History of Central Banking in US
I have seen several articles that refer to the increasing inflation that USA and other countries are experiencing. All this as a result of the “money printing” being undertaken by the central bank of each country. Inflation is a negative impact for people who save money for future use.
However, one can argue that this “money printing” is needed during these challenging times with Covid-19 impacting the economies of countries all over the world. And a question is - how would this be handled in a system where the central bank of a country was using a standard such as the gold standard or probably a bitcoin backed currency in the future.
I will look at this question in the future but today I want to look at the history of central banks in USA. When did US get it’s first central bank? How successful has this been? I focus on USA since this is still the leader when it comes to the financial world.
We need to understand this in order to design a system for the future that does not repeat mistakes from earlier. As George Santayana reportedly said ‘Those who do not learn history are doomed to repeat it’.
So let’s jump in.
Federal Reserve (Fed) is the central bank of USA. It is responsible for
ensuring that the inflation is under control
ensuring that the unemployment is under control
And it does this by either controlling the supply of money in society or by setting the interest rates for loans and deposits. Increasing the money supply and reducing the interest rates will result in more money being available. This will typically increase the inflation and reduce the unemployment. Reducing the money supply and increasing the interest rates will have the opposite effect.
So then the question is how long has the Fed been in existence. Fed was created in 1913 although the history of a central bank in the US goes back to the creation of the country in 1776.
The founding fathers of America did not like the concept of a central bank. They believed that such a bank could be used for speculation and financial manipulation and could be a source of corruption for the government.
First attempt for a central bank
Regardless, on December 31 1781, Congress chartered a bank and the Bank of North America was established. This was also the first commercial bank of the US. The government had partial ownership of the bank when the bank was set up. However, over time the government had to borrow money from the bank to feed the troops, money that was partially created from “nothing” by the bank. And the government failed to repay this loan back to the bank. Due to this the government had to give up its equity in the bank. As a result the bank stopped being a partner of the government and hence the bank did not work out.
The bank continued to operate as a private commercial bank well into the 20th century. It is now part of Wells Fargo after a result of several mergers.
Second attempt for a central bank
Congress chartered the First Bank of the United States in 1791 in spite of opposition. The Secretary of Treasury at that time, Alexander Hamilton, was a strong proponent of the bank. President George Washington signed the bill into law even though at some point he was hesitant about it.
Just like the Bank of North America, the First Bank of the United States also did not perform any of the functions expected from a central bank today. It did not set the monetary policy. It did not regulate private banks nor hold their private reserves. It also did not act as lender of last resort.
The Bank though was responsible for collecting tax revenues, making loans to the government and paying the bills of the government. The Bank was forbidden from buying US government bonds both to avoid inflation and to avoid the appearance of impropriety. The Bank also accepted deposits from the public and extended loans to businesses and citizens. Banknotes issued by this Bank were accepted throughout the country. Further, banknotes issued by this Bank were the only form of payment accepted when federal taxes had to be paid.
The banknotes issues by this Bank were backed by substantial gold reserves. This resulted in a stable national currency. The Bank also held notes issued by the state banks. It used this to indirectly impact the monetary state. It would do so by presenting these notes to the state banks for collection in gold and silver. Doing so would slow the growth of money and credit.
The First Bank’s charter expired in 1811 and was not renewed by Congress. This was because the political enemies of the bank vast outnumbered the supporters of the Bank when time came to renew the charter. The biggest supported of the bank, Alexander Hamilton, was also dead in 1811. The numerous state banks also did not like the First Bank of the United States due to the power of this bank and hence they also helped stoke the opposition to this bank.
The bank was acquired by a private individual after the charter of the First Bank of the United States expired in 1811.
Third attempt for a central bank
The govt launched the Second Bank of the United States in 1816. This was identical to the First Bank of the United States in terms of functions.
President Andrew Jackson was very much against this bank given his policies. He denounced the bank as an “engine of corruption.” and set out to destroy it. He tried to get the bank dissolved but on failing to do so did not renew the bank’s charter.
Further, in 1833, to make the bank obsolete, he created an executive order requiring all federal land payments to be made in gold or silver. In addition, federal revenue was also diverted into selected private banks.
On failing to have it’s charter renewed, the bank became a private corporation in 1836 and was liquidated in 1841. The non-renewal of the bank charter in 1836 was followed by a shortage of currency. This led to the Panic of 1837 where people lost confidence in banks.
This led to an era of no central bank.
Free banking - No Central Bank
For the next 25 years, from 1837 to 1862, the US entered the “free banking” era. The people advocating for power of the central government lost the power struggle to people advocating the right of states. Hence the concept of a central bank withered away. Each state was then responsible for chartering its banks.
This was a period when only state-chartered banks existed. Anyone who wanted to create a bank could do so by filling out the correct paperwork and by depositing an in-kind payment to the state.
State banks established interest rates for loans and deposits, regulated reserve requirements etc. State banks also attempted to take on the functions of a central bank and issued bank notes against gold and silver coins. The value of the bank notes depended on the size of the issuing bank. In addition, other organizations like drugstores, railroad companies, insurance companies were also allowed to issue their own notes. This resulted in a great time for the forgers too. Nearly one third of the paper currency issued during this period was counterfeit.
However, this financial era also ended in disaster. Half of the banks failed. The average lifespan of a state bank was five years.
Fourth Attempt
The failure of the free banking era resulted in another attempt towards addressing the problem of creating banks. In 1863, the National Banking Act was passed that
•Set up a system of national banks.
•Established a uniform national currency backed by US Treasury (banks couldn’t just print money).
•Required national banks to back up bank notes with US Treasury securities.
•Took banking out of the hands of state governments.
•Required national banks to accept each other’s currencies. This allowed banks to lend money to one another.
•Set up the comptroller of the currency to print bank notes and to help charter, regulate and supervise all national banks.
A 10% tax on state bank bills forced most state banks to convert to national banks. But National banks ran into liquidity issues whenever there were fluctuations in currency value. And without a central bank it led to bank runs and caused severe disruptions.
Federal Reserve (Fed)
American banking was a disaster in early 1900s. The Panic of 1907 convinced many of the need for a Central Bank to provide price stability and emergency credit.
Hence, the Federal Reserve Act was passed by Congress and signed by President Wilson in Dec 1913 establishing the Fed. This Act establishes a Federal Reserve System that consists of 12 regional Federal Reserve Banks.
And so the Central Bank of United States came about. In a future article, I will look at the performance of the Fed over the last century of its existence.
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