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, each bank is
responsible for controlling its nation's money supply.

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 of the constitution" (Symons, 14).

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.

The Bank of the United States had both public and private functions. Its
most important public function was to control the 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 demand (Ibid, 11-13). The
Bank's ownership was set by $10 million in capital, divided into 25,000
shares of voting stock with a par value of $400 each. About 80 percent of
the stock was sold to the public with the remainder capitalized by the
federal government. No individual 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).

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).

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
(Ibid). 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 court that
the act to incorporate the Bank of the United States is a law made in
pursuance of the Constitution, and is part of the supreme law of the land"
(Hixson, 117). The Court reaffirmed this opinion in a 1824 case Osborn v.
Bank of the United States (Ibid, 14).

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 wrote,

     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. I sincerely 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 in Briscoe 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 measures to construct a financial system.

                                 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.

Hixson, William F., Triumph of the Bankers: Money and Banking in the
Eighteenth
and Nineteenth Centuries, London: Praeger, 1993.

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

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.

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

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                                  Part II:
              The American Free-Banking Experience, 1836-1860

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
tripled within the next dozen years despite the well-known opposition to
banking of the next two Presidents, Adams and Jefferson (Hammond, 144-45).

Click here to view an 1853 state bank note.

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 necessary to create money.

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 federal
government were Constitutional.

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
Kentucky that state banks and the notes they issued were also
constitutional.

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 left with worthless
banknotes.

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 business.

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 come to literal free banking.

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 face value of the bonds, so the
performance of the bond market directly affected the system's ability to
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
     (Galbraith, 63-64).

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).

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 losses ranged from $1.6 million and $2.1 million per
state.

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 which frequently
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 notes which would be based on economic
factors, not exogenous regulations, and that this quantity of notes would
not, in theory, cause monetary instability (Sechrest, 16-17).

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.

                                 REFERENCES:

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, 1993.

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

Rolnick, Arthur J. and Warren E. Weber, The free banking era...
Federal Reserve Bank of Minneapolis, Staff Report 80, May 1982.

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 Jr. and James J. White, Banking Law, St. Paul: West
Publishing, 1984.

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                                  Part III:
                    The National Banking Acts and 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 substantial depositor losses.

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.

There were also private attempts to improve the state banking system. The
Suffolk Bank system was an example of a miniature central 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 that did not voluntarily
agree to this were "convinced" of the plan's merit when Suffolk began
hoarding the notes of uncooperative banks and then presenting them in bulk
for redemption. In effect Suffolk was imposing a required reserve ratio, a
tool we normally associate with the Federal Reserve. By 1825 most of New
England's banks were members of this system and the results were generally
good. Almost all the banknotes in the region were accepted at par which
eliminated the Gresham's Law problem that had plagued Suffolk originally. In
addition, the money supply in the New England area exhibited less volatility
than in other regions of the country.

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 Act in 1913.

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 Engraving, was
responsible for printing all national banknotes.

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.

Click here to view a 1929 national bank note.

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 government.

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 outstanding state 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.

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,
1893, and 1907 this reserve pyramid precipitated a financial crisis.

When national banks experienced a drain on their reserves as rural banks
made deposit withdrawals, reserves had to be replaced in 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 deposits
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.

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 to calm the public's fears.

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.

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                                  Part IV:
                 The Formation of the Federal Reserve System

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 were associated 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
accompanied by those features.

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, the Comptroller 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:

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

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.