A History of Money and Banking in the United States: The Colonial Era to World War II (21 page)

In June 1874, the fundamental structure of the national banking system was changed when Congress, as part of an inflationist move after the panic of 1873, eliminated all reserve requirements on notes, keeping them only on deposits. This released over $20 million of lawful money from bank reserves and allowed a further pyramiding of demand liabilities.123 In the long run, it severed the treatment of notes from deposits, with notes tied rigidly to bank holdings of government debt, and demand deposits pyramiding on top of reserve ratios in specie and greenbacks.

123See Hepburn,
History of Currency
, pp. 317–18.

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But this centralized inverse pyramiding of bank credit was not all. For, in a way modeled by the “free” banking system, every national bank’s expansion of notes was tied intimately to its ownership of U.S. government bonds. Every bank could only issue notes if it deposited an equivalent of U.S. securities as collateral at the U.S. Treasury,124 so that national banks could only expand their notes to the extent that they purchased U.S. government bonds. This provision tied the national banking system intimately to the federal government, and more particularly, to its expansion of public debt. The federal government had an assured, built-in market for its debt, and the more the banks purchased that debt, the more the banking system could inflate. Monetizing the public debt was not only inflationary per se, it provided the basis—when done by the larger city banks—of other banks pyramiding on top of their own monetary expansion.

The tie-in and the pyramiding process were cemented by several other provisions. Every national bank was obliged to redeem the obligations of every other national bank at par.

Thus, the severe market limitation on the circulation of inflated notes and deposits—depreciation as the distance from the bank increases—was abolished. And while the federal government could not exactly make the notes of a private bank legal tender, it conferred quasi–legal tender status on every national bank by agreeing to receive all its notes and deposits at par for dues and taxes.125 It is interesting and even heartening to discover that despite these enormous advantages conferred by the federal government, national bank notes fell below par with greenbacks in the financial crisis of 1867, and a number of national banks failed the next year.126

124Originally, national banks could only issue notes to the value 90

percent of their U.S. government bonds. This limitation was changed to 100 percent in 1900.

125Except, of course, as we have seen with the greenbacks, for payment of customs duties, which had to be paid in gold, to build up a fund to pay interest on the government debt in gold.

126See Smith,
Rationale
, p. 48.

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Before the Twentieth Century

Genuine redeemability, furthermore, was made very difficult under the national banking system. Laxity was ensured by the fact that national banks were required to redeem the notes and deposits of every other national bank at par, and yet it was made difficult for them to actually redeem those liabilities in specie; for one of the problems with the pre–Civil War state banking system was that interstate or even intrastate branches were illegal, thereby hobbling the clearing system for swiftly redeeming another bank’s notes and deposits. One might think that a national banking system would at least eliminate this problem, but on the contrary, branch banking continued to be prohibited, and interstate branch banking is illegal to this day.*

A bank would only have to redeem its notes at its own counter in its home office. Furthermore, the redemption of notes was crippled by the fact that the federal government imposed a maximum limit of $3 million a month by which national bank notes could be contracted.127

Reserve requirements are now considered a sound and precise way to limit bank credit expansion, but the precision can work two ways. Just as government safety codes can
decrease
safety by setting a lower limit for safety measures and inducing private firms to reduce safety
downward
to that common level, so reserve requirements can and ordinarily do serve as lowest common denominators for bank reserve ratios. Free competition can and generally will result in banks voluntarily keeping higher reserve ratios. But a uniform legal requirement will tend to push all the banks down to that minimum ratio. And indeed we can see this now in the universal propensity of all banks to be

“fully loaned up,” that is, to expand as much as is legally possible up to the limits imposed by the legal reserve ratio. Reserve 127Ibid., p. 132.

*[
Congress eliminated federal restrictions on interstate banking and branch-ing in September 1994, with the passage of the Riegle-Neal Interstate Banking
and Branching Efficiency Act.—
Ed.]

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The Colonial Era to World War II

requirements of less than 100 percent are more an inflationary than a restrictive monetary device.

The national banking system was intended to replace the state banks, but many state banks continued aloof and refused to join, despite the special privileges accorded to the national banks. The reserve and capital requirements were more onerous, and at that period, national banks were prohibited from making loans on real estate. With the state banks refusing to come to heel voluntarily, Congress, in March 1865, completed the Civil War revolution of the banking system by placing a prohibitive 10-percent tax on all bank notes—which had the desired effect of virtually outlawing all note issues by the state banks. From 1865 on, the national banks had a legal monopoly on the issue of bank notes.

At first, the state banks contracted and disappeared under the shock, and it looked as if the United States would only have national banks. The number of state banks fell from 1,466 in 1863 to 297 in 1866, and total notes and deposits in state banks fell from $733 million in 1863 to only $101 million in 1866. After several years, however, the state banks readily took their place as an expanding element in the banking system, albeit subordinated to the national banks. In order to survive, the state banks had to keep deposit accounts at national banks, from whom they could “buy” national bank notes in order to redeem their deposits. In short, the state banks now became the fourth layer of the national pyramid of money and credit, on top of the country and other banks, for the reserves of the state banks became, in addition to vault cash, demand deposits at national banks, which they could redeem in cash. The multi-layered structure of bank inflation under the national banking system was intensified.

In this new structure, the state banks began to flourish. By 1873, the total number of state banks had increased to 1,330, and their total deposits were $789 million.128

128
Historical Statistics
, pp. 628–29.

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Before the Twentieth Century

The Cooke-Chase connection with the new national banking system was simple. As secretary of the Treasury, Chase wanted an assured market for the government bonds that were being issued so heavily during the Civil War. And as the monopoly underwriter of U.S. government bonds for every year except one from 1862 to 1873, Jay Cooke was even more directly interested in an assured and expanding market for his bonds. What better method of obtaining such a market than creating an entirely new banking system, the expansion of which was directly tied to the banks’ purchases of government bonds—

from Jay Cooke?

The Cooke brothers played a major role in driving the National Banking Act of 1863 through a reluctant Congress. The Democrats, devoted to hard money, opposed the legislation almost to a man. Only a majority of Republicans could be induced to agree on the bill. After John Sherman’s decisive speech in the Senate for the measure, Henry Cooke—now head of the Washington office of the House of Cooke—wrote jubi-lantly to his brother:

It will be a great triumph, Jay, and one to which we have contributed more than any other living man. The bank had been repudiated by the House, and was without a sponsor in the Senate, and was thus virtually dead and buried when I induced Sherman to take hold of it, and we went to work with the newspapers.129

Going to work with the newspapers meant something more than mere persuasion for the Cooke brothers; as monopoly underwriter of government bonds, Cooke was paying the newspapers large sums for advertising, and so the Cookes thought—as it turned out correctly—that they could induce the newspapers to grant them an enormous amount of free space

“in which to set forth the merits of the new national banking 129Quoted in Robert P. Sharkey,
Money, Class, and Party: An Economic
Study of Civil War and Reconstruction
(Baltimore, Md.: The Johns Hopkins Press, 1959), p. 245.

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The Colonial Era to World War II

system.” Such space meant not only publicity and articles, but even more important, the fervent editorial support of most of the nation’s press. And so the press, implicitly bought for the occasion, kept up a drumfire of propaganda for the new national banking system. As Cooke himself related: For six weeks or more nearly all the newspapers in the country were filled with our editorials [written by the Cooke brothers] condemning the state bank system and explaining the great benefits to be derived from the national banking system now proposed.

And every day the indefatigable Cookes put on the desks of every member of Congress the relevant editorials from newspapers in their respective districts.130

While many state bankers, especially the conservative old-line New York bankers, opposed the national banking system, Jay Cooke, once the system was in place, plunged in with a will.

Not only did he sell the national banks their required bonds, he also set up new national banks which would have to buy his government securities. His agents formed national banks in the smaller towns of the south and west. Furthermore, he set up two large national banks, the First National Bank of Philadelphia and the First National Bank of Washington, D.C.

But the national banking system was in great need of a mighty bank in New York City to serve as the base of the inflationary pyramid for a host of country and reserve city banks.

Shortly after the inception of the system, three national banks had been organized in New York, but none of them were large enough or prestigious enough to serve as the key fulcrum of the new banking structure. Jay Cooke, however, was happy to oblige, and he quickly established the Fourth National Bank of New York, capitalized at a huge $5 million. After the war, Jay Cooke favored resumption of specie payments, but only if greenbacks could be replaced one-to-one by new national bank notes. In his unbounded enthusiasm for national bank 130See Hammond,
Sovereignty
, pp. 289–90.

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Before the Twentieth Century

notes and their dependence on the federal debt, Cooke urged repeal of the $300 million legal limit on national bank note issue. In 1865, he published a pamphlet proclaiming that in less than 20 years national bank note circulation would total $1 billion.131

The title of the pamphlet Cooke published is revealing:
How
Our National Debt May Be A National Blessing
.
The Debt is Public
Wealth, Political Union, Protection of Industry, Secure Basis for
National Currency
.132

By 1866, it was clear that the national banking system had replaced the state as the center of the monetary system of the United States. Only a year earlier, in 1865, state bank notes had totaled $142.9 million; by 1866 they had collapsed to $20 million. On the one hand, national bank notes grew from a mere $31.2 million in 1864, their first year of existence, to $276 million in 1866. And while, as we have seen, the number of state banks in existence was falling drastically from 1,466 to 297, the number of national banks grew in that same period, from 66 in 1863

to 1,634 three years later.

THE POST–CIVIL WAR ERA: 1865–1879

The United States ended the war with a depreciated inconvertible greenback currency, and a heavy burden of public debt.

The first question on the monetary agenda was what to do about the greenbacks. A powerful group of industrialists calling for continuation of greenbacks, opposing resumption and, of course, any contraction of money to prepare for specie resumption, was headed by the Pennsylvania iron and steel manufacturers. The Pennsylvania ironmasters, who had been in the forefront of the organized protective tariff movement since its beginnings in 131Actually, Cooke erred, and national bank notes never reached that total. Instead, it was demand deposits that expanded, and reached the billion-dollar mark by 1879.

132See Sharkey,
Money, Class, and Party
, p. 247.

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A History of Money and Banking in the United States:
The Colonial Era to World War II

1820,133 were led here and instructed by their intellectual mentor—himself a Pennsylvania ironmaster—the elderly economist Henry C. Carey. Carey and his fellow iron manufacturers realized that during an inflation, since the foreign exchange market anticipates further inflation, domestic currency tends to depreciate faster than domestic prices are rising. A falling dollar and a rising price of gold, they realized, make domestic prices cheaper and imported prices higher, and hence function as a surrogate tariff. A cheap-money, inflationist policy, then, could not only provide easy credit for manufacturing, it could also function as an extra tariff because of the depreciation of the dollar and the rise in the gold premium.

Imbibers of the Carey gospel of high tariffs and soft money were a host of attendees at the famous “Carey Vespers”—