The Mystery of Banking

Central Banking in the United States I
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whereas the aggregate of bank notes and deposits rose from $42.2
million in 1811 to $79 million four years later, an increase of
87.2 percent, pyramiding on top of a 9.4 percent decline in
specie. 
What happened next provides a fateful clue to the problem of
why free banking did not work as well before the Civil War as in
our theoretical model. It didn’t work well (although its record was
not nearly as bad as that of central banking) because it wasn’t
really tried. Remember that a crucial aspect of the free banking
model is that the moment a bank cannot pay its notes or deposits
in specie, it must declare bankruptcy and close up shop. But the
federal and state governments did not allow this crucial process
of insolvency—fundamental to the capitalist system—to work
itself out. 
Specifically, in the War of 1812, as the federal government
spent the new inflated notes in New England, the conservative
New England banks called on the banks of the other regions for
redemption in specie. By August 1814, it became clear that the
banks of the nation apart from New England could not pay, that
they were insolvent. Rather than allow the banks of the nation to
fail, the governments, state and federal, decided in August 1814
to allow the banks to continue in business while refusing to
redeem their obligations in specie. In other words, the banks were
allowed to refuse to pay their solemn contractual obligations,
while they could continue to issue notes and deposits and force
their debtors
to fulfill their contractual obligations. This was
unfair and unjust, as well as a special privilege of mammoth pro-
portions to the banking system; not only that, it provided carte
blanche, an open sesame, for bank credit inflation. 
Free banking did not work well in the U.S. because it was
never fully tried. The banks were allowed to continue to “suspend
specie payments” while remaining in business for 2½ years, even
though the war was over by early 1815. This general suspension
was not only highly inflationary at the time; it set a precedent for
all financial crises from then on. Whether the U.S. had a central
bank or not, the banks were assured that if they inflated together
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The Mystery of Banking
and then got in trouble, government would bail them out and
permit them to suspend specie payments for years. Such general
suspensions of specie payments occurred in 1819, 1837, 1839,
and 1857, the last three during an era generally considered to be
that of “free banking.” 
2. T
HE
S
ECOND
B
ANK OF THE
U
NITED
S
TATES
The United States emerged from the War of 1812 in a chaotic
monetary state, its monetary system at a fateful crossroads. The
banks, checked only by the varying rates of depreciation of their
notes, multiplied and expanded wildly, freed from the obligation
of redeeming their notes and deposits in specie. Clearly, the
nation could not continue indefinitely with discordant sets of
individual banks issuing fiat money. It was apparent that there
were only two ways out of this pressing problem. One was the
hard money path, advocated by the Old Republicans, and, for
their own purposes, the Federalists. The federal and state govern-
ments would then have sternly compelled the recklessly inflating
banks to redeem promptly in specie and, when most of the banks
outside of New England failed to do so, force them to liquidate.
In that way, the mass of depreciated and inflated notes would
have been liquidated quickly, and specie would have poured back
out of hoards and into the country to supply a circulating
medium. America’s inflationary experience would have been
ended, perhaps forever. 
Instead, the centrist Democrat-Republican establishment in
1816 turned to the second way: the old Federalist path of a new
inflationary central bank, the Second Bank of the United States.
Modeled closely after the First Bank, the Second Bank, a private
corporation with 1/5 of its stock owned by the federal govern-
ment, was to create a uniform national paper currency, purchase
a large part of the public debt, and receive deposits of Treasury
funds. The BUS notes and deposits were to be redeemable in
specie, and they were given quasi-legal tender status by the fed-
eral government’s receiving them in payment of taxes. 
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