Central Banks: Alchemists of Finance Part III

History of Central Banks in the United States

Many people label the First National Bank of the United States as a central bank. A central bank is different from a national bank, however, such as the First National Bank (FNB) of the United States setup during Washington’s presidency. The FNB was a private bank in which the federal government had a twenty percent equity interest. It was forbidden from buying government bonds, it had a mandatory rotation of directors, it could not issue notes or incur debt beyond its capitalization, and the federal government could withdraw its money from the FNB and place it with another bank.[1] The FNB of the United States was truly a private bank not a central bank. It did not set the policies that “affect a county’s supply of money and credit.”  It also did not issue legal tender.

The First National Bank was not a central bank, however it was a government chartered and supported enterprise, sort of like Fannie Mae and not strictly a free market enterprise either. Such enterprises are prone to inside deals.

Hamilton and Washington pushed for a nation-wide bank because the national government had to be able to pay bills throughout the nation and a national bank made this easier than working with multiple different banks. Depending on a person’s view of central banking they either vilify Hamilton or think he was a genius. Both sides seem to confuse the national bank issue with Hamilton’s efforts to put the then newly-formed United States government on a sound footing. Hamilton’ s first report on public credit did not mention a national bank, it only dealt with the state and foreign bonds left over from the revolutionary war. The report called for:

1) Assumption of the state and foreign bonds that were trading around 20-25% of their face value;

2) Paying off these state and foreign bonds at their face value by issuing new federal bonds; and

3) Tariffs and tonnage duties to back these new federal bonds.

The result of this legislation, according to Wikipedia was:

“The adoption of Hamilton’s Report had the immediate effect of converting what had been virtually worthless federal and state certificates of indebtedness into $60 million of funded government securities. Fully funded, the central government regained the ability to borrow, attracting foreign investment as social unrest destabilized Europe. In addition, the newly issued bonds provided a circulating currency, stimulating business investment.”[2]

Hamilton’s plan worked brilliantly and it had nothing to do with the First National Bank of the United States.

The First National Bank was proposed in a separate report. Hamilton would not have been in favor of a central bank. Hamilton believed that a bank run by the government would be tempted to print too much money.[3] The First National Bank was not a central bank, however it was a government chartered and supported enterprise, sort of like Fannie Mae and not strictly a free market enterprise either. Such enterprises are prone to inside deals.

The Second National Bank was modeled after the First National Bank, except it had some regulatory authority over other banks. This made it closer to a central bank, however it did not have the power of legal tender or a monopoly on the issuance of money.

Most people point to the Second National Bank of the United States created in the Madison administration as a central bank. The Second National Bank was modeled after the First National Bank, except it had some regulatory authority over other banks. This made it closer to a central bank, however it did not have the power of legal tender or a monopoly on the issuance of money. Apparently, the Second National Bank was poorly run and became involved in politics. Andrew Jackson refused to renew its charter so its operations ended in 1836.

The first real central bank in the United States is the Federal Reserve, which was created in 1913. The Federal Reserve is a private entity of sorts. It is more like Fannie Mae than a true private bank however. However, it has the power to create legal tender, it is tasked with setting interest rates to achieve policy goals, and it has regulatory control over the whole banking system in the United States.

There were two main justifications given for the Federal Reserve: 1) the United States needed a lender of last resort to avoid banking panics, and 2) the idea that the United States government almost went bankrupt a couple of times, but JP Morgan saved the day.[4]

The United States did suffer from a number of bank panics, but these were due to over-regulation, not the free market. Oddly, finance (stocks and bonds) was not regulated at all in the United States until the Kansas’ Blue Sky Law in 1911, which was the blue print for the Securities Act of 1933. Banks on the other hand were highly regulated, the most obvious of these regulations were unit banking laws. Unit banking laws required that banks could have only one location and these laws existed in a number of states and were applied to federal banks. These resulted in a lack of diversification in banks’ portfolios, which increased their risk of failure.[5] Canada, however, did not have these restrictions. Canada had many nationwide banks and as a result did not have a single bank fail during the Great Depression.[6]

Private banks had already created clearing houses that acted as a lender of last resort, before the Federal Reserve.

Economist Milton Friedman understood . . . that before the Federal Reserve Act financial panics in the U.S. were mitigated by the actions of private commercial bank clearinghouses. Friedman and Schwartz’s view of the 1930s was that the Fed, having nationalized the roles of the clearinghouse associations [CHAs], particularly the lender-of-last-resort role, did less to mitigate the panic than the CHAs had done in earlier panics like 1907 and 1893. In that sense, the economy would have been better off if the Fed had not been created. This position is perfectly consistent with the position that, provided we take the Fed’s nationalization of the clearinghouse roles for granted, the Fed was guilty of not doing its job.[7]

The idea that the United States needed a central bank is not justified by the banking failures before the Federal Reserve. The Federal Reserve, in any event, failed in its crucial clearing house function during the Great Depression.

The other justification for the creation of the Federal Reserve was the supposed bailouts of the United States federal government in 1893 and 1907 by JP Morgan. The United States was on a gold standard and the governments gold reserves were being depleted rapidly in both cases. In both cases Morgan guaranteed to buy bonds issued to purchase gold for the United States Treasury. These bonds were sold on the strength and credit of the United States and Morgan profited by both of these so-called bailouts. If the Treasury had been doing its job correctly it would have cultivated a market for these bonds long before this crisis. In addition, the federal government could also have slashed spending. Not surprisingly the bailout of 1907 happened under the bad economic policies of Teddy Roosevelt. In addition, the United States had the power to issue legal tender, which it could have done to conserve its gold. The history surrounding these events is confused and has not been fully explored.

Another narrative pushed by the banking interests is that somehow banks are different than other businesses. Banks always argue that if one bank (a large politically-connected bank) fails then the whole banking system will collapse. This narrative is trotted out every time banks demand a bailout, the most recent being the bailouts in 2008.

Another narrative pushed by the banking interests is that somehow banks are different than other businesses. Banks always argue that if one bank (a large politically-connected bank) fails then the whole banking system will collapse. This narrative is trotted out every time banks demand a bailout, the most recent being the bailouts in 2008. When a bank fails it goes through bankruptcy, which acts as a circuit breaker from a cascading series of failures. This is exactly what happens in other areas of the economy. Another solution that I do not endorse, but is better than bailouts, was the Resolution Trust Corporation that was created to liquidate the savings and loan failures of the late 1980s. The Resolution Trust Corporation was essentially a massive bankruptcy proceeding and importantly its existence was limited. It had to liquidate all its assets by 1992 (five year life).

The justifications for the Federal Reserve are weak at best and considering the damage the Federal Reserve has done to the economy and its potential for abuse it should be ended. The origins of the Federal Reserve are based on government failure, specifically interference in a free market.

 
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[1] The book, Hamilton’s Blessing, is a great reference for this but I do not have a copy anymore.

[2] https://en.wikipedia.org/wiki/First_Report_on_the_Public_Credit#Funding_the_national_debt , accessed January 15, 2017.

[3] Gordon, John Steele, Hamilton’s Blessing: The Extraordinary Life and Time of Our National Debt, Penguin Books, 1997, p. 34.

[4] http://www.investopedia.com/articles/economics/08/federal-reserve.asp, accessed January 15, 2017.

[6] CARPE DIEM, http://mjperry.blogspot.mx/2008/09/great-depression-not-single-canadian.html , accessed January 15, 2017.

[7] . https://fee.org/articles/the-great-depression-according-to-milton-friedman/,  The Great Depression According to Milton Friedman, Ivan Pongracic Jr., Saturday, September 01, 2007, accessed January 15, 2017.

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About the Author: Dale B. Halling

Dale B. Halling is a software developer with a BSEE, an MS in Physics, and a JD. He is the author of The Decline and Fall of the American Entrepreneur: How Little Known Laws and Regulations are Killing Innovation and the Source of Economic Growth. He is the coauthor of the novels Pendulum of Justice and Trails of Injustice. Dale B. Halling is also a named inventor on nine patents.