WEBVTT NOTE 13. Decentralized Banking from the 1830's to the Civil War 1 00:00:00.000 --> 00:00:05.000 Decentralized Banking from the 1830s to the Civil War 2 00:00:05.000 --> 00:00:13.000 After the central bank was eliminated in the 1830s, the battle for hard money largely shifted to the state governmental arena. 3 00:00:13.000 --> 00:00:26.000 During the 1830s, the major thrust was to prohibit the issue of small notes, which was accomplished for notes under $5 in 10 states by 1832, and subsequently five others restricted or prohibited such notes. 4 00:00:26.000 --> 00:00:30.920 The Democratic Party became ardently hard money in the various states after the shock 5 00:00:30.920 --> 00:00:35.120 of the financial crisis of 1837 and 1839. 6 00:00:35.120 --> 00:00:40.320 The Democratic drive was toward the outlawry of all fractional reserve bank paper. 7 00:00:40.320 --> 00:00:45.440 Battles were fought also in the late 1840s at constitutional conventions of many states, 8 00:00:45.440 --> 00:00:47.420 particularly in the West. 9 00:00:47.420 --> 00:00:52.080 In some Western states, the Jacksonians won temporary success, but soon the Whigs would 10 00:00:52.080 --> 00:00:55.160 return and repeal the bank prohibition. 11 00:00:55.160 --> 00:01:00.040 The Whigs, trying to find some way to overcome the general revulsion against banks after 12 00:01:00.040 --> 00:01:05.720 the crisis of the late 1830s, adopted the concept of, quote, free banking, which had 13 00:01:05.720 --> 00:01:10.180 been enacted by New York and Michigan in the late 1830s. 14 00:01:10.180 --> 00:01:15.000 From New York, the idea spread outward to the rest of the country and triumphed in 15 15 00:01:15.000 --> 00:01:17.400 states by the early 1850s. 16 00:01:17.400 --> 00:01:22.760 On the eve of the Civil War, 18 out of 33 states in the Union had adopted, quote, free 17 00:01:22.760 --> 00:01:24.740 banking laws. 18 00:01:24.740 --> 00:01:28.580 It must be realized that quote free banking as it came to be known in the United States 19 00:01:28.580 --> 00:01:33.620 before the Civil War was unrelated to the philosophic concept of free banking analyzed 20 00:01:33.620 --> 00:01:35.580 by economists. 21 00:01:35.580 --> 00:01:40.340 As we have seen earlier, genuine free banking is a system where entry into banking is totally 22 00:01:40.340 --> 00:01:41.340 free. 23 00:01:41.340 --> 00:01:45.280 The banks are neither subsidized nor regulated and at the first sign of failure to redeem 24 00:01:45.280 --> 00:01:51.020 in specie payments, a bank is forced to declare insolvency and close its doors. 25 00:01:51.020 --> 00:01:55.260 Free banking before the Civil War, on the other hand, was very different. 26 00:01:55.260 --> 00:01:59.900 As we have pointed out, the government allowed periodic general suspensions of specie payments 27 00:01:59.900 --> 00:02:03.020 whenever the banks over-expanded and got into trouble. 28 00:02:03.020 --> 00:02:06.660 The latest episode was in the Panic of 1857. 29 00:02:06.660 --> 00:02:10.920 It is true that bank incorporation was now more liberal since any bank that met the legal 30 00:02:10.920 --> 00:02:16.660 regulations could become incorporated automatically without lobbying for special legislative charters, 31 00:02:16.660 --> 00:02:18.660 as had been the case before. 32 00:02:18.660 --> 00:02:23.160 But the banks were now subject to a myriad of regulations, including edicts by state 33 00:02:23.160 --> 00:02:27.700 banking commissioners and high minimum capital requirements that greatly restricted entry 34 00:02:27.700 --> 00:02:29.640 into the banking business. 35 00:02:29.640 --> 00:02:33.940 But the most pernicious aspect of quote free banking was that the expansion of banknotes 36 00:02:33.940 --> 00:02:38.100 and deposits was directly tied to the amount of state government securities that the bank 37 00:02:38.100 --> 00:02:41.860 had invested in and posted as bond with the state. 38 00:02:41.860 --> 00:02:46.700 In effect then, state government bonds became the reserve base upon which banks were allowed 39 00:02:46.700 --> 00:02:50.700 The State government allowed to pyramid a multiple expansion of banknotes and deposits. 40 00:02:50.700 --> 00:02:55.500 Not only did the system provide explicitly or implicitly for fractional reserve banking, 41 00:02:55.500 --> 00:03:00.140 but the pyramid was tied rigidly to the amount of government bonds purchased by the banks. 42 00:03:00.140 --> 00:03:04.980 This provision deliberately tied banks and bank credit expansion to the public debt. 43 00:03:04.980 --> 00:03:08.980 It meant that the more public debt the banks purchased, the more they could create and 44 00:03:08.980 --> 00:03:10.500 lend out new money. 45 00:03:10.500 --> 00:03:14.920 Banks, in short, were encouraged to monetize the public debt. 46 00:03:14.920 --> 00:03:19.140 State governments were thereby encouraged to go into debt, and hence, government and 47 00:03:19.140 --> 00:03:22.100 bank inflation were intimately linked. 48 00:03:22.100 --> 00:03:26.760 In addition to allowing periodic suspension of specie payments, federal and state governments 49 00:03:26.760 --> 00:03:31.120 conferred upon the banks the privilege of their notes being accepted in taxes. 50 00:03:31.120 --> 00:03:36.300 Moreover, the general prohibition of interstate branch banking, and often of intrastate branches 51 00:03:36.300 --> 00:03:41.480 as well, greatly inhibited the speed by which one bank could demand payment from other banks 52 00:03:41.480 --> 00:03:42.860 in specie. 53 00:03:42.860 --> 00:03:48.060 In addition, state usury laws, pushed by the Whigs and opposed by the Democrats, made credit 54 00:03:48.060 --> 00:03:53.000 excessively cheap for the riskiest borrowers and encouraged inflation and speculative expansion 55 00:03:53.000 --> 00:03:54.460 of bank lending. 56 00:03:54.460 --> 00:03:59.580 Furthermore, the desire of state governments to finance internal improvements was an important 57 00:03:59.580 --> 00:04:03.860 factor in subsidizing and propelling expansion of bank credit. 58 00:04:03.860 --> 00:04:05.660 As Hammond admits, 59 00:04:12.860 --> 00:04:18.500 of Farmers, who were too economically astute to accept Wildcat money, but of states engaged 60 00:04:18.500 --> 00:04:21.900 in public improvements." 61 00:04:21.900 --> 00:04:26.700 Despite the flaws and problems, the decentralized nature of the pre-Civil War banking system 62 00:04:26.700 --> 00:04:31.520 meant banks were free to experiment on their own with improving the banking system. 63 00:04:31.520 --> 00:04:35.440 The most successful such device was the creation of the Suffolk system.