Structural change in America’s financial markets

 

 

Structural change in America’s financial markets [i]

The financial system, and particularly the banking system, of the mid and late 19th century was a mirror of the political tendencies of the United States of that time. Dual federalism, which was the political norm at the moment, stated that the fiscal responsibilities of the federal and state government were clearly defined by the constitution. This traditional understanding of the federal system implied that two levels of government –federal and state– rule the same land and the people. Each level has at least one area of action, which it is autonomous and there is some guarantee (…) of the autonomy of each government in its own sphere (Riker 1946, 11). Therefore, after some political and constitutional disagreements, the financial system was said to be a competence of the different state governments. It is well known the Andrew Jackson’s vetoes against a central bank charter and how he decentralized the system, transforming it into an immense web [ii] of state-chartered banks operating in the United States before the Civil War.

Before 1860s, most of these state-chartered banks were small, serving local customers and their activities were regulated by state laws. Each bank was authorize to receive deposits and issue bank notes [iii], which were legally convertible into lawful money –gold or silver, because the bimetallic standard was adopted in 1791– upon demand at the bank of issue. Since money usually circulated far from the bank of issue, the conversion to actual money was usually troublesome. As a result, the full value of these notes were only accepted in the immediate local area around the bank of issue, with a discount from their face value elsewhere. This chaotic money and banking system not only increased the costs of doing business, but also impeded the smooth flow of funds. One historic event will restructure dramatically the financial system: The civil war.

 

The Civil War: Fiat Money.

Even though The United States was a growing nation on his way towards industrialization, neither the Union nor the confederate government had the solvency to finance a major war. The federal government was still fairly limited in many fields, and they just relied upon excise taxes [iv] –which had not been levied since the 1820s–, the tariff [v], and land sales for its revenues. Since there was no central bank, the details on loans [vi] required congressional approval, making it difficult to adapt the rapid changes of the market. These problems, together with the need for money to win the war, brought fundamental changes in American Financial markets.

Prior to Civil War, the federal government sold $38 million in bonds, with different interest rates, to fund their short term debts. Once the war began, the Union treasury [vii] found it difficult to borrow money. With a probable expenditure of $361 million for 1861, Chase projected that $240 million was to be borrowed. The rest should be levied by means of taxes, some of which were created ad-hoc [viii] to solve the money problems of the federal government to finance the war. The proposed debt increase was more than three times the entire national debt at the time. Part of it –$50 million– was authorized in non-interest-bearing Treasury notes [ix], which were redeemable upon demand in specie and acceptable in payment of all debts to the government. Despite the reluctance by the public at first, the supply was eventually exhausted, and the government again needed funds. This time, the federal treasury agreed with a consortium of large banks to lend them $50 million by purchasing three-year 7.3 percent Treasury notes, with the right to take two additional $50 million that same year. Since the news from the war were quite bad, banks had difficulties in issuing the treasury notes. Together with a shortage of liquidity and the issue of another $33 million in Treasury notes, the payment of specie was suspended by the banks and the federal government, only to be resumed in 17 years time.

The suspension of convertibility raised questions about the credit of the Union government, making it even more complex to borrow more money. An alternative solution was proposed: the issue of non-interest-bearing Treasury notes, called Greenbacks, that would be legal payment for all debts public and private and nonredeemable in specie. Despite the banking opposition, the Legal Tender Actwas passed in 1862, authorizing $150 million [x] in such notes. Greenbacks were quickly spent and the Congress authorized two additional issues  of $150 million. Eventually, a total of $450 million were issued from 1862 to 1863, doubling the money stock with the resulting depreciation of its value and generating an inflationary pressure. Fiat money [xi] stayed despite the efforts of the Congress to convert it into interest-bearing bonds –redeemable in five years– or buy back Greenbacks after the war. The oversupply of Greenbacks produced a situation in which two prices were quoted: One for transactions in gold; the other, high price for transactions in Greenbacks. Therefore, the value of the dollar depended on whether it was in coin or paper.

This oversupply of paper money triggered in 1875 the creation of the Resumption Act, directing the Treasury to begin redeeming in coin any Greenbacks presented for payment. In order to fulfill this task, John Sherman –Secretary of the Treasure– believed that about $130 to $140 million in gold were required in the treasure ark’s, from which they only had 25$ million. The difference was acquired by means of American bonds sold to foreign investors at rates somewhat above those currently being offered by European governments.

 

Monetary policies: from bimetallic to Gold Standard

During the Civil War, the supplementary silver coinage virtually disappeared [xii] and it did not return until the end of the war. Even so, since the silver dollar’s mint ratio changed in 1834, these coins were more valuable on the precious metal market than in the mint. After some economic and monetary revisions in the 1870s, a recommendation of dropping the silver dollar from coinage was exposed. The proposal was adopted by The Coinage Act in 1873, declaring the silver dollar no longer usable as money. Since the market price of silver ($1.298 an ounce) was higher that the mint value silver ($1.292 an ounce), nobody paid much attention to these changes at first. However, silver prices fall sharply shortly afterwards, because of the growing offer of silver in the global market. By 1874, the price of silver had fallen to $1.238 an ounce. Therefore, silver producers were willing to sell their output to the mint [xiii], but it was no longer interested in buying because it had no longer need of silver for coinage. Political opposition to the government’s economic policies appeared after the Crime of ’73, and many political pressures to restore bimetallism were the norm during the 1870s.

Even though the pressures were resisted by the executive and the Congress, some compromises were required. The first one was the Bland-Allison Act (1878), which approved the purchase of between $2 and $4 million of silver per month at market prices for coinage into silver dollars at the 16:1 ratio. This compromise satisfied no one. On the one hand, silver purchases were too limited to increase the market price, which in fact decreased. On the other hand, the fear of inflation that would result from unlimited circulation of silver was in the head of many politicians. The second one was the Sherman Silver Purchase (1890), by which the treasury was to buy 4.5 million ounces of silver a month at market prices using specially printed Treasury notes [xiv]. Redemption [xv] in gold or silver was at the discretion of the secretary of the treasury, which meant that as long as redemption was in gold, a de facto gold standard was preserved. Therefore, the United States monetary system functioned as if it were on a gold standard, even though legally it was still bimetallic standard.

This de facto gold standard was based in the assumption that the Treasury’s gold reserves would hold out. The gold reserves dipped from $200 million in 1890 to below $100 million in 1893, which together with the financial crisis of 1893, reinforced the fear of a silver risk [xvi]. On May 1893, President Cleveland called the Congress to plead for the repeal of the Sherman Silver Purchase Act, which would eventually be repealed in both legislative Houses on October 1893. Not until 1900, when the Gold Standard Act was approved, did the United States officially establish gold as the sole monetary standard.

 

The way to a National Banking System

From 1849 to 1853 the number of banks in the United States increased. Despite the growing complexity in the banking system, the settlement procedures remained stuck in the traditional way: Banks settled their accounts by employing porters to travel from bank to bank to exchange checks for specie. As the number of banks grew, exchanges became a daily event. The official reckoning of accounts, however, did not take place until Fridays, often resulting in record keeping errors and encouraging abuses. (The Clearing House Payments Company L.L.C. 2010). The chaotic settlement process among the banks was a great setback for a proper financial development. A solution to this problem was the establishment of a clearinghouse, which provided for the daily settlement of interbank balances. The first nation’s clearinghouse was created by 52 of the largest New York City banks in 1853, and by 1913 there were 162 clearinghouses nationwide. The clearinghouse banks assumed a leadership role in the banking community, especially those in New York, with a reputation for financial integrity. The formation of the Clearinghouses brought order to what had been a twisted web of exchanges. Specie certificates soon replaced gold as the means of settling balances at the Clearinghouse, simplifying even further the process. Once the Clearinghouse certificates were exchanged for gold deposited at member banks, porters encountered fewer of the dangers they had faced previously while transporting bags of gold from bank to bank.

National banking in the America previous to the Civil War was far from what it is now. The First Bank (1791-1811) and Second Bank (1816-1836) of the United States were the only official representatives of the U.S. Treasury, and the only sources that issued and backed official U.S. money. All other national banks were operated under state charter, each bank issuing its own individual banknotes. As you traveled around the country, you never knew exactly what kind of money you would get from the local banks. With America’s population growing is size, mobility, and economic activity, this multiplicity of banks and kinds of money soon grew chaotic. In 1863, Congress passed the National Bank Act providing for a supervised system of National Banks. The Act setup an homogeneous structure upon the banking system, established minimum amounts of capital to be held by the banks, keep a minimum reserve ratios, defined how the banks were to make and administer loans (About.com 2009), and marked the first big step towards a homogeneous currency. These capital and reserve requirements were more restrictive than those from state charters. That explains the reluctance from state chartered banks to convert to federal chartered banks. In 1863, only 63 national banks were established, most of them newly created banks. Their combined note circulation was less than $4 million, compared with the circulation of state bank notes of about $290 million. In 1864 the Congress imposed a 2% tax on state bank notes, but this measure also failed to force conversion from state to federal charter[xvii]. Stronger measures were needed, and the Congress raised the tax on state bank notes to a 10%, which made unprofitable to state banks to issue notes. Therefore, state banks were finally coerced into the national banking system [xviii].

State bank membership was not erased from the American financial system. In fact, it recovered after 1870, although the value of their assets was only a fraction of those of national banks. There are different causes for the increase of state banks at the turn of the century. First, the substitution of personal check for the bank notes as a mean of payment helped to avoid the tax penalty on noncongressionally sanctioned bank notes. Second, state charted banks had a lower minimum capital requirement and reserve ratios. Thirdly, National banks were prohibited from making mortgage loans, even when real state was the principal asset in rural areas. As a result, in the 1890s, a majority of new banks adopted state, rather than federal chapters, and the two systems became locked in competition for membership. This competition, fostered with changes in the regulatory system, had the effect to weaken banking regulation to a virtually unrestricting end. Competition might have probably played a decisive role in the bank failures and suspensions in the 1890s, late 1900s and especially 1920s.

The American banking system suffered from a number of serious flaws that made it especially vulnerable to financial panics. Up to the 1870s, the traditional role of the central bank was to support free banking legislation and adopt usury ceilings on interest rates, which typically were a 6%. Many of the flaws of the new banking system arose after the National Bank Act (NBA). The Act created a tiered banking structure, consisting of country banks on the bottom, city and reserve city banks, with central reserve city banks constituting the top layer. First, differential regional interest rates reflected differential rates of monopoly power in banking arising from the NBA. For instance, in the early 1870s, the average net return for Midwestern reserve city banks (Chicago, St. Louis …) was almost 6.5%, in San Francisco was over 7.5% and in New York City less than 3.5%. Second, the congress tried to minimize the probability of a large bank’s failing by setting high reserve requirements for reserve city banks. This policy limited the ability of national banks to compete with the state banks. The growing competition will eventually weaken the regulatory structure governing the banking system. Third, Congress believed that the pooling of reserves would create a safety net from which legal tender could be drawn in times of need. However, the system resulted in the concentration of system reserves in a few New York City banks [xix]. Whatever large the reserve pool might be, there was no lender in last resort to whom the NYC banks might turn in times of crisis.

Any of these problems just described triggered the final reform that the banking system would undergo in the 1910s, but the Panic of 1907. The 1907 Bankers’ Panic was a financial crisis that occurred when the New York Stock Exchange, particularly those of the more popular companies, fell close to 30% in less than two weeks. Reserves at the NYC banks were close to legal minimum, and interest rates were tightened. In mid October, panic broke out with runs on eight banks, five of them members of the New York Clearinghouse. Although the clearinghouse bailed those banks out, the financial crisis worsened when the Knickerbocker Trust Company –New York City’s third-largest trust– collapsed and spread the fear to other Trust companies. As a consequence, loans contracted, regional banks withdrew reserves from NYC banks and the panic extended across the nation as vast numbers of people withdrew deposits from their regional banks. The panic may have deepened unless J. P. Morgan had pledged large sums of his own money and convinced other New York bankers to do the same. Even though the financial contagion had largely ended by November, a further crisis emerged when a large brokerage firm borrowed heavily using the stock of Tennessee Coal, Iron and Railroad Company (TC&I) as collateral. Collapse of TC&I’s stock price was averted by an emergency takeover by Morgan’s U.S. Steel Corporation. (Wikipedia Contributors 2010)

In 1908, Senator Nelson W. Aldrich established and chaired a commission to investigate the crisis and propose future solutions. The first legal measure was the Aldrich-Vreeland Act, which authorized what the clearinghouses had been doing, but widened coverage to include non clearinghouses members. In addition, the Aldrich-Vreeland Act created a National Monetary Commission to study the banking and monetary systems and make recommendations for their improvement. The key recommendation was the creation of a central bank, controlled by the bankers themselves, organized around a national reserve association with 15 regional associations. Not until the Democrats captured the Presidency and the Senate, the banking reform was adopted from much of Sen. N. W. Aldrich’s original proposals. The Democrat’s plan gave the federal government more power over the central agency while bankers retained control over the regional banks. The Federal Reserve Act was approved and signed by Pres. W. Wilson in 1913. 

The Federal Reserve Act created the Federal Reserve board in Washington D.C., which was composed by 5 presidential appointees serving ten-years terms and the secretary of the treasury as ex officio member. The board’s role was to determine the policy to achieve the goals and to supervise the 12 district banks. All national banks were required to become members of the Federal Reserve System, while state banks that met federal requirements were also allowed to become members. The objectives of the Federal Reserve Act were to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes [xx]. However, the Federal Reserve failed to solve the problem of creating an elastic currency and to gain regulatory control over the banking system. So long as the US remained committed to the gold standard, the Fed lacked complete control over the supply of currency and its ability to act as a lender of last resort was compromised. Similarly, supervision could not be effective when only 1/3 or so of the banks were members of the Federal Reserve System.

 


Bibliographic References.
  • About.com. The Federal Reserve System. 2009. http://usgovinfo.about.com/library/weekly/aa081599.htm (accessed February 17, 2010).
  • Atack, Jeremy, and Peter Pasell. “The market for labor in historical perspective.” Chap. 19 in A new economic view of American History. From colonial times to 1940, by Jeremy Atack and Peter Pasell, 522-553. New York: W. W. Norton & Company, 1994.
  • Atack, Jeremy, and Peter Passell. “Structural changes in America’s Financial Markets.” Chap. 18 in A new economic view of American History. From colonial times to 1940, by Jeremy Atack and Peter Passell, 493-521. New York: W. W. Norton & Company, 1994.
  • Hatton, Timothy, and Jeffrey Williamson. “Wage gaps between farm and city: Michigan in the 1890s.” Explorations in Economic History, no. 28 (1991): 341-408.
  • Higgs, Robert. Competition and Coercion: Blacks in the American Economy, 1865 – 1914. New York: Cambridge University Press, 1977.
  • Riker, William H. Federalism: origin, operation, significance. Boston (MA): Littlebrown, 1946.
  • Sullivan, Arthur, and Steve M. Sheffrin. Economics: Principles in action. Upper Saddle River (NJ): Pearson Prentice Hall, 2003.
  • The Clearing House Payments Company L.L.C. “New York Clearing House.” Historical perpective. 2010. http://www.theclearinghouse.org/docs/000591.pdf (accessed February 17, 2010).
  • Wikipedia Contributors. Excise tax in the United States. Edited by the free encyclopedia Wikipedia. January 15, 2010. http://en.wikipedia.org/w/index.php?title=Excise_tax_in_the_United_States&oldid=338041905 (accessed February 28, 2010).
  • —. Panic of 1907. Edited by the free encyclopedia Wikipedia. January 14, 2010. http://en.wikipedia.org/w/index.php?title=Panic_of_1907&oldid=337765347 (accessed February 17, 2010).
  • Wright, Gavin. Old South, New South: Revolutions in the southern Economy since the Civil War. New York: Basic Books, 1986.

 

Notes:
[i] Summary from (Atack and Passell, Structural changes in America’s Financial Markets 1994, 493-521)
[ii] More than 1600 state-chartered banks before 1860.
[iii] There were some 9000 different designs
[iv] An inland tax on the production or sale of good (Sullivan and Sheffrin 2003, 118), or narrowly as a tax on a good produced within the country. More info on (Wikipedia Contributors 2010)
[v] Tax levied on imported or exported goods.
[vi] The amount, Interests rate and terms of scale.
[vii] Under the administration of Salmon P. Chase
[viii] 1st US tax on income
[ix] Also called demand notes
[x] In denomination of $5 or more.
[xi] Currency whose value derives from the dictates of government
[xii] In 1860, $21 million of silver coins were in circulation, whereas less than $6 million were circulating in 1869.
[xiii] At $1.292 an ounce.
[xiv] These Treasury notes of 1890 were full legal tender and redeemable in silver or gold.
[xv] Repayment
[xvi] Real bimetallic standard with the attendant inflation of silver.
[xvii] 1864: 508 National Banks with a note circulation of less than $46 million.
[xviii] 1865: 1513 National Banks with a note circulation of $171 million (which will be increased in a year to $280 million).
[xix] In 1912, eight New York City Banks held about the 60% of the city’s interbank deposits.
[xx] Original Federal Reserve Act (1913): http://www.llsdc.org/attachments/files/105/FRA-LH-PL63-43.pdf

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Structural change in America’s financial markets por Iván Matellanes (Licenciado en Filologia Inglesa), a excepción del contenido de terceros y de que se indique lo contrario, se encuentra bajo una Licencia Creative Commons Attribution-Noncommercial-Share Alike 3.0 Spain Licencia.

About Iván Matellanes

Administrador, editor y creador de la e-Revista de Humanidades Sárasuatī, soy Licenciado en Filología Inglesa (UAB) y estudiante de último año de Humanidades (UOC). Además, tengo un Máster en "Teaching English as a foreign language" (UPF) y actualmente estoy cursando otro Máster oficial en "Estudios Norteamericanos" (UAH). Soy profesor de Inglés de ESO en la provincia de Castellón. Me gusta mucho la historia Americana y el pensamiento político estadounidense, ámbitos en los que me estoy especializando y alrededor de los cuales me gustaría disertar en un futuro.

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