An Intervention in the History of Banking

Reader responses to my decision to post excerpts from my qualifying exams — which I feared might turn out to be a Very Bad Idea — have been heartening.  In addition to blog comments, I have received thank-you emails from everyone from grad students to senior scholars who said they hope to see more posts like that in the future.

Well, that future is now!  Dan Allosso has sent me an excerpt from one of his doctoral exams, part of his response to Heather Richardson’s question, “How did economic change affect rural and urban Americans differently between the Revolution and Reconstruction?”  Dan said, “I wrote about the market transition, transportation, internal improvements, etc. — but the part I like best was an ‘intervention’ in the history of banking.”

What follows  is that portion of Dan’s exam answer:

According to a circular of the Mercantile Agency of New York, in 1858 157,394 country stores owed an average of $14,500 each to city jobbers and wholesalers; an aggregate debt of nearly $2.3 billion.  While Naomi Lamoreaux has conclusively characterized early New England bankers as the “financial arms” of “extended kinship networks,” as soon as the city banks in Boston, Philadelphia, and New York grew large and wealthy, this characterization was dropped by banking historians.  Large eastern banks are not imagined as operating in the interests of a small group of owners; and brand new, western banks have rarely been given credit for being even this useful or relevant, and instead have been regularly equated with fly-by-night “Wildcat” operations that, although more colorful, were always much fewer in number.  Bray Hammond (in the volume that banking historians lament is the only work on banking read by most other historians), argued that Andrew Jackson’s supposedly agrarian bank war “left the poor agrarian as poor as he had been before and it left the money power possessed of more money and more power than ever,” but he failed to adequately examine either rural banks or rural responses to the dissolution of the Second Bank of the United States.  Stephen Mihm quoted an 1839 statement by hard money enthusiasts, who said paper currency was not payment, but a “promise to pay, which, by universal understanding, is meant to signify the promise to pay on the condition of not being required to do so”  (original emphasis).  Due to his nearly exclusive focus on counterfeiting, Mihm failed to appreciate that the urban, hard money proponents objected not to counterfeiting, but to the creation of circulating currency (and thereby credit and capital) by rural banks.

It is not as if Americans did not have a single, national, currency before the Civil War.  They did, the Dollar.  Americans did not have to transact their business in Marks or Pounds or Francs, and deal with constant conversions and fluctuating exchange rates — although many merchants who consigned products to international agents, even in remote rural areas, managed these processes quite skillfully.

Historians have also misunderstood the fact that both rural and urban Americans were experts at discounting notes.  They assume this meant that many notes were passed at a discount, because the small, remote banks they came from were risky.  But the evidence suggests that people (whether in the city or the country) made a much more binary decision about the value of a note: it was either going to be paid, or it wasn’t.  Some banks were untrustworthy, and people who knew this refused to take their paper.  A 5% or 10% discount would not protect them from default, and nobody but the very largest city, clearinghouse banks received enough notes from a single source for an averaged discount to make sense as insurance against loss.  But as some historians have pointed out, most regular nineteenth century people were adept at discounting sums in their heads, and the process was taught to schoolchildren.  This was not because they were applying risk discounts to the notes of shaky banks, as many economic historians have supposed.  In fact, most of the bills of exchange, promissory notes, and even the early banknotes that changed hands in the first half of the nineteenth century carried interest.  So it was vital for a person being offered a $50 note, three weeks into its sixty day, 7% term, to be able to quickly calculate its present value so that he would know how much in present cash or goods to give for it.

Similarly, many historians have placed too much emphasis on the presence of counterfeit notes in the circulating money supply.  Estimates of 8,000 or 9,000 different types of notes circulating in the national economy are probably accurate, but they count each denomination ($1, $2, $3, $5, $10, etc.) issued by every bank.  Most of the notes of small banks circulated in a small regional radius of the institutions, and may have been virtually the only currency available in the region.  So people were familiar with the much smaller subset of the overall money supply that they actually came into contact with.  And even bankers in the central cities, who saw a larger assortment of notes, usually did not object, if the note could be passed on to another party.  In his 1884 memoir, detective agency founder Allan Pinkerton remarked, “they preferred a good counterfeit on a solid bank to any genuine bill upon [a] shyster institution.”

Traditional historians of banking, like Bray Hammond and Fritz Redlich, told their story from an urban perspective, using documents from bank and state archives and following the lead of earlier historians (who were also frequently central bankers) like Wesley Mitchell, John J. Knox, and A. Barton Hepburn.  Like them, recent banking and business historians like John Denis Haeger have often simply uncritically reported the arguments of people who were interested parties in debates over the future of American banking, not disinterested bystanders.  The elite, eastern founders of banks, insurance, and trust companies, said Haeger, believed that banks should be limited to providing operating credit, prevented from making long-term, capital loans, and especially should be barred from investing in real estate.  But he never interrogated the eastern banker/capitalists’ beliefs, or asked who benefited, when banks (especially rural banks) were prevented from doing these things.  Clearly, the biggest beneficiaries were the urban bankers and capitalists.  To secure their interests, they needed to control credit and prevent the capitalization of western land.

Howard Bodenhorn estimated that in 1820, there were about $41 million of specie in the U.S. economy, but that half of it was tied up in bank reserves leaving about $20 million for transacting business.  There were also $36 million in circulating bank notes and $27 million in deposits, against which drafts could be written.  Banks provided three quarters of the “money” in the economy.  Despite these facts, Bodenhorn followed traditional banking historians, insisting that “money creation by banks…was incidental;” that a bank’s primary role was “intermediating between borrowers and lenders.”  He came to this conclusion because he remained focused on the interests and practices of central, urban banks.

Merchants, according to Porter and Livesay, were much more successful at acquiring loans than manufacturers in the early nineteenth century, because “merchants usually were the banks.”   This was as true in the country as in the city.  Even the simplest rural merchants managed a complicated two-way flow in which local products were aggregated and sold (usually to the city) and goods that could not be produced locally were acquired (usually from the city).  They provided credit to their customers and also managed financial flows between large local producers and their distant customers.  They charged interest, discounted notes, and collected fees for “exchange” services.  Naturally, they developed all the relationships and skills needed to carry on banking.  But they could only become banks with a state charter.

Issuing banking charters was tightly controlled in most states at the beginning of the nineteenth century, and downright illegal in a few.  After New York and Michigan began much more liberal chartering under legislation known as “free banking,” most other states allowed the establishment of local banks.  Often, as in New York, newly formed banks were required to deposit either government bonds or title to unencumbered real estate, as security on their banknote issues.  While banking historians have frequently attributed changes in the banking laws in 1863 and 1865 to concerns over western bank failures caused by the default of southern bonds they had used as security, the evidence shows that by the 1860s in many areas, real estate outweighed bonds as a source of security for circulating currency.

The danger to the interests of eastern banks and their politically influential owners was that western land was virtually unlimited.  As people moved west, there was a rapid and very predictable inflation of land values.  It seems reasonable to suspect that an eastern banker, looking west in 1862, would have had little trouble perceiving that if western bankers were allowed to print money based on the value of western land, their wealth and power would quickly overwhelm that of their eastern counterparts.  This could be prevented in two ways: sever the ties between banks and real estate, or prevent banks from issuing currency.  In the long run, both measures were adopted.

I think it’s reasonable to ask whether the banking legislation of 1863 and 1865, which established a system of national banks, barred them from making mortgages on real estate, and eliminated the creation of local currency, was initiated or supported to eliminate western competition to powerful eastern banking interests?  But whether this proves to be true or not, there was clearly an impact on rural Americans that has been overlooked.  Before the legal changes, local banks had been able to issue currency.  As land values increased, the money in circulation was able to increase.  Bankers loaned this money to local people, and wealthy townspeople invested in local businesses and “internal improvements” close to home.  Local and regional rural economies were substantially independent of distant urban banking centers, and many were essentially self-contained.  In 1863-65, this all changed.  Rural banks lost the ability to create money.  Currency issue became a role of (and a significant profit center for) the national government.  Control of credit was centralized in urban banking centers, primarily New York.  Rural banks were forced to join the national banking system which prohibited real estate loans, neutralizing much of the wealth-creating potential of western land.  And rural capital, losing the ability to be safely and easily put to work in the local, rural economy, turned to railroad bonds and the stock market.