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2. Decentralized Banking from the 1830s to the Civil War

After the financial crises of 1837 and 1839, the Democratic Party became even more Jacksonian,

more ardently dedicated to hard money, than ever before. The Democrats strived during the 1840s and

1850s, for the outlawing of all fractional reserve bank paper. Battles were fought during the late 1840s, at

constitutional conventions of many western states, in which the Jacksonians would succeed in outlawing such

banking, only to find the Whigs repealing the prohibition a few years later. Trying to find some way to

overcome the general revulsion against banks, the Whigs adopted the concept of free banking, which had

been enacted in New York and Michigan in the late 1830s. Spreading outward from New York, the free

banking concept triumphed in fifteen states by the early 1850s. On the eve of the Civil War, 18 out of the 33

states in the U.S. had adopted free banking laws.9

It must be emphasized that free banking before the Civil War was scarcely the same as the economic

concept of free banking [p. 216] we have set forth earlier. Genuine free banking, as we have noted, exists

where entry into the banking business is totally free, where banks are neither subsidized nor controlled, and

where at the first sign of failure to redeem in specie, the bank is forced to declare insolvency and close its


Free banking before the Civil War, however, was very different Vera C. Smith has gone so far as to

call the banking system before the Civil War, “decentralization without freedom,” and Hugh Rockoff labeled

free banking as the “antithesis of laissez-faire banking laws.”10 We have already seen that gen eral suspensions

of specie payments were periodically allowed whenever the banks overexpanded and got into trouble; the last

such episode before the Civil War being in the Panic of 1857. It is true that under free banking incorporation

was more liberal, since any bank meeting the legal regulations could be incorporated automatically without

having to lobby for a special legislative charter. But the banks were subject to a myriad of regulations, including

edicts by state banking commissioners, along with high minimum capital requirements which greatly restricted

entry into the banking business. The most pernicious aspect of free banking was that the expansion of bank

notes and deposits was tied directly to the amount of state government bonds which the bank had invested in and posted as security with the state. In effect, then, state government bonds became the reserve base upon

which the banks were allowed to pyramid a multiple expansion of bank notes and deposits. This meant that the

more public debt the banks purchased, the more they could create and lend out new money. Thus, banks were

induced to monetize the public debt, state governments were encouraged to go into debt, and govern ment and

bank inflation were intimately linked.

In addition to allowing periodic suspension of specie payments, federal and state governments

conferred upon the banks the highly valuable privilege of having their notes accepted in taxes. And the general

prohibition of interstate (and [p. 217] sometimes intrastate) branch banking greatly inhibited the speed by

which one bank could demand payment from another in specie. The clearing of notes and deposits, and hence

the free market limit on bank credit expansion, was thereby weakened.

The desire of state governments to finance public works was an important factor in their subsidizing

and propelling the expansion of bank credit Even Bray Hammond, scarcely a hard money advocate, admits

that “the wildcats lent no money to farmers and served no farmer interest. They arose to meet the credit

demands not of farmers (who were too economically astute to accept wildcat money) but of states engaged in

public improvements.”11

Despite the flaws and problems in the decentralized nature of the pre-Civil War banking system, the

banks were free to experiment on their own to improve the banking system. The most successful such device,

which imposed a rapid and efficient clearing system on the banks of New England, was the privately

developed Suffolk System.

In 1824, the Suffolk Bank of Boston, concerned for years about an influx of depreciated notes from

various country banks in New England, decided to purchase country bank notes and systematically call on the

country banks for redemption. By 1825, country banks began to give in to the pressure to deposit specie with

the Suffolk, so as to make redemption of their notes by that bank far easier. By 1838, furthermore, almost

every bank in New England was keeping such deposits, and were redeeming their liabilities in specie through

the medium of the Suffolk Bank.

From the beginning to the end of the Suffolk System (1825-58), each country bank was obliged to

maintain a permanent specie deposit of at least $2,000 ranging upward for larger sizes of bank. In addition to

the permanent minimum deposit, each bank had to keep enough specie at the Suffolk Bank to redeem all the

notes that Suffolk received. No interest [p. 218] was paid by the Suffolk Bank on these deposits, but Suffolk

performed the invaluable service of accepting at par all the notes received from other New England banks,

crediting the depositor banks’ accounts the following day.

As the result of Suffolk acting as a private clearing bank, every New England bank could automatically

accept the notes of any other bank at par with specie. In contrast to the general state bank approval of the

Bank of the United States (and later of the Federal Reserve System), the banks greatly resented the existence

of the Suffolk Banks tight enforcement of specie pay ments. They had to play by the Suffolk rules, however,

else their notes would depreciate rapidly and circulate only in a very narrow area. Suffolk, meanwhile, made

handsome profits by lending out the permanent, noninterest paying deposits, and by making overdrafts to the

member banks.

Suffolk System members fared very well during general bank crises during this period. In the Panic of

1837, not one Connecticut bank failed, or even suspended specie payments; all were members of the Suffolk

System. And in 1857, when specie payment was suspended in Maine, all but three banks (virtually all

members of the Suffolk System) continued to pay in specie.12

The Suffolk System ended in 1858 when a competing clearing bank, the Bank of Mutual Redemption,

was organized, and the Suffolk System petulantly refused to honor the notes of any banks keeping deposits

with the new bank. The country banks then shifted to the far laxer Bank of Mutual Redemption, and the

Suffolk Bank stopped its clearing function in October 1858, becoming just another bank. Whatever the error

of management in that year, however, the Suffolk System would have been swept away in any case by the

universal suspension of specie payments at the start of the Civil War, by the National Banking System installed

during the war, and by the prohibitive federal tax on state bank notes put through during that fateful period.13

[p. 219] [p. 220] [p. 221]