13. Decentralized Banking from the 1830's to the Civil War

0:00Decentralized Banking from the 1830s to the Civil War After the central bank was eliminated in the 1830s, the battle for hard money largely shifted to the state governmental arena. During the 1830s, the major thrust was to prohibit the issue of small notes, which was accomplished for notes under $5 in 10 states by 1832, and subsequently five others restricted or prohibited such notes. The Democratic Party became ardently hard money in the various states after the shock of the financial crisis of 1837 and 1839. The Democratic drive was toward the outlawry of all fractional reserve bank paper. Battles were fought also in the late 1840s at constitutional conventions of many states, particularly in the West.

0:47In some Western states, the Jacksonians won temporary success, but soon the Whigs would return and repeal the bank prohibition. The Whigs, trying to find some way to overcome the general revulsion against banks after the crisis of the late 1830s, adopted the concept of, quote, free banking, which had been enacted by New York and Michigan in the late 1830s. From New York, the idea spread outward to the rest of the country and triumphed in 15 states by the early 1850s. On the eve of the Civil War, 18 out of 33 states in the Union had adopted, quote, free banking laws. It must be realized that quote free banking as it came to be known in the United States before the Civil War was unrelated to the philosophic concept of free banking analyzed by economists.

1:35As we have seen earlier, genuine free banking is a system where entry into banking is totally free. The banks are neither subsidized nor regulated and at the first sign of failure to redeem in specie payments, a bank is forced to declare insolvency and close its doors. Free banking before the Civil War, on the other hand, was very different. As we have pointed out, the government allowed periodic general suspensions of specie payments whenever the banks over-expanded and got into trouble. The latest episode was in the Panic of 1857. It is true that bank incorporation was now more liberal since any bank that met the legal regulations could become incorporated automatically without lobbying for special legislative charters, as had been the case before. But the banks were now subject to a myriad of regulations, including edicts by state banking commissioners and high minimum capital requirements that greatly restricted entry into the banking business.

2:29But the most pernicious aspect of quote free banking was that the expansion of banknotes and deposits was directly tied to the amount of state government securities that the bank had invested in and posted as bond with the state. In effect then, state government bonds became the reserve base upon which banks were allowed The State government allowed to pyramid a multiple expansion of banknotes and deposits. Not only did the system provide explicitly or implicitly for fractional reserve banking, but the pyramid was tied rigidly to the amount of government bonds purchased by the banks. This provision deliberately tied banks and bank credit expansion to the public debt. It meant that the more public debt the banks purchased, the more they could create and lend out new money. Banks, in short, were encouraged to monetize the public debt.

3:14State governments were thereby encouraged to go into debt, and hence, government and bank inflation were intimately linked. In addition to allowing periodic suspension of specie payments, federal and state governments conferred upon the banks the privilege of their notes being accepted in taxes. Moreover, the general prohibition of interstate branch banking, and often of intrastate branches as well, greatly inhibited the speed by which one bank could demand payment from other banks in specie. In addition, state usury laws, pushed by the Whigs and opposed by the Democrats, made credit excessively cheap for the riskiest borrowers and encouraged inflation and speculative expansion of bank lending. Furthermore, the desire of state governments to finance internal improvements was an important factor in subsidizing and propelling expansion of bank credit.

4:03As Hammond admits,

4:12of Farmers, who were too economically astute to accept Wildcat money, but of states engaged in public improvements." Despite the flaws and problems, the decentralized nature of the pre-Civil War banking system meant banks were free to experiment on their own with improving the banking system. The most successful such device was the creation of the Suffolk system.