CENTRAL BANK (ISSUE)

The idea of the central bank in the newly formed United States arose as the dusk of eighteenth-century mercantilism turned into the dawn of nineteenth-century laissez-faire economics. Its existence raised numerous issues of states rights, federal power, and the national currency. After Andrew Jackson's determination to put an end to the Second Bank of the United States during his "Bank War" of 1832 and the Panic of 1837 a few years later, the question of a central bank wasn't seriously raised again until the financial insecurities and social displacements of industrialization at the beginning of the twentieth century forced the government to establish the Federal Reserve Bank in 1913.

But for well over a century, the dispute raged between advocates of a decentralized banking system and proponents of a strong central bank. The former argued that a national bank was dangerous because it concentrated the power of granting loans and expanding currency into the hands of a relatively small group of men who would follow private rather than national interests. They argued that a large number of small state or commercial banks would better serve the nation, its people, and the economy by responding to local conditions while preventing the concentration of such powers. But proponents of a central bank disagreed. They argued that a central bank was necessary to enlarge the national manufacturing base, maintain a stable currency, and keep up with the demands of a country whose boundaries and peoples increasingly pushed westward. For them, a central bank could keep the amount of currency in circulation flexible and provide the capital and credit needed to meet the demands of population increases, territorial expansion, and heavy industrialization.

Largely through the efforts of Alexander Hamilton, the First Bank of the United States, modeled after the Bank of England, was established in 1791 and was chartered for a period of twenty years. It was a private corporation with $10 million in capital, governed by twenty-five directors, and like other commercial banks, could print notes and exchange them for borrowers' interest-bearing promises to pay. It could also extend loans to individuals and companies. But unlike other private banks, the federal government was a central partner in the enterprise. The government owned 20 percent of the Bank's holdings while the Bank served as a fiscal agent for the government. The Bank held tax receipts, paid government bills, and performed various other financial tasks. It lent money to the government and provided convenient depositories in the leading seaports like New York, Boston, Baltimore, and Charleston, where most of the federal revenues were collected. It also served the Treasury by transferring funds safely and cheaply from place to place, and facilitated the payment of taxes by increasing the supply of currency. As a partner, the government granted it special privileges unique among other state banks. It kept its cash as deposits with the Bank, giving it a huge financial base. The government borrowed from the Bank, paid it interest for the use of its notes, and also shared its profits.

According to its charter, the Bank was allowed to operate in all states, which gave it a considerable edge over state banks that could only operate in the states that chartered them. Because of this large banking network in various parts of the country and in its role as creditor, the Bank was able to hold as assets more notes issued by state banks than those banks held of their own.

Overall, the First Bank was profitable averaging 8 percent per year rate of return for those that invested in it. It succeeded in maintaining the stability of currency, in meeting government expenses, and in preventing the drain of specie from the country.

But even so, in 1812 opposition from various quarters was strong enough to prevent it from being rechartered. Thomas Jefferson and John Randolph from Virginia questioned its constitutionality, and Henry Clay from Kentucky feared the concentration of financial power. Others feared that it posed serious hurdles to the growth and spread of state banks, while an increasingly large faction criticized the growing influence that foreign investment placed on the Bank. In the end, the Bank's charter was revoked in the Senate by a tie-breaking 18-17 vote.

But within five years, federal debt associated with the War of 1812 and inflation caused in part by the rise of unregulated state banks forced Congress to reconsider its earlier decision. The Second Bank of the United States was chartered in 1816 along the same lines that the first had been. Eighty percent of its $35 million capital was private, paid in specie, 20 percent was federal, paid in government bonds, and the Bank was made the depository of government funds and also the fiscal agency of the United States. Note issues could not exceed total capital, were receivable in all payments to the United States, and were redeemable in specie on demand. It was intended that state banks would have to resume specie payments or their notes would be driven out of circulation. After the Bank's charter was granted, additional legislation was enacted to help promote specie resumption in general: all payments to the government after February 20, 1817 had to be made in coin, Treasury notes, United States Bank notes, or other convertible bank notes.

Politicians in many of the states blamed the Second Bank for the Panic of 1819. Maryland, Tennessee, Georgia, North Carolina, Kentucky and Ohio enacted laws to tax branches of the Bank out of existence. But in two Supreme Court decisions, McCulloch v. Maryland (1819) and Osborne v. United States Bank (1824), Chief Justice John Marshall declared the state acts unconstitutional.

Under the presidency of Langdon Cheves (1819-1823) and Nicholas Biddle (1823-1836), the Second Bank recaptured the standing that the First once had within the banking community. Under Biddle, the Bank and its twenty-nine branches became an effective regulator of the expanding economy. The Bank marketed government bonds, served as a reliable depository for government funds, and its bank notes provided the country with a sound paper currency. But because the Bank forced state banks to back their notes with adequate specie reserves, many, especially President Andrew Jackson, believed that this was too much power. They were afraid that the Bank's control over short-term credit was not subjected to sufficient government regulation, and that state banks risked termination under such a system. By the time of Andrew Jackson's presidency, the Bank had antagonized both those who favored "soft money" (more state-bank notes) and those who favored "hard money" (only gold and silver coins). "Soft money" proponents including land-speculators, small entrepreneurs, and anyone who was in debt felt their needs were best served with an abundant paper currency while Eastern workingmen resented receiving their wages in paper of uncertain value. On the other hand, many "hard money" advocates were hostile to banks of any kind, state or national, that issued bank notes and they tended to look upon banking in general as a parasitic enterprise.

During the Bank War, Biddle was unable to prevail over President Jackson and renew the Bank's charter with the federal government. He was, however, able to obtain a charter from the state of Pennsylvania. But during the Panic of 1837 the reorganized bank suspended specie payment and failed completely in 1841. In its absence, the number state banks rose dramatically across the country. The victorious Andrew Jackson termed these banks his "pet banks."

The charter of the Second Bank did not assign to it the public responsibilities of a central bank, as did the legislation that created the Federal Reserve System a century later. Instead, the Second Bank was responsible to its own investors, and its chief function was to earn dividends for them. Many state banks resented it not only because it forced them to maintain adequate specie reserves but also because its federal charter gave it a considerable competitive edge.

By the time that the Federal Reserve System was established under the Woodrow Wilson administration in 1913, the financial anarchy of an unregulated banking system had settled the question of the legitimacy of the central bank. In constructing the modern banking system, the Federal Reserve, established after the Panic of 1907, had two basic functions. Along with other federal agencies, it helped to investigate and insure the financial soundness of private banks. As lender of last resort, it protected banks against insufficient funds (liquid assets) when those banks were forced to cover the withdrawal demands of their depositors. This lessened the self-fulfilling fear of "bank runs," when depositors lost faith in the ability of the banking system to cover their deposits. The Federal Reserve also monitored and controlled the national money supply. It could order changes in the percentages of bank assets held as reserve. This, in turn, controlled the ability of the nation's banking system to create money by making loans. It could also affect the money supply directly by buying and selling government bonds in the market. This gave the federal government an extremely important ability to encourage growth in a sluggish economy (by creating credit) or to slow down an inflationary economy (by restricting credit). Thomas Jefferson and Andrew Jackson might not have approved, but Alexander Hamilton and Nicolas Biddle got the last laugh.

CENTRAL BANK (ISSUE)

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