A Brief History of Central Banking in the United States (Edward Flaherty)

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A Brief History of Central Banking in the United States

By Edward Flaherty

Department of Alfa-informatica, University of Groningen, The Netherlands, 1997, 13 pages

1. Introduction: What is Central Banking?2. Central Banking in the United States

3. The First Bank of the United States (1791-1811)

4. Second Bank of the United States (1816-1836)

5. States in Charge

6. Money and the Constitution

7. Michigan Act (1837)

8. Depository Safety and Economic Safety

9. State and Private Attempts at Reform

10. National Banking Acts of 1863 and 1864

11. Two Remaining Major Defects

12. Aldrich Plan (1910)

13. Federal Reserve Act (1913)

References

1. Introduction : What is Central Banking?

At its most fundamental level, a central bank is simply a bank which other banks have in common. Small rural banks might each

have deposit accounts at a larger urban bank to facilitate their transactions in the city. By this criteria, a financial system might

have several central banks. More prosaically, a central bank is usually a government sanctioned bank that has specific duties

related to the performance of the macroeconomy. Typically, an "official" central bank is charged by a central government to

control the money supply for the purpose of promoting economic stability. It may have other duties as well, such as some degree

of regulatory power over the financial system, operating a check-clearing system, or to perform general banking services for the

central government. Most industrialized economies have a central bank. The Bank of England, the Bank of Japan, the German

Bundesbank, and the United States Federal Reserve are all central banks. While their organizational structures and powers vary,

2. Central Banking in the United States

The history of central banking in the United States does not begin with the Federal Reserve. The Bank of the United States

received its charter in 1791 from the U.S. Congress and was signed by President Washington. The Bank's charter was designed

by Secretary of the Treasury Alexander Hamilton, modeling it after the Bank of England, the British central bank.

The Bank met with considerable controversy. Agrarian interests were opposed to the Bank on the grounds that they feared it

would favor commercial and industrial interests over their own, and that it would promote the use of paper currency at the

expense of gold and silver specie (Kidwell, 54). Ownership of the Bank was also an issue. By the time the Bank's charter was up

for renewal in 1811, about 70 percent of its stock was owned by foreigners. Although foreign stock had no voting power to

influence the Bank's operations, outstanding shares carried an 8.4 percent dividend. Another twenty year charter, it was argued,

would result in about $12 million in already scarce gold and silver being exported to the bank's foreign owners (Hixson, 115).

Secretary of State Thomas Jefferson believed the Bank was unconstitutional because it was an unauthorized extension of federal

power. Congress, Jefferson argued, possessed only delegated powers which were specifically enumerated in the constitution. The

only possible source of authority to charter the Bank, Jefferson believed, was in the necessary and proper clause (Art. I, Sec. 8,

Cl. 18). However, he cautioned that if the clause could be interpreted so broadly in this case, then there was no real limit to what

Congress could do. Then, curiously, in the memorandum in which he articulated his thoughts on this matter, Jefferson advised

that if the President felt that the pros and cons of constitutionality seemed about equal, then out of respect to the Congress which

passed the legislation the President could sign it (Dunne, 17-19). James Madison said the Bank was "condemned by the silence

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Hamilton conceeded that the constitution was silent on banking. He asserted, however, that Congress clearly had the power to

tax, to borrow money, and to regulate interstate and foreign commerce. Would it be reasonable for Congress to charter a

corporation to assist in carrying out these powers? He argued that the necessary and proper clause gave Congress the power to

enact any law which was necessary to execute its powers. A "necessary" law in this context Hamilton did not take to mean one

that was absolutely indispensable. Instead, he argued that it meant a law that was "needful, requisite, incidental, useful, or

conducive to." Then Hamilton offered a proposed rule of discretion: "Does the proposed measure abridge a pre-existing right of

any State or of any individual?" (Dunne, 19). Hamilton's arguments carried the day and convinced President Washington.

e an o t e n te tates a ot pu c an pr vate unct ons. ts most mportant pu c unct on was to contro t e money

supply by regulating the amount of notes state banks could issue, and by transferring reserves to different parts of the country. It

was also the depository of the Treasury's funds. This was an important function because, as later experience would prove,

without a central bank, the Treasury's deposits were placed in private commercial banks on the basis of political favoritism. The

Bank of the U.S. was also a privately owned, profit-seeking institution. It competed with state banks for deposits and loan

customers. Because the Bank was both setting the rules and competing in the marketplace especially irritated state banks, and

they joined with agrarian interests and Jeffersonians in opposition to the Bank. The Bank was supervised by the Secretary of the

Treasury who could inspect all the Bank's transactions and accounts, except those of private individuals, and order audits on

demandeposits before the bank's till ran dry lost their savings all together. Private deposit insurance was scant and unreliable.

Federal deposit insurance was non- existent. Court reaffirmed this opinion in a 1824 case Osborn v. Bank of the United States

(Ibid, 14).ndividual could own more than 30 shares. Shares were also sold to foreigners, although the Bank's charter did not

3. First Bank of the United States (1791-1811)

The First Bank of the United States is considered a success by economic historians. Treasury Secretary Albert Gallatian

commented that the Bank was "wisely and skillfully managed" (Hixson, 114). The Bank carried a remarkable amount of

liquidity. In 1809, for example, its specie/banknote ratio was about 40 percent (compared to a modern average reserve/deposit

ratio of about 12 percent) making it probably the most liquid bank in the U.S. at the time. Despite the liquidity, the Bank was

also profitable, earning most of its income through substantial loans to both government and private business. It helped to end

several bank runs by transferring funds to banks in need of temporary liquidity.

The chief argument in favor of the Bank's renewal in 1811 was that its circulation of about $5 million in paper currency

accounted for about 20 percent of the nation's money supply (Symons, 12). It was the closest thing to a national currency that the

U.S. had. Ironically, this may have contributed to its downfall because the Bank's issuance of notes came at the expense of state

banks. In addition, the currency issued by the Bank was not discounted, whereas the currency issued by the 712 state banks were

discounted anywhere from 0 to 100 percent. However, the arguments against the Bank were too strong. Foreign ownership,

constitutional questions (the Supreme Court had yet to address the issue), and a general suspicion of banking led the failure of the Bank's charter to be renewed by Congress. The Bank, along with its charter, died in 1811.

Following the Bank's disappearance, state banks, unhindered by either state regulations or the discipline imposed by the Bank of

the U.S., greatly increased the number of bank notes in circulation. John K. Galbraith writes of the period, "State banks, relieved

of the burden of forced redemption [imposed by the First Bank], were now chartered with abandon; every location large enough

to have 'a church, a tavern, or a blacksmith shop was deemed a suitable place for setting up a bank.' These banks issued notes,

and other, more surprising enterprises, imitating the banks, did likewise. 'Even barbers and bartenders competed with banks in

this respect'" (Galbraith, 58). Coupled with the disruptions associated with the war with England, this caused considerable

inflation from 1812-1815. During that period, prices rose an average of 13.3 percent per year. An 1815 attempt to establish a

new central bank failed, but by 1816 a consensus emerged for a return to central banking (Ibid, 13).

4. Second Bank of the United States (1816-1836)





















































































































































































































































































































































































The Second Bank of the U.S. was chartered in 1816 with the same responsibilities and powers as the First Bank. However, the

Second Bank would not even enjoy the limited success of the First Bank. Although foreign ownership was not a problem

(foreigners owned about 20% of the Bank's stock), the Second Bank was plagued with poor management and outright fraud

(Galbraith). The Bank was supposed to maintain a "currency principle" -- to keep its specie/deposit ratio stable at about 20

percent. Instead the ratio bounced around between 12% and 65 percent. It also quickly alienated state banks by returning to the

sudden banknote redemption practices of the First Bank. Various elements were so enraged with the Second Bank that there

were two attempts to have it struck down as unconstitutional. In McCulloch v. Maryland (1819) the Supreme Court voted 9-0 to

uphold the Second Bank as constitutional. Chief Justice Marshall wrote "After the most deliberate consideration, it is the

unanimous and decided opinion of this courtdeposits before the bank's till ran dry lost their savings all together. Private deposit

insurance was scant and unreliable. Federal deposit insurance was non- existent. Court reaffirmed this opinion in a 1824 case

Not until Nicholas Biddle became the Bank's president in 1823 did it begin to function as hoped. By the time the Bank had

regained some control of the money supply and had restored some financial stability in 1828, Andrew Jackson, an anti-Bank

candidate, had been elected President. Although the Second Bank was not a campaign issue (Biddle actually voted for Jackson),

by 1832, four years before the Bank's charter was to expire, political divisions over the Bank had already formed (Ibid). Pro-

Bank members of Congress produced a renewal bill for the Bank's charter, but Jackson vetoed it. In his veto message Jackson

A bank of the United States is in many respects convenient for the Government and for the people. Entertaining this opinion, and

deeply impressed with the belief that some of the powers and privileges possessed by the existing bank are unauthorized by the

Constitution, subversive of the rights of the States, and dangerous to the liberties of the people, I felt it my duty...to call to the

attention of Congress to the practicability of organizing an institution combining its advantages and obviating these objections. Isincerely regret that in the act before me I can perceive none of those modifications of the bank charter which are necessary, in

my opinion, to make it compatible with justice, with sound policy, or with the Constitution of our country (Ibid, 14-15).

Jackson was not opposed to central banking, per se, but to the Second Bank in particular. No other bill to renew the Bank's

charter was presented to Jackson, and so the Second Bank of the United States expired in 1836. The U.S. would be without an

official central bank until 1913 when the Federal Reserve System was formed.

Jackson believed that the nation's money supply should consist only of gold or silver coin minted by the Treasury and any

foreign coin the Congress chose to accept. This view was fully impractical. The gold and silver stocks of the U.S. were terribly

inadequate to provide a sufficient money supply of Jackson's preference. The U.S. at that time had no substantial mines of its

own and regularly had a trade deficit, so there was no dependable method to increase the money supply under what Jackson

perceived to be the only Constitutional monetary system.

However, few others shared Jackson's opinions on this matter. Even the so-called "Jacksonian" Supreme Court ruled in 1837 inBriscoe v. Bank of Kentucky that state-chartered banks, state-owned banks, and the banknotes they created were fully

Constitutional (Hixson, 119). Combined with the unanimous 1819 McCulloch ruling, the legal environment of the U.S. had

clearly established that central banking, state banking, and paper currency issued by both entities were Constitutional. That the

U.S. chose to proceed through the balance of the nineteenth century without a central bank would lead to interesting and creative

5. The States in Charge

Following the demise of the Second Bank of the United States in 1836, the American financial system entered a period

frequently termed by economic historians as the "free banking era." These were the years 1837-1862: the time between the

Second Bank and the first of the National Banking acts. The only banks in the U.S. were those chartered by the states. The

federal government neither chartered banks nor regulated the existing state banks.

Under a chartered bank system, a bank could only begin operations by a specific act of a state's legislature. The charter issued by

the legislature would specify in what activities the bank could and could not engage, the interest rates that could be charged for

loans and paid on deposits, the reserve ratio, the necessary capital ratio and so forth. The issuing state was also responsible for

regulating the activities of the banks it created.



































































































































































































The first bank licensed in this manner was the Bank of North America in 1782 and which operated in Philadelphia. It was

designed by Alexander Hamilton and modelled after the Bank of England. Although bank-like institutions existed in the colonial

period, the Bank of North America was the first bank in the modern sense of the word. The bank was permitted to accept gold

and silver coin, also called specie, for deposit and to issue banknotes in exchange. Banknotes were paper bills of credit that

promised to pay the bearer the note's face value in specie on demand. The public accepted the banknotes as money because it

had faith that the notes would in fact be redeemed by the bank in specie. The banknotes that augmented the money supply

proved effective in stimulating economic activity. Its success inspired similar banks to be chartered in New York and Boston a

few years later. By the end of Washington's administration, twenty four state banks were in operation along with the Bank of the

United States. The number ible for printing all national banknotes."convinced" of the plan's merit when Suffolk began hoarding

This is a promisory note (an IOU) printed by Farmers & Exchange Bank of Charleston, South Carolina. The bank

promises to pay to the bearer five dollars on demand, usually in gold or silver coin although this note does not specify. It

6. Money and the Constitution

The ability of banks to issue money raises some interesting questions about the nature of money and about the legal aspects of its

issuance in the United States. On these topics I will now briefly digress. Money is nothing more than a common numeraire which

reduces the search costs associated with conducting beneficial trades. Money is also a psychological abstraction. Literally

anything can serve in this capacity as long as people are willing to accept it as a medium of exchange, if it maintains its

purchasing power reasonably over time, and if it can serve as a convenient unit of measure. An official government edict is not

The Constitution contains only two sections dealing with monetary issues. Section 8 permits Congress to coin money and to

regulate its value. Section 10 denies states the right to coin or to print their own money. The framers clearly intended a national

monetary system based on coin and for the power to regulate that system to rest only with the federal government. The delegates

at the Constitutional convention rejected a clause that would have given Congress the authority to issue paper money. They also

rejected a measure that would have specifically denied that ability to the federal government (Hammond, 92). Although the

Constitution does not state that the federal government has the power to print paper currency, the Supreme Court in McCulloch

vs Maryland (1819) ruled unanimously that the Second Bank of the United States and the banknotes it issued on behalf of the

If the federal government only is permitted to issue money, coin or paper, then how could state banks issue money? State banks

did not coin money, nor did they print any "official" national currency. However, state banks could print bills of credit in

exchange for specie deposits. These notes would bear the issuing bank's name and entitle the bearer to the note's face value in

gold or silver upon presentation to the bank. State bank notes were a form of representative money; they were not gold or silver,

but they represented it. The notes were more convenient for conducting large transactions than their specie counterparts, and,more importantly for the extension of credit, could be produced easily whereas the gold and silver stock of the nation was

relatively small and for the most part declining (Hixson, 12-13). The Supreme Court ruled in 1837 in Briscoe vs Bank of

One potential problem with such a system is that banks may issue notes far in excess of their specie deposits. Customers

appeared from time to time wanting to exchange their banknotes for specie. The banks, of course, made allowances for this by

keeping some of the specie on hand at all times. If the specie/banknote ratio was too low, even a small unexpected increase in

the withdrawal rate could force the bank into insolvency. Remaining depositors who had not withdrawn their specie would be












































































































































































































































































The public accounted for this risk of non-redemption by discounting the notes of banks that were considered risky. For example,

a $20 banknote issued by a bank with a reputation of redemption problems might carry a 5 percent discount off its face value. In

other words, a local merchant might only give a customer $19 worth of goods for a $20 note with the difference compensating

the merchant for the risk of accepting the banknote. Discounts on notes among functioning banks ranged from about 95 percent

for the riskiest banks to zero for banks with a high degree of public confidence. On the advent of the free banking era, there were

712 state banks in operation in the United States, each with its own currency (Kidwell, 59). Imagine the difficulty for a local

merchant in tracking the riskiness and value of perhaps dozens of different banknotes in addition to the other concerns of his

7. Michigan Act (1837)

In the early and mid nineteenth century the supply of gold and silver coins was insufficient to serve as the only form on money as

is prescribed by a literal interpretation of the Constitution. For this reason and despite its inherent risks, state banking thrived as

a means of augmenting the money supply. To further facilitate the growth of banking, the 1837 Michigan Act was adopted as the

first of the nation's free banking laws. Literally, a free banking system is one without any form of government restriction on

banking activities, save the enforcement of legal contracts and prohibitions against fraud (Sechrest, 3). The Michigan Act did not

achieve this pure definition, but it and the other free banking laws enacted in subsequent years constitute the closest the U.S. has

The Michigan Act granted a banking charter to any person or group that satisfied established criteria, rather than requiring an act

of the Michigan legislature each time a new group petitioned to open a new bank. Specifically, the bank's owners had to

purchase at market value state bonds and then deposit those bonds with the state auditor as collateral. However, the bank could

issue banknotes up to the marketvalue of the bonds, so the performance of the bond market directly affected the system's abilityto issue notes. Banks were also required to redeem their notes on demand in gold or silver coin. Failure to do so resulted in the

bank being closed by the state, and the bank's assets being liquidated. The state's bank examiners were in charge of enforcing

this specie reserve requirement, but the banks were always one step ahead. Consider this account given by Galbraith:

At the outer extreme of compliance, a group of Michigan banks joined to cooperate in the ownership of reserves. These were

transferred from one institution to the next in advance of the examiner as he made his rounds. And on this or other occasions,

there was further economy; the top layer of gold coins in the container was given a more impressive height by a larger layer of

ten-penny nails below. But not all of the excesses of leverage were in the West. In the same years, in the more conservative

precincts of New England, a bank was closed up with $500,000 in notes outstanding and a specie reserve of $86.48 in hand

In addition, depositors were granted a lien on the bank's assets. Other than these conditions, there were no significant restrictions

on a bank's activities in the free banking system (Sechrest, 96-100).

8. Depositor Safety and Economic Stability

How did the free banking system perform in terms of depositor safety and promoting economic stability? Rolnick and Weber

(1982) studied four free banking states (New York, Indiana, Minnesota, and Wisconsin) for which they found data on 709 free

banks during the period 1838-1863. They found that about half of those banks failed with about a third of those unable to redeem

their banknotes for specie. Overall, about 16 percent of the free banks in those states could not redeem their banknotes. In

addition, free banks were short-lived relative to modern banks. About 16 percent of free banks existed for less than one year,

with the overall average about five years (Sechrest, 99). In the four states they studies, Rolnick and Weber estimate depositor

Nearly all of the free bank failures, Rolnick and Weber argue, were due to sharp declines in the market value of the bonds the

banks held rather than being caused by fraud, as seems to be the popular perception. They were caused mostly by the legal

requirement to tie note issues to the market value of the bank's bond-holdings. When the market value declined substantially, the

bank was required by law to withdraw some of its currency from circulation. It did this by calling in loans, an act whichfrequently put a tight credit vice on businesses and which shrank the money supply.

In terms of economic stability, the free banking era was characterized by considerable swings in the money supply and the price

level, as is shown in the table below.

Period % Chng in Money Supply % Chng in Price Level

------- ---------------------- ---------------------









































































































































































































































































































































































1834-37 + 61 + 28

1837-43 - 58 - 35

1843-48 + 102 + 9

1848-49 - 11 0

1849-54 + 109 + 32

1854-55 - 12 + 2

1855-57 + 18 + 1

1857-58 - 23 - 16

1858-61 + 35 - 4

(Sources: John Knox, A History of Banking in the United States, New York: Bradford Rhodes, 1903; and Historical Statistics,

1960, series E 1-12.

Kidwell and some other economists blame the state banking system for contributing to the volatility in the economy, even if it

did not directly cause it. In the initial expansionary phase of the business cycle, overly optimistic banks would issue too many

banknotes which would accelerate the growth of the economy. However, this would eventually lead to inflation and an over-

extension of credit. A random downturn in key commodity markets would then sharply reduce the market value of many bonds

and loans, and banks would be forced to call in loans and contract the money supply. Sometimes this led to cases of depositor

panic and further reductions in the money supply, which brought the next contraction of economic activity (Kidwell, 56).

Most economists regard the free banking era as on balance being a de-stabilizing influence on the developing U.S. economy.

Edward Symons writes "In some states, particularly Michigan where more than forty banks failed before the system was declared

unconstitutional, the system is better characterized as a fiasco than a failure" (Symons, 22). However, free-banking advocates

claim that this period is not a true test of their theory (Rolnick and Weber, 19-20). In particular, the legal requirement in most

free banking states that note issues be tied to the market value of bonds limited the management to sub-optimal choices in terms

of their note issues. In current free banking theory banks would have the incentive to issue a profit- maximizing volume of noteswhich would be based on economic factors, not exogenous regulations, and that this quantity of notes would not, in theory, cause

Regardless of its merits or its problems, the free banking era ended in 1863 with the passage of the first of the National Banking

Acts. These laws reasserted federal influence in the functioning of the nation's financial system.

9. State and Local Attempts at Reform

During the free banking era of 1837-1863 the federal government divorced itself from almost all attempts to regulate the banking

system. Following the demise of the Second Bank of the United States in 1836, the nation was left with state banks as its only

supplier of banking services. States were left in charge of regulating the banks they chartered, and in the states that adopted the

free banking laws, this meant little or no regular supervision. By the onset of the Civil War state banks numbered 1,562.

The problems with state banking were numerous, but three are conspicuous. First, the nation had no unified currency. State

banks issued their own banknotes as currency, a system which at worst invited severe bouts of counterfeiting and at best

introduced additional uncertainty in the task of determining the relative value of each banknote. Second, with no mitigating

influence on the issuance of banknotes, the money supply and the price level were highly unstable, introducing and perhaps

causing additional volatility in the business cycle. This was due in part to the fact that banknote issuance was frequently tied to

the market value of the bank's bond portfolio which they were required to have by law. Third, frequent bank runs resulted in








































































































































Prior to the return of the federal government to the business of bank regulation, the states made several attempts at solving some

of these problems. The New York Safety Fund was sponsored in 1829 by the state of New York as a deposit insurance system (a

century later the Federal Deposit Insurance Corporation was modeled after it). State banks in New York paid an annual premium

to the state Treasury. In the event of a bank failure within the state, the Fund would be used to pay the depositors and other

creditors of the bank. Without such protection, a bank run could destroy even a sound bank. The Safety Fund worked well for

about 10 years until a large wave of bank failures struck the Northeast economy and bankrupted the Fund.

ere were a so pr va e a emp s o mprove e s a e an ng sys em. e u o an sys em was an examp e o a m n a urecentral banking system that appeared in New England. Suffolk Bank was based in Boston and was one of the larger banks

serving New England, but there were also numerous small, rural banks operating in the region. Suffolk Bank had a good

reputation for redeeming its banknotes, so its notes were accepted at par by the public. The notes of the rural banks were deemed

riskier by the public, and were accepted at discounts of one to five percent. In accordance with Gresham's Law, the public began

to hoard Suffolk's notes and circulated the rural banknotes as their primary medium of exchange. This was harmful to Suffolk

because it was forced to keep more liquidity than it would like and therefor reduced its profitability. To remedy this situation,

Suffolk decided to accept at par the notes of any bank that agreed to keep a minimum portion of its deposits on hand as specie

reserves. The banks thadeposits before the bank's till ran dry lost their savings all together. Private deposit insurance was scant

and unreliable. Federal deposit insurance was non- existent. Court reaffirmed this opinion in a 1824 case Osborn v. Bank of the

United States (Ibid, 14).ndividual could own more than 30 shares. Shares were also sold to foreigners, although the Bank's

charter did not grant them voting rights (Phalle,

43).

Another private institution that evolved during the period was the clearinghouse. One function of the Federal Reserve or any

central bank is to act as a lender of last resort for banks that are temporarily short of liquidity. When the Second Bank of the

United States was permitted to die in 1836, the banking system was without this safety valve of liquidity. Private clearinghouses

soon appeared to perform this and some other functions of a central bank. A bank in temporary need of liquidity could borrow

money from these clearinghouses in the form of loan certificates. These certificates had short maturities and were backed with

some of the borrowing bank's assets, usually with a portion of its loan portfolio. The clearinghouse certificates were then given

to depositors instead of specie and circulated as money. During the financial panics of 1893 and 1907, the certificates

temporarily increased the money supply between 2 and 4 percent. Similar provisions were incorporated into the Federal Reserve

10. National banking Acts of 1863 and 1864

Despite these private or state-sponsored efforts at reform, the state banking system still exhibited the undesirable properties

enumerated earlier. The National Banking Acts of 1863 and 1864 were attempts to assert some degree of federal control over the banking system without the formation of another central bank. The Act had three primary purposes: (1) create a system of

national banks, (2) to create a uniform national currency, and (3) to create an active secondary market for Treasury securities to

help finance the Civil War (for the Union's side).

The first provision of the Acts was to allow for the incorporation of national banks. These banks were essentially the same as

state banks, except national banks received their charter from the federal government and not a state government. This

arrangement gave the federal government regulatory jurisdiction over the national banks it created, whereas it asserted no control

over state-chartered banks. National banks had higher capital requirements and higher reserve requirements than their state bank

counterparts. To improve liquidity and safety they were restricted from making real estate loans and could not lend to any single

person an amount exceeding ten percent of the bank's capital. The National Banking Acts also created under the Treasury

Department the office of Comptroller of the Currency which occasionally inspected the books of the national banks to insure

compliance with the above regulations, held Treasury securities deposited there by national banks, and, via the Bureau of

The second goal of the National Banking Acts was to create a uniform national currency. Rather than have several hundred, or

several thousand, forms of currency circulating in the states, conducting transactions could be greatly simplified if there were a

uniform currency. To achieve this all national banks were required to accept at par the banknotes of other national banks. This

insured that national banknotes would not suffer from the same discounting problem with which state banknotes were afflicted.

In addition, all national banknotes were printed by the Comptroller of the Currency on behalf of the national banks to guarantee

standardization in appearance and quality. This reduced the possibility of counterfeiting, an understandable wartime concern.



This 1929 note was issued by the Atlanta and Lowry National Bank. The writing over the red seal reads, "Redeemable in

lawful money of the United States at United States Treasury or at the bank of issue." At the time, lawful money referred

to gold coin, silver coin, gold or silver certificates, or United States notes. The reverse is the same as modern $20 Federal

The writing over the portrait of Andrew Jackson reads, "National currency secured by United States bonds deposited

with the Treasurer of the United States of America." This refers to the requirement of the National Banking Acts that

the amount of currency a national bank could issue be based on the market value of Treasury bonds on deposit with the

Who knows? Perhaps this very bill was used to buy a ticket to the premeir of Gone With the Wind.

The third goal of the Acts was to help finance the Civil War. The volume of notes which a national bank issued was based on the

market value of the U.S. Treasury securities the bank held. A national bank was required to keep on deposit with the Comptroller

of the Currency a sizeable volume of Treasury securities. In exchange the bank received banknotes worth 90 percent, and later

100 percent, of the market value of the deposited bonds. If the bank wished to extend additional loans to generate more profits,

then the bank had to increase its holdings of Treasury bonds. This provision had its roots in the Michigan Act, and it was

designed to create a more active secondary market for Treasury bonds and thus lower the cost of borrowing for the federal

It was the hope of Secretary of the Treasury Chase that national banks would replace state banks, and that this would create the

uniform currency he desired and ease the financing of the Civil War. By 1865 there were 1,500 national banks, about 800 of

which had converted from state banking charters. The remainder were new banks. However, this still meant that state banknotes

were dominating the currency because most of them were discounted. Accordingly, the public hoarded the national banknotes.

To reduced the proliferation of state banking and the notes it generated, Congress imposed a ten percent tax on all outstandingstate banknotes. There was no corresponding tax of national banknotes. Many state banks decided to convert to national bank

charters because the tax made state banking unprofitable. By 1870 there were 1,638 national banks and only 325 state banks.

While the tax eventually eliminated the circulation of state banknotes, it did not entirely kill state banking because state banks

began to use checking accounts as a substitute for banknotes. Checking accounts became so popular that by 1890 the

Comptroller of the Currency estimated that only ten percent of the nation's money supply was in the form of currency. Combined

with lower capital and reserve requirements, as well as the ease with which states issued banking charters, state banks again

became the dominant banking structure by the late 1880's. Consequently, the improvements to safety that the national banking

system offered were mitigated somewhat by the return of state banking.

11. Two Remaining Major Defects

There were two major defects remaining in the banking system in the post-Civil War era despite the mild success of the National

Banking Acts. The first was the inelastic currency problem. The amount of currency which a national bank could have

circulating was based on the market value of the Treasury securities it had deposited with the Comptroller of the Currency, not

the par value of the bonds. If prices in the Treasury bond market declined substantially, then the national banks had to reduce the

amount of currency they had in circulation. This could be done be refusing new loans or, in a more draconian way, by calling-in

loans already outstanding. In either case, the effect on the money supply is a restrictive one. Consequently, the size of the money

supply was tied more closely to the performance of the bond market rather than needs of the economy.



Another closely related defect was the liquidity problem. Small rural banks often kept deposits at larger urban banks. The

liquidity needs of the rural banks were driven by the liquidity demands of its primary customer, the farmers. In the planting

season the was a high demand for currency by farmers so they could make their purchases of farming implements, whereas in

harvest season there was an increase in cash deposits as farmers sold their crops. Consequently, the rural banks would take

deposits from the urban banks in the spring to meet farmers' withdrawal demands and deposit the additional liquidity in the

autumn. Larger urban banks could anticipate this seasonal demand and prepare for it most of the time. However, in 1873, 1884,

When national banks experienced a drain on their reserves as rural banks made deposit withdrawals, reserves had to be replacedin accordance with the federal law. A national bank could do this by selling bonds and stocks, by borrowing from a

clearinghouse, or by calling-in a few loans. As long as only a few national banks at a time tried to do this, liquidity was easily

supplied to the needy banks. However, a mass attempt to sell bonds or stocks caused a market crash, which in turn forced

national banks to call-in loans to comply with the currency- Treasury bond regulation, and only a small portion of banks met the

requirements to be members of the private clearinghouses. Many businesses, farmers, or households who had these loans were

unable to pay on demand and were forced into bankruptcy. The recessionary vortex became apparent. Frightened by the specter

of losing their deposits, in each episode the public stormed any bank rumored, true or not, to be in financial straights. Anyone

unable to withdraw their ible for printing all national banknotes."convinced" of the plan's merit when Suffolk began hoarding the

The 1907 crisis, also called the Wall Street Panic, was especially severe. The Panic caused what was at that time the worst

economic depression in the country's history. It appears to have begun with a market crash brought about by both a modest

speculative bubble and the liquidity problem and reserve pyramiding just discussed. Centered on New York City, the scale of the

crisis reached a proportion so great that banks across the country nearly suspended all withdrawals -- a kind of self- imposed bank holiday. Several long-standing New York banks fell. The unemployment rate reached 20 percent in the fall of 1907.

Millions lost their deposits as thousands of banks collapsed. The crisis was terminated when J.P. Morgan, a man of unscrupulous

business tactics and phenomenal wealth, personally made temporary loans to key New York banks and other financial

institutions to help them weather the storm. He also made an appeal to the clergy of New York to employ their Sunday sermons

Morgan's emergency injection of liquidity into the banking system undoubtedly prevented an already bad situation from getting

still worse. Although private clearinghouses were able to supply adequate temporary liquidity for their members, only a small

portion of banks were members of such organizations. What would happen if there were no J.P. Morgan around during the next

financial crisis? Just how bad could things really get? There began to emerge both on Wall Street and in Washington a

consensus for a institutionalized J.P. Morgan, that is, an institution that could provide emergency liquidity to the banking system

to prevent such panics from starting. The final result of the Panic of 1907 would be the Federal Reserve Act of 1913.

12. Aldrich Plan (1910)

Following the near catastrophic financial disaster of 1907, the movement for banking reform picked up steam among Wall Street

bankers, Republicans, and a few eastern Democrats. However, much of the country was still distrustful of bankers and of

banking in general, especially after 1907. After two decades of minority status, Democrats regained control of Congress in 1910

and were able to block several Republican attempts at reform, even though they recognized the need for some kind of currency

and banking changes. In 1912 Woodrow Wilson won the Democratic party's nomination for President, and in his populist-

friendly acceptance speech he warned against the "money trusts," and advised that "a concentration of the control of credit...may

at any time become infinitely dangerous to free enterprise" (Grieder, 275).

Also in 1910, Senator Nelson Aldrich, Frank Vanderlip of National City (Citibank), Henry Davison of Morgan Bank, and Paul

Warburg of the Kuhn, Loeb Investment House met secretly at Jekyll Island, a resort island off the coast of Georgia, to discuss

and formulate banking reform, including plans for a form of central banking. The meeting was held in secret because the

participants knew that any plan they generated would be rejected automatically in the House of Representatives if it wereassociated with Wall Street. Because it was secret and because it involved Wall Street, the Jekyll Island affair has always been a

source of conspiracy theories. But the conspiracy theorists overestimate the significance of the meeting. Everyone knew Wall

Street wanted reform, and the Aldrich Plan which the meeting produced was, in fact, rejected by the House.



The Aldrich Plan called for a system of fifteen regional central banks, called National Reserve Associations, whose actions

would be coordinated by a national board of commercial bankers. The Reserve Association would make emergency loans to

member banks, would create money to provide an elastic currency that could be exchanged equally for demand deposits, and

would act as a fiscal agent for the federal government. The Aldrich Plan was defeated in the House as expected, but its outline

became a model for a bill that eventually was adopted.

The problem with the Aldrich Plan was that the regional banks would be controlled individually and nationally by bankers, a

prospect that did not sit well with the populist Democratic party or with Wilson. The Democrats and Wilson were not opposed to

banking reform, nor were they opposed to a form of central banking. They were fearful that the reforms would grant more

control of the financial system to bankers, particularly to the Wall Street crowd. They also remembered their history: the First

and Second Banks of the United States were brought down in part by foreign ownership of the Banks' stock, a fear of centralized

power, and because the Banks competed with the private banks they were regulating. A return to central banking must not be

13. Federal Reserve Act (1913)

What eventually emerged was the Federal Reserve Act, also known at the time as the Currency Bill, or the Owen-Glass Act. The

bill called for a system of eight to twelve mostly autonomous regional Reserve Banks that would be owned by commerical banks

and whose actions would be coordinated by a committee appointed by the President. The Federal Reserve System would then

become a privately owned banking system that was operated in the public interest. Bankers would run the twelve Banks, but

those Banks would be supervised and by the Federal Reserve Board whose members included the Secretary of the Treasury, theComptroller of the Currency, and other officials appointed by the President to represent public interests.

The House of Representatives passed the Federal Reserve Act by a vote of 298 to 60. The Senate also passed the measure 43 to

25. In both chambers of Congress, it was the anti-banker Democrats that overwhelmingly supported the Act, while for the most

part the pro-banker Republicans opposed it. President Wilson signed the bill on December 23, 1913 and the Federal Reserve

System was born. Bankers largely opposed the Act because of the presence of the Federal Reserve Board in the legislation and

because only one of its seven members could represent the banking community.

The Federal Reserve system as it exists today is not quite the same creature that was produced in 1913. The system has

undergone rare, but susbstantial overhauls over the years. The two most important changes occurred in response to the Great

Depression and to the mini-crisis of the late 1970's. Both of these reforms will be discussed later.

References

Dunne, Gerald T., Monetary Decisions of the Supreme Court, New Brunswick, New Jersey: Rutgers University Press, 1960.

Galbraith, John K., A Short History of Financial Euphoria, New York: Penguin Books, 1990.

Galbraith, John K., Money: Whence it Came, Where it Went, Boston: Houghton Mifflin, 1995.

Greider, William, Secrets of the Temple, New York: Simon & Schuster, 1987.

Hammond, Bray, Banks and Politics in America, Princeton University Press, 1957.

Hixson, William F., Triumph of the Bankers: Money and Banking in the Eighteenth and Nineteenth Centuries, London: Praeger,

Kidwell, David S. and Richard Peterson, Financial Institutions, Markets, and Money, 5th edition, 1993.

Knox, John J., A History of Banking in the United States, New York: Bradford Rhodes, 1903.

Nussbaum, Arthur, A History of the Dollar , New York: Columbia University Press, 1957.

Phalle, Thibaut de Saint, The Federal Reserve: An Intentional Mystery, New York: Praeger, 1985.

Rolnick, Arthur J. and Warren E. Weber, The free banking era…, Federal Reserve Bank of Minneapolis, Staff Report 80, May

Sechrest, Larry J., Free Banking: Theory, History, and a Laissez-Faire Model, London: Quorum Books, 1993.Selgin, George A., The Theory of Free Banking: Money Supply Under Competitive Note Issue, Totowa, New Jersey: Rowman

and Littlefield, 1988.

Symons, Edward L., Jr. and James J. White, Banking Law, 2nd edition, 1984.

Articles:

Money Bill Goes to Wilson To-Day, New York Times, pages 1-3, December 23, 1913.

Wilson Signs the Currency Bill, New York Times, pages 1-2, December 24, 1913.



odur.let.rug.nl/~usa/E/usbank/bankxx.htm

Documents

A Brief History of Central Banking in the United States (Edward Flaherty)