Creature From Jekyll Island by G. Edward

THE CREATURE FROM JEKYLL ISLAND

The prohibition against bank notes of small denomination

deserves special notice. It was an excellent concept, but what the legislators failed to understand, or at least pretended not to understand, was that banks at this time were increasingly dealing with checkbook money, technically called demand deposits. As people gradually became accustomed to this new method of transferring funds, the importance of bank notes declined. Placing a limit on the issuance of bank notes without any restriction on the creation of demand deposits was an exercise in futility.

In 1837, as the Bank of the United States slipped into history, the nation was at the tail end of an economic boom. Professor Rothbard tells us that this expansion and the accompanying inflation had been 'fueled by the central bank.'1 Total money in circulation had risen by eighty-four per cent in just four years.

Then, as inevitable as the setting sun, that portion of the money supply which had been created by fractional- reserve banking—in other words, the part which was backed by nothing—began to contract. Sixteen per cent of all the nation's money totally disappeared in just that first year. Again, men were put out of work, businesses went into bankruptcy, homes and savings were lost.

Many banks folded also, but their operators walked away with the spoils. Only the depositors were left holding the empty bag.

There were numerous proposals advanced regarding how to

infuse stability into the banking system. But, then as now, none of them dealt with the real problem, which was fractional-reserve banking itself. As Groseclose observed, these proposals were 'each according to a particular theory of how to multiply loaves and fishes, or how to make candy wool.'2 Since the proposals presented then are identical to the ones being offered today, and since each of them was actually tried, it would seem appropriate to inquire into the actual results of these experiments.

PROPOSAL TO BASE MONEY ON BANK ASSETS

There were four schools of thought regarding the multiplication of loaves and fishes. The first of these was that the creation of money should be limited to a ratio of the bank's assets. This was the formula that was tried in the New England states. In Massachusetts, for example, the issuance of bank notes was limited to two 1. Rothbard, Mystery, p. 211.

2. Groseclose, Money and Man, p. 184.

LOAVES AND FISHES AND CIVIL WAR 363

times the amount of the bank's capital actually held in the vault.

Furthermore, this could not be in the form of paper money, bonds, securities, or other debt instruments; it had to be strictly gold or silver coin. Also, the banks were limited in the number of small-denomination bank notes they could issue and, in this, Massachusetts served as the model for Jackson's attempted reform at the federal level. By previous standards, and certainly by the standards that prevail today, this was an exceptionally conservative policy. In fact, even during the previous stress of the War of 1812, when banks were failing by the hundreds across the country, the Massachusetts banks, and most of the other New England banks as well, were able to maintain full payment in specie.

With the passage of time, however, the limit on bank notes became less important, because the banks now were using checkbook money instead. Their paper notes may have been limited to two- hundred per cent of their capital, but there was no effective limit to the numbers they could ink into people's deposit books. So the 'fraction' in fractional-reserve banking began to shrink again.

Consequently, the monetary contraction of 1837 'was like a scythe over the crop,' says Groseclose, and thirty- two Massachusetts banks collapsed between that year and 1844.1

The state attempted to patch the system by instituting a

network of bank examiners and by increasing the liability of bank stockholders for the lost funds of their depositors, but the underlying problem was still ignored. A new crop of banks then sprang into existence and a new wave of speculative mania swept through the economy. By 1862, even though the law still limited bank notes to two times capital, the banks had created $73,685,000 in total money, including checkbook money. This was supported by a base of only $9,595,000 of specie, a reserve of only thirteen per cent.

Massachusetts had not solved the problem.

PROPOSAL TO PROTECT DEPOSITS WITH A SAFETY

FUND

The second theory about how to have stable banking and allow the banks to create money out of nothing was to create a 'safety fund.' This fund, supported by all the banks, would come to the aid of any member which needed an emergency loan to cover a L Groseclose, Money and Man, pp. 188-89.

364 THE CREATURE FROM JEKYLL ISLAND

sudden drain of its reserves. It was the forerunner of today's Federal Deposit Insurance Corporation and related agencies.

The first safety fund was established in New York in 1829. The law required each bank to contribute annually one-half of one per cent of its capital stock until the total reached three per cent. The fund was first put to the test during the crisis of 1837, and was almost swamped. The only thing that saved it was that the state agreed to accept the worthless notes of all the defunct banks as payment for canal tolls. In other words, the taxpayers were compelled to make up the difference. When the fund was

exhausted, the solvent banks were punished by being forced to pay for the deficits of the insolvent ones. Naturally, this impelled all banks to act more recklessly. Why not? The up side was that profits would be higher—for a time, at least—and the down side was that, if recklessness got them into trouble, the safety fund would bail them out. The result was that the system provided a penalty for prudence and an incentive for recklessness; a situation with perfect parallel to that which exists in the banking system today.

Groseclose says: