A Case For Central Banking

I oppose a central bank.  Nevertheless, I am interested in arguments in favor of one.  The following is an extended excerpt from Henry C.K. Liu, courtesy of Max Keiser’s blog, on the early history of central banking in the United States, beginning with the first and second Banks of the United States.  The first one’s charter expired in 1811.  The second started up in 1816 until it was finally killed off by President Andrew Jackson in 1836.

One thing I think can clearly be described as an error of history is that Mr. Liu argues that a central bank is necessary for the robust development of young economies, and he asserts that the American experience with the first and second United States Banks bears this out.  Yet the period from 1836 to 1913, in which the US had no central bank, witnessed an astounding level of economic development.

Other than that, I commend this section to anyone who wants to keep an open mind and is willing to entertain ideas without necessarily accepting them:

“History and Politics of Central Banking in the US

In the United States, central banking was not born until 1913 with the establishment of the Federal Reserve System. The first national bank in the US was the Bank of the United States (BUS), founded in 1791 and operated for 20 years, until 1811. A second Bank of the United States (BUS2) was founded in 1816 and operated also for 20 years until 1836.

The first national bank (BUS) was modeled after British experience, was established by Federalists as part of a nation-building system proposed by Alexander Hamilton, the first secretary of the Treasury, who realized that the new nation could not grow and prosper without a sound financial system anchored by a national bank.

Jefferson’s opposition to the establishment of a national bank was key to his overall opposition to the entire Hamiltonian program of strong central government and elite financial leadership. Jefferson felt that a national bank would give excessive power over the national economy and unfair opportunities for large certain profits to a small group of elite private investors mostly from the New England states. The constitutionality of the bank invoked the dispute between Jefferson’s “strict construction” of the words of the constitution and Hamilton’s doctrine of “implied power” of the federal government.

Hamilton’s idea of national credit was not merely to favor the rich, albeit that it did so in practice, but to protect the infant industries in a young nation by opposing Adam Smith’s laissez-faire doctrine promoted by advocates of 19th-century British globalization for the advancement of British national interests. This is why Hamilton’s program is an apt model for all young economies finally emerging from the yoke of Western imperialism two centuries later, and in particular for opposing US neo-liberal globalization of past decades.

The creation of a national bank was one of the three measures of the Hamiltonian program to strengthen the new nation through a strong federal government, the others being 2) an excise duty on whiskey to extend federal authority to the back country of the vast nation and to compel rural settlers to engage in productive enterprise by making subsistence farming uneconomic; and 3) federal aid to manufacturing through protective tariff and direct subsidies.

To Hamilton, a central government without sovereign financial power, which had to rely on private banks to finance national programs approved by a democratically elected congress, would be truly undemocratic and to rely on foreign banks to finance national programs would be unpatriotic, if not treasonous.

Hamilton’s national program was opposed effectively by the two special-interest groups with controlling influence in Congress: the Northern trading merchants and shippers who had secured a Navigation Act to protect US shipping in 1789 and Southern planters who depended on export of unprocessed agricultural commodities, neither of which had any interest in curbing foreign trade even when such trade was harmful to the development of the national economy. Domestic manufacturing interest did not become strong enough to obtain much government protection until after the War of 1812. The dynamics of this politics is visible in the 21st century in many developing nations where the financial elite prefers comprador opportunism to economic nationalism.

Congressional opposition to the first BUS resulted in its charter expiring in 1811 without renewal. However, the financial pressure after the War of 1812 created demands for another national bank.

The Second Bank of the United States (BUS2) went into operation with a capital of $35 million in 1816, with the federal government owning only 5 percent of the stock. For a decade after the War of 1812, there existed no clear-cut party division in US politics, thus the term “Era of Good Feeling” was applied. The Republican Party abandoned its original Jeffersonian opposition to Federalism and adopted Federalist policies, starting with the establishment of the second BUS, adopting tariffs to protect struggling US industries and federal appropriation for infrastructure development.

Henry Clay proposed the “American System”, based on Hamiltonian ideals, but unlike Hamilton, Clay cultivated popular support, not only appealing to the upper class, and sought support from the agricultural South, not just the mercantile New England states. It was a national program of federal aid to domestic development and tariff protection for struggling US industry.

The disappearance of the first BUS in 1811 had left the nation’s currency system in a chaotic state. Since 1791, a large number of state banks had been chartered, reaching 208 by 1815, and except in New England, these banks were allowed to issue notes very much in excess of their capital ratio and to make loans without sufficient reserves.

BUS2 fulfilled its basic function during a period of relative prosperity and operated with popular support. The charter empowered BUS2 to act exclusively as the federal governments fiscal agent, hold its deposits, make inter-state transfers of federal funds and deal with Federal payments or receipts.

Like state chartered banks, BUS2 also had the right to issue banknotes on the basis of a fractional reserve system and to carry out conventional commercial banking activities, in return for which certain conduct of a central-bank-like nature was expected of this institution: in the words of the charter, “the bank will conciliate and lead the state banks in all that is necessary for the restoration of credit, public and private, and to steer the banking system toward serving the national interest”, at a time when profit might be higher in serving foreign interests.

Despite being 80% privately owned, BUS2 operations were subject to supervision by Congress and the president. BUS2 was dominant relative to all other banks, being responsible for some 20 percent of all bank lending in the national economy and accounting for 40 percent of the banknotes then in circulation. It was conservative in its note-issuing function, holding a specie reserve of 50 percent of the value of its notes while the norm for the remainder of the banking system was between 10-25 percent.

The 1820s and 1830s in the United States were a time of extremely rapid but also volatile economic growth. New natural resources were being exploited as the frontier expanded and the new techniques of the industrial revolution were being introduced. The old money supply of gold and silver specie was stretched and found inadequate for the liquidity needs of the growing economy. In 1830, the total value of the gold and silver specie in circulation in the economy amounted to one-fiftieth of the gross national product.

The emergence of a number of banks operating fractional reserve note-issuing systems was the automatic result. The private banknotes were underwritten by varying proportions of specie and although not legal tender, they were widely accepted in payment for debts, albeit usually discounted below their par value. The quality of banknotes varied. Fraud was commonplace by unscrupulous bankers who managed to persuade or bribe local state legislatures to grant them liberal charters to commence a banking business.

In 1828, the 17 banks chartered in Mississippi circulated notes with a face value of $6 million from a specie base of $303,000. The classic conflict between easy money and good money ensued, with the economic benefits of easy money regularly destroyed by bad money.

It was in such an environment that BUS2 operated. Among its functions was to discipline and support the state-chartered banks without shutting off easy money. As the federal government’s fiscal agent, it received banknotes in payment for taxes. The Bank would then present these banknotes to the issuing state-chartered banks in order to redeem them for the gold necessary to pay the taxes it had collected to the federal Treasury’s account.

In this way, state-chartered banks were forced to keep a higher stock of specie on reserve than would otherwise be necessary. Conversely, BUS2 could also act as a lender of last resort to state-chartered banks in trouble by not presenting these notes for redemption but rather allowing these banks to run into debt to BUS2. The state-chartered banks were institutions of economic democracy, offering credit to the masses, not just to big business. Some were named people’s banks or other names of democratic or socialist connotation. They generally financed local small business, farms and homes.

The political environment of that period was marked by the populist ideology of Jacksonian democracy. Focused around Andrew Jackson, who was elected president in 1828, this ideology was an coalition of convenience among agrarianism, nationalism, populism and libertarianism. The one unifying element of this group was a deep hostility to a privileged East Coast-based moneyed aristocracy. The Philadelphia-based BUS2 with its patrician president, Nicholas Biddle, became an easy target in this new climate.

Libertarians, while sounding sensible on a small individual scale, always fail to understand that unencumbered individual liberty has no place in organizing large-scale national enterprises. Complex organizations, whether in business or government, require wholesale compromise of individual liberty.

The ideology that underlay the struggle against a national bank was highly variegated, with contradicting internal inconsistencies. It was a peculiar blend of moral judgment, economic logic and populist sentiment fused by pragmatic calculations to attack the political legitimacy of a national bank, its legality and its economic rationale.

The role played by vested interests in motivating the anti-BUS forces can also be traced to the substantial personal gains that would accrue to key members of the Jackson administration should BUS2 be discontinued. The New York financial community at the time was competing with Philadelphia to be the country’s premier commercial center. Martin Van Buren, Jackson’s second-term vice president and eventual successor, was particularly identified with Wall Street in this Wall Street (New York internationalist) versus Chestnut Street (Philadelphia nationalist) battle.

The state-chartered banks disliked being constrained by BUS2’s practice of redeeming their banknotes with little or no notice, and with blatant arbitrariness in the selection of a target, often based on thinly disguised sectional bias. This forced a much higher bank reserve ratio and hence restricted their lending activities in geographic sections deem contrary to national priorities.

A new class of nouveau riche, self-made entrepreneurs and speculators, emerged, a class to which Jackson and many of his associates belonged. They disliked the restriction of credit generally, and credit allotment controlled by established Northeastern financiers particularly, as they relied on liberal credit from the friendly state-chartered local banks for needed funds, the way leverage-buyout financiers and corporate raiders and New Economy entrepreneurs relied on junk-bond investment bankers in the 1980s and ’90s.

The New York financial community was divided over the question of the wisdom of the attack on BUS2. Some of the state-chartered banks grudgingly acknowledged BUS2’s positive role in disciplining the banking system and its activities as a lender of last resort. Political ideology and economic logic also played a role behind the opposition of a national bank. The opposition had much popular support in national politics which enabled Jackson to dismantle BUS2. Like Ronald Reagan, Jackson was elected to Washington to rein in Washington.

The strongest opposition came from states-rights advocates who vehemently opposed the substantial power wielded by a federally chartered national bank. Many considered the chartering of the bank an unconstitutional extension of the power of Congress, particularly when, in their judgment, the first national bank had failed to serve the national interest without sectional bias and had pandered to sectional interests around the northeastern seaboard. This position was summarized by Jackson, who described BUS2 bank as an unconstitutional threat to democratic institutions by the federal authorities.

With the dismantlement of BUS2, the power of intervention in the banking and monetary systems was left in the hands of individual states until the Civil War. State-chartered banking systems served the separate interests of each state, which often were at odds with the national interest.

A key strand in the anti-national-bank thread was the libertarians. They challenged the legitimacy, more on moral than constitutional grounds, of any government intervention in the economy or in society beyond minimum necessity. Libertarians, while sounding sensible on a small scale, fail to understand that individual liberty to organize large-scale national enterprises is a mere fantasy. “Small is beautiful” remains merely a romantic slogan of hippiedom.

The 1800s were an age of primitive laissez-faire philosophy in the United States when domestic markets were not yet sophisticated enough to require government intervention against trade restraint in the sense that Adam Smith used the term “laissez-faire” to denote activist government action to keep markets free. This libertarian philosophy was related to and associated with the Free Banking school, which challenged on ideological grounds the necessity of government intervention in the monetary system.

Free Bankers were in favor of a paper currency based on a fractional reserve system. But they argued that BUS2’s regulatory function was unnecessary and ineffective because in a completely unregulated financial system, free competition would automatically protect the public against fraud through market discipline, on the principle that fraud was basically bad for business. They argued that what was wrong with the banking system was that free competition was obstructed by the monopolistic privileges granted to BUS2 in its charter and this created an unhealthy reliance on regulatory protection rather than market self-discipline, in a form of consumer moral hazard that believed naively that if a business was regulated, consumer interest would automatically be protected.

In the context of the dominant economic paradigm of the 1830s, the importance of the central government’s role in regulating the money supply was not as self-evident as is today. And for the Western frontiersman, his love of individual liberty exposed him to easy victimization by organized finance from the East.

Economist Joseph A Schumpeter (1883-1950) observed that in the first part of the 19th century, mainstream economists believed in the merit of a privately provided and competitively supplied currency. Adam Smith differed from David Hume in advocating state non-intervention in the supply of money. Smith argued that a convertible paper money could not be issued to excess by privately owned banks in a competitive banking environment, under which the Quantity Theory of Money is a mere fantasy and the Real Bills doctrine was reality. Smith never acknowledged or understood the business cycle of boom and bust.

The anti-monopolistic and anti-regulatory Free Banking School found support in agrarian and proletarian mistrust of big banks and paper money. This mistrust was reinforced by evidence of widespread fraud in the banking system, which appeared proportional to the size of the institution. Paper money was increasingly viewed as a tool used by unconscionable employers and greedy financiers to trick working men and farmers out of what was due to them. A similar attitude of distrust is currently on the rise as a result of massive and pervasive corporate and financial fraud in the so-called New Economy fueled by structured finance in the under-regulated financial markets of the 1990s, though not focused on paper money as such, but on derivatives, which is paperless virtue money.

Andrew Jackson in his farewell speech addressed the paper-money system and its natural association with monopoly and special privilege, the way Dwight D Eisenhower warned a paranoid nation against the threat of a military-industrial complex. The value of paper, Jackson stated, is liable to great and sudden fluctuations and cannot be relied upon to keep the medium of exchange uniform in amount.

In contrast to the Free Banking School, the anti-paper specie-currency zealots aimed at abolishing the system of fractional reserve paper money by removing the lender of last resort. They were further split into gold bugs, silver bugs and bimetalists.

Both advocates of the Free Banking School and proponents of specie currency saw the dismantling of the bank as very fundamental, but to divergent and conflicting ends. Against this coalition, supporters of a national bank, such as BUS2 president Nicholas Biddle and politicians such as Henry Clay and John Quincy Adams, faced a political dilemma. Both anti-federalist and primitive laissez-faire sentiments were in ascendancy at the time. The BUS2 was being attacked from both the extreme left (Free Banking advocates) and from the extreme right (anti-paper advocates).

The monetary expansion that preceded and led to the recession of 1834-37 did not come from a falling bank reserve ratio but rather from the bubble effect of an inflow of silver into the United States in the early 1830s, the result of increased silver production in Mexico, and also from an increase in British investment in America. Thus a case could be made that central banking’s role in causing or preventing recessions through management of the money supply is overstated and oversimplified.

Libertarians hold the view that the state had no right to regulate any commercial transactions between consenting individuals including paper currency. Thus all legal tenders, specie or not, are government intrusions. Yet a medium of exchange based on bank liabilities and a fractional reserve system and/or government taxable capacity are essential to an industrializing economy. Instead of destroying the fractional reserve system, the hard-money advocates had merely removed a force that acted to restrain it.

After 1837, the reserve ratio of the banking system was much higher than it had been during the period of BUS2’s existence. This reflected public mistrust of banks in the wake of the panic of 1837 when many banks failed. This lack of confidence in the paper-money system could have been ameliorated by central-bank liquidity, which would have required a lower reserve ratio, more availability of credit and an increase of money supply during the 1840s and 1850s. The evolution of the US banking system would have been less localized and fragmented in a way inconsistent with large industrialized economics, and the US economy would have been less dependent on foreign investment.

This did not happen because central banking was genetically disposed to favor the center against the periphery, which conflicted with democratic politics. This problem continues today with central banking in a globalized international finance architecture. It remains a truism that it is preferable to be self-employed poor than to be working poor. Thus economic centralism will be tolerated politically only if it can deliver wealth away from the center to the periphery. Central banking carries with it an institutional bias against economic nationalism.

The Jackson administration’s assault on BUS2 began in 1830 and became a campaign issue for a second term. In 1832, Jackson used his presidential veto to thwart a renewed federal charter for BUS2. Jackson then used his second-term presidential election victory later that year as a mandate to order the withdrawal of all federal funds from BUS2 in 1833. When the BUS2 charter expired in 1836, the Philadelphia-based institution succeeded in being rechartered only as a much reduced state-chartered bank under the auspices of the Pennsylvania state legislature as the United States Bank of Pennsylvania. In 1841, without a lender of last resort, it went bankrupt in a liquidity squeeze speculating in the cotton market.

The dismantling of the second national bank in 1836 preserved the authority of the states over banking. Large-scale federal intervention in the supply of money did not take place again until the Civil War. However, Jackson’s victory turned US political culture against centralized institutions in the banking system. The United States did not develop a central banking agency until 1913. Even then, the Federal Reserve System was highly decentralized, consisting of 12 autonomous component banks, one in each of the regional large cities. Some historians attributed the incoherent response of the monetary authorities to the 1929 crash and the resultant run on the banking system. The 1930s Great Depression was due partly to this decentralization of monetary authority. (Please see my November 16, 2002 AToL article: Critique of Central Banking: Part IIIa: The US Experience)

Central banking insulates monetary policy from national economic policy by prioritizing the preservation of the value of money over the monetary needs of a sound national economy. A global finance architecture based on universal central banking allows an often volatile foreign exchange market to operate to facilitate the instant cross-border ebb and flow of capital and debt instruments. The workings of an unregulated global financial market of both capital and debt forced central banking to prevent the application of the State Theory of Money (STM) in individual countries to use sovereign credit to finance domestic development by penalizing, with low exchange rates for their currencies, governments that run budget deficits.

STM asserts that the acceptance of government-issued legal tender, commonly known as money, is based on government’s authority to levy taxes payable in money. Thus the government can and should issue as much money in the form of credit as the economy needs for sustainable growth without fear of hyperinflation. What monetary economists call the money supply is essentially the sum total of credit aggregates in the economy, structured around government credit as bellwether. Sovereign credit is the anchor of a vibrant domestic credit market so necessary for a dynamic economy.

By making STM inoperative through the tyranny of exchange rates, central banking in a globalized financial market robs individual governments of their sovereign credit prerogative and forces sovereign nations to depend on external capital and debt to finance domestic development. The deteriorating exchange value of a nation’s currency then would lead to a corresponding drop in foreign direct or indirect investment (capital inflow), and a rise in interest cost for sovereign and private debts, since central banking essentially relies on interest policy to maintain the value of money. Central banking thus relies on domestic economic austerity caused by high interest rates to achieve its institutional mandate of maintaining price stability.

Such domestic economic austerity comes in the form of systemic credit crunches that cause high unemployment, bankruptcies, recessions and even total economic collapse, as in the case of Britain in 1992, the Asian financial crisis in 1997 and subsequent crises in Russia, Turkey, Brazil and Argentina. It is the economic equivalent of a blood-letting cure.

A national bank does not seek independence from the government. The independence of central banks is a euphemism for a shift from institutional loyalty to national economic well-being toward institutional loyalty to the smooth functioning of a global financial architecture. The international finance architecture at this moment in history is dominated by US dollar hegemony, which can be simply defined by the dollar’s unjustified status as a global reserve currency. The operation of the current international finance architecture requires the sacrifice of local economies in a financial food chain that feeds the issuer of US dollars. It is the monetary aspect of the predatory effects of globalization.

Historically, the term “central bank” has been interchangeable with the term “national bank”. In fact, the enabling act to establish the first national bank, the Bank of the United States, referred to the bank interchangeably as a central and a national bank. However, with the globalization of financial markets in recent decades, a central bank has become fundamentally different from a national bank.

The mandate of a national bank is to finance the sustainable development of the national economy, and its function aims to adjust the value of a nation’s currency at a level best suited for achieving that purpose within an international regime of exchange control. On the other hand, the mandate of a modern-day central bank is to safeguard the value of a nation’s currency in a globalized financial market of no or minimal exchange control, by adjusting the national economy to sustain that narrow objective, through economic recession and negative growth if necessary.

Central banking tends to define monetary policy within the narrow limits of price stability. In other words, the best monetary policy in the context of central banking is a non-discretionary money-supply target set by universal rules of price stability, unaffected by the economic needs or political considerations of individual nations. (Please see my November 6, 2002 article in AToL: Critique of Central Banking: Monetary Theology)”

More reading on the subject, if you can stand it, is here.