The free banking era in the USA and the Federal Reserve Act of 1913

Credit is the opium of the rich.

We can learn many important lessons about how the supply of money and banking practices have shaped our societies by studying the events between the time of the American independence, the civil war, the financial crash, the Great Depression, the creation of the federal reserve, and the modern times in which commercial and investment banks move “smart” money and financial instruments at lightning speeds. What it reveals is that worse than inflation and deflation of unpegged money supply, we have created a very commoditized, marginalized, consumptive society and class divides not seen since Dickinson’s plot of ‘Hard Times’. If religion was the opium of the poor, unchecked credit is the opium of the rich.

There was a period in early American history, 1836 – 1863, called the ‘free banking era’ during which there was neither a Central Bank or a Banking Charter, and it occurred during the presidency of Andrew Jackson. The thirty years of laissez-faire witnessed many bank failures and forlorn owners of banknotes unable to redeem their prized notes for the promised amount of gold or silver coins.

The First Bank of the United States, a vision of Alexander Hamilton, received its Charter in 1791 and continued to operate as a majority privately-owned enterprise until 1811. Unlike state banks it was able to open branches across states and issue its own notes and was a vehicle to collect federal tax receipts, accepting only its own currency as payment as opposed to the state banks’ currency. Though it was run profitably, Jeffersonian republicans and critics argued that it was too frugal and favored aristocracy and foreign interests and so its charter was not renewed. The building and all the furniture were purchased by a Philadelphia merchant Stephen Girard who found his own Girard Bank at the same address in South Third Street.

The Second Bank was formed in 1816 and it too ended operations in 1836 under clouds of controversy followed by a thirty-year hiatus known as the ‘free banking era’ in which state banks operated under state rules.

Alexander Hamilton wanted to expand federal fiscal and monetary powers and a central mint funded by excise taxes on whiskey. He wanted to do away with the Continental Congress’s currency which was not backed by gold or silver and had no control over it to check printing of notes. As a federalist, he desired the central government to assume the embryonic nation’s war debts and raise taxes, and have a common national currency. He understood that by doing so, the nation’s bank could benefit from credit from within and outside the territories of the new nation.

Monopoly money

During the free banking era, there were often wild fluctuations in money supply and prices. Local states imposed their own rules over local banks who issued their own currency, On the whole, this period was marked as a failure with the collapse of many banks however, New York state was relatively successful. Unlike the modern dollar note, the notes of that time were a promise by the state to exchange for a specified amount of the gold and silver coins or federal government bonds.

A merchant who wanted to start a bank was required to provide an amount of gold or coinage as capital which would be used to buy state or federal bonds that would be deposited with the authority. The state would then issue the bank with many bills as IOU’s which would be loaned to borrowers, crediting and debiting the ledger at the same time. As long as the IOU’s were covered by capital, depositors would always get their money back.

The free banking era ended during the civil war (1861 – 1865) and the Congress’ passing of the National Bank Act in 1863. The Act aimed to have a national currency and float the war loans to finance the war. For a time, people could not swap their bills or notes for gold and silver coins. This was followed by the passing of the Legal Tender Act when the government printed $150M of greenbacks which though legal tender was not backed by gold or silver. The fifteen hundred or so state banks had to convert to national banks or be taxed out of business. Anyone desiring to start a national bank would have to buy government bonds before they were allowed to issue their notes up to 90% of the value of these bonds. These national banks issued $300M of notes but mostly circulated on the East Side, which became a political issue since the West was also demanding more money for its expansion activities.

Crash of 1907 and the Knickerbocker Trust

Before the passing of the Federal Reserve Act of 1913, we had two newsworthy events, the earthquake in San Francisco in 1906 which led to $500M of damage and flattened the city, and the actions in 1907 of a disgraced mine owner called Augustus Heinz, who spectacularly miscalculated in his attempt to corner the shares of his company United Copper Company Incorporated. He thought he could control the price to other investors who were trying to unwind their ‘short’ position. The NYSE index dived 50% in three weeks which caused a run on the New York banks with panic spreading to the other states. No one could stop the panic as there was no central control over cash.

Knickerbocker Trust Company was the third largest of its kind, operating as a pseudo bank, skirting around the national banking system’s rules operating with thin cash reserves, was already insolvent, and promptly went bust. Charles Barney, President of Knickerbocker Trust, whilst in his bedroom shot himself in the abdomen with his 0.32 revolver and died later the same day. The trigger to the abdomen triggered panic in the NYSE stock market.

TRUST US!

Meanwhile, another trust, The Trust Company of America was also in trouble however, Mr. John Pierpont Morgan and John D Rockefeller ‘saved’ the company by organizing loans and orderly liquidation of assets.

GREASY TACTICS

By early 1907, Standard Oil was already in financial trouble. The company was led by Rockefeller and owned oil refineries in Cleveland and other parts of the midwest. The ownership of these companies was not always disclosed and through clandestine monopolistic tactics, price, and quota agreements, he was able to apply pressure on the oil producers and the railroads who were always at loggerheads with him. When Standard Oil’s behavior became known to the authorities, several of the company officials were indicted by the Grand Jury in Pennsylvania. However, the more serious challenge came from a group of oil producers who had managed to construct a pipeline to the East Side and transport oil more cheaply, bypassing the railroads, straight to the shipping ports. Rockefeller was compelled to move his operations to the eastern shore but to do this he needed board control over his spider web of companies, so he created the Standard Oil Trust headquartered in New York and wrested control from the conglomeration of subsidiaries and also circumventing state laws. By the turn of the twentieth century, Standard Oil had control over 90% of the pipelines in the USA, The company was eventually broken up and changed its name to Exxon.

STEAM ENGINE

Leading up to the events of the financial crash of 1907, the US steam train was chunking along at breakneck speed, by now over $4bn of monopoly money was in circulation and plenty of stock speculation in consolidated ventures involving railroad, shipping, and mining operations under the not so watchful eye of President McKinley. There was so much business that gold production could not keep up with the demand for notes. Businesses were also demanding deregulation.

THE FEDERAL RESERVE ACT OF 1913

The National Bank Act of 1863 had ushered in a national currency though there was still no central bank as yet. There were many independent banks but they were not allowed to have branches in other states. There were opposing forces at work, agrarian interests in the south versus the financial interests in the east versus businesses, and manufacturing who wanted easy commerce. After the civil war, the federal government, in 1861, unhinged the dollar note from the gold and the indebted and harvest affected farmers and planters opposed the return to the gold standard fearing deflation. However, the dollar did eventually return to the gold standard in 1879 at a time when the economy was fairly buoyant. Nevertheless, after the 1907 crash, opposing states and interests finally agreed that a central bank was necessary for providing short term liquidity at times of crisis to snuff out a future panic. So, in December 1913 President Woodrow Wilson signed the Federal Reserve Act which created the Federal Reserve System with twelve federal reserve banks. The Federal Open Market Committee (FOMC), which was established later after the Banking Act of 1935, is now only responsible for monetary policy.

IT ALL TUMBLES DOWN

Forty years earlier, in the summer of 1893, the stock market had experienced great falls due to the contraction in the money supply led by a fear that the US was about to leave the gold standard and the temporary restriction of conversion of notes for gold coins. This started a flight of gold from New York to London. Banks in the south were particularly affected because of low agricultural prices and one-third of the railroad business went bust.

Some of the same symptoms appeared in the Great Depression of 1929 -33, low agricultural prices, the collapse of banks, and subsequent tightening of reserves. There was a prevalence of small banks across many states and a few large banks in a few states. Those in one state were prohibited from opening branches in other states causing liquidity issues. So when state banks instituted ‘bank holidays’, periods where no withdrawal of cash was allowed, it caused further panic. By the time President Roosevelt came to office, twenty-five percent of the labor force was unemployed.

Meer & Co
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