Critique of Central Banking

Henry C K Liu

Part I:   Monetary theology
Part II: The European Experience

Part IIIa: The US experience

This article appeared in AToL on November 16, 2002

In the United States, central banking was not born until 1913 with the establishment of the Federal Reserve System. The first national bank in the US was the Bank of the United States (BUS), founded in 1791 and operated for 20 years, until 1811. A second Bank of the United States (BUS2) was founded in 1816 and operated also for 20 years until 1836. The first national bank, modeled after British experience, was established by Federalists as part of a nation-building system proposed by Alexander Hamilton, the first secretary of the Treasury, who realized that the new nation could not grow and prosper without a sound financial system anchored by a national bank.

The national bank charter was approved by Congress and signed into law by president George Washington in 1791 when the federal government of the new nation was only three years old. The new national bank, known as the Bank of the United States, was to assist the newly formed federal government by holding its funds and, when necessary, by making loans to it. By issuing notes that would circulate as legal tender, the national bank would help to maintain an adequate supply of stable money and by extending government credit to support an industrial policy to promote economic expansion.

To understand the thinking behind Hamilton's proposal for a national bank, it is necessary to remember that the Treasury was restricted by law to limit its issuance of money to the coinage of gold and silver, and not to print paper money. According to orthodox monetary theory under the influence of the Quantity Theory of Money (QTM), specie (gold- or silver-backed) money was the only reliable currency, though it could be supplemented by banknotes fully and freely redeemable for gold or silver. Congress granted a 20-year charter for the BUS despite arguments by Thomas Jefferson that the constitution did not give Congress power to establish a national bank and the charge that the national bank was designed to favor mercantile interests over agrarian interests, and the rich over the common man, in the name of national interest.

The federal government subscribed one-fifth of the capital of $10 million of the BUS, with a loan of $2 million immediately advanced from the BUS to the government, with the remaining $8 million subscribed by private investors. The BUS acted as exclusive fiscal agent for the government and also conducted commercial banking business. Despite being well managed and financially profitable, the BUS antagonized state-chartered banks and Western frontier and Southern agrarian interests, which formed a coalition that successfully blocked its rechartering in 1811.

Jefferson's opposition to the establishment of a national bank was key to his overall opposition to the entire Hamiltonian program of strong central government and elite financial leadership. Jefferson felt that a national bank would give excessive power over the national economy and unfair opportunities for large certain profits to a small group of elite private investors mostly from the New England states. The constitutionality of the bank invoked the dispute between Jefferson's "strict construction" of the words of the constitution and Hamilton's doctrine of "implied power" of the federal government.

Throughout the history of the United States, up to the present time, this dispute, along with the controversy between specie money and fiat money, remains philosophically unresolved, although in practice both the constitutionality of "implied power" doctrine and the legality of fiat currency have been repeatedly upheld by the Supreme Court. Jefferson considered the whole Hamiltonian banking scheme an unconstitutional threat to the basic fabric of American civilization. Jefferson prophesied: "If the American people allow the banks to control the issuance of their currency, first by inflation, and then by deflation, the banks and corporations that will grow up around them will deprive people of all property until their children will wake up homeless on the continent their fathers occupied ... The issuing power of money should be taken from the banks and restored to Congress and the people to whom it belongs." It was a definitive statement against the political "independence" of central banks. This warning applies to the people of the world as well.

The most significant achievement of the Jefferson presidency was the Louisiana Purchase. In 1800, the Treaty of San Ildefonso secretly transferred Louisiana from Spain to France, which presented the United States with the alarming prospect of a vigorous and expansionist European power controlling the mouth of the Mississippi river to block the westward expansion of the US. James Monroe was sent to Paris to negotiate the purchase of Louisiana from a willing Napoleon Bonaparte, who earlier had sent an expeditionary army to Haiti to put down a black slave rebellion with subsequent plans to occupy New Orleans to exercise French control over Louisiana. The decimation of the French expeditionary army by yellow fever, the need for more troops for renewed Napoleonic wars in Europe, and the difficulty of running the British naval blockade convinced Napoleon that strengthening the United States as a potential ally under a pro-French Jefferson and as a potential rival of Britain might serve French interests.

France agreed to sell Louisiana in 1803 for $15 million, including in the package an immense territory extending northward as far as Canada and westward to the Rocky Mountains, covering more than a million square miles. The purchase was financed through the then four-year-old BUS. But according to a strict construction of the constitution, the federal government did not have authority to acquire new territory or, as provided under the treaty with Napoleon, to grant full citizenship to its inhabitants, not to mention the chartering of a national bank. Jefferson swallowed his scruples about the constitution, became in effect an "implied powers" advocate and lobbied energetically for Senate ratification of the Louisiana Purchase.

Hamilton's idea of national credit was not merely to favor the rich, albeit that it did so in practice, but to protect the infant industries in a young nation by opposing Adam Smith's laissez-faire doctrine promoted by advocates of 19th-century British globalization for the advancement of British national interests. This is why Hamilton's program is an apt model for all young economies finally emerging from the yoke of Western imperialism two centuries later, and in particular for opposing US neo-liberal globalization of past decades.

The creation of a national bank was one of the three measures of the Hamiltonian program to strengthen the new nation through a strong federal government, the other two being 1) an excise duty on whiskey to extend federal authority to the back country of the vast nation and to compel rural settlers to engage in productive enterprise by making subsistence farming uneconomic; and 2) federal aid to manufacturing through protective tariff and direct subsidies. To Hamilton, a central government without sovereign financial power, which had to rely on private banks to finance national programs approved by a democratically elected congress, would be truly undemocratic and to rely on foreign banks to finance national programs would be unpatriotic, if not treasonous.

Hamilton's national program was opposed effectively by the two special-interest groups with controlling influence in Congress: the Northern trading merchants and shippers who had secured a Navigation Act to protect US shipping in 1789 and Southern planters who depended on export of unprocessed agricultural commodities, neither of which had any interest in curbing foreign trade even when such trade was harmful to the development of the national economy. Domestic manufacturing interest did not become strong enough to obtain much government protection until after the War of 1812. The dynamics of this politics is visible in the 21st century in many developing nations where the financial elite prefers compradore opportunism to economic nationalism.

Congressional opposition to the first BUS resulted in its charter expiring in 1811 without renewal. However, the financial pressure after the War of 1812 created demands for another national bank. By 1807, France under Napoleon controlled most of Europe while Britain commanded the sea by destroying the French fleet at Trafalgar in 1805. This land-sea stalemate pushed the two rival superpowers to economic warfare through British blockades against French overseas trade, answered by Napoleon's Continental System applying sanction against all trade with Britain, making the neutral United States a collateral-damage victim of interrupted trade. In the US, agrarian westward expansionism, facing effective native American resistance under a tribal confederacy coordinated by Chief Tecumseh, agitated for US conquest of British Canada, justified as retaliation against the British blockade of US shipping, despite the fact that most US shippers did not want to antagonize a powerful Britain in full control of the sea.

The Western Expansionist Movement found political expression in the election of 1810 and sent to Congress a group of young representatives who became known as the War Hawks, led by Henry Clay as House Speaker. Despite belligerent speeches by the War Hawks, the US was unprepared for war, the most significant shortage being government finance. With tax revenue covering less than two-thirds of government expenditure, and without a national bank, the government was compelled to borrow from banks owned by Eastern mercantile interests who opposed the war for fear of more British measures against US shipping, leaving the US war effort ill-financed.

By 1814, having defeated Napoleon in Europe at the battle of Leipzig in October 1813 with a coalition of Eastern European agrarian feudalism, Spanish clericalism and German nationalism financed by British capitalism to the tune of Stg23 million, supported by the matchless British navy and the combined armies of Russia, Prussia and Austria, the British was able to send an expeditionary army to foil US hopes of conquering Canada. The British also landed an invasion army on Chesapeake Bay in the summer of 1814 and marched into Washington, burning the White House, nearly capturing president James Madison himself, but were finally repulsed at Baltimore, a battle that inspired Francis Scott Key to write The Star Spangled Banner, which later was adopted as the national anthem.

On January 8, 1815, another British expeditionary army of veterans from the Napoleonic Wars was defeated near New Orleans by Andrew Jackson with a kill ratio of 2,000:13 against the British, in a decisive demonstration of the effectiveness of modern riflemen against 18th-century European troop formations. It was reminiscent of the triumph of British longbow archers over French aristocratic calvary in the Battle of Agincourt in 1415, which decimated the French armored knights, the flower of French nobility, and ended its role henceforth as an effective fighting force.

The Treaty of Ghent declared the end of the War of 1812, in which neither side achieved military victory or gained any political advantage. While the treaty was being signed, a group of delegates from New England met at Hartford, Connecticut, to discuss secession from the union. By deviating from Hamilton's cause of national unity, the neo-Federalists spelled their own political end but not the policy demise of Federalism, which remained US policy until the Jackson administration. Had the BUS been in operation, the US war effort might have been better financed and Canada might have become a part of the United States.

The second Bank of the United States went into operation with a capital of $35 million in 1816, with the federal government owning only 5 percent of the stock. For a decade after the War of 1812, there existed no clear-cut party division in US politics, thus the term "era of good feeling" was applied. The Republican Party abandoned its original Jeffersonian opposition to Federalism and adopted Federalist policies, starting with the establishment of the second BUS, adopting tariffs to protect struggling US industries and federal appropriation for infrastructure development. Henry Clay proposed the "American System", based on Hamiltonian ideals, but unlike Hamilton, Clay cultivated popular support, not only appealing to the upper class, and sought support from the agricultural South, not just the mercantile New England states. It was a national program of federal aid to domestic development and tariff protection for struggling US industry.

The disappearance of the first BUS had left the nation's currency system in a chaotic state. Since 1791, a large number of state banks had been chartered, reaching 208 by 1815, and except in New England, these banks were allowed to issue notes very much in excess of their capital ratio and to make loans without sufficient reserves.

BUS2 fulfilled its basic function during a period of relative prosperity and operated with popular support. The charter empowered BUS2 to act exclusively as the federal governments fiscal agent, hold its deposits, make inter-state transfers of federal funds and deal with Federal payments or receipts. Like state chartered banks, BUS2 also had the right to issue banknotes on the basis of a fractional reserve system and to carry out conventional commercial banking activities, in return for which certain conduct of a central-bank-like nature was expected of this institution: in the words of the charter, "the bank will conciliate and lead the state banks in all that is necessary for the restoration of credit, public and private, and to steer the banking system toward serving the national interest", at a time when profit might be higher in serving foreign interests. Despite being 80 percent privately owned, BUS2 operations were subject to supervision by Congress and the president. BUS2 was dominant relative to all other banks, being responsible for some 20 percent of all bank lending in the national economy and accounting for 40 percent of the banknotes then in circulation. It was conservative in its note-issuing function, holding a specie reserve of 50 percent of the value of its notes while the norm for the remainder of the banking system was between 10-25 percent.

In 1821, the Monroe administration forced a declining Spain to sell Florida to the United States for $5 million, most of which was paid to US citizens with claims against the Spanish government, for failure to close the Florida border to runaway slaves and marauding Seminole native Americans. In return, the US renounced its claim to Texas. The purchase was financed by BUS2. On December 2, 1823, the US declared the Monroe Doctrine against European intervention and colonization in the Americas, from Argentina to Alaska.

The hopes of Clay's national program in diminishing sectional conflict and class differences were not realized. The chief beneficiaries of the banking and tariff legislation were the trading businesses in the northeastern states at the neglect of Southern planters and Western farmers. BUS2 quickly came under the control of eastern seaboard interests, which were accused of seeking to dominate and exploit the West in sectional conflicts. During the decade of 1810-19, five new states - Louisiana, Mississippi and Alabama in the Southwest; Indiana and Illinois in the Midwest or old Northwest - came into being. The Land Law of 1800 stimulated public land sale with generous terms of payment spread over four years, rising from 1 million acres in 1815 to 5 million acres in 1819. A speculative bubble on land was financed by state banks and government seller credit, which burst in 1819. The collapse was attributed throughout the West as being caused by the policies of BUS2, which had made a practice of buying up the notes of state banks and suddenly presenting them for payment, forcing the state banks to call in loans to Western farmers, driving them into bankruptcy, with much Western land falling into the hand of BUS2 private shareholders through foreclosures.

The 1820s and 1830s in the United States were a time of extremely rapid but also volatile economic growth. New natural resources were being exploited as the frontier expanded and the new techniques of the industrial revolution were being introduced. The old money supply of gold and silver specie was stretched and found inadequate for the liquidity needs of the growing economy. In 1830, the total value of the gold and silver specie in circulation in the economy amounted to one-fiftieth of the gross national product. The emergence of a number of banks operating fractional reserve note-issuing systems was the automatic result. The private banknotes were underwritten by varying proportions of specie and although not legal tender, they were widely accepted in payment for debts, albeit usually discounted below their par value. The quality of banknotes varied. Fraud was commonplace by unscrupulous bankers who managed to persuade or bribe local state legislatures to grant them liberal charters to commence a banking business. In 1828, the 17 banks chartered in Mississippi circulated notes with a face value of $6 million from a specie base of $303,000. The classic conflict between easy money and good money ensued, with the economic benefits of easy money regularly destroyed by bad money.

It was in such an environment that BUS2 operated. Among its functions was to discipline and support the state-chartered banks without shutting off easy money. As the federal government's fiscal agent, it received banknotes in payment for taxes. The Bank would then present these banknotes to the issuing state-chartered banks in order to redeem them for the gold necessary to pay the taxes it had collected to the federal Treasury's account. In this way, state-chartered banks were forced to keep a higher stock of specie on reserve than would otherwise be necessary. Conversely, BUS2 could also act as a lender of last resort to state-chartered banks in trouble by not presenting these notes for redemption but rather allowing these banks to run into debt to BUS2. The state-chartered banks were institutions of economic democracy, offering credit to the masses, not just to big business. Some were named people's banks or other names of democratic or socialist connotation. They generally financed local small business, farms and homes.

The political environment of that period was marked by the populist ideology of Jacksonian democracy. Focused around Andrew Jackson, who was elected president in 1828, this ideology was an coalition of convenience among agrarianism, nationalism, populism and libertarianism. The one unifying element of this group was a deep hostility to a privileged East Coast-based moneyed aristocracy. The Philadelphia-based BUS2 with its patrician president, Nicholas Biddle, became an easy target in this new climate. Libertarians, while sounding sensible on a small scale, always fail to understand that individual liberty has no place in organizing large-scale national enterprises. Complex organizations, whether in business or government, require wholesale compromise of individual liberty.

The ideology that underlay the struggle against a national bank was highly variegated, with contradicting internal inconsistencies. It was a peculiar blend of moral judgment, economic logic and populist sentiment fused by pragmatic calculations to attack the political legitimacy of a national bank, its legality and its economic rationale.

The role played by vested interests in motivating the anti-BUS forces can also be traced to the substantial personal gains that would accrue to key members of the Jackson administration should BUS2 be discontinued. The New York financial community at the time was competing with Philadelphia to be the country's premier commercial center. Martin Van Buren, Jackson's second-term vice president and eventual successor, was particularly identified with Wall Street in this Wall Street (New York internationalist) versus Chestnut Street (Philadelphia nationalist) battle.

The state-chartered banks disliked being constrained by BUS2's practice of redeeming their banknotes with little or no notice, and with blatant arbitrariness in the selection of a target, often based on thinly disguised sectional bias. This forced a much higher bank reserve ratio and hence restricted their lending activities in geographic sections deem contrary to national priorities. A new class of nouveau riche, self-made entrepreneurs and speculators, emerged, a class to which Jackson and many of his associates belonged. They disliked the restriction of credit generally, and credit allotment controlled by established Northeastern financiers particularly, as they relied on liberal credit from the friendly state-chartered local banks for needed funds, the way leverage-buyout financiers and corporate raiders and New Economy entrepreneurs relied on junk-bond investment bankers in the 1980s and '90s.

The New York financial community was divided over the question of the wisdom of the attack on BUS2. Some of the state-chartered banks grudgingly acknowledged BUS2's positive role in disciplining the banking system and its activities as a lender of last resort. Political ideology and economic logic also played a role behind the opposition of a national bank. The opposition had much popular support in national politics which enabled Jackson to dismantle BUS2. Like Ronald Reagan, Jackson was elected to Washington to rein in Washington.

The strongest opposition came from states-rights advocates who vehemently opposed the substantial power wielded by a federally chartered national bank. Many considered the chartering of the bank an unconstitutional extension of the power of Congress, particularly when, in their judgment, the first national bank had failed to serve the national interest without sectional bias and had pandered to sectional interests around the northeastern seaboard. This position was summarized by Jackson, who described BUS2 bank as an unconstitutional threat to democratic institutions by the federal authorities. With the dismantlement of BUS2, the power of intervention in the banking and monetary systems was left in the hands of individual states until the Civil War. State-chartered banking systems served the separate interests of each state, which often were at odds with the national interest.

A key strand in the anti-national-bank thread was the libertarians. They challenged the legitimacy, more on moral than constitutional grounds, of any government intervention in the economy or in society beyond minimum necessity. Libertarians, while sounding sensible on a small scale, fail to understand that individual liberty to organize large-scale national enterprises is a mere fantasy. "Small is beautiful" remains merely a romantic slogan of hippiedom.

The 1800s were an age of primitive laissez-faire philosophy in the United States when domestic markets were not yet sophisticated enough to require government intervention against trade restraint in the sense that Adam Smith used the term "laissez-faire" to denote activist government action to keep markets free. This libertarian philosophy was related to and associated with the Free Banking school, which challenged on ideological grounds the necessity of government intervention in the monetary system.

Free Bankers were in favor of a paper currency based on a fractional reserve system. But they argued that BUS2's regulatory function was unnecessary and ineffective because in a completely unregulated financial system, free competition would automatically protect the public against fraud through market discipline, on the principle that fraud was basically bad for business. They argued that what was wrong with the banking system was that free competition was obstructed by the monopolistic privileges granted to BUS2 in its charter and this created an unhealthy reliance on regulatory protection rather than market self-discipline, in a form of consumer moral hazard that believed naively that if a business was regulated, consumer interest would automatically be protected. In the context of the dominant economic paradigm of the 1830s, the importance of the central government's role in regulating the money supply was not as self-evident as is today. And for the Western frontiersman, his love of individual liberty exposed him to easy victimization by organized finance from the East.

Economist Joseph A Schumpeter (1883-1950) observed that in the first part of the 19th century, mainstream economists believed in the merit of a privately provided and competitively supplied currency. Adam Smith differed from David Hume in advocating state non-intervention in the supply of money. Smith argued that a convertible paper money could not be issued to excess by privately owned banks in a competitive banking environment, under which the Quantity Theory of Money is a mere fantasy and the Real Bills doctrine was reality. Smith never acknowledged or understood the business cycle of boom and bust.

The anti-monopolistic and anti-regulatory Free Banking School found support in agrarian and proletarian mistrust of big banks and paper money. This mistrust was reinforced by evidence of widespread fraud in the banking system, which appeared proportional to the size of the institution. Paper money was increasingly viewed as a tool used by unconscionable employers and greedy financiers to trick working men and farmers out of what was due to them. A similar attitude of distrust is currently on the rise as a result of massive and pervasive corporate and financial fraud in the so-called New Economy fueled by structured finance in the under-regulated financial markets of the 1990s, though not focused on paper money as such, but on derivatives, which is paperless virtue money.

Andrew Jackson in his farewell speech addressed the paper-money system and its natural association with monopoly and special privilege, the way Dwight D Eisenhower warned a paranoid nation against the threat of a military-industrial complex. The value of paper, Jackson stated, is liable to great and sudden fluctuations and cannot be relied upon to keep the medium of exchange uniform in amount.

In contrast to the Free Banking School, the anti-paper specie-currency zealots aimed at abolishing the system of fractional reserve paper money by removing the lender of last resort. They were further split into gold bugs, silver bugs and bimetalists.

Both advocates of the Free Banking School and proponents of specie currency saw the dismantling of the bank as very fundamental, but to divergent and conflicting ends. Against this coalition, supporters of a national bank, such as BUS2 president Nicholas Biddle and politicians such as Henry Clay and John Quincy Adams, faced a political dilemma. Both anti-federalist and primitive laissez-faire sentiments were in ascendancy at the time. The BUS2 was being attacked from both the extreme left (Free Banking advocates) and from the extreme right (anti-paper advocates).

The monetary expansion that preceded and led to the recession of 1834-37 did not come from a falling bank reserve ratio but rather from the bubble effect of an inflow of silver into the United States in the early 1830s, the result of increased silver production in Mexico, and also from an increase in British investment in America. Thus a case could be made that central banking's role in causing or preventing recessions through management of the money supply is overstated and oversimplified.

Libertarians hold the view that the state had no right to regulate any commercial transactions between consenting individuals including paper currency. Thus all legal tenders, specie or not, are government intrusions. Yet a medium of exchange based on bank liabilities and a fractional reserve system and/or government taxable capacity is essential to an industrializing economy. Instead of destroying the fractional reserve system, the hard-money advocates had merely removed a force that acted to restrain it.

After 1837, the reserve ratio of the banking system was much higher than it had been during the period of BUS2's existence. This reflected public mistrust of banks in the wake of the panic of 1837 when many banks failed. This lack of confidence in the paper-money system could have been ameliorated by central-bank liquidity, which would have required a lower reserve ratio, more availability of credit and an increase of money supply during the 1840s and 1850s. The evolution of the US banking system would have been less localized and fragmented in a way inconsistent with large industrialized economics, and the US economy would have been less dependent on foreign investment. This did not happen because central banking was genetically disposed to favor the center against the periphery, which conflicted with democratic politics. This problem continues today with central banking in a globalized international finance architecture. It remains a truism that it is preferable to be self-employed poor than to be working poor. Thus economic centralism will be tolerated politically only if it can deliver wealth away from the center to the periphery. Central banking carries with it an institutional bias against economic nationalism.

The Jackson administration's assault on BUS2 began in 1830 and became a campaign issue for a second term. In 1832, Jackson used his presidential veto to thwart a renewed federal charter for BUS2. Jackson then used his second-term presidential election victory later that year as a mandate to order the withdrawal of all federal funds from BUS2 in 1833. When the BUS2 charter expired in 1836, the Philadelphia-based institution succeeded in being rechartered only as a much reduced state-chartered bank under the auspices of the Pennsylvania state legislature as the United States Bank of Pennsylvania. In 1841, without a lender of last resort, it went bankrupt in a liquidity squeeze speculating in the cotton market.

The dismantling of the second national bank preserved the authority of the states over banking. Large-scale federal intervention in the supply of money did not take place again until the Civil War. However, Jackson's victory turned US political culture against centralized institutions in the banking system. The United States did not develop a central banking agency until 1913. Even then, the Federal Reserve System was highly decentralized, consisting of 12 autonomous component banks, one in each of the regional large cities. Some historians attributed the incoherent response of the monetary authorities to the 1929 crash and the resultant run on the banking system. The 1930s Great Depression was due partly to this decentralization of monetary authority.

Martin Van Buren succeeded Jackson as president in the 1836 election. The Jackson administration was able to appoint eight new Supreme Court justices, including new chief justice Roger Taney from Maryland, who succeeded John Marshall. The fundamental issues in US politics have often been manifested more clearly by changes in judiciary attitude. Whereas Marshall extended the power of the federal government through his upholding of the implied power doctrine, Taney believed in protecting the rights of the states, upheld their right to regulate commerce within their territories and to set economic policy autonomously. While Marshall regarded sanctity of contracts and private property right with religious reference, Taney was prepared to allow state regulation of private property rights for the promotion of the general welfare.

Before his nomination as chief justice, Taney was Jackson's Treasury secretary, and it was he who carried out Jackson's order to withdraw federal deposits from BUS2 beginning in September 1833 to a number of state-chartered banks that, free of BUS2 supervision, pushed the economy quickly into a debt bubble, much of it centering on speculation on the sale of public land. The boom produced a sudden increase of government revenue and, in 1835, for the first and last time in history, the US paid off its national debt completely, with a mounting surplus in the Treasury. In 1836, Congress passed a bill to distribute the surplus to the states. Far from being an economic blessing, this development turned out to be an economic disaster.

The fall in money supply led to a crash in early 1837, precipitated by the Treasury secretary's issuance of the Specie Circular, requiring payment for public land sale be made only in gold or silver, not banknotes. The resultant depression lasted throughout Van Buren's administration, but his commitment to strict constitutional construction prevented him from taking any federal action toward recovery. Van Buren's main focus was putting government's finances on a sound footing. The widespread failure of state-chartered banks showed the danger of trusting private banks with government money, and Van Buren decided henceforth to divorce government finance from private banking. The government should keep its money in an Independent Treasury, with "vaults" constructed in major cities where government official would receive and pay out funds on a strict specie basis.

The federal government had no further connection with the banking industry until the National Bank Act of 1863. Although the Independent Treasury did restrict reckless speculative expansion of credit, it also tended to create a new set of economic problems. In periods of prosperity, revenue surpluses accumulated in the Treasury, reducing hard-money circulation, tightening credit, and restraining even legitimate expansion of trade and production. In periods of depression and panic, on the other hand, when banks suspended specie payments and hard money was hoarded, the government's insistence on being paid in specie tended to aggravate economic difficulties by limiting the amount of specie available for private credit.

The 1863 US National Bank Act amended and expanded the provisions of the Currency Act of the previous year. Any group of five or more persons with no criminal record was allowed to set up a bank, subject to certain minimum capital requirements. As these banks were authorized by the federal government, not the states, they are known as national banks, not to be confused with a national bank in the Hamiltonian sense. To secure the privilege of note issue they had to buy government bonds and deposit them with the comptroller of the currency.

When the Civil War began in 1861, newly installed president Abraham Lincoln, finding the Independent Treasury empty and payments in gold having to be suspended, appealed to the state-chartered private banks for loans to pay for supplies needed to mobilize and equip the Union Army. At that time, there were 1,600 banks chartered by 29 different states, and altogether they were issuing 7,000 different kinds of banknotes.

Lincoln immediately induced the Congress to authorize the issuing of government notes (called greenbacks) promising to pay "on demand" the amount shown on the face of the note. These notes were not issued as "dollars" but as promissory notes authorized under the borrowing power of the constitution. The total cost of the war came to $3 billion. The government raised the tariff, imposed a variety of excise duties, and imposed the first income tax in US history, but only managed to collect a total of $660 million during the four years of Civil War. Between February 1862 and March 1863, $450 million of paper money was issued. The rest of the cost was handled through war bonds, which were successfully issued through Jay Cooke, an investment banker in Philadelphia, at great private profit. The greenbacks were supposed to be gradually turned in for payment of taxes, to allow the government to pay off these greenback notes in an orderly way without interest. Still, during the gloomiest period of the war when Union victory was in serious doubt, the greenback dollar had a market price of only 39 cents in gold. Undoubtedly these greenback notes helped Lincoln save the Union. Lincoln wrote: "We finally accomplished it and gave to the people of this Republic the greatest blessing they ever had - their own paper to pay their own debts." The importance of the lesson was never taught to Third World governments by neo-liberal monetarists.

In 1863, Congress passed the National Bank Act. While its immediate purpose was to stimulate the sale of war bonds, it served also to create a stable paper currency. Banks capitalized above a certain minimum could qualify for federal charter if they contributed at least one-third of their capital to the purchase of war bonds. In return, the federal government would give these banks national banknotes to the value of 90 percent of the face value of their bond holdings. This measure was profitable to the banks, since with the same initial capital, they could buy war bonds and collect interest from the government, and at the same time put the national banknotes in circulation and collect interest from borrowers. As long as government credit was sound, national banknotes could not depreciate in value, since the quantity of banknotes in circulation was limited by war-bond purchases. And since war bonds served as backing for the notes, the effect was to establish a stable currency.

The system did not work perfectly. The currency it provided was not sufficiently elastic for the needs of an expanding economy. As the government redeemed war bonds, the quantity of notes in circulation decreased, causing deflation and severe hardship for debtors. Money seemed to be concentrated in the Northeast, and Western and Southern farmers continued to suffer chronic scarcity of cash and credit, not unlike current conditions faced by Third World debtor economies.

After the Civil War, the Independent Treasury continued in modified form, as each administration tried to cope with its weaknesses in various ways. Treasury secretary Leslie M Shaw (1902-07) made many innovations; he attempted to use Treasury funds to expand and contract the money supply according to the nation's credit needs. The panic of 1907, however, finally revealed the inability of the system to stabilize the money market; agitation for a more effective banking system led to the passage of the Federal Reserve Act in 1913. Government funds were gradually transferred from sub-treasury "vaults" to district Federal Reserve Banks, and an act of Congress in 1920 mandated the closing of the last sub-treasuries in the following year, thus bringing the Independent Treasury System to an end.

John P Altgeld, a German immigrant populist who became the Democratic governor of Illinois in 1890, attacked big corporations and promoted the interest of farmers and workers, gave the state an able, courageous and progressive administration. The question of currency was central to the US populist movement. Farmers knew from first-hand experience that the fall in farm prices was caused by the policy of deflation adopted by the federal government after the Civil War and only ineffectively checked by the Bland-Allison Act of 1878, coining silver at a fixed ratio of 16:1 with gold, and the Sherman Silver Purchase Act of 1890. The Treasury's redemption of silver with gold increased the value of money and deflated prices.

Despite the rapid growth of business, the government engineered a sharp fall in the per capita quantity of money in circulation. The National Bank Act of 1863 also limited banks' notes to the amount of government bonds held by banks. The Treasury paid down 60 percent of the national debt and reduced considerably the monetary base, not unlike the bond-buyback program of the Treasury in 1999. To farmers, it was unfair to have borrowed when wheat sold for $1 per bushel and to have to repay the same debt amount with wheat selling for 63 cents a bushel, when the fall in price was engineered by the lenders. To them, the gold standard was a global conspiracy, with willing participation by the US Northeastern bankers - the money trusts who were agents of international finance, mostly British-controlled.

President Grover Cleveland, despite winning the 1892 election with populist support within the Democratic Party, gave no support to populist programs. Cleveland saw his main responsibilities as maintaining the solvency of the federal government and protecting the gold standard. Declining business confidence caused gold to drain from the Treasury at an alarming rate. The Treasury then bought gold at high prices from the Morgan and Belmont banking houses at great profit to them. Populists saw this effort to save the gold standard as a direct transfer of wealth from the people to the bankers and as the government's capitulation to international finance capital. Cleveland even sent federal troops to Illinois to break the railroad strike of 1894, over the vigorous protest of governor Altgeld.

The election of 1896 was about the gold standard. Cleveland lost control of the Democratic Party, which nominated 36-year-old William Jenning Bryan, who declared in one of the most famous speeches in US history (though mostly shunned these days): "You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold." The banking and industrial interests raised $16 million for William McKinley to defeat Bryan, who suffered a defeat worse than Jimmy Carter's. With the McKinley victory, the Hamiltonian ideal was firmly ordained, but with most of its nationalist elements sanitized. It was not dissimilar to the Reagan victory over Carter in 1980.

The 16th amendment to the US constitution calling for a "small" income tax was enacted to compensate for the anticipated loss of revenue from the lowering of tariffs from 37 to 27 percent as authorized by the Underwood Tariff of 1913, the same year the Federal Reserve System was established. "Small" now translates into an average of 50 percent with federal and state income taxes combined.

The Glass-Owen Federal Reserve Act was passed in December 1913 under the administration of president Woodrow Wilson. The system set up five decades ago by the National Bank Act of 1863 had two major faults: 1) the supply of money had no relation to the needs of the economy, since the money in circulation was limited by the amount of government bonds held by banks; and 2) each bank was independent and enjoyed no systemic liquidity protection. These problems were more severe in the South and the West, where farmers were frequently victimized by bank crises often created by Northeastern money trusts.

The money elite wanted a central bank controlled by bankers, along Hamiltonian lines, but internationalist rather than nationalist. But the Wilson administration, faithful to Jacksonian tradition despite political debts to the moneyed elite, insisted that banking must remain decentralized, away from the control of Northeastern money trusts, and control must belong to the national government, not to private financiers with international links, despite the internationalist outlook of Wilson. Twelve Federal Reserve Banks were set up in different regions across the country, while supervision of the whole system was entrusted to a Federal Reserve Board, consisting of the Treasury secretary, the comptroller of the currency and five other members appointed by the president for 10-year terms. All nationally chartered banks were required and state-chartered banks were invited to be members of the new system. All private banknotes were to be replaced by Federal Reserve notes, exchangeable at regional Federal Reserve Banks not only for bonds or gold, but also for top-rated commercial paper, with the hope of causing the money supply to expand and contract along with the volume of business. With the reserves of all banks deposited with the Federal Reserve (Fed), systemic stability was supposed to be assured.

The circumstances that created the climate in the United States for the adoption of a central bank came ironically from internecine war on Wall Street that spread economic devastation across the nation during 1907-08, the direct result of one huge money trust trying to cannibalize its competition.

The Rockefeller interests of "Amalgamated Copper" had a plan to destroy the Heinze combination, which owned Union Copper Co. By manipulating the stock market, the Rockefeller faction drove down Heinze stock in Union Copper from 60 to 10. The rumor was then spread that not only Heinze Copper but also the Heinze banks were folding under Rockefeller pressure. J P Morgan joined the Rockefeller enclave to announce that he thought the Knickerbocker Trust Co would be the first Heinze bank to fail. Panicked depositors stormed the tellers' cages of the Knickerbocker Bank to withdraw their money. Within a few days the bank was forced to close its doors. Similar fear spread to other Heinze banks and then to the whole banking world. The crash of 1907 was on.

Millions of people were sold out penniless and rendered homeless by bank foreclosures, and their savings wiped out by bank failures. The destitute and the hungry fended for themselves as best they could, which was not very well. Circulating money was hoarded by any who happened to still have some, so before long a viable medium of exchange became practically non-existent. Many business concerns began printing private IOUs and exchanging these for raw materials as well as giving them to their workers for wages. These "tokens" passed around as a temporary medium of exchange.

At this critical juncture, J P Morgan offered to salvage the last operating Heinze bank (Trust Co of America) on condition of a fire sale of the valuable Tennessee Coal and Iron Co in Birmingham to add to the monopolistic US Steel Co, which he had earlier purchased from Andrew Carnegie.

This arrangement violated existing anti-trust laws but in the prevailing climate of depression crisis, the proposed transaction was quickly approved in Washington. Morgan was also intrigued by the paper IOUs that various business houses were being allowed to circulate as a medium of exchange. He persuaded Congress to let him put out $200 million in such "tokens" issued by one of the Morgan financial entities, claiming this flow of Morgan "certificates" would revive the stalled economy. As these new forms of Morgan "money" began circulating, the public regained its confidence and hoarded money began to circulate again as well. Morgan circulated $200 million in "certificates" created out of nothing more than his own "corporate credit" with formal government approval. It was a superb device to make millions. GE Capital in the 1990s did the same thing with commercial papers and derivatives to create hundreds of billions in profits.

Conspiracy theorists assert that the seeds for the Federal Reserve System had been sown with the Morgan certificates. On the surface J P Morgan seemed to have saved the economy - like first throwing a child into the river and then being lionized for saving him with a rope that only he was allowed to own, as some of his critics said. On the other hand, Woodrow Wilson wrote: "All this trouble [the 1907 depression] could be averted if we appointed a committee of six or seven public-spirited men like J P Morgan to handle the affairs of our country." Both Morgan and Wilson were internationalists.

By 1908, J P Morgan was working with senator Nelson Aldrich of Rhode Island, who was related to the Rockefeller family by marriage, and whose surname was the middle name of vice president Nelson A Rockefeller, to establish a private central banking system. Aldrich was the maternal grandfather of Nelson Rockefeller.

Ironically, the initial idea of the need for a central bank came from the populist movement, which began in Lampasas County in Texas when a group of desperate farmers formed in 1877 the Knights of Reliance to educate themselves speedily against the time "when all the balance of labor's products would become concentrated into the hands of a few, there to constitute a power that would enslave posterity". Uninhibited by the awesome high science of economics, average citizens in the late-19th-century United States were pragmatically aware of the political implications of monetary policy. The Farmers Alliance, renamed from the Knights of Reliance, held regular traveling lectures that quickly concluded that the causes of their members' financial ruin were the gold standard and the private banking system that enforced its confiscatory terms.

The populists proposed a solution in August 1886 in a convention in Cleburne, Texas. The "Cleburne Demand" called for federal regulation of the banking system and a fiat national currency to meet the liquidity needs of an expanding economy. Public pressure was making increasingly vocal demands for a plan to eliminate Wall Street control and exploitation of the economy for narrow private benefit.

In response, Morgan's ally, senator Aldrich, arranged to become chairman of the National Monetary Commission, which received an assignment from Congress to study the US monetary system and make recommendations of ways to improve it. Paul Warburg, whose brother Max was in charge of the Reichsbank, the privately owned national bank of Germany, emphasized the absolute necessity of setting up a new national banking system that would prevent Wall Street from putting the United States through devastating "boom and bust" cycles as it had in the past.

On November 22, 1910, a private railroad car pulled out of the station at Hoboken, New Jersey, with several powerful people aboard. Others joined the meeting later. They met at the J P Morgan estate on Jekyll's Island, Georgia. This secret meeting included senator Nelson Aldrich; A P Andrews, professional economist and assistant secretary of the Treasury; Frank Vanderlip, president of the National Bank of New York City, which later became Citibank; Harry P Davidson, senior partner of the J P Morgan Co; Charles D Norton, president of Morgan's First National Bank of New York; Paul Warburg, partner of the banking house of Kuhn, Loeb Co in New York; and Benjamin Strong of the J P Morgan Co central office in New York, who later became the first president of the New York Fed and dominated the new central bank for the first two decades. After nine days, they produced a bill for Congress that was later submitted as the "Aldrich Plan". Conspiracy theorists made much about this infamous secret meeting.

The main resistance to the Aldrich Plan came from the House of Representatives, where an official investigation had revealed some of the ruthless operations of powerful financial interests on Wall Street and definitely fixed responsibility on Wall Street (especially Rockefeller and Morgan) for the crash of 1907-08, similar to current public indignation over Enronitis.

With the tide of popular opposition rising, it was obvious that the Republicans were not going to be able to get the Aldrich Plan adopted. Strategy then switched to influencing the Democratic Party, which immediately came up with an "alternative" plan to be called the Federal Reserve Association. It was in essence the Aldrich Plan with a different name. The next task was to defeat the sitting Republican president, William Howard Taft of Ohio, in the 1912 election and get a more sympathetic Democratic administration in power. Taft was popular, but he opposed the Aldrich Plan. The political strategy was therefore redesigned to induce another Republican, popular Teddy Roosevelt, to run on a Progressive ticket against Taft and thus divide the Republican Party.

Morgan officers provided both the money and the strategy to help Roosevelt win Republican votes away from Taft. George Harvey, president of the Morgan-controlled Harpers Weekly, and Rockefeller money got behind Wilson. The Wilson team included Cleveland H Dodge of Rockefeller National City Bank, J Ogden Armour, James Stillman, George F Baker, Jacob Schiff, Bernard Baruch, Henry Morgenthau, and the publisher of the New York Times, Adolph Ochs. The Morgan officials who managed Teddy Roosevelt's campaign were also found to have put extensive money behind Wilson. As might have been expected, the strategy worked and Wilson was elected with 6.29 million votes while Roosevelt drew 4.12 million votes and Taft, who won with 7.68 million votes over William J Bryan's 6.4 million in his first-term victory, drew only 3.46 million votes.

Progressivism reached its high-water mark in the 1912 campaign. Taft plainly had no chance of re-election, the main contest being between Roosevelt and Wilson. Both men proposed to revitalize democracy by limiting the powers of big business. Wilson, winning 42 percent of the popular vote, polled fewer than Bryan had done in each of his three unsuccessful campaigns. But with the Republicans split between Taft and Roosevelt, he carried 40 states to become a minority president.

When Woodrow Wilson took over the White House in 1913, he brought with him his Wall Street advisers, including "Colonel" Edward Mandell House, who is now known to have been the major policy-maker and manager of the entire Wilson administration. In his personal writings, House describes the pile-driver tactics that were used to force a bill through Congress that would authorize the setting-up of the new Federal Reserve System as a privately owned central bank.

The leading financiers of Wall Street pretended to protest vehemently against the bill. In his autobiography, William McAdoo, Wilson's son-in-law, who became secretary of the Treasury, says he was very impressed by the way the "bankers fought the Federal Reserve legislation - and every provision of the Federal Reserve Act - with the tireless energy of men fighting a forest fire. They attacked it as populist, socialistic, half-baked, destructive, infantile, badly conceived and unworkable." But McAdoo found that when he engaged these bankers in private conversation, he realized their opposition was merely a smokescreen to hide their true feelings. He wrote: "These interviews with bankers led me to an interesting conclusion. I perceived gradually, through all the haze and smoke of controversy, that the banking world was not really as much opposed to the bill as it pretended to be."

On December 22, 1913, with the prospect of the Christmas holiday pressuring Congress into final action before the session closed, the House voted 298-60 in favor of the new Federal Reserve System, and the Senate passed it 43-25.

From its beginning, the dominant guiding principle of the Fed was financial rather than economic, though its charter directed it to "accommodate the needs of commerce and industry". Fed policy-makers concentrated on preventing inflation to calm investor fear, not on lowering unemployment or restoring falling farm prices. Fed officials spoke of "liquidation of labor" as part of sound central-banking principle, which harbors a bias toward preserving the health of the financial sector over the real economy. In order to restore the former, it was necessary to punish the latter. Lose weight to save the heart.

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