The First and Second Banks of the United States
Although central banks can greatly improve an economy and are important to governments, the central banks of the United States had a tumultuous history. Central banks for the United States government spanned little more than 40 years until the creation of the Federal Reserve in 1913. Primarily the result of the greater powers of the state governments over the federal government in early America, state banks were the primary banks until 1863, when the federal government passed the National Banking Act, creating national banks based on a federal charter.
To finance the Revolutionary War, the Continental Congress issued continentals that, in the beginning were redeemable in specie—gold or silver coins. However, the Continental Congress had no taxing authority yet, and expenses and debts increased so rapidly that the Continental Congress stopped redeeming its notes in specie and simply adopted the expediency of printing more and more money. This served the new nation in the beginning before the population began to realize that the continentals were becoming more worthless as they accumulated them, but the printing of excess money that was not accompanied by a parallel increase in the economy simply decreased their value to the point were no one accepted it as money. As Benjamin Franklin pointed out, the depreciation of the continental dollar served as a type of inflation tax, proportional to the time when a person received it to when he ultimately spent it, the amount of the depreciation equaling the amount of the tax. Hence, the phrase "not worth a continental."
The exchange rate between continentals and 1 silver coin:
So much paper money was printed to finance the Revolutionary War, that by its end, shoes in Virginia sold for $5000 and clothes cost almost a million dollars. As George Washington was said to have said: "A wagon load of continentals would hardly purchase a wagon load of provisions." In 1780, the new government of the United States borrowed money from France and Spain and redeemed the continentals, paying $1 in specie for $40 in bills; the continentals were then destroyed.
Bank of North America
The first Bank of North America was actually a state bank chartered by the state of Pennsylvania in 1781. It was the first bank to receive deposits and to issue its own banknotes. These banknotes were printed by Benjamin Franklin's grandson, Benjamin Franklin Bache on marbled paper that Franklin brought home from France in 1779; the unique quality of the paper help to deter counterfeiters. In 1784, 2 more banks were established that also issued their own banknotes: the Bank of New York and the Massachusetts Bank.
In 1790, Congress debated whether to have the Bank of North America serve as a central bank for the new federal government, as England, Holland, and Sweden had at this time. However, Alexander Hamilton argued for a nationally chartered bank, where the federal government would have more control.
Bank of the United States
Alexander Hamilton, a founding father of the United States and the First Secretary of the Treasury under President George Washington, realized the importance of the banking system for the United States, and advocated for its creation. Hamilton argued that a federal bank would benefit the nation and cost taxpayers nothing, while providing a safe place for the federal government to deposit tax revenues, provide low-cost loans to the government when tax revenue was insufficient to fund the government, and help relieve the scarcity of hard cash by issuing banknotes that could circulate as money, providing much-needed liquidity and credit to expand the economy. Additionally, the federal bank could be given the authority to regulate state banks.
However, many people opposed a federal bank. Opponents of the bank argued that public creditors would be favored over those of other Americans and that it could become a tool of Congress, where it could be operated for their own benefit. Southern states feared that wealthy northeastern merchants would control the bank. Additionally, it was claimed to be unconstitutional, since the Constitution did not provide any authorization to issue charters of incorporation. As to the unconstitutionality argument, Hamilton argued that Congress was allowed to enact all measures that were "necessary and proper," thus arguing for a loose interpretation of the Constitution rather than the strict interpretation that many others — who were fearful of a big, centralized government — wanted. Thus, Hamilton argued that only activities that were specifically forbidden by the Constitution should be considered unconstitutional. It also helped that Hamilton had significant influence over George Washington. The new bank was approved by a narrow margin. Nonetheless, the First Bank of the United States did not last long, but states started chartering their own banks, which became the most prevalent banks in early America.
As Secretary of the Treasury, Hamilton presented a report to Congress, presenting the benefits of a national bank. Subsequently, the bill establishing the First Bank was cleared by Congress, then signed by George Washington, thus establishing the First Bank of the United States. Called the First Bank of the United States, since it was the First Bank chartered by the United States government, the bank served as the federal government's fiscal agent, collecting tax revenues, providing a vault to store the gold and silver held by the government, making loans to the government, transferring government deposits to the bank's branch network, paying government bills, including the interest on US government securities bought by European investors.
It also issued banknotes, but only up to its capitalization, initially $10 million, of which $2 million came from the federal government, while the rest came from private investors. Investors could invest in the bank because it was a private corporation. Initially, it had 8 branches in major port cities with its headquarters in Philadelphia. Port city locations facilitated the collection of tax revenues, which mainly came from custom duties and also facilitated the financing of international trade and provided the opportunity to sell US government securities to foreigners.
The bank also accepted deposits from the public and made loans to both private citizens and businesses. But it's charter required that it seek approval from Congress to make any loans to states or to foreigners. The interest rate for loans was capped at 6%. Hamilton had set up a federal sinking fund for the bank, to accumulate a cash surplus that the treasury could use to buy government securities in the open market to pay off its debt before maturity, if that was profitable.
Although the United States government was the largest shareholder and received a portion of the bank's profits, it did not directly manage the bank. The Treasury Secretary, however, did have the right to inspect the bank's condition, but no more than once a week.
The major source of its banknotes for the economy was as part of the loan process rather than through the purchase of United States government securities, as is done today. However, the First Bank did not set monetary policy nor did it regulate other banks. Even though it did not set monetary policy, it could help to provide more money and credit for the economy by holding onto the state banknotes instead of redeeming them at the state banks, thus allowing state banks to issue more loans through the issuance of banknotes. However, only notes from the First Bank were accepted as payment for federal taxes.
Its charter expired in 1811 and was not renewed for several reasons. First, many people thought that the federal government had no constitutional right to charter a bank because the Constitution only gave Congress, not a private corporation, the right to print money. Second, Britons had come to own 70% of the stock, and since the bank paid dividends in specie, it was feared that they would transfer the gold and silver specie back to England, thus, depleting America of much needed commodity money that served as the basis of their banknotes.
However, the major opposition came from state banks because people preferred the federal banknotes, thereby diminishing the value of their own notes, and because it limited the credit and profit potential of the state banks by forcing them to be fiscally responsible. The Bank of the United States would receive banknotes from most of the major state banks during the course of its business. Periodically, it would present these notes to the banks for payment in gold or silver coins. The state banks had to pay because otherwise people would lose faith in the bank's notes and it would fail. Naturally, the state banks resented this because they wanted to print money that was not all backed by specie.
There were 101 state banks when the First Bank's charter expired in 1811; the number increased to 205 by 1816. The War of 1812 caused the federal government to greatly increase its debt, and without the First Bank, it had to deposit its tax receipts in state banks. Consequently, state banks started issuing more banknotes, increasing the amount of money in circulation, increasing inflation.
The unrestrained proliferation of banknotes would eventually cause the Panic of 1819. After the demise of the First Bank, state banks were being formed for the sole purpose of providing banknotes to its owners so that they could speculate in land prices. In other words, these banks, which didn't even have depositors, were not created because there was capital to invest, or to provide loans to businesses or farmers, but to simply print banknotes to give to its owners, men without real capital and who would not have been able to get a real loan based on their creditworthiness. These notes were used to buy land, subdivide the land, then sell the subdivisions to farmers at exorbitant prices. Naturally, this house of cards had to fall.
Second Bank of the United States (B.U.S.)
The War of 1812 had depleted the coffers of the United States government, revealing the shortcomings of not having a central bank. Hence, people in government and business deemed it necessary to create another central bank.
The Second Bank of the United States was chartered in 1816 for a 20-year term. Modeled after the First Bank of the United States, B.U.S. or BUS, as it was often referred to at this time, had $35 million of initial capital, 25 branches, and the President of the United States appointed 5 members of the board of directors. BUS was also a private institution. It was poorly managed, at first, by William Jones. But Langdon Cheves repaired most of the damage in the 3 years that he managed it. Nicholas Biddle then took over and managed it competently for the remainder of the bank's existence. Its charter expired in 1836, but it continued as a Pennsylvania state bank for another 5 years.
As the federal government's fiscal agent, it received tax collections and the proceeds from government land sales and paid the government's bills. It also sold government bonds when necessary. Since it redeemed in specie not only its own banknotes, but also those of state banks, it had vaults to store the gold and silver. Redeeming state banknotes made the Second Bank of the United States a creditor to the state banks because it could present the banknotes to their issuing bank to redeem in specie, which it did. This forced financially stressed state banks to call in their loans to farmers and land speculators, causing their insolvency, which caused deflation and an economic depression for the whole economy, since the money supply quickly contracted.
As for any powerful institution, BUS had its critics. Many were concerned that BUS was a private institution that had control over the money supply, but was governed by a private board of directors rather than by an elected official, or even anyone working in government. And Wall Street, becoming increasingly important in financial matters, didn't like such a powerful financial institution headquartered in Philadelphia. And it didn't help that the President of the United States, Andrew Jackson, also hated the bank.
But probably the most important reason was that state bankers couldn't be free to print banknotes to finance the great land speculation out west while BUS, at any time, could present their banknotes for redemption in specie. This possibility made BUS a de facto regulator of state banks. Indeed, Biddle suggested to Congress that he could ruin virtually any state bank simply by presenting its banknotes for redemption into specie, for if the bank could not redeem its notes, then not only would its banknotes become worthless, but there would also probably be a run on the bank as people attempted to exchange their worthless banknotes for specie.
The End of BUS
President Andrew Jackson hated BUS and was determined to see it end, even before its charter expired, since there was a good chance that it would be renewed. In 1833, Jackson started putting government receipts into his favorite state banks, "pet banks" as called by his opponents, instead of BUS, while BUS continued paying government bills, thus depleting the bank's money. Its deposits fell from $10,000,000 to $4,000,000.
However, the American economy was to pay dearly for Jackson's misfeasance. To increase BUS deposits, Biddle called in loans to state banks, which caused their failure, wiping out the savings of their depositors. Making things worse, Congress passed a distribution bill in 1836, giving $37 million to the states for internal improvements. This money was deposited in state banks, which used it to finance more land speculation. And to Jackson's chagrin, the 89 state banks holding the federal deposits were also using the money to finance land speculation.
In 1836, BUS's charter expired, and with it, the modest amount of fiscal restraint imposed on state banks by BUS. Land prices soared.
Finally, Jackson stopped the sale of all federal land and issued the Specie Circular, which required that government land be paid in gold or silver; banknotes were not accepted. Unable to pay the government, Western land speculators went bankrupt, since they were unable to sell the land to farmers, who didn't have specie to pay. Banknotes became more worthless as they become more numerous, and gold and silver coins were removed from circulation (bad money driving out the good), causing the financial panic of 1837.
Jackson hated powerful special interest groups, but in destroying BUS, he catered to other special interests, especially the state banks, that hurt the American economy significantly. Of course, state banks would not have had to worry about BUS, or anybody else, presenting its notes for redemption if they simply held enough specie to cover their notes as they were supposed to, but this crimped profits.
Although BUS was a much needed institution and did its job well, there would not be another central bank of the United States until the creation of the Federal Reserve in 1913. Most of the financial panics throughout American history could have been avoided if government officials didn't cater to special interests, but it's hard to resist money.
Indeed, here I am, writing this in June, 2009, in the midst of the credit crisis which resulted from easy credit during 2001-2007 that gave rise to wild speculations in real estate, stocks, and commodities, driving their prices to ever greater heights as if it could never end. But, it did end. But even after this debacle, mainly caused by the biggest banks, which had to be bailed out by taxpayers, these same banks have formed a lobbying group to lobby Congress not to increase restrictions on their practices. This same basic scenario has happened repeatedly throughout America's history.
Those who cannot learn from history are doomed to repeat it. — George Santayana