THE BANK OF NORTH AMERICA AND THE FIRST BANK OF THE UNITED STATES - The Mystery of Banking

The first commercial bank in the United States was also designed to be the first central bank. Morris, a wealthy Philadelphia merchant and Congress man, had assumed virtually total economic and financial power during the Revolutionary War. As a war contractor, Morris siphoned off millions from the public treasury into contracts to his own mercantile and shipping firm and to those of his associates. Morris was also leader of the powerful Nationalist forces in the embattled new country whose aim was to reimpose in the new United States a system of mercantilism and big government similar to that in Great Britain, against which the colonists had rebelled. The object was to have a strong central government, particularly a strong president or king as chief executive, built up by high taxes and heavy public debt. The strong central government was to impose high tariffs to subsidize domestic manufacturers, develop a big navy to open up and subsidize foreign markets for American exports, and launch a massive system of internal public works. In short, the United States was to have a British system without Great Britain.

Part of the Morris scheme was to organize and head a central bank, to provide cheap credit and expanded money for himself and his allies. The new privately owned Bank of North America was deliberately modeled after the Bank of England. Its money liabilities were to be grounded upon specie, with a controlled monetary inflation pyramiding credit upon a reserve of specie.

The Bank of North America received a federal charter very quickly in a Congress dominated by its founder and major owner. Like the Bank of England, the Bank of North America was granted the monopoly privilege of its notes being receivable in all duties and taxes to state and federal governments, and at par with specie. Further more, no other banks were allowed to operate in the country. In return for this monopoly license to issue paper money, the Bank graciously agreed to lend most of its newly created money to the federal government. In return for this agreement, of course, the hapless tax payers would have to pay the Bank principal and interest.

Despite the monopoly privileges conferred upon the Bank of North America and its nominal redeem ability in specie, the market’slack of confidence in the inflated notes led to their depreciation outside the Bank’s home base in Philadelphia. The Bank even tried to bolster the value of its notes by hiring people to urge redeemers of its notes not to insist on specie—a move scarcely calculated to improve long-run confidence in the Bank.

After a year of operation, Morris’s political power slipped, and he moved quickly to shift the Bank of North America from a central bank to a purely commercial bank chartered by the state of Pennsylvania. By the end of 1783, all the federal government’s stock in the Bank, amounting to 5/8 of its capital, had been sold into private hands, and all U.S. government debt to the Bank repaid. The first experiment with a central bank in the United States had ended.

But the U.S. was not to be allowed to be without a central bank for very long. In 1787–88, the Nationalist forces pushed through a new Constitution replacing the decentralist Articles of Confederation. The Nationalists were on their way to re-establishing the mercantilist and statist British model, even though they were grudgingly forced to accept the libertarian Bill of Rights as the price for the Anti-Federalists—who commanded the support of the majority of Americans—not insisting on a second constitutional convention to return to something very like the decentralized Articles.

The successful Federalists (the term the Nationalists called themselves) proceeded to put through their cherished program:high tariffs, domestic taxes, public works, and a high public debt. A crucial part of their program was put through in 1791 by their leader, Secretary of the Treasury, Alexander Hamilton, a disciple of Robert Morris. Hamilton put through Congress the First Bank of the United States, a privately owned central bank, with the federal government owning 1/5 of the shares. Hamilton argued that an alleged “scarcity” of specie had to be overcome by infusions of paper money, to be issued by the new Bank and invested in the public debt and in subsidies of cheap credit to manufacturers. The Bank notes were to be legally redeemable in specie on demand, and they were to be kept at par with specie by the federal government’s accepting its notes in taxes, thus giving it a quasi-legal tender status. The federal government would also confer upon the Bank the privileges of being the depository for its funds. Further more, for the 20-year period of its charter, the First Bank of the United States was to be the only bank with the privilege of having a national charter.

The First Bank of the United States was modeled after the old Bank of North America, and in a significant gesture of continuity the latter’s long time president and former partner of Robert Morris, Thomas Willing of Philadelphia, was made president of the new Bank.

The First Bank of the United States promptly fulfilled its inflationary potential by issuing millions of dollars in paper money and demand deposits, pyramiding on top of $2 million of specie. The BUS invested heavily in $8.2 million of loans to the U.S. government by 1796. As a result, wholesale prices rose from an index of 85 in 1791 to a peak of 146 in 1796, an increase of 72 percent. In addition, speculation mounted in government securities and real estate. Pyramiding on top of BUS expansion, and aggravating the paper money expansion and the inflation, was a flood of newly created commercial banks. Only three commercial banks had existed at the inception of the Constitution, and only four by the time of the establishment of the BUS. But eight new banks were founded shortly there after, in 1791 and 1792, and 10 more by 1796. Thus, the BUS and its monetary expansion spurred the creation of 18 new banks in five years, on top of the original four.

Despite the official hostility of the Jeffersonians to commercialas well as central banks, the Democratic-Republicans, under the control of quasi-Federalist moderates rather than militant Old Republicans, made no move to repeal the charter of the BUS before its expiration in 1811. Moreover, they happily multiplied the number of state chartered banks and bank credit during the two decades of the BUS existence. Thus in 1800, there were 28 state banks; by 1811, the number had grown to 117, a four fold increase.

When the time came for rechartering the BUS in 1811, the re-charter bill was defeated by one vote each in the House and Senate. Recharter was fought for by the quasi-Federalist Madison administration, aided by nearly all the Federalists in Congress, but was narrowly defeated by the bulk of the Democratic-Republicans, led by the hard money Old Republican forces. In view of the widely held misconception among historians that central banks serve, and are looked upon, as restraints on state bank inflation, it is instructive to note that the major forces in favor of were merchants, Chambers of Commerce, and most of the state banks. Merchants found that the BUS had expanded credit at cheap interest rates, and eased the eternal complaints about a“scarcity of money.” Even more suggestive is the support of the state banks, which hailed the BUS as “advantageous” and worried about a contraction of credit should the Bank be forced to liquidate. The Bank of New York, which had been founded by Alexander Hamilton, even lauded the BUS because it had been able “in case of any sudden pressure upon the merchants to step forward to their aid in a degree which the state institutions were unable to do.”

But free banking was not to have much of a chance. The very next year, the United States launched an unsuccessful war against Great Britain. Most of the industry and most of the capital was in New England, a pro-British region highly unsympathetic to theWar of 1812. New England capital and the conservative New England banks were not about to invest heavily in debt to finance the war. Therefore, the U.S. government encouraged an enormous expansion in the number of banks and in bank notes and deposits to purchase the growing war debt. These new and recklessly inflationary banks in the Middle Atlantic, Southern, and Western states, printed enormous quantities of new notes to purchase government bonds. The federal government then used these notes to purchase arms and manufactured goods in New England. Thus, from 1811 to 1815, the number of banks in the country increased from 117 to 246. The estimated total of specie in all banks fell from $14.9 million in 1811 to $13.5 million in 1815, John Thom Holdsworth, The First Bank of the United States (Washington, D.C.: National Monetary Commission, 1910), p. 83. Holdsworth, the premier historian of the First BUS, saw this overwhelmingly supported by the state banks, but still inconsistently clung to the myth that the BUS functioned as a restraint on their expansion: “The state banks, though their note issues and discounts had been kept in check by the superior resources and power of the Bank of the United States, favored the extension of the charter, and memorialized Congress to that effect.” I bid., p. 90. Odd that they would be acting so contrary to their self-interest! where as the aggregate of bank notes and deposits rose from $42.2 million in 1811 to $79 million four years later, an increase of 87.2 percent, pyramiding on top of a 9.4 percent decline in specie.

What happened next provides a fateful clue to the problem of why free banking did not work as well before the Civil War as in our theoretical model. It didn’t work well (although its record was not nearly as bad as that of central banking) because it wasn’treally tried. Remember that a crucial aspect of the free banking model is that the moment a bank cannot pay its notes or deposits in specie, it must declare bankruptcy and close up shop. But the federal and state governments did not allow this crucial process of insolvency—fundamental to the capitalist system—to work itself out.

Specifically, in the War of 1812, as the federal government spent the new inflated notes in New England, the conservative New England banks called on the banks of the other regions for redemption in specie. By August 1814, it became clear that the banks of the nation apart from New England could not pay, that they were insolvent. Rather than allow the banks of the nation to fail, the governments, state and federal, decided in August 1814 to allow the banks to continue in business while refusing to redeem their obligations in specie. In other words, the banks were allowed to refuse to pay their solemn contractual obligations, while they could continue to issue notes and deposits and force their debtors to fulfill their contractual obligations. This was unfair and unjust, as well as a special privilege of mammoth proportions to the banking system; not only that, it provided carte blanche, an open sesame, for bank credit inflation.

Free banking did not work well in the U.S. because it was never fully tried. The banks were allowed to continue to “suspend specie payments” while remaining in business for 2½ years, even though the war was over by early 1815. This general suspension was not only highly inflationary at the time; it set a precedent for all financial crises from then on. Whether the U.S. had a central bank or not, the banks were assured that if they inflated together 198 The Mystery of Banking and then got in trouble, government would bail them out and permit them to suspend specie payments for years. Such general suspensions of specie payments occurred in 1819, 1837, 1839, and 1857, the last three during an era generally considered to be that of “free banking.”


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