FRtR > Essays > Central Banking in the US > Two Remaining Major Defects

A Brief History of Central Banking in the United States


11/13 Two Remaining Major Defects

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There were two major defects remaining in the banking system in the post-Civil War era despite the mild success of the National Banking Acts. The first was the inelastic currency problem. The amount of currency which a national bank could have circulating was based on the market value of the Treasury securities it had deposited with the Comptroller of the Currency, not the par value of the bonds. If prices in the Treasury bond market declined substantially, then the national banks had to reduce the amount of currency they had in circulation. This could be done be refusing new loans or, in a more draconian way, by calling-in loans already outstanding. In either case, the effect on the money supply is a restrictive one. Consequently, the size of the money supply was tied more closely to the performance of the bond market rather than needs of the economy.

Another closely related defect was the liquidity problem. Small rural banks often kept deposits at larger urban banks. The liquidity needs of the rural banks were driven by the liquidity demands of its primary customer, the farmers. In the planting season the was a high demand for currency by farmers so they could make their purchases of farming implements, whereas in harvest season there was an increase in cash deposits as farmers sold their crops. Consequently, the rural banks would take deposits from the urban banks in the spring to meet farmers' withdrawal demands and deposit the additional liquidity in the autumn. Larger urban banks could anticipate this seasonal demand and prepare for it most of the time. However, in 1873, 1884, 1893, and 1907 this reserve pyramid precipitated a financial crisis.

When national banks experienced a drain on their reserves as rural banks made deposit withdrawals, reserves had to be replaced in accordance with the federal law. A national bank could do this by selling bonds and stocks, by borrowing from a clearinghouse, or by calling-in a few loans. As long as only a few national banks at a time tried to do this, liquidity was easily supplied to the needy banks. However, a mass attempt to sell bonds or stocks caused a market crash, which in turn forced national banks to call-in loans to comply with the currency- Treasury bond regulation, and only a small portion of banks met the requirements to be members of the private clearinghouses. Many businesses, farmers, or households who had these loans were unable to pay on demand and were forced into bankruptcy. The recessionary vortex became apparent. Frightened by the specter of losing their deposits, in each episode the public stormed any bank rumored, true or not, to be in financial straights. Anyone unable to withdraw their deposits before the bank's till ran dry lost their savings all together. Private deposit insurance was scant and unreliable. Federal deposit insurance was non- existent.

The 1907 crisis, also called the Wall Street Panic, was especially severe. The Panic caused what was at that time the worst economic depression in the country's history. It appears to have begun with a market crash brought about by both a modest speculative bubble and the liquidity problem and reserve pyramiding just discussed. Centered on New York City, the scale of the crisis reached a proportion so great that banks across the country nearly suspended all withdrawals -- a kind of self- imposed bank holiday. Several long-standing New York banks fell. The unemployment rate reached 20 percent in the fall of 1907. Millions lost their deposits as thousands of banks collapsed. The crisis was terminated when J.P. Morgan, a man of unscrupulous business tactics and phenomenal wealth, personally made temporary loans to key New York banks and other financial institutions to help them weather the storm. He also made an appeal to the clergy of New York to employ their Sunday sermons to calm the public's fears.

Morgan's emergency injection of liquidity into the banking system undoubtedly prevented an already bad situation from getting still worse. Although private clearinghouses were able to supply adequate temporary liquidity for their members, only a small portion of banks were members of such organizations. What would happen if there were no J.P. Morgan around during the next financial crisis? Just how bad could things really get? There began to emerge both on Wall Street and in Washington a consensus for a institutionalized J.P. Morgan, that is, an institution that could provide emergency liquidity to the banking system to prevent such panics from starting. The final result of the Panic of 1907 would be the Federal Reserve Act of 1913.

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