Richard Sylla, 10.15.08, 2:00 PM ET
Banking has been a highly politicized business throughout American history. With the US treasury now planning to inject $250 billion of equity capital into our banks, the business may well become even more politicized. A quick review of what we have learned from past episodes of politicized banking might therefore be in order.
The very first U.S. bank, the Bank of North America in Philadelphia, was chartered by Congress in 1781 at the behest of Robert Morris, the superintendent of finance, to help fund the American Revolution. Morris used the proceeds of a French loan to buy most of the bank's shares for the national government.
Several states, doubting that Congress had the authority to charter a bank, blessed the venture with charters of their own. Pennsylvania's legislature revoked the bank's charter in the mid-1780s, forcing it to obtain one from Delaware to continue in business. But the bank was able to secure a more restrictive charter from Pennsylvania a couple of years later. From that time to now, banking has been a political issue between U.S. states as well as between the states and the federal government.
Treasury Secretary Alexander Hamilton in 1790 recommended that Congress charter a Bank of the United States as a national and proto-central bank. Federalist majorities enacted the plan, which called for the bank to have 20% government ownership. But the Republican opposition, led by Congressman James Madison and Thomas Jefferson, the secretary of state, advised President Washington that the measure was unconstitutional. Hamilton effectively countered their arguments, and Washington signed the bill into law. The bank became an effective institution, aiding federal finances and opening branches in several states so that the country had interstate banking.
That would not last. In 1811, on the negative vote of the vice president breaking a tie in the Senate, the bank's charter was allowed to lapse. Some states-rights proponents still thought a federal bank was unconstitutional. More important was the opposition of many state-chartered banks, some of which were partly owned by states, and state legislators representing the banking interests. These interests reasoned that, with the federal bank gone, they would both get rid of a regulator and get the federal government's banking business.
It was just the wrong time to abandon a central bank. A year later, the War of 1812 broke out, and the absence of the national bank made war finance difficult, which reduced the effectiveness of U.S. military efforts. At least a lesson was learned. Right after the war, Congress chartered a second Bank of the United States, with many of the first bank's opponents, including President Madison, becoming staunch supporters of the new central bank. After a rocky start connected with post-war deflation, the second bank gave the country financial stability during the Era of Good Feeling in the 1820s and the early 1830s.
Once again, it did not last. President Andrew Jackson vetoed Congress's re-charter of the second bank in 1832, and it ceased to be America's central bank in 1836. The reasons were the same ones as in 1811. Jackson thought the bank was an unconstitutional conferral of special privileges on elites. And the 700 or so state banks once again reasoned that they would benefit by getting rid of a central-bank regulator and getting the federal government's banking business. Jackson pleased them by removing government deposits from the second bank and placing them in state "pet banks" friendly to his Democratic party.
Without a central bank, the country immediately plunged into a protracted period of financial instability. There were bank panics in 1837 and 1839. As land and other asset prices plunged, state revenues declined, and by 1842, nine states had defaulted on debts incurred to build transportation and financial infrastructures. Congressmen from those states asked for a federal bailout, but Congress voted down that proposal.
Aided by investment in railroads and gold discoveries in California, the US economy recovered from the Jackson-inspired financial disaster. But the country's currency was a mess, with each of some 1,500 banks issuing several denominations of individual bank notes. Counterfeiting was rife. And the system was unstable, with several minor crises and a major financial panic in 1857.
The Civil War provided an opportunity for Abraham Lincoln's administration to bring some order out of the chaos. In 1863 to 1864, Congress passed National Currency and Banking acts to create the National Banking System of federally chartered national banks.
These banks would issue a uniform national currency backed by U.S. government bonds, which not so incidentally aided the war effort by enlarging the demand for those bonds. State bank notes were taxed out of existence in the hope that all banks would be forced into the national system. That didn't work because some state banks, preferring laxer state regulation, abandoned note issuing and continued as deposit banks. This was the origin of our so-called dual banking system of federal- and state-chartered banks.
By the early 20th century, the U.S. had by far the largest banking system of any country. Its more than 20,000 individual banks held more than 40% of the world's bank deposits.
What the U.S. lacked was a central bank, having abandoned that concept in the 1830s. As a result, the world's largest economy was prone to financial instability. Major banking panics occurred in 1873, 1884, 1893 and 1907, in part because there was no lender of last resort to provide liquidity during bank runs.
After the panic of 1907, in which private banker J. P. Morgan acted as a one-man central bank, Congress studied other countries' financial systems and created a new central bank, the Federal Reserve System, in 1913 to 1914. The Fed made major mistakes in the Great Depression of the 1930s and the Great Inflation of the 1970s, but the U.S. had far fewer financial crises under the Fed than it did when there was no central bank.
Something like the current Treasury plan for capital injections into banks occurred in the Great Depression. President Hoover established the Reconstruction Finance Corp. in 1932 to lend to distressed banks and other businesses. In 1933, President Roosevelt expanded that mandate to authorize the RFC to invest in preferred stock in banks.
From then until 1935, the RFC purchased approximately $1.3 billion of such preferred stock in approximately 6,000 banks. As a percent of gross domestic product then, this was roughly equivalent to the current $250 billion plan. Along with FDIC deposit insurance that came in at the same time, the 1930s injections did stabilize the banking system. There were far fewer bank failure after 1933 than before.
It's clear from this review of government involvement in banking over the course of U.S. history that the current interventions are not without precedents extending back more than two centuries. We don't like our governments to be involved in banking, fearing that it such involvement will politicize what should be economic and business matters.
Secretary Paulson this week blurted out that he wished he didn't have to take the actions he was taking, but he saw no reasonable alternative. Government finance and banking are both part of an integrated U.S. financial system. They can't avoid being heavily involved with each other. It has been that way from the birth of our country. We might as well get used to it.
Richard Sylla is the Henry Kaufman professor of the history of financial institutions and markets and professor of economics at the Stern Business School at NYU.