5. The National Banking System (1865-1913)

 

This era ended with the secession of the South and the onset of the Civil War (1861-5).  Republican President Abraham Lincoln (1861-5) temporarily decided to abolish the gold standard, and instead issue government-created fiat “greenback” dollar bills.  This was money created and controlled purely by the government, not private bankers.  However, the greenbacks circulated as currency, even though they were openly fiat, and a greenback was always worth less than a standard, 100% backed dollar bank note.  Lincoln was forced to take the dollar off the gold standard in 1862, to prevent dollars being traded in for gold.  Unsurprisingly, Lincoln dramatically increased the money supply, to fund his invasion of the South.  Furthermore, banks (not required to hold gold reserves for the greenbacks, practiced fractional reserve banking, increasing the money supply even more.  There were the same distortions and transfers of wealth as with any inflation of the money supply.

 

Seeking to establish a system of controlled fractional reserve banking of greenbacks, the banks successfully persuaded the government to set up the National Banking System through Acts of 1863, 1864 and 1865.  It was to be a “half-way house” towards a full central banking system.  Whereas the Peel Act granted to one Bank of England the monopoly of all bank notes, the National Banking Acts granted such a monopoly to a group of banks, who were to be federally chartered and called “national banks”.  The existing commercial banks not granted a charter were to be called “state banks”, and they were not allowed to issue money substitutes.  Like the commercial banks in England had to keep Bank notes in reserve at the central bank, the state banks had to keep reserves at national banks.

 

The national banks were themselves organized in a tripartite structure: at the bottom were the “central reserve city” banks, most of them based in New York City, then the next layer was “reserve city” banks in all cities over 500,000 population, which had reserves in central reserve city banks.  Then there were the “country” banks, serving the rest of the country, which held reserves at the reserve city banks and central reserve city banks.  Fractional reserve requirements of 25%, 25% and 15% respectively allowed a massive, controlled expansion of the money supply.  Banks were free to practice fractional reserve banking as they pleased to expand the money supply further.  The commercial banks meanwhile were encouraged to keep deposits in greenbacks rather than gold or redeemable gold certificates.

 

The libertarian-leaning Democratic Party took a decade to recover from the Civil War.  With the Republicans in power, greenbacks were inflated, and this caused a boom which led to a bust in 1873.  The recession that followed resulted in calls to restore the gold standard, and Republican President Ulysses Grant (1869-77) was forced to pass an act whereby specie payments for all dollars would resume in 1879.  Inflationists still argued against gold, and there was considerable dispute about whether to make dollars redeemable in either gold or silver, with prices fixed against both – a bimetallic standard.  By 1900, that dispute was resolved and bimetallism (a flawed concept) disappeared from the picture.

 

Unfortunately by that time the Democratic Party had been taken over by inflationist Populists such as William Jennings Bryan, who wanted inflation, but outside of the control of the banking system.  He sought to restore something more like Lincoln’s system of government-created dollar bills.  Thus they had lost their status as hard-money advocates.  The Democratic Party did not have the will to restore the Jacksonian system of free and decentralized banking.