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Can anyone explain how money worked in the US before the Federal Reserve?

I was reading an article about the creation of the Federal Reserve Bank (boo, hiss) in 1913 and I came across this:

Faced with the supreme necessity of sustaining the national credit and providing a market for Government securities, the Secretary of the Treasury in 1863 passed a National Bank Act basing the issue of currency by the banks upon the purchase of an equal amount of Government bonds. That was a cardinal error which still remains uncorrected. It has entailed a vast locking-up of banking capital in Government bonds as security for notes, and it has made impossible a normal and elastic currency system based on commercial paper and similar assets and automatically adapting itself to the daily needs of business.

Cue utter confusion. For starters, why would a bank want to issue currency? Surely, a bank has all the money it wishes to lend out in the form of deposits. And what is meant here by currency? notes and coins or money in general?

…it has made impossible a normal and elastic currency system based on commercial paper and similar assets and automatically adapting itself to the daily needs of business.

This is really confusing. I can understand how notes work in a goldsmith system. Briefly, a depositor deposits some gold with the goldsmith and in return receives a receipt for that gold. The receipt, or note, is then capable of being used as money because it is literally “as good as gold”. I can see how government bonds might replace gold but it requires a depositor. And surely, once a depositor has deposited his bond the bank can issue its own receipts/notes rather than having anything to do with the government. Or maybe that’s illegal. Or maybe depositors would prefer to use government notes as they are accepted in more places.

“…a normal and elastic currency system”. What do they mean by “elastic”? Do they mean what modern-day Austrian economists mean i.e. inflationary? I doubt it because at the time the UK was on a gold standard which tends to be anti-inflationary [notwithstanding comments I have made about how there was some inflation at the time].

And what’s all this about commercial paper? The modern meaning is short-term business debt. I can kind of see how that would replace government bonds although presumably it would have to be extremely homogenous and what happens when the term is up?

And where, if anywhere, is the link with gold which, as I understand it, was one of the main issues in the 1896 presidential election?

Whatever the case may be it seems clear that the US monetary system was far from being a free market before the Fed came along.

One last thought: there are times when I think the confusion that monetary matters generate is deliberate rather than accidental.

The Times 10 September 1913 page 8

The Times 10 September 1913 page 8

25 comments to Can anyone explain how money worked in the US before the Federal Reserve?

  • Gary Poteat

    Not knowledgeable about these issues but…
    1. Allowing banks to create currency based on purchase of GOVT bonds helps the government sell bonds at a time when many thought the South would win and when government debt was considered less sound loan (imagine that) than commercial loans. Government debt in that era often paid higher rates than top commercial debt.
    2. Allowed banks to double their income. Take in deposits, lend to borrowers for income OR take in deposits buy govt bonds (get income) and then create equal amount of currency to lend (get more income).
    Banks that finance governments have always been well paid and made lots of money. The government doesn’t care, it isn’t their money. And, as a bonus, the banks are willing to pay bribes to government officials. Everyone wins (except taxpayers) so what’s not to like.
    The serfs did not disappear, they just started calling them taxpayers.

  • Surellin

    Confusing indeed, since we are used to money being a government monopoly. But it wasn’t always – the “free banking era” in the US extended from Andrew Jackson’s dissolution of the Bank of the United States in the 1830s to the 1863 Act to which you refer. Wiki has some interesting stuff under “Private Currency”.

  • Alsadius

    For what it’s worth, a big chunk of Canadian money was printed by the big banks until the 1940s. For a few years after the country was founded, we didn’t even have an official currency.

  • Laird

    Where to begin? There is so much confusion embedded in that extract that it’s impossible to address it all. For starters, it conflates “money” with “currency”, which aren’t the same thing at all (although most of us do tend to use the terms interchangeably). “Money” is a storehouse of value; “currency” is a token which stands in the place of, and is redeemable for, money.

    The reference to a “normal and elastic currency system” is a reiteration of the common fallacy that the “money supply” (meaning currency in circulation) must expand with the growth of the economy. That’s a common belief, but it’s wrong. Elastic currencies are useful to governments, of course, because they permit the government to inflate and thus steal value without having to resort to taxation, but they have always, without exception, lead to ruin. We’re on that path today. The article merely shows that the misunderstanding of the role of currency was endemic even in that pre-Keynsian era.

    Historically (pre-Fed) in the US, currencies were issued by private banks and the federal government (there were state-issued currencies too, in the colonial era before the feds took over that role). They were ultimately backed by gold, whether in the form of circulating coin or bullion. Private currencies were common well into the 19th century, before they were made illegal by the federal government, which needed to control the currency in order to be able to sell its debt. (That’s the same reason the Bank of England was created centuries earlier.) One can understand the public’s desire for a common (federal) currency, in an era when it was difficult to conduct transactions far away using local currencies, and when private banks routinely over-extended themselves (fractional reserve banking, another discussion) and sometimes failed, wiping out the value of their currencies. But someday (probably fairly soon) those chickens will come home to roost, demonstrating that the cure was worse than the disease.

    There is no theoretical harm in government currency provided it’s backed by gold, which it (mostly) was in those days, and of course its issuance of precious metal coinage is unobjectionable (at least, until they start debasing it with base metals). It’s the de-coupling of the currency from gold or some other storehouse of value which creates the problem.

    Probably the best place I can cite to you for a concise description of the banking system, fiat currencies and central banking is Detlev Schlichter’s book Paper Money Collapse. http://www.amazon.com/Paper-Money-Collapse-Monetary-Breakdown/dp/1118095758/ref=sr_1_1?s=books&ie=UTF8&qid=1379598544&sr=1-1&keywords=detlev+schlichter. I can’t recommend it highly enough. Not always the easiest read but well worth the effort.

    Incidentally, for those who didn’t see his announcement, Schlichter is terminating his blog, and says that it will be shut down. http://detlevschlichter.com/2013/09/final-blog-thank-you-and-good-bye-for-now/. I hope that he leaves it open simply for archival purposes, even if he stops writing for it, but that’s not what he says. While it’s still open there are a wealth of his essays there which are worth reading.

  • Laird, he says there that most of his posts were reposted elsewhere, such as at Cobden Centre.

  • Laird, I am not unfamiliar with Schlichter’s book which was one of the reasons that extract took me aback. I’ve also had the chance to have a look at Rothbard on this and he seems to confirm what The Times is saying.

    It occurs to me that government currency (meaning notes and coins) might be at an advantage in an age where branch banking is more or less forbidden (at least in the US). It’s a currency you can use wherever you go.

  • llamas

    What Laird said (mostly).

    Prior to the Federalization of paper money during/after the Civil War, US banking was just the sort of riotously-informal yet gloriously-effective system that no government can tolerate for long – because it can’t be controlled, and therefore suborned to act as a tool of Government debt and deficit budgeting (as Laird describes).

    Anyone could and did issue banknotes – the Feds held the monopoly on coinage (as set out in the Constitution) and I think I’m right in saying that no State until the War of Northern Aggression coined its own. Naturally, the only real problem in the US banking system at that time was the chronic shortage of coin – the one part of the system administered by the Feds.

    Free-market solutions sprang up all over. Private banknotes of all kinds, tokens, all sorts of commercial paper, truck-and-barter systems, the list is endless. And it all worked. However, since this glorious riot of commerce was complately-incapable of being centrally controlled and manipulated, it was total anathema to the growing statist class, and so it was quickly suppressed, the Civil War and its aftermath providing the necessary justifications. The banking acts passed at that time took regulation of banking out of the hands of the states and established the Feds as the sole issues of legal tender.

    Effectively, the riskier aspects of unregulated and private banking were exchanged for the solid reliability and security of a centrally-controlled-and regulated Federal banking and currency system, with the prudent and judicious oversight of the Congress always present to ensure the stability and economic fitness of the system. (/sarcasm off)



  • RRS

    P C –

    That depends on whether you are really interested to learn, or are looking to deprecate the current perversions of the functions of the Federal Reserve System.

    Suggested reading:

    A Monetary History of the United States: 1867 – 1960 Friedman and Schwartz (NBER 1963) Princeton University Press 1971

    A History of the Federal Reserve Alan Meltzer (University of Chicago Press 2004)

    The term “how money worked” seems to be intended to ask “what worked as money.”

    Believe it or not banks can still issue “Banknotes.” However, the Federal Government Levies a Tax on the Issuance in the Amount of 100% of the Face Value of the Notes, Payable in Legal Tender.

    Up through 1907, many things performed the functions of money. Prior to that date my father, as a merchant in the small town of Malta, Illinois, served as a “clearinghouse” through accounts in his store ledgers of barter transactions, to which he assigned US specie (coins) and metal certificates as units of account. I have been told that his ledgers are at one of the schools of the University of Illinois at Chicago (I do not think it is the University of Chicago) as an example of a non-currency monetary accounting system of trading. Of course, he had “cash” or “hard money” transactions, which were kept on separate ledgers. Those items would’ve involved most of his purchases of common inventories such as threads, salt fish, hardware, etc.

    So, money, as a unit of account, “worked” just as it does today.

  • Current

    I’m not a big fan of Schlichter or the 100% reserve crowd. I don’t think paper money will collapse anytime soon.

    As others have explained, in the early 19th century in the US banks were free to issue their own banknotes. The government had a monopoly on coils, but not on banknotes. There were many other limitations on banks though, in some states banks were not permitted to have branches, they could only have one premises. In most places they couldn’t operate across state boundaries. In some states they were required to hold bonds issued by that state as capital. These banks were unstable. I put that instability down to the limitations placed on them, I’m sure that 100% reservers would put it down to there being fractionally-reserved.

    Patrick writes “Surely, a bank has all the money it wishes to lend out in the form of deposits.” In the 19th century that wasn’t true. Bank balances weren’t that useful except to the rich because transfers between banks were cumbersome. Would you want a balance at a bank with only one branch in a tiny American town? What the public wanted was banknotes, they were much more useful.

    As far as I understand Laird’s terminology banknotes are “currency” and what the government issues is “money”. That’s not standard terminology though, generally we call what the central bank and government issue “outside money” and what commercial banks issue “inside money”.

    The fractional-reserve commercial banks kept assets, such as loans, to offset their liabilities: the deposits and banknotes. Before the National Banking system those assets weren’t restricted much by Federal law. They were often restricted by state law, states often required that banks hold the bonds of that state. The justification for this was that the government debt would be safer than commercial debt that banks may otherwise use, making banking safer for the public. But, the federal and state governments benefited from it significantly because it created a captive market for government debt, reducing the interest rate that the government had to pay. The NBS expanded what states had already been doing to the national level.

    Variants of this method have often being used by governments for funding. The most common method is to sell bonds to the central bank and have the central bank issue corresponding money (either notes or bank balances), that was how most hyperinflations have happened. A less damaging and smarter tactic is to require banks to hold a very high reserve percentage, central bank reserves themselves correspond to government debt. Normally reserves earn no interest or low interest, so the cost of this is passed on to the banknote and bank balance holders. Britain used this method, the BoE had a reserve requirement of 20%, and that’s one reason why banks were so expensive to use before the 70s.

    The sentence about “a normal and elastic currency system based on commercial paper and similar assets and automatically adapting itself to the daily needs of business.” refers to the Real-Bills Doctrine. This is the “Banking School” view that the total quantity of money (inside and outside) is determined by the quantity of outstanding debt and that the two should move in synchronous with each other. This view doesn’t make very much sense and there are numerous critiques of it on the internet.

  • Laird

    I agree with Current’s summary of banking history, and with most of the rest of his comment. Indeed, many of those state (and sometimes later federal) restrictions on banks (branch prohibitions, restrictions on interstate banking, etc.) didn’t disappear until the 1980s. And they were indeed a reason that banks were more unstable than necessary. The only quibble I have with his post is the implication that Schlichter (and I) are members of the “100% reserve crowd”. Neither of us is opposed to fractional-reserve banking in principle. Anyway, that is not the focus of this thread, and I’d rather not start down that rathole here. (We’re not even free of the LVT debate yet!)

  • PaulD

    The backing of much of the paper (and banks) was not gold, but land, prior to the Civil War.

    To understand what was being addressed in 1863, you need to look into the veto of the the Bank of the United States charter renewal by President Andrew Jackson in 1837. Central banking as a concept was condemned by many as a tool of absolutist government, potentially allowing the President to circumvent Congressional budgetary control. Banking issues were central to the growing divide between North and South. The legislation of this era is based on that more than on economic ideas. After the War, gold and silver became much more plentiful.

  • CaptDMO

    Well, we could fix it, but…but…well, it’s complicated.
    Let’s ask the folks at Treasury (IRS).

  • Paul Marks

    Patrick – you know I love comments, but I am not sure that this is really suitable for a comment. To cover all the questions you have raised here the comment would have to as long as a book.

    So I will (in an arbitrary way) just make a few points.

    Even before the Civil War banking was a mess – because banks tended to lend out (in various complex interactions based on the terrible way banks do their books) more “money” than they actually really had, i.e. the created credit bubbles (hence boom-busts – the bust is when the bank credit shrinks back down towards the monetary base of actual physical money).

    During the Civil War “Greenbacks” (fiat money) was created – but I will not tell you that story (how it carried on for many decades after the Civil War, but with a fixed amount of Greenbacks, but…..) because you (and everyone else) would lose the will to live by the time I got about half way through the story.

    The “National Banking Acts” really covered something else.

    They were about creating a special status for the big New York Banks….

    For example, not ALLOWING other banks to “discount” the debt paper of the bit New York “National” banks.

    This was supposed to make the financial system more stable – it did the reverse.

    In spite of the efforts of J.P. Morgan it was clear the new system did not really work.

    So the government (and the leading interests) decided to make it WORSE in 1913 by…..

    Well you know the rest.

  • Mr Ed

    I heard today how the great French polymath Pascal’s father, a civil servant, invested heavily in government bonds during a period of war and lost the lot. How can people not learn the most simple lessons from history? Is it because they expect not to be the last one holding the parcel when the music stops and it is revealed to contain fresh air?

    In Scotland today, three banks issue their own notes, RBS, Clydesdale and Bank of Scotland, similar in Northern Ireland. I even managed to spend a Scottish fiver in Cumbria on the M6 services the other day, much to my delight.

    It would be a better world if people understood how money worked after the Federal Reserve and acted in the light of that knowledge.

  • RRS

    PMO –

    Maybe two books.

    I thought surely someone, most likely the PMO, would touch on the evolution of demand deposit accounts and “checking,” the creation of which (in lending procedures)steadily replaced the issuance of banknotes in extensions of credits.

    As you note, Beeeg topic; not one for an article that may have survived the bottom of a bird cage.

  • Regional

    California started to flourish when gold deposits were exploited and read about coal to Newcastle to understand nearly everything is bullshit.

  • I would like to thank Gary for explaining why banks would want to buy government bonds. I am still a bit confused over what exactly depositors were depositing: gold, US government currency, private currency?

  • MadNumismatist

    From what I have read of Antal Fekete it was Real Bills of trade that created a self liquidating credit system. A bill was presented at the bank and credit created, let’s say 90 days. When the goods arrived, the bill was redeemed and the credit liquidated.

    As for the currency, I also believe with a mint open to anybody currency could be created and destroyed at whim. This was one of the problems of the gold standard; higher gold prices in India meant gold left the UK causing contraction in money supply.

    In addition Fekete notes that the real bills clearing system was based in The City and was dismantled sometime after WW- I. It also means, without that clearing system a gold standard could and never would work again. This is why Churchill tried and failed to reintroduce the gold standard in 1921.

    Real bills are also why only 30% of currency was backed by gold, with the remaining 70% backed by the real bills- genuine trade. This also allowed a self stabilizing monetary base that expanded and contracted as trade grew or fell.

  • Current

    There’s approximately one issue in Monetary theory where Paul Marks and I agree, and where we agree with the majority of economists too. That’s the Real Bills Doctrine.

    I agree with you that short-term debts, which is what “Real Bills” can be used as backing for banknotes and bank balances. But, there is no natural link between the quantity of those bills and the demand for money. Advocates of the Real bills doctrine talk about how as trade increase the transactional demand for money increases. So, more exchanges means more money is needed for exchanges.

    That’s not true because demand for money to execute trades is a pseudo-demand not a real demand. Let’s say I want to buy a car, that means I want to dissolve some of the wealth I own into money, then spend the money on a car. It means I demand the use of money for approximately a hour to perform the transaction. This form of demand is insignificant. The significant form of demand for money is demand to *hold* money. What people want is a stable store of wealth with a known value.

    The demand to hold money generally varies inversely with the economic cycle. The demand is higher during recessions and lower during booms. See the statistics gathered by the Bank of England, for example. The reward for keeping money in a bank balance is interest and banking services. In recent years interest has fallen to virtually nothing and increasingly banks are charging for services. Yet, the total quantity of bank balances has grown. Why? Because there’s been a recession and rather than hold wealth in volatile investments like shares and property people have demanded bank balances instead.

  • PersonFromPorlock

    Heretic that I am, I think the only sensible currency is a world currency, like the Euro only moreso. That at least reduces all the problems of private or national currency to keeping one issuing authority sensible and honest. How to do that so as to preserve the value of the currency? Pay the responsible parties an amount in the world currency which can only be decreased (for deflation), forbid them any outside income and make ‘corruption in office’ an affirmative defense for injuring or killing them.

  • Paul Marks

    Patrick – before 1913 people could deposit (a bad word as the money is not really “deposited” – it is lent out) “Greenbacks” (those Civil War notes that were still in circulation) or gold (gold Dollar coins – or just gold). All this gold was stolen by the Federal government in 1933.

    After 1913 Federal Reserve notes were added to the mix – they could be “deposited” also.

    All this stuff was lent out.

    The trouble is that a lot of other (non-existent) “Dollars” were lent out also.

  • Laird

    PfP, there used to be a “world currency”: gold. Oh, the coins had various rulers’ profiles stamped on them, but as long as they were of the advertised weight and purity it didn’t matter; they were accepted anywhere. (In colonial America the most common currency was the Spanish doubloon, notwithstanding that this was a British colony). And whenever one country started to debase its coinage by adulterating it with base metals or shaving the weight (a fairly regular occurrence) people figured it out pretty quickly, the coin fell out of favor, and Gresham’s Law kicked in. No problem. That was an excellent system, and if that was what you were advocating I’d be with you.

    But if you’re talking a single world fiat currency, I’m sorry but that’s the single worst idea I’ve seen posted here since we left the LVT debate. There is absolutely no way to effectively, let alone permanently, control that single issuer; the allure of debasement would be irresistible, just as it is today with multiple currencies, only infinitely greater. At least today we have some amount of protection through market competition. A single fiat currency would eliminate even that fragile control. Wishing for a single world fiat currency is not heresy; it’s a dangerous delusion and a fantasy.

  • Deerehunter

    So what’s the best way to avoid the collapse? Own land or gold or both?