Sunday, October 30, 2011

Banking on Hamilton 2

America drifted around without a clear path forward until 1862. The period before 1862 is known as the Free Banking Era. Mostly because it was possible to buy banks for free—just kidding. But in the absence of a strong central bank, larger banks filled in the de facto role of a central bank: they provided deposit insurance, guaranteed their notes with bullion, and acted as a bank note clearinghouse honoring notes from collapsed banks.

Note that the US up until 1863, when the National Banking Act and Legal Tender Act went into effect, did not have a standard currency. The US government minted coins that were worth their weight but never a specific currency, e.g. dollars. That meant that bank notes were the only standard non-bullion currency (states were prohibited from printing by Article 1 Section 10 of the constitution). These notes were wildly different in their reliability and value; it depended solely on how strong the issuing bank was. The NBA and LTA established a national currency that the US government backed with reserves of gold bullion (the gold standard).

So, in 1846, the Polk administration started the change to a national system, eventually culminating in the passage of the NBA where a system of national banks was set up, all of them backed by the new national currency—commonly known as greenbacks. Banks were required by Gresham's law to honor other bank notes at par value, effectively forced to transition to the new currency (if they had not done so already) and to back up their notes with Treasury securities. That increased the general liquidity greatly. Hamilton would have been pleased.

It also had problems. Securities could fluctuate in value because the Treasury used Gresham's law as a way to also control monetary policy. While there was gold bullion, securities were released and held for policy reasons, effectively constraining markets for political reasons. Secondly, the system of banks borrowing from banks caused problems too. Small rural banks that needed currency during planting season drained reserves of large urban banks in seasonal cycles.

Some of these factors led to the Panic of 1907. The NYSE fell more than 50%. Of course rabid speculation on different unregulated markets also greatly exacerbated the Panic when the bottom fell out on those (do I even have to say it?). Basically big trusts and banks went bankrupt over the failure of a speculative insider bid to take over the United Copper Company. People panicked at the uncertainty created and tried to withdraw their assets from banks and trusts associated with the failed attempt. This constricted banks in their liquidity and forced many to default on their obligations.

The government was powerless to stop the downward spiral. There was no central bank to inject money into the system nor was there an adequate fiscal policy available to restore confidence. J.P. Morgan pledged a ton of his personal wealth to shoring up banks. He also convinced a bunch of other rich guys to do the same (very Warren Buffet/bank bailout of Mr. Morgan).

Obviously the government really didn't want that happening again. It had led to the collapse of many small banks, the amalgamation of Tennessee Coal, Iron, and Railroad Company with US Steel (J.P. Morgan's company), and a drastic failure of markets to right themselves (yeah, I know right).

Enter the Federal Reserve. Until the Federal Reserve Act of 1913, banks borrowed from banks and relied on a complex pyramidal system of loans to do business. When the Treasuries securities lost or gained value, the pyramid would skew wildly, tipping and nearly collapsing on several occasions. It took nearly seven years for a non-partisan commission to come up with and finally pass the Federal Reserve Act (Glass-Owen Act). The Federal Reserve Board of Governors is a seven member board appointed by the president and approved by the Senate. They are mostly left to their own devices, controlling monetary policy in America as they see would cause the most benefit. They are the men and women behind the curtain; they can drastically change how an economy will grow and develop using the instruments at their disposal. Their policies have been attributed to the bubble of the 1920s, much of the growth of the 1950s, stagflation in the 1970s, and much more. They are supposed to be non-partisan, but to believe that would be foolish. They try their best to stay non-partisan but their personal beliefs about how the system operates heavily influences the policy routes they choose.

In the 1950s the Fed expanded its power to its modern times, asserting its autonomy (past appointments of course) and reaching a deal with the Treasury as to how their duties would be split. This solidified the Fed as a centralized banking system for the US.

In the 1960s, America, under Nixon's presidency, left the gold standard and sent our currency into a free-floating system. This works pretty well as long as the big international governments remain on good terms and fairly stable, but huge economic shocks can create imbalances (this has been happening in miniature with the Canadian dollar, the Euro, and the Chinese Yuan). Countries still keep large reserves of gold to hedge their bets but use the US dollar—and more recently the Euro—as the reserve currency; a standard against their own currency.

In a more modern and less international context this all comes back to Mr. Hamilton. The advocate for a strong central bank, largely independent of the government, in control of the monetary policy of the US was all his idea. He argued aggressively that the free market was an unwieldy one subject to the greed and prejudices of those in control of it. He favored using the government and a strong intervening force as ways to control the wild fluctuations and corruption that he saw inherent to an unregulated system.

No matter how 'free market' a person may be, the market was conceived of by Hamilton as being firmly under control by a democratic people.