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Thursday, September 9, 2010

Say’s Law of Markets, Part VIII: The Battle of the Bank

It is no coincidence that the rise of State absolutism and the rejection of Say’s Law of Markets and the real bills doctrine went hand-in-hand. Say’s Law and the real bills doctrine make it clear that everyone — in theory — has access to the power to create money simply by being able to produce, whether by one’s labor or by one’s capital.

The First Bank of the United States

What is a coincidence is that the first sound defense of Say’s Law and the real bills doctrine, and the rebirth of the idea of sovereignty of the human person under God both came in 1776, the former with the publication of Adam Smith’s The Wealth of Nations, and the latter with the signing of the Declaration of Independence in Philadelphia on July 4. The Declaration of Independence asserted humanity’s natural rights as “self-evident,” while The Wealth of Nations outlined the basic financial and economic theory that would allow people to secure those rights and make them effective.

Thus it comes as no surprise that Alexander Hamilton, the first Secretary of the Treasury of the United States, wasted no time in trying to establish an economic and financial system that embodied Say’s Law and the real bills doctrine. This meant establishing a commercial banking system backed up with a national bank, the “Bank of the United States,” to ensure a sound and uniform currency for the new country.

There had already been one successful attempt to start a bank, the “Bank of North America.” Financier Robert Morris convinced the Continental Congress to pass a resolution on May 26, 1781 approving the Bank of North America as a national bank. (Edward S. Kaplan, The Bank of the United States and the American Economy. Westport, Connecticut: Greenwood Press, 1999, 11.) Due probably to the suspicion of “the money power” that had almost ruined the new country through the issuance of the Continental Currency, the Bank of North America was rechartered as a strictly local institution on March 7, 1787 for a period of 14 years. (Ibid.) It continued to operate under the laws of Pennsylvania until it was absorbed into the National Bank system in 1863. (Charles A. Conant, A History of Modern Banks of Issue. New York: G. P. Putnam’s Sons, 1927, 335.) In 1929 the Bank of North America became part of the First Pennsylvania Banking and Trust Company, (Kaplan, op. cit., 13) which was reorganized in 1983, adopting the name, “CoreStates Financial Corp,” (Terrence A. Larsen, CoreStates Financial Corp: Drawing Strength from History, Community and Diversity, New York: Newcomen Society, 1993.). Later CoreStates merged with Wachovia, which subsequently was taken over by Wells Fargo.

Hamilton’s goals for the Bank of the United States were to 1) establish a uniform currency that passed at par everywhere, 2) establish and maintain the credit of the new government, and 3) do something about the Continental Currency, by this time nearly worthless. (Hildreth, op. cit., 51.)

Hamilton modeled the Bank of the United States on the Bank of England with a little input from Adam Smith’s The Wealth of Nations, (Kaplan, op. cit., 21) but with more safeguards built in to the system in an effort to prevent a takeover of the bank by the federal government. Hamilton’s requirements were, one, the bank must be completely independent of the federal government. This meant it must be a private company and it could not under any circumstances purchase government bonds.

Two, the bank must be a monopoly at the federal level, thereby ensuring a uniform national currency. To regulate the monopoly, the charter would run for only twenty years to be renewed by Congress’s option, and the Secretary of the Treasury would have the right at any time to audit the books, remove government deposits for any reason, and to demand weekly financial statements if deemed necessary. As a further check on the bank’s power, individual states could charter banks to operate exclusively within the state. The bank could neither issue notes nor incur debts in excess of its capitalization.

Three, there would be a mandatory rotation of directors. Foreigners could hold bank stock, but could not vote.

The primary function of the Bank would be to provide liquidity for commerce and industry by discounting and rediscounting bills of exchange. As far as the federal government was concerned, the Bank would be restricted to acting as a depository for federal funds and making short-term loans to cover temporary shortfalls in tax revenues. This was considered a very important function, but secondary to the needs of the private sector.

The bank was chartered on February 25, 1791 for a period of twenty years. To get the bill through Congress, Hamilton struck a deal to support the efforts to move the capital from Philadelphia to what would become Washington, DC. After a delay, and with reservations, Washington signed the bill into law.

Reaction to the Bank

Many people believed that the Bank would manipulate interest rates, thereby harming the very commerce and industry it was intended to foster. There was also a significant group that believed the Bank was unconstitutional. When Hamilton stepped down as Treasury Secretary in 1795, his successor, Oliver Wolcott, Jr., presented Congress with a choice to provide funds for a projected shortfall in revenues. Either 1) raise taxes, or 2) sell the shares the federal government held in the Bank. Wolcott favored the latter, as did most of Congress, thereby weakening the Bank’s position dramatically. For this and other reasons, when the Bank’s charter was up for renewal in 1811, President James Madison let it expire.

Soon after the charter of the first Bank of the United States was allowed to lapse (though not as a consequence!) the United States became involved in the War of 1812 — “Mister Madison’s War.” The war set off high inflation and there was a serious problem with financing military operations, due in large measure to the lack of a uniform national paper currency. (Conant, op. cit., 341-342.) As a result, the credit of the United States fell to its lowest point since 1776. A depression hit the country hard in 1815, suggesting to many people that the termination of the Bank of the United States may have been premature. This group included President Madison, whose decision not to renew the Bank’s charter may have been influenced by his battles with Hamilton over the bank. (Broadus Mitchell, Alexander Hamilton: A Concise Biography. New York: Barnes and Noble, 1999, 189-192, 200-205, 250-255, 266.)

The Second Bank of the United States

Consequently, many of the congressmen who had refused to renew the charter of the Bank of the United States in 1811 now led the effort to establish the Second Bank of the United States in 1816. (Ibid., 343.) The Second Bank of the United States was, like the first, chartered for twenty years, to be up for renewal in 1836. Initially operating out of Carpenters’ Hall in Philadelphia, it soon had its own facility and opened branches throughout the country. Almost immediately it became a symbol of the rapid growth of concentrated financial and political power, something anathema to Jacksonian Democracy.

Consequently, once in office, Andrew Jackson made the elimination of the Second Bank of the United States his primary objective. (Conant, op. cit., 349-357.) Even though the effective destruction of the Bank was based on an extremely naïve view of money, credit, and the needs of an increasingly industrialized national economy, people in the 21st century still hearken back to Jackson’s war with the Bank as a work of both populist genius and high patriotism.

At first glance the build up and aftermath of the “Panic of 1837” seem strikingly similar to those that led up to the infamous Stock Market Crash of 1929 and the recent housing bubble. Traditional accounts of the Panic blame it on a speculative fever fed by banks — especially the Second Bank of the United States — over-enthusiastically investing in canals, roads, and other infrastructure. Gamblers presumably caused the situation by speculating in the state bond issues floated to finance the projects.

Economic historians have discovered, however, that (contrary to popular misconception), evidence suggests that the exact opposite is the case. Had banks been lending without regard to the soundness of the projects being financed and creating a credit boom, there would have been a large drop in reserve ratios as bad debts were written off without being repaid, or the money supply was expanded without regard to existing reserves. During the early 1830s, however, the average reserve ratios of banks were not decreasing, but, on the contrary, remained relatively stable.

Part of the misunderstanding is the failure to realize that “reserves” can take the form of any financially sound asset, combined with the mistaken notion that reserves must be in the form of gold or silver. Prior to the Federal Reserve Act of 1913, commercial banks could hold their reserves in the form of any presumably sound security.

Under the state banking system in place in the United States before the National Bank Act of 1864, there were four primary sources of commercial banks reserves:
• “Issues upon general assets” (Conant, op. cit., 359.)

• “Issues protected by a general safety fund,” (Ibid.)

• “Issues based upon public securities,” (Ibid.) and

• “Issues based upon the faith and credit of the States.” (Ibid.)
“General assets” were real bills. If a bank extended only financially sound loans, the bills — commercial paper — could be sold at need for gold and silver to other banks or private investors. Contrary to the accepted accounts, if we include all forms of credit instruments in the concept of “money,” (John Fullarton, On the Regulation of Currencies; Being an Examination of the Principles, on Which It is Proposed to Restrict, Within Certain Fixed Limits, the Future Issues on Credit of The Bank of England, and of the Other Banking Establishments Throughout the Country. London: John Murray, 1845, 28-55.) issues of state and private banks were not backed by specie to any great degree. (George Tucker, The Theory of Money & Banks Investigated. Boston: Charles C. Little and James Brown, 1839, 130-144 (directly), 164-165, 173-182 (indirectly).) On the contrary (as a number of authorities make clear), paper money backed with commercial loans made for productive purposes (“mercantile paper”), equity shares of sound companies (including other banks), and other instruments conveying liens on existing, “hard” assets were absolutely essential if the United States was to develop economically, or even stay where it was. Popular misconceptions aside, paper money could and did, in fact, make up the bulk of circulating media, inadequately supplemented with foreign coin and sparse domestic issues.

The Attack on the Bank

Citing official Congressional reports, George Tucker, a noted early 19th century American Congressman, novelist, and political economist, observed that the circulating media of the United States was primarily paper representing credit extended by commercial banks of issue. While the net imports of gold from 1834 through 1838 seem enormous at nearly $50 million, this was dwarfed by the amount of bank paper in circulation meeting the needs of commerce. As Tucker stated, writing in 1838,

By far the largest proportion of this class of credits is in promissory notes, especially in the mutual dealings of mercantile men. We may form some idea of their vast amount, when we find those which were discounted at the several banks in the United States, amounting, on the 1st of January [1838] to $485,000,000, and on the 1st of January preceding [1837], to 40,000,000 more. These discounts, moreover, constitute but a part, and, perhaps, not the largest part, of this description of credits. (Ibid., 132.)

Thus, in light of sound banking theory, the usual theories as to the origin of the Panic of 1837 are not tenable. Instead, the Panic of 1837 appears to have been largely the result of Andrew Jackson’s rather naïve economic policies. By the middle of his first term as president, Jackson’s hatred of the Second Bank of the United States had developed into a virtual mania. Ostensibly this was due to the prevalence of fraud and corruption in the Bank, but it cannot be denied that his personal feelings and beliefs had a great deal to do with inspiring his attacks. In common with virtually every other institution in the country, public and private, the Bank officers, notably Nicholas Biddle, the president, had used Bank resources in an effort to influence elections . . . especially that of Andrew Jackson. Biddle and the others argued that this was purely in self-defense, but it did not change the facts.

To secure the Bank’s future, Biddle decided to try and lock in a renewal of the charter four years ahead of schedule. This was a reasonable move to make in view of the obvious hostility of the administration, for it would give the Bank four years to rally support in the event the re-charter effort failed — and allow Biddle and supporters of the Bank to identify opponents.

While a sound tactic, the re-charter effort proved to be a serious mistake. It gave Jackson the opening for which he had been looking. While the re-charter bill passed Congress, Jackson vetoed it, making the veto an attack on the rich and the foreign investors who were the Bank’s principal shareholders.

Biddle declared that the veto was a “manifesto of anarchy,” while Daniel Webster suggested that Jackson only vetoed the bill in order to bolster popular support for his campaign for a second term. If so, it was successful, for Jackson defeated Henry Clay for the presidency the following November.

Jackson then moved against the Bank’s principal business: acting as a depository for federal funds. In 1833, two years before the expiration of the bank’s charter, Jackson instructed Louis McLane, his second Secretary of the Treasury to withdraw Federal funds from the bank and deposit them in (other) private banks.

McLane refused. Jackson then effectively fired McLane by removing him from the position of Secretary of the Treasury and appointing him Secretary of State. Jackson then appointed William Duane in his place. William John Duane (1780-1865) was an Irish-born politician and lawyer from Pennsylvania. Duane, however, proved to be less than amenable. He, too, refused to carry out an act so obviously detrimental to the common weal by delaying taking action for four months, whereupon Jackson removed him in turn.

The president then looked around until he found someone sufficiently acquiescent to obey his orders: Roger B. Taney, his former Attorney General and the future Supreme Court Chief Justice.

Despite Taney’s acquiescence in removing federal funds from the Bank, many in the Senate condemned Jackson’s decision. Ironically, Taney transferred the federal government’s Pennsylvania deposits in the Second Bank of the United States to the Bank of Girard in Philadelphia. The Bank of Girard was the successor bank to the Bank of Stephen Girard. Stephen Girard had purchased the assets of the First Bank of the United States when its charter was not renewed in 1811. Girard then named his new bank after himself. He became a major financier of the War of 1812, including most of the war loan of 1813. He was also the original organizer and a major shareholder of the Second Bank of the United States.

The Second Bank of the United States soon began to lose money. Biddle, desperate to save his bank, called in all of his loans and refused to extend any new credit. This angered many of the bank’s clients, causing them to pressure Biddle to re-adopt its previous loan policy. This caused him to authorize many loans that were not sound, and which went into default as a result of the Panic of 1837. The Bank lost its federal charter in 1836, and shut down in 1841. (Conant, op. cit., 355.)

Most authorities credit the failure of the Second Bank of the United States to Andrew Jackson’s personal animosity. This had been stirred up when one of Jackson’s political appointees, Isaac Hill, falsely accused one Mr. Mason, manager of the Portsmouth, New Hampshire branch of the Bank, of favoring Jackson’s political opponents in the matter of loans granted. The fact was that Mason had been contracting loans out of a fear that the Bank was overextended and, ironically in view of later accusations of fraud, to correct previous mismanagement, and Hill had been refused a loan. Hill appears to have made up the story about political favoritism in revenge. (Ibid., 350.)

Despite Jackson’s charges of corruption and failure, the Second Bank of the United States had, in fact, been successful at maintaining a uniform paper currency that passed at par with gold and silver, and at stabilizing the exchange rates between state banks. Further, the Bank had been extremely successful in virtually stopping speculation and gambling by currency dealers who had been in the habit of making enormous profits from the wildly fluctuating values of state bank notes. Senator Smith of Maryland declared in 1832 from the floor of the Senate that the notes of the Bank were “more valuable than silver,” and, in fact, often passed at more than their face value in silver. (Ibid., 348.)

The Panic of 1837

None of this carried any weight with Jackson. Taney’s opportunistic behavior in removing federal deposits from the Bank may even have given Jackson the impetus to issue the “Specie Circular” by executive order in 1836 as a way of stopping speculation in the purchase of Federal lands and further restricting the issuance of paper money. Jackson probably considered this necessary because, while his alteration of the ratio from 15 to 1, to 16 to 1 had significantly increased the flow of gold into the country (and forced down the real price of American exports, chiefly cotton), it caused silver — the chief circulating specie — to decrease. Consequently, the amount of gold and silver in circulation or held in banks as reserves actually decreased due to hoarding, being replaced for the most part with domestic bills of exchange. (Ibid.) As coin disappeared from circulation, more paper issues and merchant’s tokens made their appearance to supply the needs of commerce.

The Specie Circular Act required that all government loans, especially loans extended for the purchase of government land (notably the land from which the Cherokee had been removed), be repaid with gold and silver instead of bank notes. As most bank reserves were not in the form of bullion or coined gold and silver, but commercial loan paper and equity shares, this created an enormously increased demand for gold and silver coin at a time when existing supplies were already insufficient to meet the ordinary demand for circulating media.

Consequently, on May 10, 1837, a few weeks after Martin Van Buren took office (and which caused him to be assigned much of the blame for the Panic), all the banks in New York City (the financial center of the country) stopped payment of specie, that is, paying out gold and silver coin. Obviously, in light of the Specie Circular, this meant that no land could be purchased, and no payments made on loans for past sales. As land was the chief productive asset of the time, this brought commercial activity to a virtual standstill.

As dictated by the basic tenets of Jacksonian democracy in which the central government was considered secondary to the states, Van Buren refused to allow the Federal government to intervene. Van Buren was, thus (naturally) accused of prolonging the depression, “Hard Times,” that followed. Banks failed, and unemployment reached record highs.

Possibly the longest-lasting effect of the Panic of 1837 was to give most Americans an even greater distrust of banks and a fundamental misunderstanding of their role in the economy. Jacksonian Democrats had a field day, blaming the banks both for fueling rampant speculation in canal-building, and by reintroducing inflated paper money issues by printing money backed by commercial loans instead of bullion.

Consequently, the accepted theory of how the tremendous economic growth of the United States over the next century was financed was based on a factual error. People had the fixed idea that only gold and silver, or paper money backed with gold and silver, is sound currency or even “real” money. Since it is impossible to create money through the banking system under those restrictions (that is, without the ability to “leverage” the purchase of capital assets), the only way to finance capital formation is to cut consumption, save, then invest.