The Mystery of Banking

Central Banking in the United States II
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The Mystery of Banking
The crisis of 1839 ushered in four years of massive monetary
and price deflation. Many unsound banks were finally eliminated,
the number of banks declining during these years by 23 percent.
The money supply fell from $240 million at the beginning of
1839 to $158 million in 1843, a seemingly cataclysmic drop of 34
percent, or 8.5 percent per annum. Wholesale prices fell even fur-
ther, from 125 in February 1839 to 67 in March 1843, a tremen-
dous drop of 42 percent, or 10.5 percent per year. The collapse
of money and prices after 1839 also brought the swollen state
government debts into jeopardy. 
State government debt had totaled a modest $26.5 million in
1830. By 1835 it had reached $66.5 million, and by 1839 it had
escalated to $170 million. It was now clear that many states were
in danger of default on the debt. At this point, the Whigs, taking
a leaf from their Federalist forebears, called for the federal gov-
ernment to issue $200 million worth of bonds in order to assume
all the state debt. 
The American people, however, strongly opposed federal aid,
including even the citizens of the states in difficulty. The British
noted in wonder that the average American seemed far more con-
cerned about the status of his personal debts than about the debts
of his state. To the worried question, Suppose foreign capitalists
did not lend any further to the states? the 
Floridian
replied, “Well
who cares if they don’t. We are now as a community heels over
head in debt and can scarcely pay the interest.”
6
6
The Floridian
, March 14, 1840. Quoted in Reginald C. McGrane, 
For-
eign Bondholders and American State Debts
(New York: Macmillan, 1935),
pp. 39–40. Americans also pointed out that the banks, including the BUS,
who were presuming to take the lead in denouncing repudiation of state
debt, had already suspended specie payments and were largely responsible
for the contraction. 
Let the bondholders look to the United States Bank and to
the other banks for their payment declared the people. Why
should the poor be taxed to support the opulent classes in
foreign lands who, it was believed, held the bulk of these
securities. (p. 48)
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Central Banking in the United States II
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The implication was clear: The disappearance of foreign
credit to the states would be a good thing; it would have the
healthy effect of cutting off their further wasteful spending, as
well as avoiding the imposition of a crippling tax burden to pay
for the interest and principal. There was in this astute response an
awareness by the public that they and their governments were
separate and sometimes even hostile entities rather than all part
of one and the same organism. 
The advent of the Jacksonian Polk administration in 1845 put
an end to the agitation for Federal assumption of the debt, and by
1847, four western and southern states had repudiated all or part
of their debts, while six other states had defaulted from three to
six years before resuming payment.
7
Evidently, the 1839–43 contraction and deflation was a
healthy event for the economy, since it liquidated unsound invest-
ments, debts, and banks, including the pernicious Bank of the
United States. But didn’t the massive deflation have catastrophic
effects—on production, trade, and employment—as we have gen-
erally been led to believe? Oddly enough, no. It is true that real
investment fell by 23 percent during the four years of deflation,
but, in contrast, real consumption 
increased
by 21 percent and
real GNP by 16 percent during this period. It seems that only the
initial months of the contraction worked a hardship. And most of
the deflation period was an era of economic growth.
8
7
The four states which repudiated all or part of their debts were Mis-
sissippi, Arkansas, Florida, and Michigan; the others were Maryland, Penn-
sylvania, Louisiana, Illinois, and Indiana.
8
In a fascinating comparative analysis, Professor Temin contrasts this
record with the disastrous contraction a century later, from 1929–33. Dur-
ing the latter four years, the money supply and prices fell by slightly less
than in the earlier period, and the number of banks in existence by more.
But the impact on the real economy was strikingly different. For in the later
deflation, real consumption and GNP fell substantially, while real invest-
ment fell catastrophically. Temin properly suggests that the very different
impact of the two deflations stemmed from the downward flexibility of
wages and prices in the nineteenth century, so that massive monetary
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The Mystery of Banking
contraction lowered prices but did not cripple real production, growth, or
living standards. In contrast, the government of the 1930s placed massive
roadblocks on the downward fall of prices and particularly wages, bringing
about a far greater impact on production and unemployment. Temin, 
Jack-
sonian Economy
, pp. 155ff.
The Jacksonians had no intention of leaving a permanent sys-
tem of pet banks, and so Jackson’s chosen successor Martin Van
Buren fought to establish the Independent Treasury System, in
which the federal government conferred no special privilege or
inflationary prop on any bank; instead of a central bank or pet
banks, the government was to keep its funds solely in specie, in its
own Treasury vaults or “subtreasury” branches. Van Buren man-
aged to establish the Independent Treasury in 1840, but the Whig
administration repealed it the following year. Finally, however,
Democratic President Polk installed the Independent Treasury
System in 1846, lasting until the Civil War. At long last, the Jack-
sonians had achieved their dream of severing the federal govern-
ment totally from the banking system, and placing its finances on
a purely hard money, specie basis. From now on, the battle over
money would shift to the arena of the states. 
2. D
ECENTRALIZED
B
ANKING FROM THE
1830
S TO THE
C
IVIL
W
AR
After the financial crises of 1837 and 1839, the Democratic