A Brief Overview of Early American Monetary Policy: The Rise and Fall of A Private Solution to A Public Problem

Libertarians love to theorize about how a true free market economy would regulate business sans government. Cynics often write off such conjecture as unrealistic and naïve by claiming libertarian theory has no historical precedent. Detractors assume that in the early history of the United States, there was little government interference in the economy. They point to the many financial panics of the nineteenth century and blame the chronic economic instability on the government’s laissez faire approach towards the issuance of the more than ten thousand types of private banknotes circulating throughout the country. In fact, the financially irresponsible bank behavior that contributed to these panics was indirectly promoted by the policies of President Andrew Jackson. Detractors of libertarian monetary theory paint an incorrect picture of the early years of the United States and deem our cause hopeless, stopping the debate in its tracks. Here, I hope to show that some historical evidence does suggest that participants in a free market economy could regulate business and that such efforts have been rendered ineffective in the past by government interference in the economy.

To begin with, state governments regulated banking in the antebellum United States. To open a single office (branch banking was illegal), a bank had to acquire a corporate charter from the state and once approved, it had to deposit bonds and other assets with the government. They were also often required to buy government bonds and the bonds of railroad and canal companies to prop up unwise internal improvement projects. These regulations greatly furthered economic instability. Corporate charters were not issued based on merit, but rather motivated by bribes and log rolling. The number of banks in the United States jumped from close to 200 in 1815 to 711 in 1840. Historian Stephen Mihm has written that these tactics “permitted most every special interest or class to have its own bank: tradesmen, merchants, mechanics, farmers, and others.” Without government privilege, it is conceivable that fewer irresponsible institutions would have been created. Additionally, as Steve Horwitz has pointed out, the ban on branch banking prevented banks from diversifying, making their failure much more likely. The bond requirements also skewed the incentives of bankers and diverted their time and resources towards ventures they otherwise would not finance. It was in their best interest to serve the government rather than to focus on competing for the support of workers and consumers due to the benefits offered by state governments, such as the ability to raise money from state lotteries.

Despite these incentives, at least one bank bucked the trends of faulty loaning and speculation. The Suffolk Bank of Massachusetts was the ultimate success story of responsible banking. It regulated regional banks by buying up their notes and sending them back for specie redemption, thus forcing the banks to keep permanent reserves. This private solution to a public problem eliminated the uncertainty, risk, and costs created by multiple currencies. Other banks welcomed and encouraged this centralization and the Suffolk was able to curtail the overissue of banknotes and lower the number of bank defaults in the Northeast. They formed the New England Association to combat counterfeiting, a problem state governments were notoriously incapable of remedying. Prior to the Civil War, counterfeit notes comprised between 10% and half of circulating bank notes. The lines between legal and illegal were blurred with lawyers frequently helped out the counterfeiters they were supposed to prosecute. Indeed, the infamous New York counterfeiting twins Horace and Hannibal Bonney started out as police officers.

The New England Association provided an alternative and at its peak, over half the banks in New England joined. The only bank in Boston that did not join, the Commonwealth Bank, was run by David Henshaw, the head of the Democratic Party in Massachusetts. Henshaw was notorious for his corruption; as federal collector of the port in Boston, he deposited taxpayer money into his own accounts to finance his own speculation. The New England Association created a fund that financed investigations and prosecutions as well as bounties for private agents to make arrests. Their crowning achievement was a massive attack on the counterfeiters’ headquarters in Canada in 1833. They tried to expand their mandate to prosecuting bank robbers as well, but the Massachusetts legislature proved uncooperative, refusing to reimburse the association’s expenses and vetoing their appeal.

Unfortunately, the New England Association had to suspend specie payments during the Panic of 1837 and gradually fell apart as banks lacked the resources to continue to contribute to the fund in such a hostile economic climate. However, their failure rates were much lower than the rates of many regions, when a quarter of all the nation’s banks failed. What caused the panic? While there were many important international factors, the economic downturn was exacerbated by the policies of President Jackson. He issued an executive order in 1836 to force specie out West in hopes of curbing inflation but actually ending up doing the opposite. His Deposit Act of the same year also had disastrous consequences. While he had the noble goal of dismantling the Second Bank of the United States, his actions were far more indicative of cronyism. He deposited federal funds in 100 politically motivated pet banks and prevented them from issuing paper money in amounts smaller than $5 in hopes of creating a cash and carry economy. Instead, his efforts hurt laborers who often made less than a dollar a day. These two policies caused western banks, flushed with funds, to pump credit into the economy. The number of banks doubled in the five years following Jackson’s reelection and rampant land speculation underwrote the wave of bank loans, which increased from $200 million in 1830 to $525 million in 1836. As a result, prices increased while wages stagnated and specie was transferred from the main commercial hubs in the East, forcing Eastern banks to scale back their loans, contributing to the panic.

With horrible timing, the nation’s first free banking laws were passed in Michigan in 1837. Unfortunately, by 1842 all but three of the banks created under these laws failed as a result of market corrections for the inflated real estate prices that had resulted from government-induced speculation through stay laws, which prevented banks from collecting debts. Most historians don’t recognize the types of free market regulations exhibited by the New England Association and those that do simply point to its ultimate failure, and the failure of Michigan’s free banking laws, as proof that banks can’t be trusted to operate without government regulation, failing to realize that government regulation actually significantly helped cause their demise. Hopefully some day historians will learn to look beyond first glance and realize philosopher kings of finance and supposedly disinterested aristocrats cannot outthink the dispersed knowledge of millions built into free markets.