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BANKING
BUNKUM
Part 3a: The US
experience
By Henry C K Liu
Part
1: Monetary theology
Part
2: The European experience
In the United
States, central banking was not born until 1913 with the
establishment of the Federal Reserve System. The first
national bank in the US was the Bank of the United
States (BUS), founded in 1791 and operated for 20 years,
until 1811. A second Bank of the United States (BUS2)
was founded in 1816 and operated also for 20 years until
1836. The first national bank, modeled after British
experience, was established by Federalists as part of a
nation-building system proposed by Alexander Hamilton,
the first secretary of the Treasury, who realized that
the new nation could not grow and prosper without a
sound financial system anchored by a national bank.
The national bank charter was approved by
Congress and signed into law by president George
Washington in 1791 when the federal government of the
new nation was only three years old. The new national
bank, known as the Bank of the United States, was to
assist the newly formed federal government by holding
its funds and, when necessary, by making loans to it. By
issuing notes that would circulate as legal tender, the
national bank would help to maintain an adequate supply
of stable money and by extending government credit to
support an industrial policy to promote economic
expansion.
To understand the thinking behind
Hamilton's proposal for a national bank, it is necessary
to remember that the Treasury was restricted by law to
limit its issuance of money to the coinage of gold and
silver, and not to print paper money. According to
orthodox monetary theory under the influence of the
Quantity Theory of Money (QTM), specie (gold- or
silver-backed) money was the only reliable currency,
though it could be supplemented by banknotes fully and
freely redeemable for gold or silver. Congress granted a
20-year charter for the BUS despite arguments by Thomas
Jefferson that the constitution did not give Congress
power to establish a national bank and the charge that
the national bank was designed to favor mercantile
interests over agrarian interests, and the rich over the
common man, in the name of national interest.
The federal government subscribed one-fifth of
the capital of $10 million of the BUS, with a loan of $2
million immediately advanced from the BUS to the
government, with the remaining $8 million subscribed by
private investors. The BUS acted as exclusive fiscal
agent for the government and also conducted commercial
banking business. Despite being well managed and
financially profitable, the BUS antagonized
state-chartered banks and Western frontier and Southern
agrarian interests, which formed a coalition that
successfully blocked its rechartering in 1811.
Jefferson's opposition to the establishment of a
national bank was key to his overall opposition to the
entire Hamiltonian program of strong central government
and elite financial leadership. Jefferson felt that a
national bank would give excessive power over the
national economy and unfair opportunities for large
certain profits to a small group of elite private
investors mostly from the New England states. The
constitutionality of the bank invoked the dispute
between Jefferson's "strict construction" of the words
of the constitution and Hamilton's doctrine of "implied
power" of the federal government.
Throughout the
history of the United States, up to the present time,
this dispute, along with the controversy between specie
money and fiat money, remains philosophically
unresolved, although in practice both the
constitutionality of "implied power" doctrine and the
legality of fiat currency have been repeatedly upheld by
the Supreme Court. Jefferson considered the whole
Hamiltonian banking scheme an unconstitutional threat to
the basic fabric of American civilization. Jefferson
prophesied: "If the American people allow the banks to
control the issuance of their currency, first by
inflation, and then by deflation, the banks and
corporations that will grow up around them will deprive
people of all property until their children will wake up
homeless on the continent their fathers occupied ... The
issuing power of money should be taken from the banks
and restored to Congress and the people to whom it
belongs." It was a definitive statement against the
political "independence" of central banks. This warning
applies to the people of the world as well.
The
most significant achievement of the Jefferson presidency
was the Louisiana Purchase. In 1800, the Treaty of San
Ildefonso secretly transferred Louisiana from Spain to
France, which presented the United States with the
alarming prospect of a vigorous and expansionist
European power controlling the mouth of the Mississippi
river to block the westward expansion of the US. James
Monroe was sent to Paris to negotiate the purchase of
Louisiana from a willing Napoleon Bonaparte, who earlier
had sent an expeditionary army to Haiti to put down a
black slave rebellion with subsequent plans to occupy
New Orleans to exercise French control over Louisiana.
The decimation of the French expeditionary army by
yellow fever, the need for more troops for renewed
Napoleonic wars in Europe, and the difficulty of running
the British naval blockade convinced Napoleon that
strengthening the United States as a potential ally
under a pro-French Jefferson and as a potential rival of
Britain might serve French interests.
France
agreed to sell Louisiana in 1803 for $15 million,
including in the package an immense territory extending
northward as far as Canada and westward to the Rocky
Mountains, covering more than a million square miles.
The purchase was financed through the then four-year-old
BUS. But according to a strict construction of the
constitution, the federal government did not have
authority to acquire new territory or, as provided under
the treaty with Napoleon, to grant full citizenship to
its inhabitants, not to mention the chartering of a
national bank. Jefferson swallowed his scruples about
the constitution, became in effect an "implied powers"
advocate and lobbied energetically for Senate
ratification of the Louisiana Purchase.
Hamilton's idea of national credit was not
merely to favor the rich, albeit that it did so in
practice, but to protect the infant industries in a
young nation by opposing Adam Smith's laissez-faire
doctrine promoted by advocates of 19th-century British
globalization for the advancement of British national
interests. This is why Hamilton's program is an apt
model for all young economies finally emerging from the
yoke of Western imperialism two centuries later, and in
particular for opposing US neo-liberal globalization of
past decades.
The creation of a national bank
was one of the three measures of the Hamiltonian program
to strengthen the new nation through a strong federal
government, the other two being 1) an excise duty on
whiskey to extend federal authority to the back country
of the vast nation and to compel rural settlers to
engage in productive enterprise by making subsistence
farming uneconomic; and 2) federal aid to manufacturing
through protective tariff and direct subsidies. To
Hamilton, a central government without sovereign
financial power, which had to rely on private banks to
finance national programs approved by a democratically
elected congress, would be truly undemocratic and to
rely on foreign banks to finance national programs would
be unpatriotic, if not treasonous.
Hamilton's
national program was opposed effectively by the two
special-interest groups with controlling influence in
Congress: the Northern trading merchants and shippers
who had secured a Navigation Act to protect US shipping
in 1789 and Southern planters who depended on export of
unprocessed agricultural commodities, neither of which
had any interest in curbing foreign trade even when such
trade was harmful to the development of the national
economy. Domestic manufacturing interest did not become
strong enough to obtain much government protection until
after the War of 1812. The dynamics of this politics is
visible in the 21st century in many developing nations
where the financial elite prefers compradore opportunism
to economic nationalism.
Congressional
opposition to the first BUS resulted in its charter
expiring in 1811 without renewal. However, the financial
pressure after the War of 1812 created demands for
another national bank. By 1807, France under Napoleon
controlled most of Europe while Britain commanded the
sea by destroying the French fleet at Trafalgar in 1805.
This land-sea stalemate pushed the two rival superpowers
to economic warfare through British blockades against
French overseas trade, answered by Napoleon's
Continental System applying sanction against all trade
with Britain, making the neutral United States a
collateral-damage victim of interrupted trade. In the
US, agrarian westward expansionism, facing effective
native American resistance under a tribal confederacy
coordinated by Chief Tecumseh, agitated for US conquest
of British Canada, justified as retaliation against the
British blockade of US shipping, despite the fact that
most US shippers did not want to antagonize a powerful
Britain in full control of the sea.
The Western
Expansionist Movement found political expression in the
election of 1810 and sent to Congress a group of young
representatives who became known as the War Hawks, led
by Henry Clay as House Speaker. Despite belligerent
speeches by the War Hawks, the US was unprepared for
war, the most significant shortage being government
finance. With tax revenue covering less than two-thirds
of government expenditure, and without a national bank,
the government was compelled to borrow from banks owned
by Eastern mercantile interests who opposed the war for
fear of more British measures against US shipping,
leaving the US war effort ill-financed.
By 1814,
having defeated Napoleon in Europe at the battle of
Leipzig in October 1813 with a coalition of Eastern
European agrarian feudalism, Spanish clericalism and
German nationalism financed by British capitalism to the
tune of Stg23 million, supported by the matchless
British navy and the combined armies of Russia, Prussia
and Austria, the British was able to send an
expeditionary army to foil US hopes of conquering
Canada. The British also landed an invasion army on
Chesapeake Bay in the summer of 1814 and marched into
Washington, burning the White House, nearly capturing
president James Madison himself, but were finally
repulsed at Baltimore, a battle that inspired Francis
Scott Key to write The Star Spangled Banner,
which later was adopted as the national anthem.
On January 8, 1815, another British
expeditionary army of veterans from the Napoleonic Wars
was defeated near New Orleans by Andrew Jackson with a
kill ratio of 2,000:13 against the British, in a
decisive demonstration of the effectiveness of modern
riflemen against 18th-century European troop formations.
It was reminiscent of the triumph of British longbow
archers over French aristocratic calvary in the Battle
of Agincourt in 1415, which decimated the French armored
knights, the flower of French nobility, and ended its
role henceforth as an effective fighting force.
The Treaty of Ghent declared the end of the War
of 1812, in which neither side achieved military victory
or gained any political advantage. While the treaty was
being signed, a group of delegates from New England met
at Hartford, Connecticut, to discuss secession from the
union. By deviating from Hamilton's cause of national
unity, the neo-Federalists spelled their own political
end but not the policy demise of Federalism, which
remained US policy until the Jackson administration. Had
the BUS been in operation, the US war effort might have
been better financed and Canada might have become a part
of the United States.
The second Bank of the
United States went into operation with a capital of $35
million in 1816, with the federal government owning only
5 percent of the stock. For a decade after the War of
1812, there existed no clear-cut party division in US
politics, thus the term "era of good feeling" was
applied. The Republican Party abandoned its original
Jeffersonian opposition to Federalism and adopted
Federalist policies, starting with the establishment of
the second BUS, adopting tariffs to protect struggling
US industries and federal appropriation for
infrastructure development. Henry Clay proposed the
"American System", based on Hamiltonian ideals, but
unlike Hamilton, Clay cultivated popular support, not
only appealing to the upper class, and sought support
from the agricultural South, not just the mercantile New
England states. It was a national program of federal aid
to domestic development and tariff protection for
struggling US industry.
The disappearance of the
first BUS had left the nation's currency system in a
chaotic state. Since 1791, a large number of state banks
had been chartered, reaching 208 by 1815, and except in
New England, these banks were allowed to issue notes
very much in excess of their capital ratio and to make
loans without sufficient reserves.
BUS2
fulfilled its basic function during a period of relative
prosperity and operated with popular support. The
charter empowered BUS2 to act exclusively as the federal
governments fiscal agent, hold its deposits, make
inter-state transfers of federal funds and deal with
Federal payments or receipts. Like state chartered
banks, BUS2 also had the right to issue banknotes on the
basis of a fractional reserve system and to carry out
conventional commercial banking activities, in return
for which certain conduct of a central-bank-like nature
was expected of this institution: in the words of the
charter, "the bank will conciliate and lead the state
banks in all that is necessary for the restoration of
credit, public and private, and to steer the banking
system toward serving the national interest", at a time
when profit might be higher in serving foreign
interests. Despite being 80 percent privately owned,
BUS2 operations were subject to supervision by Congress
and the president. BUS2 was dominant relative to all
other banks, being responsible for some 20 percent of
all bank lending in the national economy and accounting
for 40 percent of the banknotes then in circulation. It
was conservative in its note-issuing function, holding a
specie reserve of 50 percent of the value of its notes
while the norm for the remainder of the banking system
was between 10-25 percent.
In 1821, the Monroe
administration forced a declining Spain to sell Florida
to the United States for $5 million, most of which was
paid to US citizens with claims against the Spanish
government, for failure to close the Florida border to
runaway slaves and marauding Seminole native Americans.
In return, the US renounced its claim to Texas. The
purchase was financed by BUS2. On December 2, 1823, the
US declared the Monroe Doctrine against European
intervention and colonization in the Americas, from
Argentina to Alaska.
The hopes of Clay's
national program in diminishing sectional conflict and
class differences were not realized. The chief
beneficiaries of the banking and tariff legislation were
the trading businesses in the northeastern states at the
neglect of Southern planters and Western farmers. BUS2
quickly came under the control of eastern seaboard
interests, which were accused of seeking to dominate and
exploit the West in sectional conflicts. During the
decade of 1810-19, five new states - Louisiana,
Mississippi and Alabama in the Southwest; Indiana and
Illinois in the Midwest or old Northwest - came into
being. The Land Law of 1800 stimulated public land sale
with generous terms of payment spread over four years,
rising from 1 million acres in 1815 to 5 million acres
in 1819. A speculative bubble on land was financed by
state banks and government seller credit, which burst in
1819. The collapse was attributed throughout the West as
being caused by the policies of BUS2, which had made a
practice of buying up the notes of state banks and
suddenly presenting them for payment, forcing the state
banks to call in loans to Western farmers, driving them
into bankruptcy, with much Western land falling into the
hand of BUS2 private shareholders through foreclosures.
The 1820s and 1830s in the United States were a
time of extremely rapid but also volatile economic
growth. New natural resources were being exploited as
the frontier expanded and the new techniques of the
industrial revolution were being introduced. The old
money supply of gold and silver specie was stretched and
found inadequate for the liquidity needs of the growing
economy. In 1830, the total value of the gold and silver
specie in circulation in the economy amounted to
one-fiftieth of the gross national product. The
emergence of a number of banks operating fractional
reserve note-issuing systems was the automatic result.
The private banknotes were underwritten by varying
proportions of specie and although not legal tender,
they were widely accepted in payment for debts, albeit
usually discounted below their par value. The quality of
banknotes varied. Fraud was commonplace by unscrupulous
bankers who managed to persuade or bribe local state
legislatures to grant them liberal charters to commence
a banking business. In 1828, the 17 banks chartered in
Mississippi circulated notes with a face value of $6
million from a specie base of $303,000. The classic
conflict between easy money and good money ensued, with
the economic benefits of easy money regularly destroyed
by bad money.
It was in such an environment that
BUS2 operated. Among its functions was to discipline and
support the state-chartered banks without shutting off
easy money. As the federal government's fiscal agent, it
received banknotes in payment for taxes. The Bank would
then present these banknotes to the issuing
state-chartered banks in order to redeem them for the
gold necessary to pay the taxes it had collected to the
federal Treasury's account. In this way, state-chartered
banks were forced to keep a higher stock of specie on
reserve than would otherwise be necessary. Conversely,
BUS2 could also act as a lender of last resort to
state-chartered banks in trouble by not presenting these
notes for redemption but rather allowing these banks to
run into debt to BUS2. The state-chartered banks were
institutions of economic democracy, offering credit to
the masses, not just to big business. Some were named
people's banks or other names of democratic or socialist
connotation. They generally financed local small
business, farms and homes.
The political
environment of that period was marked by the populist
ideology of Jacksonian democracy. Focused around Andrew
Jackson, who was elected president in 1828, this
ideology was an coalition of convenience among
agrarianism, nationalism, populism and libertarianism.
The one unifying element of this group was a deep
hostility to a privileged East Coast-based moneyed
aristocracy. The Philadelphia-based BUS2 with its
patrician president, Nicholas Biddle, became an easy
target in this new climate. Libertarians, while sounding
sensible on a small scale, always fail to understand
that individual liberty has no place in organizing
large-scale national enterprises. Complex organizations,
whether in business or government, require wholesale
compromise of individual liberty.
The ideology
that underlay the struggle against a national bank was
highly variegated, with contradicting internal
inconsistencies. It was a peculiar blend of moral
judgment, economic logic and populist sentiment fused by
pragmatic calculations to attack the political
legitimacy of a national bank, its legality and its
economic rationale.
The role played by vested
interests in motivating the anti-BUS forces can also be
traced to the substantial personal gains that would
accrue to key members of the Jackson administration
should BUS2 be discontinued. The New York financial
community at the time was competing with Philadelphia to
be the country's premier commercial center. Martin Van
Buren, Jackson's second-term vice president and eventual
successor, was particularly identified with Wall Street
in this Wall Street (New York internationalist) versus
Chestnut Street (Philadelphia nationalist) battle.
The state-chartered banks disliked being
constrained by BUS2's practice of redeeming their
banknotes with little or no notice, and with blatant
arbitrariness in the selection of a target, often based
on thinly disguised sectional bias. This forced a much
higher bank reserve ratio and hence restricted their
lending activities in geographic sections deem contrary
to national priorities. A new class of nouveau
riche, self-made entrepreneurs and speculators,
emerged, a class to which Jackson and many of his
associates belonged. They disliked the restriction of
credit generally, and credit allotment controlled by
established Northeastern financiers particularly, as
they relied on liberal credit from the friendly
state-chartered local banks for needed funds, the way
leverage-buyout financiers and corporate raiders and New
Economy entrepreneurs relied on junk-bond investment
bankers in the 1980s and '90s.
The New York
financial community was divided over the question of the
wisdom of the attack on BUS2. Some of the
state-chartered banks grudgingly acknowledged BUS2's
positive role in disciplining the banking system and its
activities as a lender of last resort. Political
ideology and economic logic also played a role behind
the opposition of a national bank. The opposition had
much popular support in national politics which enabled
Jackson to dismantle BUS2. Like Ronald Reagan, Jackson
was elected to Washington to rein in Washington.
The strongest opposition came from states-rights
advocates who vehemently opposed the substantial power
wielded by a federally chartered national bank. Many
considered the chartering of the bank an
unconstitutional extension of the power of Congress,
particularly when, in their judgment, the first national
bank had failed to serve the national interest without
sectional bias and had pandered to sectional interests
around the northeastern seaboard. This position was
summarized by Jackson, who described BUS2 bank as an
unconstitutional threat to democratic institutions by
the federal authorities. With the dismantlement of BUS2,
the power of intervention in the banking and monetary
systems was left in the hands of individual states until
the Civil War. State-chartered banking systems served
the separate interests of each state, which often were
at odds with the national interest.
A key strand
in the anti-national-bank thread was the libertarians.
They challenged the legitimacy, more on moral than
constitutional grounds, of any government intervention
in the economy or in society beyond minimum necessity.
Libertarians, while sounding sensible on a small scale,
fail to understand that individual liberty to organize
large-scale national enterprises is a mere fantasy.
"Small is beautiful" remains merely a romantic slogan of
hippiedom.
The 1800s were an age of primitive
laissez-faire philosophy in the United States when
domestic markets were not yet sophisticated enough to
require government intervention against trade restraint
in the sense that Adam Smith used the term
"laissez-faire" to denote activist government action to
keep markets free. This libertarian philosophy was
related to and associated with the Free Banking school,
which challenged on ideological grounds the necessity of
government intervention in the monetary system.
Free Bankers were in favor of a paper currency
based on a fractional reserve system. But they argued
that BUS2's regulatory function was unnecessary and
ineffective because in a completely unregulated
financial system, free competition would automatically
protect the public against fraud through market
discipline, on the principle that fraud was basically
bad for business. They argued that what was wrong with
the banking system was that free competition was
obstructed by the monopolistic privileges granted to
BUS2 in its charter and this created an unhealthy
reliance on regulatory protection rather than market
self-discipline, in a form of consumer moral hazard that
believed naively that if a business was regulated,
consumer interest would automatically be protected. In
the context of the dominant economic paradigm of the
1830s, the importance of the central government's role
in regulating the money supply was not as self-evident
as is today. And for the Western frontiersman, his love
of individual liberty exposed him to easy victimization
by organized finance from the East.
Economist
Joseph A Schumpeter (1883-1950) observed that in the
first part of the 19th century, mainstream economists
believed in the merit of a privately provided and
competitively supplied currency. Adam Smith differed
from David Hume in advocating state non-intervention in
the supply of money. Smith argued that a convertible
paper money could not be issued to excess by privately
owned banks in a competitive banking environment, under
which the Quantity Theory of Money is a mere fantasy and
the Real Bills doctrine was reality. Smith never
acknowledged or understood the business cycle of boom
and bust.
The anti-monopolistic and
anti-regulatory Free Banking School found support in
agrarian and proletarian mistrust of big banks and paper
money. This mistrust was reinforced by evidence of
widespread fraud in the banking system, which appeared
proportional to the size of the institution. Paper money
was increasingly viewed as a tool used by unconscionable
employers and greedy financiers to trick working men and
farmers out of what was due to them. A similar attitude
of distrust is currently on the rise as a result of
massive and pervasive corporate and financial fraud in
the so-called New Economy fueled by structured finance
in the under-regulated financial markets of the 1990s,
though not focused on paper money as such, but on
derivatives, which is paperless virtue money.
Andrew Jackson in his farewell speech addressed
the paper-money system and its natural association with
monopoly and special privilege, the way Dwight D
Eisenhower warned a paranoid nation against the threat
of a military-industrial complex. The value of paper,
Jackson stated, is liable to great and sudden
fluctuations and cannot be relied upon to keep the
medium of exchange uniform in amount.
In
contrast to the Free Banking School, the anti-paper
specie-currency zealots aimed at abolishing the system
of fractional reserve paper money by removing the lender
of last resort. They were further split into gold bugs,
silver bugs and bimetalists.
Both advocates of
the Free Banking School and proponents of specie
currency saw the dismantling of the bank as very
fundamental, but to divergent and conflicting ends.
Against this coalition, supporters of a national bank,
such as BUS2 president Nicholas Biddle and politicians
such as Henry Clay and John Quincy Adams, faced a
political dilemma. Both anti-federalist and primitive
laissez-faire sentiments were in ascendancy at the time.
The BUS2 was being attacked from both the extreme left
(Free Banking advocates) and from the extreme right
(anti-paper advocates).
The monetary expansion
that preceded and led to the recession of 1834-37 did
not come from a falling bank reserve ratio but rather
from the bubble effect of an inflow of silver into the
United States in the early 1830s, the result of
increased silver production in Mexico, and also from an
increase in British investment in America. Thus a case
could be made that central banking's role in causing or
preventing recessions through management of the money
supply is overstated and oversimplified.
Libertarians hold the view that the state had no
right to regulate any commercial transactions between
consenting individuals including paper currency. Thus
all legal tenders, specie or not, are government
intrusions. Yet a medium of exchange based on bank
liabilities and a fractional reserve system and/or
government taxable capacity is essential to an
industrializing economy. Instead of destroying the
fractional reserve system, the hard-money advocates had
merely removed a force that acted to restrain it.
After 1837, the reserve ratio of the banking
system was much higher than it had been during the
period of BUS2's existence. This reflected public
mistrust of banks in the wake of the panic of 1837 when
many banks failed. This lack of confidence in the
paper-money system could have been ameliorated by
central-bank liquidity, which would have required a
lower reserve ratio, more availability of credit and an
increase of money supply during the 1840s and 1850s. The
evolution of the US banking system would have been less
localized and fragmented in a way inconsistent with
large industrialized economics, and the US economy would
have been less dependent on foreign investment. This did
not happen because central banking was genetically
disposed to favor the center against the periphery,
which conflicted with democratic politics. This problem
continues today with central banking in a globalized
international finance architecture. It remains a truism
that it is preferable to be self-employed poor than to
be working poor. Thus economic centralism will be
tolerated politically only if it can deliver wealth away
from the center to the periphery. Central banking
carries with it an institutional bias against economic
nationalism.
The Jackson administration's
assault on BUS2 began in 1830 and became a campaign
issue for a second term. In 1832, Jackson used his
presidential veto to thwart a renewed federal charter
for BUS2. Jackson then used his second-term presidential
election victory later that year as a mandate to order
the withdrawal of all federal funds from BUS2 in 1833.
When the BUS2 charter expired in 1836, the
Philadelphia-based institution succeeded in being
rechartered only as a much reduced state-chartered bank
under the auspices of the Pennsylvania state legislature
as the United States Bank of Pennsylvania. In 1841,
without a lender of last resort, it went bankrupt in a
liquidity squeeze speculating in the cotton market.
The dismantling of the second national bank
preserved the authority of the states over banking.
Large-scale federal intervention in the supply of money
did not take place again until the Civil War. However,
Jackson's victory turned US political culture against
centralized institutions in the banking system. The
United States did not develop a central banking agency
until 1913. Even then, the Federal Reserve System was
highly decentralized, consisting of 12 autonomous
component banks, one in each of the regional large
cities. Some historians attributed the incoherent
response of the monetary authorities to the 1929 crash
and the resultant run on the banking system. The 1930s
Great Depression was due partly to this decentralization
of monetary authority.
Martin Van Buren
succeeded Jackson as president in the 1836 election. The
Jackson administration was able to appoint eight new
Supreme Court justices, including new chief justice
Roger Taney from Maryland, who succeeded John Marshall.
The fundamental issues in US politics have often been
manifested more clearly by changes in judiciary
attitude. Whereas Marshall extended the power of the
federal government through his upholding of the implied
power doctrine, Taney believed in protecting the rights
of the states, upheld their right to regulate commerce
within their territories and to set economic policy
autonomously. While Marshall regarded sanctity of
contracts and private property right with religious
reference, Taney was prepared to allow state regulation
of private property rights for the promotion of the
general welfare.
Before his nomination as chief
justice, Taney was Jackson's Treasury secretary, and it
was he who carried out Jackson's order to withdraw
federal deposits from BUS2 beginning in September 1833
to a number of state-chartered banks that, free of BUS2
supervision, pushed the economy quickly into a debt
bubble, much of it centering on speculation on the sale
of public land. The boom produced a sudden increase of
government revenue and, in 1835, for the first and last
time in history, the US paid off its national debt
completely, with a mounting surplus in the Treasury. In
1836, Congress passed a bill to distribute the surplus
to the states. Far from being an economic blessing, this
development turned out to be an economic disaster.
The fall in money supply led to a crash in early
1837, precipitated by the Treasury secretary's issuance
of the Specie Circular, requiring payment for public
land sale be made only in gold or silver, not banknotes.
The resultant depression lasted throughout Van Buren's
administration, but his commitment to strict
constitutional construction prevented him from taking
any federal action toward recovery. Van Buren's main
focus was putting government's finances on a sound
footing. The widespread failure of state-chartered banks
showed the danger of trusting private banks with
government money, and Van Buren decided henceforth to
divorce government finance from private banking. The
government should keep its money in an Independent
Treasury, with "vaults" constructed in major cities
where government official would receive and pay out
funds on a strict specie basis.
The federal
government had no further connection with the banking
industry until the National Bank Act of 1863. Although
the Independent Treasury did restrict reckless
speculative expansion of credit, it also tended to
create a new set of economic problems. In periods of
prosperity, revenue surpluses accumulated in the
Treasury, reducing hard-money circulation, tightening
credit, and restraining even legitimate expansion of
trade and production. In periods of depression and
panic, on the other hand, when banks suspended specie
payments and hard money was hoarded, the government's
insistence on being paid in specie tended to aggravate
economic difficulties by limiting the amount of specie
available for private credit.
The 1863 US
National Bank Act amended and expanded the provisions of
the Currency Act of the previous year. Any group of five
or more persons with no criminal record was allowed to
set up a bank, subject to certain minimum capital
requirements. As these banks were authorized by the
federal government, not the states, they are known as
national banks, not to be confused with a national bank
in the Hamiltonian sense. To secure the privilege of
note issue they had to buy government bonds and deposit
them with the comptroller of the currency.
When
the Civil War began in 1861, newly installed president
Abraham Lincoln, finding the Independent Treasury empty
and payments in gold having to be suspended, appealed to
the state-chartered private banks for loans to pay for
supplies needed to mobilize and equip the Union Army. At
that time, there were 1,600 banks chartered by 29
different states, and altogether they were issuing 7,000
different kinds of banknotes.
Lincoln
immediately induced the Congress to authorize the
issuing of government notes (called greenbacks)
promising to pay "on demand" the amount shown on the
face of the note. These notes were not issued as
"dollars" but as promissory notes authorized under the
borrowing power of the constitution. The total cost of
the war came to $3 billion. The government raised the
tariff, imposed a variety of excise duties, and imposed
the first income tax in US history, but only managed to
collect a total of $660 million during the four years of
Civil War. Between February 1862 and March 1863, $450
million of paper money was issued. The rest of the cost
was handled through war bonds, which were successfully
issued through Jay Cooke, an investment banker in
Philadelphia, at great private profit. The greenbacks
were supposed to be gradually turned in for payment of
taxes, to allow the government to pay off these
greenback notes in an orderly way without interest.
Still, during the gloomiest period of the war when Union
victory was in serious doubt, the greenback dollar had a
market price of only 39 cents in gold. Undoubtedly these
greenback notes helped Lincoln save the Union. Lincoln
wrote: "We finally accomplished it and gave to the
people of this Republic the greatest blessing they ever
had - their own paper to pay their own debts." The
importance of the lesson was never taught to Third World
governments by neo-liberal monetarists.
In 1863,
Congress passed the National Bank Act. While its
immediate purpose was to stimulate the sale of war
bonds, it served also to create a stable paper currency.
Banks capitalized above a certain minimum could qualify
for federal charter if they contributed at least
one-third of their capital to the purchase of war bonds.
In return, the federal government would give these banks
national banknotes to the value of 90 percent of the
face value of their bond holdings. This measure was
profitable to the banks, since with the same initial
capital, they could buy war bonds and collect interest
from the government, and at the same time put the
national banknotes in circulation and collect interest
from borrowers. As long as government credit was sound,
national banknotes could not depreciate in value, since
the quantity of banknotes in circulation was limited by
war-bond purchases. And since war bonds served as
backing for the notes, the effect was to establish a
stable currency.
The system did not work
perfectly. The currency it provided was not sufficiently
elastic for the needs of an expanding economy. As the
government redeemed war bonds, the quantity of notes in
circulation decreased, causing deflation and severe
hardship for debtors. Money seemed to be concentrated in
the Northeast, and Western and Southern farmers
continued to suffer chronic scarcity of cash and credit,
not unlike current conditions faced by Third World
debtor economies.
After the Civil War, the
Independent Treasury continued in modified form, as each
administration tried to cope with its weaknesses in
various ways. Treasury secretary Leslie M Shaw (1902-07)
made many innovations; he attempted to use Treasury
funds to expand and contract the money supply according
to the nation's credit needs. The panic of 1907,
however, finally revealed the inability of the system to
stabilize the money market; agitation for a more
effective banking system led to the passage of the
Federal Reserve Act in 1913. Government funds were
gradually transferred from sub-treasury "vaults" to
district Federal Reserve Banks, and an act of Congress
in 1920 mandated the closing of the last sub-treasuries
in the following year, thus bringing the Independent
Treasury System to an end.
John P Altgeld, a
German immigrant populist who became the Democratic
governor of Illinois in 1890, attacked big corporations
and promoted the interest of farmers and workers, gave
the state an able, courageous and progressive
administration. The question of currency was central to
the US populist movement. Farmers knew from first-hand
experience that the fall in farm prices was caused by
the policy of deflation adopted by the federal
government after the Civil War and only ineffectively
checked by the Bland-Allison Act of 1878, coining silver
at a fixed ratio of 16:1 with gold, and the Sherman
Silver Purchase Act of 1890. The Treasury's redemption
of silver with gold increased the value of money and
deflated prices.
Despite the rapid growth of
business, the government engineered a sharp fall in the
per capita quantity of money in circulation. The
National Bank Act of 1863 also limited banks' notes to
the amount of government bonds held by banks. The
Treasury paid down 60 percent of the national debt and
reduced considerably the monetary base, not unlike the
bond-buyback program of the Treasury in 1999. To
farmers, it was unfair to have borrowed when wheat sold
for $1 per bushel and to have to repay the same debt
amount with wheat selling for 63 cents a bushel, when
the fall in price was engineered by the lenders. To
them, the gold standard was a global conspiracy, with
willing participation by the US Northeastern bankers -
the money trusts who were agents of international
finance, mostly British-controlled.
President
Grover Cleveland, despite winning the 1892 election with
populist support within the Democratic Party, gave no
support to populist programs. Cleveland saw his main
responsibilities as maintaining the solvency of the
federal government and protecting the gold standard.
Declining business confidence caused gold to drain from
the Treasury at an alarming rate. The Treasury then
bought gold at high prices from the Morgan and Belmont
banking houses at great profit to them. Populists saw
this effort to save the gold standard as a direct
transfer of wealth from the people to the bankers and as
the government's capitulation to international finance
capital. Cleveland even sent federal troops to Illinois
to break the railroad strike of 1894, over the vigorous
protest of governor Altgeld.
The election of
1896 was about the gold standard. Cleveland lost control
of the Democratic Party, which nominated 36-year-old
William Jenning Bryan, who declared in one of the most
famous speeches in US history (though mostly shunned
these days): "You shall not press down upon the brow of
labor this crown of thorns, you shall not crucify
mankind upon a cross of gold." The banking and
industrial interests raised $16 million for William
McKinley to defeat Bryan, who suffered a defeat worse
than Jimmy Carter's. With the McKinley victory, the
Hamiltonian ideal was firmly ordained, but with most of
its nationalist elements sanitized. It was not
dissimilar to the Reagan victory over Carter in 1980.
The 16th amendment to the US constitution
calling for a "small" income tax was enacted to
compensate for the anticipated loss of revenue from the
lowering of tariffs from 37 to 27 percent as authorized
by the Underwood Tariff of 1913, the same year the
Federal Reserve System was established. "Small" now
translates into an average of 50 percent with federal
and state income taxes combined.
The Glass-Owen
Federal Reserve Act was passed in December 1913 under
the administration of president Woodrow Wilson. The
system set up five decades ago by the National Bank Act
of 1863 had two major faults: 1) the supply of money had
no relation to the needs of the economy, since the money
in circulation was limited by the amount of government
bonds held by banks; and 2) each bank was independent
and enjoyed no systemic liquidity protection. These
problems were more severe in the South and the West,
where farmers were frequently victimized by bank crises
often created by Northeastern money trusts.
The
money elite wanted a central bank controlled by bankers,
along Hamiltonian lines, but internationalist rather
than nationalist. But the Wilson administration,
faithful to Jacksonian tradition despite political debts
to the moneyed elite, insisted that banking must remain
decentralized, away from the control of Northeastern
money trusts, and control must belong to the national
government, not to private financiers with international
links, despite the internationalist outlook of Wilson.
Twelve Federal Reserve Banks were set up in different
regions across the country, while supervision of the
whole system was entrusted to a Federal Reserve Board,
consisting of the Treasury secretary, the comptroller of
the currency and five other members appointed by the
president for 10-year terms. All nationally chartered
banks were required and state-chartered banks were
invited to be members of the new system. All private
banknotes were to be replaced by Federal Reserve notes,
exchangeable at regional Federal Reserve Banks not only
for bonds or gold, but also for top-rated commercial
paper, with the hope of causing the money supply to
expand and contract along with the volume of business.
With the reserves of all banks deposited with the
Federal Reserve (Fed), systemic stability was supposed
to be assured.
The circumstances that created
the climate in the United States for the adoption of a
central bank came ironically from internecine war on
Wall Street that spread economic devastation across the
nation during 1907-08, the direct result of one huge
money trust trying to cannibalize its competition.
The Rockefeller interests of "Amalgamated
Copper" had a plan to destroy the Heinze combination,
which owned Union Copper Co. By manipulating the stock
market, the Rockefeller faction drove down Heinze stock
in Union Copper from 60 to 10. The rumor was then spread
that not only Heinze Copper but also the Heinze banks
were folding under Rockefeller pressure. J P Morgan
joined the Rockefeller enclave to announce that he
thought the Knickerbocker Trust Co would be the first
Heinze bank to fail. Panicked depositors stormed the
tellers' cages of the Knickerbocker Bank to withdraw
their money. Within a few days the bank was forced to
close its doors. Similar fear spread to other Heinze
banks and then to the whole banking world. The crash of
1907 was on.
Millions of people were sold out
penniless and rendered homeless by bank foreclosures,
and their savings wiped out by bank failures. The
destitute and the hungry fended for themselves as best
they could, which was not very well. Circulating money
was hoarded by any who happened to still have some, so
before long a viable medium of exchange became
practically non-existent. Many business concerns began
printing private IOUs and exchanging these for raw
materials as well as giving them to their workers for
wages. These "tokens" passed around as a temporary
medium of exchange.
At this critical juncture, J
P Morgan offered to salvage the last operating Heinze
bank (Trust Co of America) on condition of a fire sale
of the valuable Tennessee Coal and Iron Co in Birmingham
to add to the monopolistic US Steel Co, which he had
earlier purchased from Andrew Carnegie.
This
arrangement violated existing anti-trust laws but in the
prevailing climate of depression crisis, the proposed
transaction was quickly approved in Washington. Morgan
was also intrigued by the paper IOUs that various
business houses were being allowed to circulate as a
medium of exchange. He persuaded Congress to let him put
out $200 million in such "tokens" issued by one of the
Morgan financial entities, claiming this flow of Morgan
"certificates" would revive the stalled economy. As
these new forms of Morgan "money" began circulating, the
public regained its confidence and hoarded money began
to circulate again as well. Morgan circulated $200
million in "certificates" created out of nothing more
than his own "corporate credit" with formal government
approval. It was a superb device to make millions. GE
Capital in the 1990s did the same thing with commercial
papers and derivatives to create hundreds of billions in
profits.
Conspiracy theorists assert that the
seeds for the Federal Reserve System had been sown with
the Morgan certificates. On the surface J P Morgan
seemed to have saved the economy - like first throwing a
child into the river and then being lionized for saving
him with a rope that only he was allowed to own, as some
of his critics said. On the other hand, Woodrow Wilson
wrote: "All this trouble [the 1907 depression] could be
averted if we appointed a committee of six or seven
public-spirited men like J P Morgan to handle the
affairs of our country." Both Morgan and Wilson were
internationalists.
By 1908, J P Morgan was
working with senator Nelson Aldrich of Rhode Island, who
was related to the Rockefeller family by marriage, and
whose surname was the middle name of vice president
Nelson A Rockefeller, to establish a private central
banking system. Aldrich was the maternal grandfather of
Nelson Rockefeller.
Ironically, the initial idea
of the need for a central bank came from the populist
movement, which began in Lampasas County in Texas when a
group of desperate farmers formed in 1877 the Knights of
Reliance to educate themselves speedily against the time
"when all the balance of labor's products would become
concentrated into the hands of a few, there to
constitute a power that would enslave posterity".
Uninhibited by the awesome high science of economics,
average citizens in the late-19th-century United States
were pragmatically aware of the political implications
of monetary policy. The Farmers Alliance, renamed from
the Knights of Reliance, held regular traveling lectures
that quickly concluded that the causes of their members'
financial ruin were the gold standard and the private
banking system that enforced its confiscatory terms.
The populists proposed a solution in August 1886
in a convention in Cleburne, Texas. The "Cleburne
Demand" called for federal regulation of the banking
system and a fiat national currency to meet the
liquidity needs of an expanding economy. Public pressure
was making increasingly vocal demands for a plan to
eliminate Wall Street control and exploitation of the
economy for narrow private benefit.
In response,
Morgan's ally, senator Aldrich, arranged to become
chairman of the National Monetary Commission, which
received an assignment from Congress to study the US
monetary system and make recommendations of ways to
improve it. Paul Warburg, whose brother Max was in
charge of the Reichsbank, the privately owned national
bank of Germany, emphasized the absolute necessity of
setting up a new national banking system that would
prevent Wall Street from putting the United States
through devastating "boom and bust" cycles as it had in
the past.
On November 22, 1910, a private
railroad car pulled out of the station at Hoboken, New
Jersey, with several powerful people aboard. Others
joined the meeting later. They met at the J P Morgan
estate on Jekyll's Island, Georgia. This secret meeting
included senator Nelson Aldrich; A P Andrews,
professional economist and assistant secretary of the
Treasury; Frank Vanderlip, president of the National
Bank of New York City, which later became Citibank;
Harry P Davidson, senior partner of the J P Morgan Co;
Charles D Norton, president of Morgan's First National
Bank of New York; Paul Warburg, partner of the banking
house of Kuhn, Loeb Co in New York; and Benjamin Strong
of the J P Morgan Co central office in New York, who
later became the first president of the New York Fed and
dominated the new central bank for the first two
decades. After nine days, they produced a bill for
Congress that was later submitted as the "Aldrich Plan".
Conspiracy theorists made much about this infamous
secret meeting.
The main resistance to the
Aldrich Plan came from the House of Representatives,
where an official investigation had revealed some of the
ruthless operations of powerful financial interests on
Wall Street and definitely fixed responsibility on Wall
Street (especially Rockefeller and Morgan) for the crash
of 1907-08, similar to current public indignation over
Enronitis.
With the tide of popular opposition
rising, it was obvious that the Republicans were not
going to be able to get the Aldrich Plan adopted.
Strategy then switched to influencing the Democratic
Party, which immediately came up with an "alternative"
plan to be called the Federal Reserve Association. It
was in essence the Aldrich Plan with a different name.
The next task was to defeat the sitting Republican
president, William Howard Taft of Ohio, in the 1912
election and get a more sympathetic Democratic
administration in power. Taft was popular, but he
opposed the Aldrich Plan. The political strategy was
therefore redesigned to induce another Republican,
popular Teddy Roosevelt, to run on a Progressive ticket
against Taft and thus divide the Republican Party.
Morgan officers provided both the money and the
strategy to help Roosevelt win Republican votes away
from Taft. George Harvey, president of the
Morgan-controlled Harpers Weekly, and Rockefeller money
got behind Wilson. The Wilson team included Cleveland H
Dodge of Rockefeller National City Bank, J Ogden Armour,
James Stillman, George F Baker, Jacob Schiff, Bernard
Baruch, Henry Morgenthau, and the publisher of the New
York Times, Adolph Ochs. The Morgan officials who
managed Teddy Roosevelt's campaign were also found to
have put extensive money behind Wilson. As might have
been expected, the strategy worked and Wilson was
elected with 6.29 million votes while Roosevelt drew
4.12 million votes and Taft, who won with 7.68 million
votes over William J Bryan's 6.4 million in his
first-term victory, drew only 3.46 million votes.
Progressivism reached its high-water mark in the
1912 campaign. Taft plainly had no chance of
re-election, the main contest being between Roosevelt
and Wilson. Both men proposed to revitalize democracy by
limiting the powers of big business. Wilson, winning 42
percent of the popular vote, polled fewer than Bryan had
done in each of his three unsuccessful campaigns. But
with the Republicans split between Taft and Roosevelt,
he carried 40 states to become a minority president.
When Woodrow Wilson took over the White House in
1913, he brought with him his Wall Street advisers,
including "Colonel" Edward Mandell House, who is now
known to have been the major policy-maker and manager of
the entire Wilson administration. In his personal
writings, House describes the pile-driver tactics that
were used to force a bill through Congress that would
authorize the setting-up of the new Federal Reserve
System as a privately owned central bank.
The
leading financiers of Wall Street pretended to protest
vehemently against the bill. In his autobiography,
William McAdoo, Wilson's son-in-law, who became
secretary of the Treasury, says he was very impressed by
the way the "bankers fought the Federal Reserve
legislation - and every provision of the Federal Reserve
Act - with the tireless energy of men fighting a forest
fire. They attacked it as populist, socialistic,
half-baked, destructive, infantile, badly conceived and
unworkable." But McAdoo found that when he engaged these
bankers in private conversation, he realized their
opposition was merely a smokescreen to hide their true
feelings. He wrote: "These interviews with bankers led
me to an interesting conclusion. I perceived gradually,
through all the haze and smoke of controversy, that the
banking world was not really as much opposed to the bill
as it pretended to be."
On December 22, 1913,
with the prospect of the Christmas holiday pressuring
Congress into final action before the session closed,
the House voted 298-60 in favor of the new Federal
Reserve System, and the Senate passed it 43-25.
From its beginning, the dominant guiding
principle of the Fed was financial rather than economic,
though its charter directed it to "accommodate the needs
of commerce and industry". Fed policy-makers
concentrated on preventing inflation to calm investor
fear, not on lowering unemployment or restoring falling
farm prices. Fed officials spoke of "liquidation of
labor" as part of sound central-banking principle, which
harbors a bias toward preserving the health of the
financial sector over the real economy. In order to
restore the former, it was necessary to punish the
latter. Lose weight to save the heart.
Next: More on the US experience
Henry C K Liu is chairman of the New
York-based Liu Investment Group.
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Times Online Co, Ltd. All rights reserved. Please
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