The positivist method helps not only explain the antipathy towards fundamental generalizations regarding the crisis, but partially accounts for the general hostility toward private banking and the gold standard. This is due to the creation of what I dubbed the "mythical narrative of the 19th century" in which the positivist observes the occurrence of boom-busts in the 19th century, despite the presence of a gold standard and supposed laissez faire conditions, concluding that gold and private banking must not prevent the boom-bust cycle. In other words, the inability to properly abstract the relevant economic principles, which explain outcomes in varying contexts, renders these intellectuals incapable of reaching a full understanding.
As Murray Rothbard conclusively demonstrates in A History of Money and Banking in the United States, the government has been intimately involved in the monetary system since the inception of the country, leading to one disaster after another. The 19th century saw an almost constant political tug of war between hard money advocates and those advocating inflationary policies - a battle ultimately culminating in the formation of the Federal Reserve. It is certainly not my intention to recount the entire history here. However, I believe there are several major takeaways to help better understand the evolution of our current system.
Historically, it appears that government intervention in the monetary system takes two general forms. The first form I will call direct intervention where, for example, the government pyramids paper money on top of specie. The second form of intervention represents a default by the government to perform its legitimate and necessary function as a protector of property - which I will call misintervention. I claim that this misintervention took two primary forms. First, during various crises, it failed to uphold banks contractual obligations to redeem in specie. Second, through various legal precedents, it failed to legally define property in such a way as to effectively outlaw the practice known as fractional reserve banking, i.e., legally distinguish between a deposit and a loan contract.
Therefore, it is my contention that government intervention (or misintervention) caused the banking crises and panics of the 19th century, not the gold standard per se. In fact, it was gold that kept any semblance of price stability and which helped lead to phenomenal economic expansion. To observe this latter point graphically, see Peter Bernholz excellent book, Monetary Regimes and Inflation, wherein he charts consumer prices from 1750 to the present in four different countries. The chart reveals that prices remained virtually flat for 150 years (under a gold standard) and then spike exponentially after 1900 after the advent of the Federal Reserve. (Also, see this chart at nowandfutures.com.) Bernholz states that:
All hyperinflations in history occurred after 1914 under discretionary paper money standards except for the French case during the Revolution of 1789-96, when a paper money standard was introduced with the assignats. (I discussed hyperinflation during the French Revolution at length in this post)In fact, since the creation of the Fed in 1913, the dollar has lost approximately 95% of its purchasing power. So, in fact, even given the various panics which occurred in the 19th century, the monetary environment under gold was a bastion of stability compared to what has occurred under central banking. It's tempting to stop there, however, it's important to understand why even under this form of gold standard, periodic panics and major disruptions rocked the financial system, because these panics and bank runs are always cited as justification for central banking.
Below I propose four major categories of government intervention or misintervention which I hold, in essence, accounts for virtually every panic of the 19th century.
1. Direct creation and pyramiding of paper money on top of specie by the government
2. Private bank pyramiding of paper money on top of specie (fractional reserve banking) legally sanctioned by the government's inability to properly distinguish a deposit from a loan
3. Government suspension of banks contractual obligation to redeem in specie during various panics
4. Statutory decrees setting the the relative value of gold to silver (bimetallism) rather than allowing prevailing free market rates (see my post Where's Grover Cleveland When You Need Him which discusses how government policy, in this case the Sherman Silver Purchase Act, led to the panic of 1893.)
Of course, the particular details in each instance varied, however, I believe the root causes derive from these categories. A general pattern tended to occur repeatedly throughout the 19th century:
Depositors would exchange gold with a bank for banknotes redeemable in specie. The bank would create more banknotes than it had deposits to make loans - a process known as fractional reserve banking. For example, since not everybody wanted their money at the same time, the bank could create say $100 of paper for every $10 of gold in the bank. Fractional reserve based credit expansion led to temporary booms for the same reasons cited in Part I, and all was well, until everyone wanted their money at the same time - a phenomena known as a bank run. Bank runs were precipitated by banks issuing too much paper money followed by a panic that the bank would not be able to fully redeem their depositor's gold. Then, during the crisis phase, the state and federal governments repeatedly allowed banks to suspend redeemability thus encouraging banks to expand credit over and over again, knowing that they would be bailed out if depositors ever panicked.
The War of 1812-1815 had momentous consequences...The government therefore encouraged the formation of new and recklessly inflationary banks in the Mid-Atlantic, Southern, and Western states, which printed huge quantities of new notes to purchase government bonds. The federal government thereupon used these notes to purchase manufactured goods in New England.The number of new banks exploded and pyramid ratios (the ratio of bank notes outstanding to actual specie) were close to 20-1 in some states.
The monetary situation meant that the United States government was paying for New England manufactured goods with a mass of inflated bank paper outside the region. Soon, as the New England banks called upon the other banks to redeem their notes in specie, the mass of inflating banks faced imminent insolvency.Rothbard explains the "fateful decision" then made by the government.
This decision had far reaching consequences in terms of so-called moral hazard.
As the banks all faced failure, the governments, in August 1814, permitted all of them to suspend specie payments-that is, to stop all redemption of notes and deposits in gold or silver-and yet to continue in operation. In short, in one of the most flagrant violations of property rights in American history, the banks were permitted to waive their contractual obligations to pay in specie while they themselves could expand their loans and operations and force their own debtors to repay their loans as usual.
It is obvious that the governments failure to uphold the contractual obligation to redeem in specie encouraged reckless inflationary expansion on the part of many banks. If the government had simply forced the banks unable to redeem to "incur immediate insolvency and liquidation" the problem would likely have been limited in scope. However, suspensions became the norm not the exception. Rothbard writes:
From then on, every time there was a banking crisis brought on by inflationary expansion and demands for redemption in specie, state and federal governments looked the other way and permitted general suspension of specie payments while bank operations continue flourish. It thus became clear to the banks that in a general crisis they would not be required to meet the ordinary obligations of contract law or of respect for property rights, so their inflationary expansion was permanently encouraged by this massive failure of government to fulfill its obligation to enforce contracts and defend the rights of property.
Suspensions of specie payments informally or officially permeated the economy outside of New England during the panic of 1819, occurred everywhere outside of New England in 1837, and in all states south and west of New Jersey in 1839. A general suspension of specie payments occurred throughout the country once again in the panic of 1857.Again, in this instance we see the pattern discussed above wherein banks would massively inflate leading to price inflation and a temporary boom followed by a bust, a run on banks, and government sanctioned suspension of specie redemption. It was not only private banks that engaged in inflationary operations. The first attempt at a central bank occurred in 1791 when the First Bank of the United States was chartered. It's inflationary policies are discussed in detail in Rothbard. That bank's twenty year charter failed to be renewed in 1811, but that did not stop the formation of the Second Bank of the United States in 1816.
With the nation emerging from the War of 1812 in monetary chaos, and "with banks multiplying and inflating ad lib, checked only by the varying rates of depreciation of their notes" and "with banks freed from redeeming their obligations in specie, the number of incorporated banks" continued to increase. Rothbard writes:
It was apparent that there were two ways out of the problem: one was the hard-money path...The federal and state governments would have sternly compelled the rollicking banks to redeem promptly in specie, and, when most of the banks outside of New England could not, to force them to liquidate. In that way, the mass of depreciated and inflated notes and deposits would have been swiftly liquidated, and specie would have poured back out of hoards...and the inflationary experience would have been over.Instead, the Second Bank of the United States was established to "support the state banks in their inflationary course rather than crack down on them." The Second Bank struck a sweetheart deal with the state banks in which it agreed to issue mass amounts of credit "before insisting on specie payments from debts due to it from the state banks." In exchange for this "massive inflation" the state banks "graciously" agreed to resume specie payments and "moreover, the Second Bank and the state banks agreed to mutually support each other in any emergency, which of course meant in in practice that the far stronger Bank of the United States was committed to the propping up of the weaker state banks."
It can be seen that from the start, the government formed an intimate and symbiotic relationship with private banks - a relationship that continues today. Rothbard quotes William H. Wells, an opponent of the Second Bank, in saying that the bank was
ostensibly for the purpose of correcting the diseased state of our paper currency by restraining and curtailing the over issue of bank paper, and yet it came prepared to inflict upon us the same evil, being itself nothing more than simply a paper-making machine.The Second Bank "launched a spectacular inflation of money and credit" which began to come apart in 1818 when "the enormous inflation of money and credit, aggravated by the massive fraud, had put the Bank of the United States in real danger of going under and illegally failing to sustain specie payments." The bank undertook a massive contraction of credit and
Sound familiar? Fortunately, President Andrew Jackson, a hard money advocate, was able to veto recharter of the Second Bank in 1831 and set about to completely "disestablish" the bank. (It's also interesting, although beyond the scope of this post, that a system known as the Suffolk System emerged from about 1825-1858 and functioned as a free market central bank. In other words, the Suffolk Bank in Massachusetts was willing to redeem or clear the notes of other banks (at par) as it required outside banks to maintain sufficient deposits with Suffolk.)
The result of the contraction was a massive rash of defaults, bankruptcies of business and manufacturers, and liquidation of unsound investments during the boom. There was a vast drop in real estate values and rents...and public land sales dropped greatly as a result of the contraction..
The Civil War would fundamentally alter the monetary system forever. The dire straights of the federal government during the war led to the issuance of the unbacked "greenback" and ultimately paved the way for the Legal Tender Cases, the National Bank Act of 1863, and ultimately the formation of the Federal Reserve itself in 1913. In other words, the disasters caused by government intervention and misintervention begot calls for more government intervention followed by more disasters justifying creation of the Federal Reserve, the abolition of gold, fiat currency, unlimited government deficit spending, chronic inflation and an even more dramatic inflation-depression cycle!
In connection to the inflationary policies of both public and private banks, a further question necessarily arises - should it be legal for banks to create more bank notes than for which they have deposits? Should fractional reserve banking be legal in the first place?
In a previous post, I followed Jesus Huerta de Soto book, Money Bank Credit and Economic Cycles, and Rothbard's, The Mystery of Banking, to offer a brief history and explanation of the essentials of fractional reserve banking including definitions of various terms: bailment, regular and irregular deposit contract, etc. as well as sketch their arguments as to why it should not be upheld by the courts. (Also, Michael Labeit has an excellent synopsis of Jesus Huerta de Soto's argument against fractional reserve banking. Those posts should be read with the following.)
To summarize, when you deposit money in a demand checking account today, the bank obligates itself to give you your money whenever you ask. However, the bank does not literally keep your money laying around. Under fractional reserve banking, the banking system takes the $100 you deposited and can create about $1,000 in loans. In other words, banks only need to keep about 10% of their depositors money in reserve. [Bank A takes $100, holds $10 in reserve and lends $90. Borrower deposits the $90 in Bank B and that bank sets aside $9 in reserves and lends $81, and so on. Ultimately, at the end, the original $100 will have turned into $1,000 of demandable funds even though only $100 actually exists.] Similarly, in the 19th century, one would deposit gold in a bank and receive a banknote redeemable in gold. Through the loan process, the banks would create more banknotes than they held in gold. This is what led to the temporary inflations and bank crises I described above.
How is it possible that the bank could simultaneously obligate itself to make the gold available on demand while loaning it out? Should banks be allowed to engage in this practice?
I believe this issue has its roots in the philosophy of law and, in particular, the proper distinction between a deposit contract and a loan contract. When you enter into a "deposit" contract, one does not transfer title of his property. The counter party provides a safekeeping function. (In the post, I describe the Bank of Amsterdam 150 year run as a 100% deposit bank.) This should be distinguished from the "loan" contract (which gives rise to separate loan banking), in which you transfer legal ownership of something, like money, to another party and allow them to use it in any way they wish (or in a way specified in the contract). In this case, you are transferring title to someone else in exchange for future goods specified in the contract such as the amount of money plus interest. These transactions are based on two very distinct concepts. In one case, you actually pay someone a fee to perform the service of safekeeping property to which you retain title. In the other case, you transfer ownership of property in the present in exchange for future goods, i.e., for payment in the future.
I hold that it is a contradiction for the government to uphold a conflation of these distinct legal concepts. How exactly can a court reconcile a contract in which the parties agree that title to property is and is not transferred at the same time? This would be similar to asking the courts to uphold a contract where a painter is contracted to paint one's house both blue and red at the same time. In other words, prohibition of this practice is not a question of violating the freedom of contract, it is a question of the legal validity and status of a contract based upon a contradictory, and ultimately, fraudulent property claim. [update: by "prohibition", I mean that the courts should refuse to uphold a contradictory contract which would effectively end the practice.]
This issue came to a head in several court cases in the 19th Century. In The Mystery of Banking, Rothbard writes:
Thus, in England, the goldsmiths, and the deposit banks which developed subsequently, boldly printed counterfeit warehouse receipts, confident that the law would not deal harshly with them. Oddly enough, no one tested the matter in the courts during the late seventeenth or eighteenth centuries. The first fateful case was decided in 1811, in Carr v. Carr. The court had to decide whether the term debts mentioned in a will included a cash balance in a bank deposit account. Unfortunately, Master of the Rolls Sir William Grant ruled that it did. Grant maintaned that since the money had been paid generally into the bank, and was not earmarked in sealed bag, it had become a loan rather than a bailment.In the follow up case of Devaynes v. Noble, Rothbard writes:
The seminal ruling was made by Judge Lord Cottenham in the 1848 case Foley v. Hill. De Soto writes about the case:
one of the counsel argued, correctly, that "a banker is rather a bailee of his customer's funds than his debtor...because the money in...[his] hands is rather a deposit than a debt, and may therefore be instantly demanded and taken up." But the same Judge Grant again insisted-in contrast to what would be happening later in grain warehouse law-that "money paid into a banker's becomes immediately a part of his general assets; and he is merely a debtor for the amount."
In the decision, Lord Cottenham wrote:
At the end of the eighteenth century and throughout the first half of the nineteenth, various lawsuits were filed by which depositors, upon finding they could not secure the repayment of their deposits, sued their bankers for misappropriation and fraud in the exercise of their safekeeping obligations. Unfortunately, however, British case-law judgments fell prey to pressures exerted by bankers, banking customs, and even the government, and it was ruled that the monetary irregular-deposit contract was no different from the loan contract, and therefore that bankers making self-interested use of their depositors' money did not committ misappropriation.
Money, when paid into a bank, ceases altogether to be the money of the customer; it is then the money of the banker, who is bound to return an equivalent by paying a similar sum to that deposited with him when he is asked for it. The money paid into the banker's is money known by the customer to be placed there for the purpose of being under the control of the banker. It is then the banker's money; he is known to deal with it as his own...The money placed in the custody of a banker is to all intents and purposes the money of the banker, to do with it as he pleases. He is guilty of no breach of trust in employing it; he is not answerable to the customer if he puts it into jeopardy, if he engages in a hazardous speculation; he is not bound to keep it or deal with it as the property of the customer, but he is, of course, answerable for the amount, because he has contracted, having received that money, to repay to the customer, is when demanded, a sum equivalent to that paid into his hands.This ruling would make fractional reserve banking a permanent fixture on the monetary scene. De Soto offers compelling arguments to demonstrate not only the inflationary boom-bust effects that follow from fractional-reserve banking but also to demonstrate that "from a legal point of view, it is impossible to equate these two contracts" (the monetary irregular deposit contract and the loan or mutuum contract). He writes:
It should be noted that the primary culprit today is not fractional reserve banking per se. If bank notes are ultimately redeemable in specie, and the government upholds banks obligations to redeem, the practice would necessarily be limited (see the Suffolk Bank mentioned earlier). In other words, fractional reserve banking would have the potential to create a moderate business cycle but it would be nowhere near the magnitude witnessed today. This can be seen empirically in charts of prices throughout the 19th century as compared to price charts in the 20th century under fiat money. This follows from the fact that today, unlike the 19th century, there is no obligation on the part of banks to redeem in specie. The government, through the Federal Reserve system, can print arbitrary amounts of money which it has effectively done. Fractional reserve banking serves only to multiply this ever increasing pile of money created by virtue of government deficit spending.
We therefore conclude that past attempts to legally justify fractional-reserve banking with respect to demand deposits have failed. This explains the ambiguity constantly present in doctrines on this type of bank contract, the desperate efforts to avoid clairty and openness in its treament, the generalized lack of accountability and ultimately (since fractional-reserve banking cannot possibly survive economically on its own), the fact that it has been provided with the support of a central bank which institutes the regulations and supplies the liquidity necessary at all times to prevent the whole setup from collapsing.
For example, if the banking system has $100 then fractional reserve banking can multiply it to $1,000. If the government creates another $10,000, then fractional reserve banking can multiply it to $100,000, and so on. However, if the government had not created the extra money, the money stock would have been limited to the $1,000. In other words, it is the arbitrary creation of money out of thin air which is the primary culprit in today's boom bust cycles. That is not to say that fractional reserve banking should be legal. I hold that it should not be upheld by the courts for the reasons I cited. This would simply lead to a 100% reserve gold standard and a separation of deposit and loan banking.
What I have attempted to show is that today's destructive inflation-depression cycle is an instance of a reoccuring pattern that has played out over centuries. The Federal Reserve system, rather than being the solution, has exacerbated the very causal factors which allegedly led to its creation. When analyzed from an integrated historical perspective, the various problems related to the 19th century monetary system can be seen to have stemmed from government intervention and misintervention - problems which could have readily been solved by a full 100% gold reserve private banking system. Instead, the United States has gone in the exact opposite direction leading to the predictably unfortunate and ever worsening circumstances we find ourselves in today.
In Part 4, I will analyze the so-called "tools" that the Federal Reserve claims will allow it to reign in its massive creation of reserves.