Just for the sake of clarity, while the central bank of England established in 1694 as a private banking cartel under a grant by the government became the model for central banks, the very first central bank was the Riksbank of Sweden, established in 1668. The Riksbank was not a private cartel and operated instead under the auspices of the Swedish parliament. On the other hand, the English bank was privately operated until 1946. Most of the central banks of the western nations operated under the English model. Of course, communist, socialist, fascist nations (governments) controlled all aspects of their economies, including the central banking functions.
A prime question to ask is “Are central banks necessary?” In this modern world, it is difficult to find a single main stream economist who would reply in the negative. Almost exclusively, either the monetarist school of economics or the Keynesian school are taught in all American colleges and universities. A recent article in the Huffington Post explains that the Federal Reserve has essentially co-opted the main stream economics profession. If one asked an Austrian economist the same question, he would reply not only no but hell, no. It is the central banks that are causing the vast majority of economic problems that currently exist. How could this be?
Back to some history again.
Central banks, as already indicated, got their start from their ability to create debt money that was backed by the “full faith and credit” of which ever government gave the bank its charter in the first place. Let’s first define debt money. Debt money is “money” (von Mises called debt money fiduciary media) that is created from nothing. Fiduciary media is money that a bank issues to a debtor who eventually must repay all the funds created from nothing and in addition, the debtor must pay interest on this debt. So this is one of those dirty little secrets. The debt money comes from no where but when all is said and done, the bank makes a profit on the money from no where.
In the beginning, because gold was still considered money, central banks were limited in their ability to create money from nothing. What central banking did was to tie together the assets of all the banks which joined the cartel. The larger the cartel, the greater the power. Since the cartel had an exclusive grant to issue money in the name of the government, banks which did not join the cartel had greater difficulty gaining clients and therefor profits. Still, not all banks joined the cartel. By pooling their assets, the cartel had greater control over “bank runs” when certain segments of the public became concerned about the balance sheets (liabilities) of specific banks.
However, as long as gold was still considered money and the paper receipts issued by the banks required the bank to redeem the notes in gold specie, the central banks were limited (the central bankers might use the term, frustrated) in the amount of debt money that could be issued. The bank must always concern itself with redeeming issued notes with real gold. This was the case around the world from 1694 until 1913.
The United States had toyed with the concept of a central bank from just after the Constitution was ratified in 1788 until 1913. The First Bank of the United States was promulgated by the first Secretary of the Treasury, Alexander Hamilton in 1791 over the strenuous objection of the Secretary of State, Thomas Jefferson. Hamilton proposed the bank and President Washington asked Jefferson, Hamilton and Attorney General Edmund Randolph for their opinions on constitutionality. Jefferson provided an extensive response citing profusely from the Constitution to demonstrate that such a bank was not in any way authorized by the Constitution. In “Hamilton’s Curse” Thomas Di Lorenzo states that in response,
The crux of his [Hamilton’s] opinion was that Jefferson did not understand the meaning of the word necessary. Although Webster’s Dictionary defines the word as meaning “essential,” “inevitable,” and “required,” Hamilton argued that it is “a matter of opinion.” The powers enumerated in the Constitution ought to be construed “on principles of liberal construction,” he said, “in advancement of the public good.” This would require giving politicians like himself “great latitude of discretion” in dealing with the limits of federal government powers. In other words, such powers should be made up, even fabricated, on the whims of politicians posing as guardians of “the public good.”
Hamilton won the argument. Washington asked his allies in Congress to introduce the legislation and the charter was granted in 1791 for 20 years. Jefferson fought the bank tooth and nail throughout his years in office and in 1811, during Madison’s administration when the bank’s charter expired, it was not renewed. The War of 1812 brought new demands for debt money because the government was funding yet another war (are you getting the picture yet) and even though Madison had, with Jefferson, opposed the first bank, he encouraged the charter of the second bank which was approved in early 1817 as he was getting ready to leave the presidential office.
I am not going into a complete history of this second bank. It’s a long and complex story involving not just banking privileges but also the distinct personalities of Andrew Jackson, the president who oversaw its demise and Nicholas Biddle, the president of the Second Bank of the Untied States. It was a bitterly fought battle and is easily available for your pursual with a google search. From the death of the second bank in the 1830′s until the Federal Reserve Act of 1913, the US had no central bank. Except during the War for Southern Independence, the US functioned with a relatively (but not completely) free banking system and essentially a gold standard.
Though Lincoln is far from my favorite president, he did prove one point that I posed at the start of this part. He funded the war he started with debt money created by the United States government with no intermediary. He recognized that banks create debt money that require repayment plus interest. He reasoned that the US could issue its own debt money and avoid the interest. Thus Lincoln’s famous “greenbacks” were issued. And, most interestingly, these notes were all eventually (1879) fully paid off in gold specie. It would seem that on this basis alone, central banks are not required.
During the period from the end of the war in 1865 until the beginning of WW 1, the US experienced the most magnificent growth rate that history has ever recorded for any society. There were a number of factors involved including the fact that the US was expanding its economic might in the vast western territories with little real opposition. But a major factor was also the existence of relatively free banking and sound money based on a gold standard. Just to bing some attention to an often heard but little understood phrase that is frequently repeated, let’s come to grips with William Jennings Bryan famous speech to the Democrat convention in 1896 which ended with the line:
You shall not crucify mankind upon a cross of gold.
The cross of gold was the gold standard. Bryan at the time was a little known populist politician who represented the interests of silver and silver miners. The problem was that the gold supply was relatively limited, not withstanding the gold discoveries in California and in the Yukon. In 1873, as silver was being discovered in ever greater quantities the federal government had declared a defacto gold standard, essentially demonetizing silver. The purpose was to protect the nation against inflation. (Boy, isn’t that amazing–the US government actually trying to prevent inflation of the money supply. The concept that inflation can be caused by too much silver or even too much gold is an important one and will be discussed in the future.) Bryan was not opposed to the gold standard but he wanted to reinstate a bi-metal standard with both gold and silver enjoying the protection of the US government in establishing a fixed value. Bryan won the nomination of his party in 1896 but lost the election to McKinley. He lost again four years later to TR and thus the gold standard continued to hold sway and continued to protect the nation from both inflation and from excessive control by bankers. As long as bankers could not produce debt money (fiduciary media) at will, as long as they were subject to bank runs, the nation was safe from any significant financial problems.
I should point out that bankers were held personally liable for bank defaults. You can imagine how careful bankers were with respect to investing since they could be held personally responsible for losses. Knowing that losses could lead to their own personal bankruptcy, they tended to avoid risky, bubble like ventures. Instead, they mostly maintained a conservative, well balanced approach.
It is also interesting to note that from about 1790 to 1913 the level of inflation (as indicated by prices of goods) was relatively level. It is true that during times of war, 1812 to 1814, 1861 to 1865, etc there were inflationary spikes but shortly after each war time period, prices returned to close to those of the pre-war period. Thus with no central bank in existence but only free banking and gold and silver as specie money, inflation was just about nonexistent. And the US economy kept growing throughout this time. Yes, there were bank panics from time to time and even a recession or two but nothing that was long lasting or particularly severe.
Another quite severe financial and banking crisis occurred in 1907. There were runs on the banks as depositors rushed to take out their money before they ran out of specie. The stock market dropped to half its peak 1906 average. The main cause of the crash was stock market and real estate speculation. Also contributing were attempted company takeovers and the San Francisco earthquake of 1906. Much of the real estate of San Francisco was insured by companies in London. Payouts to San Francisco drained money from the U.K., which raised interest rates there and in the U.S. But interest rates mostly rose due to borrowing for speculation, and the high rates and real estate prices then halted investment in capital goods. The U.S. stock market crashed on March 14, 1907 and then again after a failed attempt on October 16, 1907, of a scheme to corner the stock of the United Copper Company, which highlighted the close connections then among banks, trusts, and brokers. The panic began on October 18, 1907, following the collapse of United Copper share prices. On October 21, there was a run on the large Knickerbocker Trust Company, which then shut down.
To restore confidence, banker chief J. P. Morgan, working together with the Secretary of the Treasury, organized some bank executives and the U.S. Treasury to transfer money to troubled banks and buy stocks. That soon ended the panic.
The fundamental causes of the Panic of 1907 were the flawed monetary and fiscal systems of the United States. The federal government’s control of the money during and after the Civil War created a rigid money supply that did not respond to the demand for money. While the government allowed free banking, it was closely controlling the value (price might be a better word) of money (gold and silver). In a completely free market, the “value” of money will fluctuate along with other goods. During that era, agriculture dominated the economy, and the inflexible money supply created a crunch and a spike up in interest rates whenever farmers and others needed to borrow funds. Had the value of money been allowed to fluctuate to meet demands, there would have been no crisis, just a disturbance in the financial system that would have been self correcting.
The Panic of 1907 shook confidence in the U.S. financial system, but the people and the government officials learned the wrong lessons. The problem with the banking system was the federal control of the money supply, and the effective remedy would have been completely free market banking, where the banks and other private firms would issue private currency backed by gold with the ability to slowly change in value. With competitive banking, the private bank notes and deposited funds would expand flexibly in accord with the demand for money and borrowing, while the redemption into gold would prevent inflation. That is how the Scottish free banking system worked for many years.
Because the wrong lessons were learned, J.P. Morgan and others were able to influence the direction of government control over banking. The crisis of 1907 led almost directly to the Federal Reserve Act which was passed in 1913 thus bringing the US into conformity with most other western nation/state governments. There are some historical economists who suspect that Morgan helped to induce the panic by introducing the rumor that the Knickerbocker Trust might be in trouble.
Now the real fun–and trouble begin as we shall see in the next installment.