America's Bank: The Epic Struggle to Create the Federal Reserve - Softcover

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ROGER LOWENSTEIN reported for The Wall Street Journal for more than a decade. His work has appeared in The Wall Street Journal, Bloomberg , The New York Review of Books, Fortune, The New York Times Magazine, and other publications. His books include Buffett, When Genius Failed, Origins of the Crash, While America Aged, and The End of Wall Street. He has three children and lives with his wife in Newton, Massachusetts.

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***This excerpt is from an advance uncorrected proof***

Copyright © 2015 Roger Lowenstein

Chapter One

The Forbidden Words

I am in favor of a national bank. —Abraham Lincoln, 1832

When Carter Glass was born in 1858, the United States was an industrializing nation with a banking system stuck in frontier times. As the country put up factories and laid down rails, the tension between its antiquated finances and its smokestack-dotted towns grew ever more acute. Heated battles over “the money question” came to dominate the country’s politics, but no matter how unsatisfied the people, any solution that tended toward centralization was, due to the prevailing prejudice, off the table.

America was a monetary Babel with thousands of currencies; each state regulated its own banks and they collectively provided the country’s money. Officially, America was on a hard-money basis, but the amount of gold in circulation was insignificant. In any event, as a contemporary would write, it was impractical for a traveler “to carry with him the coin necessary to meet his expenses for a protracted journey.” If he traveled with notes of any but a few of the biggest banks in New York, Boston, and Philadelphia, his money was likely to be refused, or greatly discounted. If he did carry gold, then, “at the hotel, in the railroad car, on the river or lake,” he would be of­fered slips of engraved paper that, in the words of a western banker, might include “the frequently worthless issues of the State of Maine and of other New England States, the shinplasters of Michigan, the wild cats of Georgia, of Canada, and Pennsylvania, the red dogs of Indiana and Nebraska, the miserably engraved notes of North Caro­lina, Kentucky, Missouri and Virginia, and the not-to-be-forgotten stump tails of Illinois and Wisconsin.”

In theory, these notes were redeemable in gold or in state bonds, but notes from western banks were notoriously unreliable. Bankers, not surprisingly, sought to circulate their paper as far as possible from the point of issue. That way, the notes might never—or not for a very long while—return and the bank avoided the annoying detail of having to redeem its debts. There was no institution to regulate either the quality or the quantity of money, and after states adopted so-called free banking, a promoter needed little more than a printing press to set up shop. In 1853, Indiana’s governor lamented, “The spec­ulator comes to Indianapolis with a bundle of banknotes in one hand and the stock in the other; in twenty-four hours he is on his way to some distant point of the union to circulate what he denominates a legal currency, authorized by the legislature of Indiana.” The system was certainly democratic—almost anyone could issue “money”—but it was just as certain to lead to credit booms and inevitable busts.

According to Jay Cooke, a Philadelphia financier, some banks issued notes equal to twenty-five times their capital “with no other security than the good faith of their institution.” Since such faith was often short-lived, Cooke hardly needed to add, “confusion . . . was the order of the day.” During the Civil War, the Chicago Tribune counted 1,395 banks in the Union states, each with bills of various denominations—some 8,370 varieties of notes in all. Even for the careful bank teller, scrutinizing this profusion of paper became an almost hopeless task. In addition to bank failures, the country was plagued by con men whose note forgeries could be worthy of a Rem­brandt. So widespread were phony notes that “Counterfeit Detectors” were published, and these guides were widely circulated.

This monetary chaos formed the tableau for late-nineteenth­century reformers, and it is key to understanding how people of Glass’s generation thought about money. Money—generally, gold or silver—was something of intrinsic value. Circulating paper, even though it served as a medium of exchange, was but a token, a promise of the real thing, discounted according to the degree to which people feared that the promise might not be kept.

Legislation during the Civil War provided a remedy—somewhat. With the government desperate for credit, Lincoln’s Treasury secre­tary, Salmon P. Chase, was left no choice but to propose, and Con­gress to approve, a new system of nationally chartered banks, which were permitted to issue circulating paper money in the form of National Bank Notes. These notes were to be a new, and mercifully uniform, currency, with a standard engraving on one side and the bank’s name on the other.

However, note circulation was tightly controlled. National banks had to hold a reserve and submit to federal banking examinations. Also, to issue notes, they had to invest in a proportionate amount of government bonds and deposit them with the Treasury as collateral. This requirement heightened the demand for government securities—which was, of course, Chase’s purpose. By giving banks an incentive to invest in government debt, the United States contrived a means of financing the war. National banks were formed at a rapid clip, and many state banks converted to federal charters so they could qualify to circulate notes.[i]

The new notes were surely an improvement, but they had the drawback of arbitrariness. The quantity in circulation was determined by the level of investment in government bonds, and this bore no re­lation to the needs of trade. Perversely, circulation often fell as busi­ness activity expanded and banks found better outlets for their capital. Just as worrisome, the note supply was inelastic—banks held the quantity of bonds that they held, and no new notes could be issued in a crisis. The modern notion of a central bank to supply extra liquidity when needed simply did not exist.

It is hard to overly blame Chase because, as he said, his goal was “first to provide for the vast demands of the war.” Chase was lauded for standardizing the currency and blunting the prior ability of banks to create inflation by circulating worthless paper. William G. Sum­ner, an influential economist at Yale, fairly rejoiced: “This system of currency has put an end at once and forever to the old bankers’ trick of expansion and contraction.” That economies do expand—and that currency needs to expand with them—was largely overlooked.

Also overlooked, for the moment, was the precarious manner in which the National Banking Act marshaled the country’s reserves. In Great Britain or in France, reserves were stored in the central bank. In America, the Banking Act introduced an intricate and fragile sys­tem, with the reserves of one bank piled upon another.

The law recognized three distinct tiers of banks. The smallest, so-called country banks, had to either keep reserves in their vaults or deposit a portion with middle-tier banks in the city. The latter, in turn, could hold cash in the vault or deposit a portion of their reserves with banks in the highest tier, those in the “central reserve cities” of New York, Chicago, and St. Louis. In practice, since banks did not want to hold idle cash, reserves flowed to New York. And since the New York banks did not want idle money either, they lent their spare cash to the stock market. Thus, America’s banking system was perched on a speculative pyramid. Whenever credit was in short sup­ply, the entire chain backed into reverse, with country banks calling their loans, by means of urgent telegrams, to banks in reserve cities and thence to New...