In the last chapter, we learned about how England first developed central banks and bank notes. But how did this come about in America? At least in part, war was responsible…
Some of the founding fathers didn’t want central banking
While England went forward with its implementation of a central bank, many of America’s founding fathers saw central banking as a bad thing. They felt that England controlling the monetary supply of the colonies was oppressive and viewed this as a direct cause of the American Revolutionary War.
Meanwhile, others, like the superintendent of finance, Robert Morris, were in support of a central bank. So Morris made it happen. In 1783, the Bank of North America was established, becoming the first commercial bank in the United States.
However, the bank didn’t quite work out because it was said to have “alarming foreign influence and fictitious credit.” Moreover, it was overtly corrupt and tried to implement unfair policies against state banks issuing their bank notes. As a result, the bank’s charter was eventually repealed.
First Bank of the United States
In spite of the difficulties, Robert Morris was not giving up. Through some clever agreements, he got Congress to charter the First Bank of the United States in 1791, and soon after, George Washington signed off on it.
The First Bank of the United States was modeled after the Bank of England, which had impressed Alexander Hamilton. He believed it did a good job serving as the central bank for the growing British Empire.
However, unlike the Bank of England, the First Bank of the United States was not solely responsible for the country’s supply of bank notes. Rather, it was responsible for only 20% of the currency supply while state banks printed the rest.
Founding fathers like Thomas Jefferson were not fond of the idea of a central bank. They felt that the bank could be used for speculation, financial manipulation, and corruption. Twenty years later, in 1811, the First Bank’s charter expired and was not renewed by Congress.
This happened at the same time that the War of 1812 was being waged. With the national bank closing, the government suddenly struggled to fund the conflict. (PS: One big reason governments want a central bank is because it makes it easier for them to print money and fund wars.)
But since the First Bank had ended operations, the only way to fund the war was for the federal government to issue treasury notes. Treasury notes were short-term debt instruments that served as credit to fund the war.
Second Bank of the United States
Five years after the First Bank shut its doors, plagued by inflation, the government decided to launch the Second Bank of the United States in 1816 to try and curtail the issue. The Second Bank was basically a copy of the First Bank.
Andrew Jackson, who became president in 1828, denounced the bank as an “engine of corruption.” He set out to destroy the bank, which caused major political issues in the 1830s. Jackson portrayed the bank as a tool of the special interests at the expense of “regular” people. In fact, this is what led to the second party system (Democrats opposed banks and Whigs supported them).
When Jackson was unable to get the bank dissolved, he refused to renew its charter. In an effort to make the bank obsolete, he also decided to create an executive order requiring all federal land payments to be made in gold or silver.
This was one of the major contributing factors to the Panic of 1837, and the Whigs blamed Andrew Jackson for it.
The Panic of 1837 was the first of many panics in the USA (as we’ll learn in future posts). Those of you reading this may or may not have lived through a financial panic. If you did, you may have been too young to understand what was going on. So let’s take a minute to understand what a panic is.
What causes panics?
Financial panics happen when people suddenly lose confidence in one or more banks and no longer feel comfortable depositing their money in that bank.
Let’s take a look at an example:
Imagine there is a bank. This bank, like all banks, finances itself by taking deposits from ordinary people and paying them a tiny interest payment on their deposits. Then the bank turns around and uses those deposits to make loans to consumers.
Now, imagine that a rumor goes around that this bank is giving out loans to people who have a high risk of defaulting on their loans. The depositors who deposited their money with this bank hear the rumor, and they start to question the bank’s ability to recoup its loans. So what do they do? They pull their deposits out of the bank. One by one, depositors line up and try to get their cash.
But remember that banks don’t just take your cash and hold onto it. No bank holds all the cash of its depositors.
Instead, they hold onto a portion of the cash deposited (e.g. 50%) and lend out the rest as loans. Banks earn interest on these loans, and that is how they generate money as a business.
In reality, most modern banks only keep 10% in reserves, and lend out the rest to other banks or people:
This system is known as a “fractional reserve system”. Can you see how a fractional reserve system could be an issue if there is a financial panic?
When there is a panic, suddenly the bank has too many people knocking on its doors, wanting to get back the money they have deposited. But remember that a lot of the money is not sitting there idle. It’s already been lent out to borrowers. So the only way the bank can give the depositors their cash (after it goes through its reserves) is to sell the loans. It takes time to do this, and so the bank ends up having a liquidity crisis and failing.
Once one bank fails, consumers get even more worried and start to lose confidence in other banks as well. This ends up creating a negative spiral and causes all sorts of problems, including:
- Widespread bank runs
- Restrictions on depositors’ access to their funds
- Bank failures
- Stock market crashes
- Economic contractions.
In short, banking panics are a bad thing. We want to avoid them as much as possible.
This is exactly what happened during the Panic of 1837 after the Second Bank of the United States failed. The panic led to a major depression and a lot of pessimism in the USA. Banks collapsed, businesses failed, prices declined, and unemployment soared.
To Recap
So, we’ve looked at some colossal failures in the early United States’ attempts at banking — the Bank of North America in 1782, the First Bank of the United States in 1791, and the Second Bank of the United States in 1816. But eventually, the country did figure it out and moved onto the next era in finance…the free bank era, which we’ll learn about next.
So far we’ve seen how the first three attempts at creating a central bank in the USA were less than successful. One by one, the following banks collapsed: the Bank of North America, the First Bank of the United States, and the Second Bank of the United States. Through a combination of mismanagement and outright sabotage, none of the country’s earliest banks stood a chance. So what was next? Well, for the next 25 years, from 1837 to 1862, the US entered what was known as the “free banking” era.
The Free Banking Era
Also known as the Wildcat banking era, the free banking era was a period when only state-chartered banks existed. As there was no central bank, state banks attempted to take on the functions of a central bank.
State banks issued bank notes against gold and silver coins and regulated their own reserve requirements, established interest rates for loans and deposits, set the necessary capital ratio, etc.
However, this financial era didn’t prove any more successful than the previous one. Half of the banks failed, with a third of them going out of business because they could not redeem their notes. Something had to be done.
In 1863, the National Banking Act was established to help clean up the mess.
The act established a system of national banks that were held to higher standards than state banks. More importantly, in the eyes of certain bureaucrats, the government needed stronger taxation abilities (of course ;)) and a national banking system would allow that.
What did the National Banking Act do?
For one, it established a uniform national currency that had to be backed by the US Treasury (i.e., banks couldn’t just print money willy-nilly).
Furthermore, all national banks were required to accept each other’s currencies at par value. This was to prevent banks from defaulting during difficult economic times by allowing them to lend money to one another when liquidity issues arose.
Finally, to prevent counterfeiting, bank notes were printed by the comptroller of the currency, which was an independent bureau established by the Treasury to help charter, regulate, and supervise all national banks.
NATIONAL BANK IN IOWA
The National Banking Act was a step towards driving out the bad money created by state banks during the Free Banking Era. Nonetheless, some state banks still persisted.
BANK NOTE FROM 1865
As a result of this lingering of banks from a previous era, the government decided to place a 10% tax on state bank bills to discourage competition, which then forced most state banks to convert to national banks.
So…problem solved, right? Everything was great after the national banks were established?
…not quite.
National Banks weren’t it
National banks were supposed to resolve the problems created during the free banking era, but they didn’t. Since the national banks had to back up their bank notes with US Treasury securities, they started to run into liquidity issues whenever there were fluctuations in currency value. But since the US didn’t have a central bank to come to the rescue in situations like this, it led to bank runs and caused severe disruptions, including the Panic of 1907. Yes. Another panic!
Now, we’ll learn how the Panic of 1907 led to the invention of a new Central Bank for the USA, known as the Federal Reserve. Spoiler alert: yes, this system does actually turn out to work…Sort of. It’s our modern-day banking system.
A quick recap
As you’ll know from earlier in this chapter, American banking was an all-out disaster at the turn of the century. The would-be (but not really) central banks failed. The free banks failed. And the national banks failed.
Since the end of the Civil War, the United States experienced panics of varying severity. The panics of 1873, 1884, 1890, 1893, and 1896, and now again in 1907.
What happened during the panic, exactly? Well…as you might expect, panic. A lot of it.
Within three weeks, the NY Stock Exchange fell by 50% from its peak the previous year. There was widespread panic, leading to bank runs, and as a result, many businesses went bankrupt.
DOW JONES INDUSTRIAL AVERAGE 1904–1910
The panic really (and understandably) made many people question the resiliency of the US economy.
Financier J. P. Morgan (yes, you’ve definitely heard of him; his banks are still around today!) pledged a large amount of his own money to help prevent the economy from sliding into a deeper recession, and he convinced other New York bankers to do the same.
Each of these financial panics caused serious damage to the US economy. Bankers felt it was crucial to have a central bank that provided stability and emergency credit as needed. European states, for example, could expand the supply of money when banks were starting to have low cash reserves, and vice versa. The US did not have such a system.
The invention of the Federal Reserve
Five years later, under President Woodrow Wilson, Congress passed the Federal Reserve Act, which was signed into law in December 1913. With the Federal Reserve now official, the US finally had a central bank.
Originally, the Federal Reserve was created to address bank runs by being the money-creator of last resort whenever there was a downward spiral in the economy. While calming panics was the main goal, the founders of the Fed also had another goal: to expand the use of the US dollar globally and make it a more prominent currency in international trade.
The US was incredibly successful in meeting the second objective, in part due to a fluke of timing. Just as the Federal Reserve was established, World War I disrupted European financial markets and reduced the power of European banks to supply credit to international markets, which in turn provided a perfect opportunity for US banks.
By the mid 1920s, over half of US imports and exports were dollar-denominated. The relative strength of the US economy at the time paved the way for the dollar to eventually become the world’s leading reserve currency.
Conclusion
We started with a recap, so let’s end with another one:
So far, we’ve learned what money is, the functions it serves, the properties it has, and how money evolved from commodities to collectibles to metals to the greenish-gray paper you now fill your wallet with.
We’ve also learned how the concept of a central bank was first created in Europe, followed by the series of events that led to a central bank being created in the USA.
In the next chapter, we’ll take a closer look at what exactly the central bank’s role is and how it tries to keep the general public from having even more economic panic attacks. Stay tuned!
