The National Banking Acts: When War Bonds Became Currency

A dry-goods merchant in Cincinnati in the autumn of 1862 could not price a sale until he had priced the money. Notes crossed his counter from banks in Indiana, Michigan, Georgia and towns he had never heard of, each issue worth something less than its face value depending on the issuer's distance, reputation and continued existence. To settle the question he reached for Thompson's Bank Note and Commercial Reporter, a periodical John Thompson had published out of New York since 1836, which listed the going discount on genuine notes and described the counterfeits then in circulation. Hundreds of banks issued their own paper. Every one of those issues was a small private act of monetary policy, and the merchant's job was to guess which ones would still be worth something on Monday.

Thompson did well out of the confusion. He also helped end it: he went on to found the First National Bank of the City of New York and, later, the institution he named after the Treasury Secretary who abolished his market — Chase National Bank.

What Lincoln Asked For

Abraham Lincoln put the proposal to Congress in his annual message of 1 December 1862, in the middle of a war being financed with paper. Having reviewed the schemes on offer for restoring a sound circulating medium, he told the House and Senate: "I know of none which promises so certain results and is at the same time so unobjectionable as the organization of banking associations, under a general act of Congress, well guarded in its provisions."

The mechanism he described in the next sentences is the whole design in miniature. "To such associations the Government might furnish circulating notes, on the security of United States bonds deposited in the Treasury. These notes, prepared under the supervision of proper officers, being uniform in appearance and security and convertible always into coin, would at once protect labor against the evils of a vicious currency and facilitate commerce by cheap and safe exchanges."

Salmon P. Chase, Lincoln's Treasury Secretary, had been pressing versions of the idea since 1861, and he had a second motive that the message left implicit. Bonds deposited as collateral for note issue are bonds somebody has bought. A banking system built on federal debt would create a permanent, growing, price-insensitive bid for the securities the Treasury needed to sell to keep armies in the field.

John Sherman of Ohio carried the bill on the Senate floor and made no secret of the third motive. In his address of 10 February 1863 he argued that a common currency would do political work that no tariff or army could: "The policy of this country ought to be to make everything national as far as possible; to nationalize our country, so that we shall love our country. If we are dependent on the United States for a currency and a medium of exchange, we shall have a broader and more generous nationality." Two days later the Senate passed it. Lincoln signed the National Currency Act on 25 February 1863.

The Machinery

Congress rewrote the statute almost immediately. Hugh McCulloch, an Indiana banker who had opposed the original bill and was then appointed the first Comptroller of the Currency to administer it, redrafted the provisions he thought unworkable, and the revised version — the act of 3 June 1864 — is the one that governed American banking for the next half-century.

A bank seeking a national charter had to deposit United States bonds with the Comptroller. Against that deposit it received engraved notes bearing its own name and charter number, up to 90 percent of the market value of the bonds. Capital minimums scaled with the size of the town: $50,000 where the population was 6,000 or less, more in cities. Aggregate note issue for the whole system was capped at $300 million, apportioned among the states.

Every element of that arrangement did two things at once. Bond collateral made the notes safe, and it also locked the banks into holding federal debt. The charter-number imprint let a holder identify the issuer, and it let the Comptroller track every note ever printed. Uniform engraving killed the discount tables, and it handed the Bureau of Engraving and Printing a monopoly over what American money looked like.

Killing the State Bank Note

Charters alone would not clear the field, because a state bank could keep issuing its own notes and paying no attention to Washington. Congress solved that with taxation rather than prohibition. A revenue act of 3 March 1865 laid a 10 percent tax on state bank notes paid out after 1 July 1866, and the act of 13 July 1866 extended the tax to notes paid out by any person or state banking association after 1 August. A 10 percent levy on circulation is not a tax on a business; it is the end of one.

State bank note circulation fell from $143 million in 1865 to about $4 million by 1867. National bank notes moved the other way, passing $290 million by 1868 and pressing against the statutory ceiling. By 1870 the country had 1,638 national banks and only 325 state banks, though the state institutions would return in force once they discovered they could live on deposits instead of notes.

The Veazie Bank of Maine sued. When the case reached the Supreme Court, the Chief Justice who wrote the majority opinion upholding the tax on 13 December 1869 was Salmon P. Chase, the same man who had designed the system as Treasury Secretary six years earlier. Congress, he held, had the power to provide a currency for the whole country and to restrain the circulation of any other: "Without this power, indeed, its attempts to secure a sound and uniform currency for the country must be futile." The vote was five to two.

A Currency That Could Not Grow

Here the design turned against itself. Notes were issued against bonds, so the quantity of money the banks could supply depended on the quantity and price of federal debt rather than on anything happening in the economy. When the Treasury ran surpluses and retired bonds through the 1880s, the collateral disappeared. When the remaining long bonds rose well above par, buying them at market to back notes issued at 90 percent of value stopped making sense.

Removing the ceiling in 1875 changed almost nothing, which is the striking fact about the whole period. Banks left most of their permitted issue unused. Through the 1880s the notes outstanding ran at roughly 20 percent of the legal maximum their bond holdings would have supported; by 1900 the share had risen to about 28 percent, and by the First World War to about 80 percent. Phillip Cagan's appraisal of the system's first fifty years treated this underissuance as its central defect rather than an accident of bond supply (Cagan, 1963). Later work computing the actual return on note issue found that putting notes into circulation simply was not profitable in the years from 1884 to 1891, which explains the behaviour without appealing to banker conservatism (Champ, 2007).

Circulation contracted in absolute terms as well. National bank notes in circulation, having pressed against the cap in the late 1860s, fell year after year to $207.2 million in 1889, and the total outstanding was down to $123 million by 1891 — an average of some $33,000 per bank. The Comptroller's own explanation that year was unsentimental: "The rapid redemption of the Government bonds, which were the basis of the circulating notes, and the high prices of the longer date bonds, which forced many banks to retire circulation which it was no longer profitable to maintain, and in many cases to go out of business altogether, will largely explain the low point to which national-bank circulation fell in 1891."

An economy whose population and output were growing fast was being served by a note supply that shrank whenever the Treasury's finances improved. Farmers in the western and southern states drew the obvious conclusion about who the arrangement served, and the currency question became the organising grievance of a generation of American politics, running through the greenback campaigns to the silver movement of the 1890s.

The Reserve Pyramid

A second structural flaw sat in the reserve rules, and it did more damage than the inelastic note issue. The 1864 act sorted banks into tiers and let the lower tiers count deposits at the higher tiers as legal reserves.

Reserves therefore flowed uphill. A country bank in Nebraska kept its cushion as a balance in Chicago or New York, where it earned interest, and the New York bank lent those balances out on call against stock-exchange collateral because call loans could in principle be recovered in a day. John A. James traced how thoroughly this plumbing tied rural credit conditions to the Manhattan money market (James, 1978).

The system worked until everyone reached for the same reserves at once, which happened every autumn. Harvests had to be paid for in cash, so country banks withdrew their New York balances in September and October; New York banks called their loans; call rates spiked and stock prices fell. In a year when something else was already wrong, the seasonal squeeze became a panic. O. M. W. Sprague, writing for the National Monetary Commission, worked through the episodes of 1873, 1884, 1890, 1893 and 1907 and showed that the same mechanism recurred in each, with no institution anywhere in the structure obliged to supply cash when every bank wanted it simultaneously (Sprague, 1910).

What substituted for a central bank was the New York Clearing House, which in each crisis issued loan certificates that member banks could use to settle among themselves, conserving currency for depositors. It was an improvisation by a private club with no public mandate, and its limits were on display when Jay Cooke's railroad bonds broke the American economy in 1873 and again when J. P. Morgan personally organised the rescue of 1907.

The Exit

Congress responded to 1907 first with the Aldrich-Vreeland Act of 30 May 1908, which allowed emergency currency against commercial paper and other securities, and second with the National Monetary Commission, whose research programme — Sprague's volume among it — built the case for something permanent. The result was the Federal Reserve Act of 1913, which supplied the two things the national banking system structurally could not: a note issue that expanded with demand rather than with the bond market, and an institution obliged to lend when reserves ran short.

National bank notes did not vanish with the Act. Banks could now sell their bonds to the Reserve Banks and leave the currency business, and over the following two decades most did; the last national bank notes were printed in 1935, and the ones still in drawers and collections remain legal tender. Charters granted under McCulloch's 1864 redraft outlasted the currency entirely, and the office he created still supervises the banks that hold them.

Seventy years of American money carried, in small type beside the portrait, the charter number of a particular bank in a particular town — a reminder that the notes were a private institution's promise, made good by government bonds locked in a Treasury vault. The system Chase built to sell war debt worked so well at that job that it could not be made to do the other one.