertaking. Under such a system all banks would not only be allowed the same rights, but would also be subjected to the same responsibilities as other business enterprises. If they failed to meet their obligations they would be declared bankrupt and put into liquidation, and their assets used to meet the claims of their creditors, in which case the shareholders would lose the whole or part of their capital, and the penalty for failure would be paid, at least for the most part, by those responsible for the policy of the bank. Notes issued under this system would be “promises to pay,” and such obligations must be met on demand in the generally accepted medium which we will assume to be gold. No bank would have the right to call on the government or on any other institution for special help in time of need. … A general abandonment of the gold standard is inconceivable under these conditions, and with a strict interpretation of the bankruptcy laws any bank suspending payments would at once be put into the hands of a receiver.
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 [i]de facto[/i] 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.
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. – History of Money and Banking
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.