Column by George F. Smith
Exclusive to STR
Summary: Though banking and government have had a corrupt relationship throughout history, the Suffolk Bank and Independent Treasury System, both of which were prominent during the “wildcat banking” era of the 19th Century, represent significant efforts at reform.
Throughout recorded history . . . commodity money has been the rule. So long as money was predominantly coin or bullion, very rapid inflation was not physically feasible. The extent of debasement was limited by the ratio of the value of a given physical quantity of the precious metal to the base metal used as alloy. It took the invention and widespread use of paper money to make technically feasible the kind of rapid inflations that have occurred in more recent times.
The printing press, invented in the mid-15th
Century by Johannes Gutenberg, a goldsmith by profession, reflected the “the entrepreneurial spirit of emerging capitalism” in late medieval society. Banking, too, was coming of age during this period of “emerging capitalism,” as bankers were eager to take advantage of increasing loan opportunities. With notable exceptions such as the Bank of Amsterdam, most banks continued the tradition of maintaining only a fraction of their deposits in their lending activities. 
Loan banking, as an intermediary business that borrows from savers to lend to borrowers, does not increase the supply of money and is a legitimate and vital process in a growing economy. But when money warehouses act as loan banks, there is at minimum a violation of the depositor’s trust and the potential for serious harm from uncovered demand liabilities.
The incentive for a warehouseman to embezzle deposits arises initially from two facts: (1) money, as gold coin, is fungible, and (2) unlike other fungible items such as grain, which are eventually used up in other products, gold as money does not have to be used at all. [2
] The deposited funds, in other words, are mutually interchangeable and can be stored indefinitely. As long as the warehouseman-lender maintains a reputation for trust, he can estimate the fraction of deposits he needs to keep on hand for redemption then loan out the rest with minimum risk of detection.
Although early Roman jurists had documented the principles that apply to monetary demand accounts, their findings have been largely ignored. [3
] Bankers in every era of history have violated these principles, with the result being bank failures, stiffed depositors, economic crises, and worst of all, war.
A Mutual Admiration Society
How has banking succeeded in conducting itself in such a reckless and unethical manner? It found a friend in government and formed a relationship in which each protects the other from failure. Consequently, throughout history, when depositors came calling for their gold or silver, government allowed favored banks to turn them away while still staying in business. And when war was the order of the day, bankers were willing to make extensive loans to help pay for it.
In U.S. history, both banking and government have come of age in this manner. In August 1814, the government allowed banks outside New England to suspend specie payment while permitting them to remain in business. The war and the suspension created a banking bubble, as the number of banks rose from 88 in 1811 to 208 by 1815, while bank notes in circulation doubled from $2.3 million to $4.6 million during the same period. [4
] Even after the war was over, banks continued to expand in number and note issue without the obligation to redeem. [5
In a misguided attempt to establish a uniform and sound currency, Congress authorized a Second Bank of the United States, requiring it to redeem its notes in specie. Redemption was neither certain nor universal, though, and the premium on specie and the discount on banknotes varied widely from place to place. [6
] The Second BUS began operations in January, 1817, and turned out to be, in the words of Federalist Senator William H. Wells of Delaware, “nothing more than simply a paper-making machine,” [7
] and helped prolong the expansion of state banks and their notes. [8
The Suffolk Bank and the Independent Treasury
In the interval between the War of 1812 and the Civil War, banking was de-centralized into state-chartered banks issuing banknotes redeemable in gold or silver coins. One of the highlights of this period was the development of a clearinghouse in Boston called the Suffolk Bank. Formed by prominent merchants, the Suffolk System allowed New England banks to accept the notes of other banks, including country banks, at par with specie. Members of the system had to keep a sufficient reserve of specie at Suffolk to redeem all the notes it received. Suffolk could not keep banks from inflating but it could remove them from the list of approved banks and cause their notes to trade at discount.
Though Suffolk exercised a stabilizing influence on the New England economy, it was not operating as a public service. It was a highly profitable enterprise and had the highest priced stock of any bank in Boston. [9
] Suffolk members did well during banking crises. No Connecticut bank failed or suspended specie payment during the Panic of 1837, and when Maine banks suspended payments in the Panic of 1857, all but three Suffolk banks continued redemption. [10
Comparing the Suffolk System to the National Banking System established during the Civil War, John Jay Knox, historian and former U.S. Comptroller of the Currency, writing in 1900, found that Suffolk had an average annual redemption of $229 million during its period of existence (1825-1858), whereas the national system averaged only $54 million from its start in 1863 to about 1898. At its peak in 1858, Suffolk redeemed $400 million in notes. Since the money supply of New England was only $40 million, it meant the average note was redeemed 10 times that year. [11
Another innovation that resisted inflation before the Civil War was the adoption of the Independent Treasury. First proposed by Philadelphia editor and political economist William M. Gouge in 1833 and supported a year later by another Philadelphian, political economist Condy Raguet, the Independent Treasury made the government’s revenue flow a specie-only, in-house operation. The Treasury accepted payments in constitutional money only--either gold or silver coin. The Treasury itself or regional offices known as subtreasuries collected payments and disbursed them in the form of coins or drafts drawn on deposited coins. The object of the system was to create a hard-money government divorced from banking.
The Independent Treasury had several anti-inflation features. It prevented banks from using government deposits as loanable funds and kept a sharp distinction in the public mind between bank paper and real money. Since government employees and contractors were paid in coin, it increased the demand for specie. It also pressured banks to keep more specie in reserve to meet the additional demands of customers needing to make payments to the government. [12
] Some hard-money members of Congress hoped that by removing government support for banknotes, they might eventually cease to circulate. [13
The first Independent Treasury became law under Martin Van Buren’s pen in 1840 but a Whig majority in Congress overturned it a year later. Democrat James K. Polk took it up four years later and signed the second Independent Treasury Act on August 6, 1846, when the country had been at war with Mexico for three months. Polk chose not to inflate or raise taxes to pay for the war. During the war’s two-year stretch, the Treasury borrowed $49 million without the aid of the banks, all of it subscribed in specie. The Mexican War has been the only war in American history that was not financed with inflation. The war-time boom was absent, as well as the post-war depression when the war ended. [14
A hard-money central government did not keep the state banks from inflating the money supply during this period of “free banking.” Banks were pyramiding credit on the debt of individual states, and the more debt they purchased, the more loans they could make. Since state governments had a ready market for their securities, they were encouraged to expand their debt. The “wildcat” banks that proliferated during this period were mostly established for buying state debt to finance the various Whig programs of internal improvements. Certain laws provided additional incentives to inflate, such as the prohibition of branch banking that imposed delays in redeeming banknotes for specie, and state usury laws that kept interest rates low, encouraging more credit expansion. These features of the banking system, along with the suspension of specie redemption during crises, reflected not “free banking” in any economic sense, but the corrupt union of banking and government that has persisted throughout history. [15
Bank inflation aside, the Independent Treasury fared well during its antebellum period. Though inflation per capita increased by 53% from 1847-1860, productivity gains kept commodity prices almost even at an annual inflation rate of only 0.28 percent. The amount of specie in the country more than doubled during this period, while banks increased their specie by a factor of three. Also, the Panic of 1857 was much milder than the previous panics of 1819 and 1837. The recessions following the earlier panics lasted four years, whereas the recession following the Panic of 1857 was over in six months. Banks suspended for years in the earlier recessions, while banks in the later one suspended for only a few months. [16
With the arrival of war in 1861, inflation went from a foe to an ally and was largely responsible for its lengthy duration.
Jesus Huerta de Soto, Money, Bank Credit, and Business Cycles
, Mises Institute, Auburn, AL, 2006, p. 99
Murray N. Rothbard, The Mystery of Banking
, Mises Institute, Auburn, AL, 2008, p. 90
3. Money, Bank Credit, and Economic Cycles
, pp. 25-26
Murray N. Rothbard, The Panic of 1819: Reactions and Policies
, Mises Institute, Auburn, AL, 2007, p. 4
Murray N. Rothbard, A History of Money and Banking in the United States: The Colonial Era to World War II
, Mises Institute, Auburn, AL, 2002, p. 85
John Denson, Ed., Reassessing the Presidency: The Rise of the Executive State and the Decline of Freedom
, Mises Institute, Auburn, AL, 2001, pp. 180-181