Question

The assigned reading from Calomiris and Haber’s book Fragile by Design, they make the argument that our financial system is fractured and inherently unstable, particularly compared to Canada’s relatively stable financial system. What is the basis of their argument? In other words, why is the U.S. financial system as unstable as it is. Note that the assigned reading only covers the period up to the Civil War, so what I’m asking about here is the roots of the instability. I’m not at this point asking about anything that happens after 1860, though we certainly will cover that time period in future modules.  

Answer 1

From the establishment of the First Bank of the United States in 1791 to the National Banking Act of 1863, banking regulation in America was an experimental mix of federal and state legislation. The regulation was motivated, on the one hand, by the need for increased centralized control to maintain stability in finance and, by extension, the overall economy. While on the other hand, it was motivated by the fear of too much control being concentrated in too few hands.

Despite bringing a relative degree of financial and economic stability, the First Bank of the United States was opposed to being unconstitutional, with many fearing that it relegated undue powers to the federal government. Consequently, its charter was not renewed in 1811. With the government turning to state banks to finance the War of 1812 and the significant over-expansion of credit that followed, it became increasingly apparent that financial order needed to be reinstated. In 1816, the Second Bank of the United States would receive a charter, but it too would later succumb to political fears over the amount of control it gave the federal government and was dissolved in 1836.

Not only at the federal level, but also at the level of state banking, obtaining an official legislative charter was highly political. Far from being granted on the basis of proven competence in financial matters, successful acquisition of a charter depended more on political affiliations, and bribing the legislature was commonplace. By the time of the dissolution of the Second Bank, there was a growing sense of a need to escape the politically corrupt nature of legislative chartering. A new era of “free banking” emerged with a number of states passing laws in 1837 that abolished the requirement to obtain an officially legislated charter to operate a bank. By 1860, a majority of states had issued such laws.

In this environment of free banking, anyone could operate a bank on the condition, among others, that all notes issued were back by proper security. While this condition served to reinforce the credibility of note issuance, it did not guarantee immediate redemption in specie (gold or silver), which would serve to be a crucial point. The era of free banking suffered from financial instability with several banking crises occurring, and it made for a disorderly currency characterized by thousands of different banknotes circulating at varying discount rates. It is this instability and disorder that would renew the call for more regulation and central oversight in the 1860s.