A History of Money and Banking in the United States: The Colonial Era to World War II (20 page)

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

telegraph. He taught the American people to buy bonds, using lavish advertising in newspapers, broadsides, and posters. God, destiny, duty, courage, patriotism—all sum-moned “Farmers, Mechanics, and Capitalists” to invest in loans118

—loans which of course they had to purchase from Jay Cooke.

And purchase the loans they did, for Cooke’s bond sales soon reached the enormous figure of $1 million to $2 million dollars a day. Perhaps $2 billion in bonds were bought and underwritten by Jay Cooke during the war. Cooke lost his monopoly in 1864, under pressure of rival bankers; but a year later he was reappointed to keep that highly lucrative post until the House of Cooke crashed in the panic of 1873.

In the Civil War, Jay Cooke began as a moderately successful promoter; he emerged at war’s end a millionaire, a man who had spawned the popular motto, “as rich as Jay Cooke.” Surely he must have counted the $100,000 he had poured into Salmon Chase’s political fortunes by 1864 as one of the most lucrative investments he had ever made.

It is not surprising that Jay Cooke acquired enormous political influence in the Republican administration of the Civil War and after. Hugh McCulloch, secretary of the Treasury from 1865 to 1869, was a close friend of Cooke’s, and when McCulloch left office he assumed the post as head of Cooke’s London office. The Cooke brothers were also good friends of General Ulysses Grant, so they wielded great influence during the Grant administration.

No sooner had Cooke secured the monopoly of government bond underwriting than he teamed up with his associates, Secretary of the Treasury Chase and Ohio’s Senator John Sherman, to drive through a measure which was destined to have far more fateful effects than greenbacks on the American monetary system: the national banking system. The National Banking 118Kirkland,
Industry
, pp. 20–21.

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Before the Twentieth Century

Acts destroyed the previously decentralized and fairly successful state banking system, and substituted a new, centralized, and far more inflationary banking system under the aegis of Washington and a handful of Wall Street banks.

Whereas the effects of the greenbacks were finally eliminated by the resumption of specie payments in 1879, the effects of the national banking system are still with us. Not only was this system in place until 1913, but it paved the way for the Federal Reserve System by instituting a quasi–central banking type of monetary system. The “inner contradictions” of the national banking system were such that the nation was driven either to go onward to a frankly central bank or else to scrap centralized banking altogether and go back to decentralized state banking. Given the inner dynamic of state intervention to keep intensifying, coupled with the almost universal adoption of statist ideology after the turn of the twentieth century, which course the nation would take was unfortunately inevitable.

Chase and Sherman drove the new system through under cover of war necessity, but it was designed to alter the banking system permanently. The wartime ground was to set up national banks, which were so structured as to necessarily purchase large amounts of U.S. government bonds. Patterned after the “free” banking systems, this tied the nation’s banks with the federal government and the public debt in a close symbiotic relationship. The Jacksonian embarrassment of the independent Treasury was de facto swept away, and the Treasury would now keep its deposits in a new series of “pets”: the national banks, chartered directly by the federal government. In this way, the Republican Party was able to use the wartime emergency to fulfill the Whig-Republican dream of a federally-controlled centralized banking system able to inflate the supply of money and credit in a uniform manner. Meshing with this was a profound political goal: As Sherman expressly pointed out, a vital object of the national banking system was to eradicate the
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A History of Money and Banking in the United States:
The Colonial Era to World War II

embarrassing doctrine of state’s rights and to nationalize American politics.119

As established in the bank acts of 1863 and 1864, the national banking system provided for the chartering of national banks by the Office of the Comptroller of the Currency in Washington, D.C. The banks were “free” in that any institution meeting the requirements could obtain a charter, but the requirements were so high (from $50,000 for rural banks to $200,000 in the bigger cities) that small national banks were ruled out, particularly in the large cities.120

The national banking system created three sets of national banks: c
entral reserve city
, which was only New York;
reserve
city
, others cities with over 500,000 population; and
country
, which included all other national banks.

Central reserve city banks were required to keep 25 percent of their notes and deposits in reserve of vault cash or “lawful money,” which included gold, silver, and greenbacks. This 119In his important work on Northern intellectuals and the Civil War, George Frederickson discusses an influential article by one Samuel Fowler written at the end of the war:

The Civil War which has changed the current of our ideas, and crowded into a few years the emotions of a lifetime,” Fowler wrote, “has in measure given to the preceding period of our history the character of a remote state of political existence.” Fowler described the way in which the war, a triumph of nationalism and a demonstration of “the universal tendency to combination,” had provided the
coup de grace
for the Jefferson philosophy of government with its emphasis on decentralization and the protection of local and individual liberties. (George Frederickson,
The Inner Civil War:
Northern Intellectuals and the Crisis of the Union
[New York: Harper and Row, 1965], p. 184)

See also Merrill D. Peterson,
The Jeffersonian Image in the American Mind
(New York: Oxford University Press, 1960), pp. 217–18.

120For a particularly lucid exposition of the structure of the national banking system, see John J. Klein,
Money and the Economy,
2nd ed. (New York: Harcourt, Brace and World, 1970), pp. 140–47.

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Before the Twentieth Century

provision incorporated the “reserve requirement” concept that had been a feature of the “free” banking system. Reserve city banks, on the other hand, were allowed to keep one-half of their required reserves in vault cash, while the other half could be kept as demand deposits (checking deposits) in central reserve city banks. Finally, country banks only had to keep a minimum reserve ratio of 15 percent of their notes and deposits; and only 40 percent of these reserves had to be in the form of vault cash.

The other 60 percent could be in the form of demand deposits either at reserve city or central reserve city banks.

The upshot of this system was to replace the individualized structure of the pre–Civil War state banking system by an inverted pyramid of country banks expanding on top of reserve city banks, which in turn expanded on top of New York City banks. Before the Civil War, every bank had to keep its own specie reserves, and any pyramiding of notes and deposits on top of that was severely limited by calls for redemption in specie by other, competing banks as well as by the general public. But now, reserve city banks could keep half of their reserves as deposits in New York City banks, and country banks could keep most of theirs in one or the other, so that as a result, all the national banks in the country could pyramid in two layers on top of the relatively small base of reserves in the New York banks. And furthermore, those reserves could consist of inflated greenbacks as well as specie.

A simplified schematic diagram can portray the essence of this revolution in American banking:

Figure 1

Notes and

Deposits

Specie

Figure 1 shows state banks in the decentralized system before the Civil War. Every bank must stand or fall on its bottom. It can
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A History of Money and Banking in the United States:
The Colonial Era to World War II

pyramid notes and deposits on top of specie, but its room for such inflationary expansion is limited, because any bank’s expansion will cause increased spending by its clients on the goods or services of other banks. Notes or checks on the expanding bank will go into the coffers of other banks, which will call on the expanding bank for redemption. This will put severe pressure on the expanding bank, which cannot redeem all of its liabilities as it is, and whose reserve ratio has declined, so it will be forced to either contract its loans and liabilities or else go under.

Figure 2

Country Banks

Reserve City Banks

New York City Banks

Reserves: Specie and Greenbacks

Figure 2 depicts the inverted pyramid of the national banking system. New York City banks pyramid notes and deposits on top of specie and greenbacks; reserve city banks pyramid their notes and deposits on top of specie, greenbacks,
and
deposits at New York City; and country banks pyramid on top of both. This means that, for example, if New York City banks inflate and expand their notes and deposits, they will not be checked by other banks calling upon them for redemption. Instead, reserve city banks will be able to expand their own loans and liabilities by pyramiding on top of their own increased deposits at New York banks. In turn, the country banks will be able to inflate their credit by pyramiding on top of their increased deposits at both reserve city and New York banks. The whole nation is able to inflate uniformly and relatively unchecked by pyramiding on top of a few New York City banks.

The national banks were not compelled to keep part of their reserves as deposits in larger banks, but they tended to do so—in the long run, so that they could expand uniformly on top of the
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larger banks, and in the short run because of the advantages of having a line of credit with a larger “correspondent” bank as well as earning interest on demand deposits at that bank.121

Let us illustrate in another way how the national banking system pyramided by centralizing reserves. Let us consider the hypothetical balance sheets of the various banks.122 Suppose that the country banks begin with $1 million in vault cash as their reserves. With the national banking system in place, the country banks can now deposit three-fifths, or $600,000, of their cash in reserve city banks, in return for interest-paying demand deposits at those banks.

The balance-sheet changes are now as follows: COUNTRY BANKS

Assets Liabilities + Equity Reserves

Vault cash
–
$600,000

Deposits at

reserve city

banks
+
$600,000

RESERVE CITY BANKS

Assets Liabilities + Equity Reserves

Vault cash
+
$600,000 Demand deposits due country

banks
+
$600,000

121Banks generally paid interest on demand deposits until the practice was outlawed in 1934.

122Adapted from Klein,
Money and the Economy
, pp. 144–45.

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

Total reserves for the two sets of banks have not changed.

But now because the country banks can use as their reserves deposits in reserve city banks, the same total reserves can be used by the banks to expand far more of their credit. For now $400,000 in cash supports the same total of notes and deposits that the country banks had previously backed by $1 million, and the reserve city banks can now expand $2.4 million on top of the new $600,000 in cash—or rather, $1.8 million in addition to the $600,000 due to the city banks. In short, country bank reserves have remained the same, but reserve city bank reserves have increased by $600,000, and they can engage in 4-to-1 pyramiding of credit on top of that.

But that is not all. The reserve city banks can deposit half of their reserves at the New York banks. When they do that, then the balance sheets of the respective banks change as follows:

RESERVE CITY BANKS

Assets Liabilities + Equity Reserves

Vault cash
+
$300,000

Deposits at

Demand deposits

central reserve

due country

city banks
+
$300,000 banks

+
$600,000

CENTRAL RESERVE CITY BANKS

Assets Liabilities + Equity Reserves

Vault cash
+
$300,000 Demand deposits due reserve

city banks
+
$300,000

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Before the Twentieth Century

Note that since the reserve city banks are allowed to keep half of their reserves in the central reserve city banks, the former can still pyramid $2.4 million on top of their new $600,000, and yet deposit $300,000 in cash at the New York banks. The latter, then, can expand another 4-to-1 on top of the new cash of $300,000, or increase their total notes and deposits to $1.2 million.

In short, not only did the national banking system allow pyramiding of the entire banking structure on top of a few large Wall Street banks, but the very initiating of the system allowed a multiple expansion of all bank liabilities by centralizing a large part of the nation’s cash reserves from the individual state banks into the hands of the larger, and especially the New York, banks. For the expansion of $1.2 million on top of the new $300,000 at New York banks served to expand the liabilities going to the smaller banks, which in turn could pyramid on top of their increased deposits. But even without that further expansion, $1 million which, we will assume, originally supported $6 million in notes and deposits, will now support, in addition to that $6 million, $2.4 million issued by the reserve city banks, and $1.2 million by the New York banks—to say nothing of further expansion by the latter two sets of banks which will allow country banks to pyramid more liabilities.