The usual story of the need for a Federal Reserve is not the full history of the development of central banking in the U.S. The most familiar story depicts pre-Federal Reserve banking in the U.S. as chaotic, rife with uncertainty and bank failure—if not outright fraud—and excessive risk, with losses falling on bank depositors and bank shareholders.
Bank stability was an issue in some states, and bank failures, the purchasing power of money, and the ability to redeem bank-issued notes (private money) for gold at the face value of the note were important concerns of the time. In the regulation vs. deregulation debate, there are important instances of well-functioning free enterprise banking.
Two attempts were made to create a central bank during the 19th century. Neither lasted beyond its initial charter. The First Bank of the U.S. (1791-1811) was the brainchild of Alexander Hamilton. Debate over the First Bank divided U.S. financial and political interests between Northern and Southern states. Challenged on constitutional grounds on the one hand, and promoted as a necessary expediency on the other, the charter for the First Bank was reportedly dubbed ‘a masterpiece of obfuscation’ by Thomas Jefferson. The charter was finally approved under President Washington’s authority, but expired without renewal in 1811.
A second opportunity to consolidate money and credit creation came with the Second Bank of the U.S. (1816-36). With the Second Bank came an intention to create a coordinated monetary and credit authority, and serve as a depository for the Treasury’s tax collections. The bank and its goals met strong political opposition from President Andrew Jackson, and in 1833, Jackson preemptively withdrew federal revenues from the Second Bank, redepositing the monies into state (the so-called ‘pet’) banks. By 1836, the Second Bank had few funds, little remaining functionality, and insufficient support to win the fight for renewal of its charter.
Both during and after the separate tenures of the U.S. Banks— the period from 1811 until at least 1853, and definitely by the time legal tender laws appeared in 1862—interesting developments in banking were occurring at the state level. State banking laws were autonomous. In most of New England, where state charters did not specify the type or quantity of reserve assets, including gold, that banks should hold, banks issued private, competitive, redeemable paper money—gold receipts—that could circulate gold for purposes of commerce. The banks were operationally laissez-faire. To become profitable, naturally, a bank would have to make loans. That meant it first it had to attract gold deposits. However, no depositor who feared for the safety of his deposited gold would agree to such an arrangement if the bank’s reputation were not (forgive the pun) sterling.
The key to profitability, survival, and safety rested in the power of institutional reputation. Enter the private clearinghouse.
In the Boston commercial hub, and eventually the surrounding New England states, a nineteenth century bank’s reputation hinged on its performance at the clearinghouse. A clearinghouse operated by collecting all of the various bank notes issued by competing banks, much like the Fed does today with checks drawn on banks from around the country, and presenting them for payment in gold at the issuing bank’s redemption window. Centered at the Suffolk Bank of Boston, the clearinghouse was an entrepreneurial response to a market need. And as a hub, the Suffolk Bank functioned as a quasi-central bank, its clearing and deposit operations becoming known as the Suffolk Clearinghouse System . The Suffolk did not, unlike today’s Fed, have the ability to control the money supply for the banking system, making it by comparison a weak central bank in that respect.
It is interesting to note the role of unintended consequences in the development of banking in the New England region, especially in relation to the Suffolk Bank. In a competitive note-issue system, each bank’s notes are money, so money is a private, competitively produced good. And with redeemable currency, each bank must have enough gold on hand to exchange bank notes for gold, on demand. Modern demand deposits (our checkbook) accounts work similarly, except that we have claims to cash, not gold, from the bank. Because everyone doesn’t cash out their entire account at once, there is always some cash in the vault, a fractional reserve of the total deposits.
Long-distance transactions presented a different problem. Distance in a non-instant -information age dramatically increased the uncertainty and risk associated with accepting at face value any bank’s notes. Wanting to squelch the distribution and acceptance of ‘country’ bank notes in Boston, the Suffolk Bank instituted an aggressive collection and redemption program. If the Suffolk could embarrass the country banks (those outside of Boston proper) by shortening the time between note issue and the demand for gold it would eliminate the float they enjoyed and drive them out of business. At very least, the Suffolk hoped to drive down the purchasing power and acceptability of rival country bank notes relative to its own. The revelation that a bank could not redeem in gold all of the notes presented on a given day was highly damaging to its marketability.
The result? A truly unintended consequence: the country notes got ‘better’ in quality, became more and more widely acceptable, and the discount against their face value fell as a result of the Suffolk’s clearinghouse activities. At some points (in 1820, for example) the discount fell so low that the Suffolk suspended its country note redemption temporarily, as simply unprofitable. Rather than driving the country banks’ notes out of the market, the Suffolk’s market discipline forced their more distant competitors either to regulate themselves, or to fold. Very few folded.
Absent from this clearinghouse system were formal reserve requirements, yet reserve ratios were quite low in practice, and very few insolvency or bank failure issues arose. The Suffolk could require a redemption deposit, and did, under various conditions. If a bank’s notes were refused or discounted at the Suffolk, vendors refused to accept the bank’s notes at face value. Newspapers and Bank Note Reporters routinely published lists of banks, and the discount rate imposed by the Suffolk, for all to reference. The reporting mechanism provided an added and ongoing check against the possibility of untrustworthy or incompetent bank managers. Here, the market protected consumers, businesses, and shareholders alike. Another way to say this is to acknowledge that honesty was the best policy, due not to its moral, but rather to its survival value.
In truth, the Suffolk System was only possible under a relatively laissez-faire approach to bank regulation. It functioned as a de facto supervisor of its regional banks, provided inter-bank clearing of accounts, and generated strong incentives for banks themselves to maintain the quality and safety of their products.
The Suffolk Bank and System have legitimately been called quasi central banking, but there are important differences between it and the modern Fed. Paper money in 19th century America was privately and competitively issued. There was no monopoly agency in charge of the nation’s money supply, or able to influence credit markets and interest rates as our current Federal Reserve does. In other words, we could not conduct macroeconomic policy by manipulating the supply of money or credit. And the market for state and federal government debt, at least early on, had to compete on an equal footing with other possible investment assets for banks. Depending on your perspective, these are either positives or negatives of a Suffolk-type system.
Finally: inflation and ‘ripple effects.’ Except with the discovery of new, large gold deposits (which occasionally happened), economy-wide inflation could not take place. For obvious reasons, any one bank that ‘inflated’ its money supply would soon be embarrassed and discredited. Gold-discovery-based inflation, then, was generally a one-time event.
Ripple effects and contagion effects were both limited, if present. One bank’s problems could have limited ‘ripple’ effects elsewhere in the economy, given the laissez-faire situation in New England, since banks were not required hold (or avoid) specific, uniform assets, or be exposed to identical risks. As for the ‘contagion’ effect, one bank in trouble did not indicate a systemic problem. Each bank managed its reserves, loans, and notes autonomously. Evidence suggests that bank failures in this setting were relatively few, and almost always confined to the offending bank(s).
In general, American banks in the mid-to-late 1800’s provided a sound (reliable purchasing power) currency, enough credit to conduct commercial and personal affairs, a relatively safe means of storing and transferring money locally and over distances, and a simple way to keep account of monetary wealth as long as two conditions were met. Repeating from the earlier FMM, those conditions are that deliberate fraud or managerial incompetence were detectable, and revealed, well before the bank failed, and that the means by which banks would simultaneously satisfy the demands of depositors, and the needs of borrowers, was left largely to banks themselves to discover and adjust—through market mechanisms and competition.
For this material I have relied on many published works in banking and the history of banking in the U.S., and on an unpublished doctoral dissertation “Free Banking and Laissez-Faire Banking in New York and New England: Stability and Monetary Crises 1811-1863,” (George Mason University, 1989). With apologies for the unusual length of this FMM.