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The Origins of the Federal Reserve: The Advent of the National Banking System

It should now be crystal clear what the attitude of commercial banks is and almost always will be toward the Central Bank in their country. The Central Bank is their support, their staff and shield against the winds of competition and of people trying to obtain money which they believe to be their own property waiting in the banks' vaults. The Central Bank crucially bolsters the confidence of the gulled public in the banks and deters runs upon them. The Central Bank is the banks' lender of last resort, and the cartelizer that enables all the banks to expand together so that one set of banks doesn't lose reserves to another and is forced to contract sharply or go under. The Central Bank is almost critically necessary to the prosperity of the commercial banks, to their professional career as manufacturers of new money through issuing illusory warehouse receipts to standard cash.

Also we can now see the mendacity of the common claim that private commercial banks are “inflation hawks” or that Central Banks are eternally guarding the pass against inflation. Instead, they are all jointly the inflation-creators, and the only inflation-creators, in the economy.

Now this does not mean, of course, that banks are never griping about their Central Bank. In every “marriage” there is friction, and there is often grousing by the banks against their shepherd and protector. But the complaint, almost always, is that the Central Bank is not inflating, is not protecting them, intensely or consistently enough. The Central Bank, while the leader and mentor of the commercial banks, must also consider other pressures, largely political. Even when, as now, their notes are standard cash, they must worry about public opinion, or about populist complaints against inflation, or about instinctively shrewd if often unsophisticated public denunciations of the “money power.” The attitude of a bank toward the Central Bank and government is akin to general bellyaching by welfare “clients” or by industries seeking subsidies, against the government. The complaints are almost always directed, not against the existence of the welfare system or the subsidy program, but against alleged “deficiencies” in the intensity and scope of the subventions. Ask the complainers if they wish to abolish welfare or subsidies and you will see the horror of their response, if indeed they can be induced to treat the question seriously. In the same way, ask any bankers if they wish to abolish their Central Bank and the reaction of horror will be very similar.12

For the first century of the history of the American Republic, money and banking were crucial policy issues between the political parties. A Central Bank was a live issue from the beginning of the American nation. At each step of the way, the champions of the Central Bank were the enthusiastic Nationalists, the advocates of a Big Central Government. In fact, in 1781, even before the Revolutionary War was over, the leading Nationalist, Philadelphia's merchant tycoon Robert Morris, who was Congress's virtual wartime economic czar, got Congress to charter the first Central Bank, his own Bank of North America (BNA). Like the Bank of England, Congress bestowed on Morris's private BNA the monopoly privilege of issuing paper notes throughout the country. Most of these notes were issued in the purchase of newly-issued federal debt, and the BNA was made the depository of all congressional funds. Over half the capital of the BNA was officially subscribed by Congress.13 The BNA notes were supposedly redeemable in specie, but of course the fractional-reserve expansion indulged in by the BNA led to the depreciation of its notes outside its home base in Philadelphia. After the end of the Revolutionary War, Morris lost his national political power, and he was forced to privatize the BNA swiftly and to shift it to the status of a regular private bank shorn of government privilege.

Throughout the first century of the Republic, the party favoring a Central Bank, first the Hamiltonian High Federalists, then the Whigs and then the Republicans, was the party of Big Central Government, of a large public debt, of high protective tariffs, of large-scale public works, and of subsidies to large businesses in that early version of “partnership between government and industry,” Protective tariffs were to subsidize domestic manufactures, while paper money, fractional reserve banking, and Central Banking were all advocated by the nationalists as part of a comprehensive policy of inflation and cheap credit in order to benefit favored businesses. These favorites were firms and industries that were part of the financial elite, centered from the beginning through the Civil War in Philadelphia and New York, with New York assuming first place after the end of that war.

Ranged against this powerful group of nationalists was an equally powerful movement dedicated to laissez-faire, free markets, free trade, ultra-minimal and decentralized government, and, in the monetary sphere, a hard-money system based squarely on gold and silver, with banks shorn of all special privileges and hopefully confined to 100-percent specie banking. These hard-money libertarians made up the heart and soul of the Jeffersonian Democratic-Republican and then the Jacksonian Democratic party, and their potential constituents permeated every occupation except those of banker and the banker's favored elite clientele.

After the First Bank of the United States was established by Hamilton, followed by a Second Bank put in by pro-bank Democrat-Republicans after the War of 1812, President Andrew Jackson managed to eliminate the Central Bank after a titanic struggle waged during the 1830s. While the Jacksonian Democrats were not able to enact their entire hard money program during the 1840s and 1850s because of the growing Democratic split over slavery, the regime of those decades, in addition to establishing free trade for the last time in the United States, also managed to eliminate not only the Central Bank but all traces of centralized banking.

While the new Republican Party of the 1850s contained many former Jacksonian Democrats, the economic agenda of the Republicans was firmly fixed by the former Whigs in the party. The victorious Republicans took advantage of the near one-party Congress after the secession of the South to drive through their cherished agenda of economic nationalism and statism. This nationalist program included: a huge increase in central government power fueled by the first income tax and by heavy taxes on liquor and tobacco, vast land grants as well as monetary subsidies to new transcontinental railroads; and the reestablishment of a protective tariff.

Not the least of the Republican statist revolution was effected on the monetary and financial front. To finance the war effort against the South, the federal government went off the gold standard and issued irredeemable fiat paper money, called “Greenbacks” (technically, U.S. Notes). When the irredeemable paper, after two years, sank to 50 cents on the dollar on the market in terms of gold, the federal government turned increasingly to issuing public debt to finance the war.

Thus, the Republican-Whig program managed to dump the traditional Jefferson-Jackson Democratic devotion to hard money and gold, as well as their hatred of the public debt. (Both Jefferson, and later Jackson, in their administrations, managed, for the last time in American history, to pay off the federal public debt!) In addition, while the Republicans did not yet feel strong enough to bring back a Central Bank, they effectively put an end to the relatively free and non-inflationary banking system of the post-Jacksonian era, and created a new National Banking System that centralized the nation's banks, and established what amounted to a halfway house toward Central Banking.

The state banks had been happy, from the beginning of the war, to pyramid an expansion of fractional-reserve notes and demand deposits on top of the increase of federal green-backs, thus expanding the total supply of money. Later in the Civil War, the federal government created the National Banking System, in the Bank Acts of 1863, 1864, and 1865. Whereas the Peel Act had granted to one Bank of England the monopoly of all bank notes, the National Banking Acts granted such a monopoly to a new category of federally chartered “national banks”; the existing state banks were prohibited from any issue of notes, and had to be confined to issuing bank deposits.14 In other words, to obtain cash, or paper notes, the state banks had to keep their own deposit accounts at the national banks, so as to draw down their accounts and obtain cash to redeem their customers' deposits if necessary. For their part, the national banks were established in a centralized tripartite hierarchy. At the top of the hierarchy were leading “central reserve city” banks, a category originally confined to large banks in New York City; beneath that were “reserve city” banks, in cities of over 500,000 population; and beneath those were the rest, or “country banks.” The new legislation featured a device pioneered by Whig state governments, especially New York and Michigan, in the 1840s: legal minimum fractional-reserve requirements of bank reserves to their notes and deposits. The reserve requirements fashioned an instrument of control by the upper strata of the banking hierarchy over the lower. The crucial point was to induce the lower tiers of banks to keep much of their reserves, not in legal cash (gold, silver, or greenbacks) but in demand deposit accounts in the higher tier banks.

Thus, the country banks had to keep a minimum ratio of 15 percent of reserves to their notes and demand deposits outstanding. Of that 15 percent, only 40 percent had to be in cash; the rest could be in the form of demand deposits at either reserve city or central reserve city banks. For their part, the reserve city banks, with a minimum reserve ratio of 25 percent, could keep no more than half of these reserves in cash; the other half could be kept as demand deposits in central reserve city banks, which also had to keep a minimum reserve ratio of 25 percent. These various national banks were to be chartered by a federal comptroller of the currency, an official of the Treasury Department. To obtain a charter, a bank had to obey high minimum capital requirements, requirements rising through the hierarchical categories of banks. Thus, the country banks needed to put up at least $50,000 in capital, and the reserve city banks faced a capital requirement of $200,000.

Before the Civil War, each state bank could only pyramid notes and deposits upon its own stock of gold and silver, and any undue expansion could easily bring it down from the redemption demands of other banks or the public. Each bank had to subsist on its own bottom. Moreover, any bank suspected of not being able to redeem its warehouse receipts, found its notes depreciating on the market compared either to gold or to the notes of other, sounder banks.

After the installation of the National Banking System, however, each bank was conspicuously not forced to stand on its own and be responsible for its own debts. The U. S. Government had now fashioned a hierarchical structure of four inverse pyramids, each inverse pyramid resting on top of a smaller, narrower one. At the bottom of this multi-tiered inverse pyramid were a handful of very large, central reserve city, Wall Street banks. On top of their reserves of gold, silver, and greenbacks, the Wall Street Banks could pyramid an expansion of notes and deposits by 4:1. On their deposits at the Central Reserve City banks, the reserve city banks could pyramid by 4:1, and then the country banks could pyramid their warehouse receipts by 6.67:1 on top of their deposits at the reserve banks. Finally, the state banks, forced to keep deposits at national banks, could pyramid their expansion of money and credit on top of their deposit accounts at the country or reserve city banks.

To eliminate the restriction on bank credit expansion of the depreciation of notes on the market, the Congress required all the national banks to accept each other's notes at par. The federal government conferred quasi-legal tender status on each national bank note by agreeing to accept them at par in taxes, and branch banking continued to be illegal as before the Civil War, so that a bank was only required to redeem notes in specie at the counter at its home office. In addition, the federal government made redemption in specie difficult by imposing a $3 million per month maximum limit on the contraction (i.e., net redemption) of national bank notes.

Thus, the country was saddled with a new, centralized, and far more unsound and inflationary banking system that could and did inflate on top of expansion by Wall Street banks. By being at the bottom of that pyramid, Wall Street banks could control as well as generate a multiple expansion of the nation's money and credit. Under cover of a “wartime emergency,” the Republican Party had permanently transformed the nation's banking system from a fairly sound and decentralized one into an inflationary system under central Wall Street control.

The Democrats in Congress, devoted to hard money, had opposed the National Banking System almost to a man. It took the Democrats about a decade to recover politically from the Civil War, and their monetary energies were devoted during this period to end greenback inflationism and return to the gold standard, a victory which came in 1879 and which the Republicans resisted strongly. Particularly active in pushing for continued greenback inflation were the industrial and financial power elite among the Radical Republicans: the iron and steel industrialists and the big railroads. It was really the collapse of nationalist bankers, tycoons, and subsidized and over-expanded railroads in the mighty Panic of 1873 that humbled their political and economic power and permitted the victory of gold. The Panic was the consequence of the wartime and post-war inflationary boom generated by the new Banking System. And such dominant financial powers as Jay Cooke, the monopoly underwriter of government bonds from the Civil War on, and the main architect of the National Banking System, was, in a fit of poetic justice, driven into bankruptcy by the Panic. But even after 1879, gold was still challenged by inflationist attempts to bring back or add silver to the monetary standard, and it took until 1900 before the silver threat was finally beaten back and gold established as the single monetary standard. Unfortunately, by that time, the Democrats had lost their status as a hard-money party, and were becoming more inflationist than the Republicans. In the midst of these struggles over the basic monetary standard, the dwindling stock of hard-money Democrats had neither the ability nor the inclination to try to restore the free and decentralized banking structure as it had existed before the Civil War.

  • 12. It is a commonly accepted myth that the “state banks” (the state-chartered private commercial banks) strongly supported Andrew Jackson's abolition of the Second Bank of the United States—the Central Bank of that time. However (apart from the fact that this was a pre-Peel Act Central Bank that did not have a monopoly on bank notes and hence competed with commercial banks as well as providing reserves for their expansion) this view is sheer legend, based on the faulty view of historians that since the state banks were supposedly “restrained” in their expansion by the Bank of the United States, they must have favored its abolition. On the contrary, as later historians have shown, the overwhelming majority of the banks supported retention of the Bank of the United States, as our analysis would lead us to predict. See John M. McFaul, The Politics of Jacksonian Finance (Ithaca, N.Y.: Cornell University Press, 1972), pp. 16–57; and Jean Alexander Wilburn, Biddle's Bank: The Crucial Years (New York: University Press, 1970), pp. 118–19.1212
  • 13. When Morris failed to raise the specie capital legally required to launch the BNA, he simply appropriated specie loaned to the U.S. Treasury by France and invested it for the U.S. government in his own bank. On this episode, and on the history of the war over a Central Bank in America from then through the nineteenth century, see “The Minority Report of the U.S. Gold Commission of 1981,” in the latest edition, The Ron Paul Money Book (Clute, Texas: Plantation Publishing, 1991), pp. 44–136.
  • 14. Strictly, this prohibition was accomplished by a prohibitive 10-percent tax on state bank notes, levied by Congress in the spring of 1865 when the state banks disappointed Republican hopes by failing to rush to join the National Banking structure as set up in the two previous years.