The Mystery of Banking

Central Banking in the United States III
227
after the Panic of 1873, eliminated all reserve requirements on
notes, keeping them only on deposits. This action released over
$20 million of lawful money from bank reserves and allowed a
further pyramiding of demand liabilities. The result was a separa-
tion of notes from deposits, with notes tied rigidly to bank hold-
ings of government debt, while demand deposits pyramided on
top of reserve ratios in specie and greenbacks. 
Reserve requirements are now considered a sound and precise
way to limit bank credit expansion, but the precision can cut two
ways. Just as government safety codes can 
decrease
safety by set-
ting a lower limit for safety measures and inducing private firms
to reduce safety downward to that common level, so reserve
requirements can serve as lowest common denominators for bank
reserve ratios. Free competition, on the other hand, will generally
result in banks voluntarily keeping higher reserve ratios. Banks
now keep fully loaned up, expanding to the limit imposed by the
legal reserve ratio. Reserve requirements are more an inflationary
than a restrictive monetary device. 
The national banking system was intended to replace the state
banks completely, but many state banks refused to join as mem-
bers, despite the special privileges accorded to the national banks.
The reserve and capital requirements for state banks were more
onerous, and national banks were prohibited from making loans
on real estate. With the state banks refusing to come to heel vol-
untarily, Congress, in March 1865, completed the Civil War rev-
olution of the banking system by placing a prohibitive 10 percent
tax upon all state bank notes. The tax virtually outlawed all note
issues by the state banks. From 1865 national banks had a legal
monopoly to issue bank notes. 
At first, the state banks contracted and withered under the
shock, and it looked as if the United States would indeed have
only national banks. The number of state banks fell from 1,466 in
1863 to 297 in 1866, and total notes and deposits in state banks
fell from $733 million in 1863 to only $101 million in 1866.
After several years, however, the state banks began expanding
again, albeit in a role subordinated to the national banks. In order
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228
The Mystery of Banking
8
Actually, Cooke erred, and national bank notes never reached that
total. Instead, it was demand deposits that expanded, and reached the bil-
lion dollar mark by 1879.
to survive, the state banks had to keep deposit accounts at
national banks, from whom they could “buy” national bank notes
in order to redeem their deposits. In short, the state banks now
became the fourth layer of the national pyramid of money and
credit, on top of the country and the other national banks. The
reserves of the state banks were kept, in addition to vault cash, as
demand deposits at national banks, from whom they could
redeem in cash. The multilayered structure of bank inflation
under the national banking system was now compounded. 
Once the national banking system was in place, Jay Cooke
plunged in with a will. He not only sold the national banks their
required bonds, but he himself set up new national banks which
would have to buy his government securities. His agents formed
national banks in the smaller towns of the South and West. Fur-
thermore, he set up his own national banks, the First National
Bank of Philadelphia and the First National Bank of Washington,
D.C. 
But the national banking system was in great need of a pow-
erful bank in New York City to serve as the base of the inflation-
ary pyramid for the country and reserve city banks. Shortly after
the start of the system, three national banks had been organized
in New York, but none of them was large or prestigious enough
to serve as the fulcrum of the new banking structure. Jay Cooke,
however, was happy to step into the breach, and he quickly estab-
lished the Fourth National Bank of New York, capitalized at an
enormous $5 million. After the war, Cooke favored resumption
of specie payments, but only if greenbacks could be replaced one-
to-one by new national bank notes. In his unbounded enthusiasm
for national bank notes and their dependence on the federal debt,
Cooke, in 1865, published a pamphlet proclaiming that in less
than 20 years national bank note circulation would total $1 bil-
lion.
8
The title of Cooke’s pamphlet is revealing: 
How our
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