Monday, April 29, 2013

Why a Central Bank?, II: Where Did It Come From?


Why was the Federal Reserve System established?  After Andrew Jackson shut down the Second Bank of the United States in the 1830s, the United States lacked a uniform and stable currency.  Gold and silver coin did not circulate much outside cities in the East, and there wasn’t enough of it, anyway.  Most people made do either with accounts with people and businesses with which they did business, or state bank and private bank banknotes, many of which fluctuated wildly in value, rarely passing at a full dollar-for-dollar.

During the Civil War, against the advice of businessmen and bankers, the Union at first tried to finance the war using debt instead of taxes.  The U.S. saw its first paper money issued at the national level under the Constitution.  This upset those who still remembered the debacle of the Continental Currency.

When Treasury Secretary organized the National Banking System as a quasi-central bank in 1863, it embodied four serious flaws.  One, small lenders were generally not able to discount bills of exchange, limiting them to the rapidly shrinking pool of past savings to finance small capital development.

Two, the currency issued by the National Banks was backed 100% by government debt.

Three, the currency was inelastic, with the amount fixed by law.

Four, until 1879 and the restoration of convertibility of the paper currency into gold, the paper currencies (the United States Notes — “Greenbacks” — and the National Bank Notes) did not pass at par with gold and silver coin.  Prices in paper were higher than prices in gold or silver.

The Panics of 1873, 1893 and 1907 revealed serious flaws in the U.S. financial system, most of which were directly traceable to an inelastic currency that was insufficient for the needs of commerce, especially for financing small capital and carrying out the daily consumer transactions that provide the backbone of a domestic economy.

This was the fertile ground on which grew the populist demand for cheap money.  Depending on one’s particular sympathies or interests, this was usually either in the form of increased government debt to inflate the United States Note or National Bank Note currencies, or increased coinage of rapidly depreciating silver.

Despite the “Great Depressions” that followed the Panics of 1873 and 1893, there was no effective agitation for reform until the Panic of 1907.  This is, perhaps, understandable.  Where there was significant doubt in many people’s minds over the causes of the previous Panics, the “Bankers’ Panic” could be traced to the machinations of one man: financier J. P. Morgan.  Morgan caused the Panic by closing off clearinghouse privileges and refusing an emergency loan of reserves to the third largest bank in New York, the Knickerbocker Bank and Trust, when it got into trouble speculating in copper shares.

One of the biggest issues of the presidential campaign of 1912 was reform of the financial system.  Woodrow Wilson won the election when William Jennings Bryan gave Wilson his endorsement, which allowed Wilson to defeat Theodore Roosevelt.  Taft came in a distant third, trailed even more distantly by Eugene C. Debs, the socialist party candidate.  Wilson had originally run on a platform supporting far-right capitalism, but was persuaded by Bryan and others that a more progressive stance was essential to defeating Roosevelt.

#30#

No comments: