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A Free Market Central Bank: Suffolk Bank

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May 01, 2012 – Comments (1)

I'm going to do something different here. This is one section of Murray Rothbard's "A History of Money and Banking in the United States: The Colonial Era to World War II".   

My main motivation for doing this is two fold. First, I have the itch to write but not the time to craft anything original or interesting. Second, I think American banking history is probably the least understood area of economic history among the American public, the casual investor, the serious investor, and even the primmed Ivy League economist.

I hope reprinting this section will inspire you to pick up a copy (it's free here) and breeze through some more sections, and perhaps the entire book.  I promise it will greatly widen your knowledge of American banking history and explode many fallacies about how/why our current system came into being.

Most people know the Federal Reserve was created in 1913.  That's the extent on what is agreed upon and understood by the wider section of the population that cares about economics.  Many claim it was created in response to the Panic of 1907.  That explanation is so common, Fed apologists toss it out as if it settles any debate.  However, that's only superficially true. The drive to create a new central bank started as early as 1896, in response to William Jennings Byran's stunning upset at the Democratic Convention.  Or it perhaps can be said that it started as early as the Civil War, when Republicans (strongly in favor of a centralized power) began work on the National Banking System. 

And of course, the Federal Reserve was not the first central bank in American history.  Twice before, America had flirted with central banking, with the First and Second Banks of the United States.  And we can't leave out the Bank of North America, founded in 1781, which acted as a quasi central bank with the express purpose of increasing the public debt for its founder's profit, Robert Morris. In fact, we could all the way back to the Revolution, when Morris mentored young Alexander Hamilton on the brilliance of public finance (which would help line Morris' pockets, of course.)

Finally, how many of our friends are aware that for 30+ years a private bank called would act as a central bank to great profit and as a check on the inflationary impulses of wildcat country banks before the Civil War?  

It seems that the entire history of American banking is shrouded in more secrecy than the minutes of a Federal Reserve Board meeting.  Let's rip down the carpet and see this Oz in all its rich, and often sordid, history.

Enjoy this section on America's one and only free market central bank and pick up the book when you have some free time.

David in Liberty

excerpted from History of Money and Banking in the United States: Colonial Era to World War II by Murray N. Rothbard, reprinted with permission of the Ludwig Von Mises Institute

A Free Market "Central Bank"

It is a fact, almost never recalled, that there once existed an American private bank that brought order and convenience to a myriad of privately issued bank notes. Further, this Suffolk Bank restrained the overissuance of these notes. In short, it was a private central bank that kept the other banks honest. As such, it made New England an island of monetary stability in an America contending with currency chaos.

Chaos was, in fact, that condition in which New England found herself just before the Suffolk Bank was established. There was a myriad of bank notes circulating in the area’s largest financial center, Boston. Some were issued by Boston banks which all in Boston knew to be solvent. But others were issued by state-chartered banks. These could be quite far away, and in those days such distance impeded both general knowledge about their solvency and easy access in bringing the banks’ notes in for redemption into gold or silver. Thus, while at the beginning these country notes were accepted in Boston at par value, this just encouraged some faraway banks to issue far more notes than they had gold to back them. So country bank
notes began to be generally traded at discounts to par, of from 1 percent to 5 percent.

City banks finally refused to accept country bank notes altogether. This gave rise to the money brokers mentioned earlier in this chapter. But it also caused hardship for Boston merchants, who had to accept country notes whose real value they could not be certain of. When they exchanged the notes with the brokers, they ended up assuming the full cost of discounting the bills they had accepted at par.

A FALSE START

Matters began to change in 1814. The New England Bank of Boston announced it too would go into the money broker business, accepting country notes from holders and turning them over to the issuing bank for redemption. The note holders, though, still had to pay the cost. In 1818, a group of prominent merchants formed the Suffolk Bank to do the same thing. This enlarged competition brought the basic rate of country-note discount down from 3 percent in 1814 to 1 percent in 1818 and finally to a bare one-half of 1 percent in 1820. But this did not necessarily mean that country banks were behaving more responsibly in their note creation. By the end of 1820 the business had become clearly unprofitable, and both banks stopped competing with the private money brokers. The Suffolk became just another Boston bank.

OPERATION BEGINS

During the next several years city banks found their notes representing an ever smaller part of the total New England oney supply. Country banks were simply issuing far more notes in proportion to their capital (that is, gold and silver) than were the Boston banks.

Concerned about this influx of paper money of lesser worth, both Suffolk Bank and New England Bank began again in 1824 to purchase country notes. But this time they did so not to make a profit on redemption, but simply to reduce the number of country notes in circulation in Boston. They had the foolish hope that this would increase the use of their (better) notes, thus increasing their own loans and profits.

But the more they purchased country notes, the more notes of even worse quality (particularly from faraway Maine banks) would replace them. Buying these latter involved more risk, so the Suffolk proposed to six other city banks a joint fund to purchase and send these notes back to the issuing bank for redemption. These seven banks, known as the Associated Banks, raised $300,000 for this purpose. With the Suffolk acting as agent and buying country notes from the other six, operations began March 24, 1824. The volume of country notes bought in this way increased greatly, to $2 million per month by the end of 1825. By then, Suffolk felt strong enough to go it alone. Further, it now had the leverage to pressure country banks into depositing gold and silver with the Suffolk, to make note redemption easier. By 1838, almost all banks in New England did so, and were redeeming their notes through the Suffolk Bank.

The Suffolk ground rules from beginning (1825) to end (1858) were as follows: Each country bank had to maintain a permanent deposit of specie of at least $2,000 for the smallest bank, plus enough to redeem all its notes that Suffolk received. These gold and silver deposits did not have to be at Suffolk, as long as they were at some place convenient to Suffolk, so that the notes would not have to be sent home for redemption. But in practice, nearly all reserves were at Suffolk. (City banks had only to deposit a fixed amount, which decreased to $5,000 by 1835.) No nterest was paid on any of these deposits. But, in exchange, the Suffolk began performing an invaluable service: It agreed to accept at par all the notes it received as deposits from other New England banks in the system, and credit the depositor banks’ accounts on the following day.

With the Suffolk acting as a “clearing bank,” accepting, sorting, and crediting bank notes, it was now possible for any New England bank to accept the notes of any other bank, however far away, and at face value. This drastically cut down on the time and inconvenience of applying to each bank separately for specie redemption. Moreover, the certainty spread that the notes of the Suffolk member banks would be valued at par: It spread at first among other bankers and then to the general public.

THE COUNTRY BANKS RESIST

How did the inflationist country banks react to this? Not very well, for as one could see the Suffolk system put limits on the amount of notes they could issue. They resented par redemption and detested systematic specie redemption because that forced them to stay honest. But country banks knew that any bank that did not play by the rules would be shunned by the banks that did (or at least see its notes accepted
only at discount, and not in a very wide area, at that). All legal means to stop Suffolk failed: The Massachusetts Supreme Court upheld in 1827 Suffolk’s right to demand gold or silver for country bank notes, and the state legislature refused to charter a clearing bank run by country banks, probably rightly assuming that these banks would run much less strict operations. Stung by these setbacks, the country banks played by the rules, bided their time, and awaited their revenge.

SUFFOLK'S STABILIZING EFFECTS

Even though Suffolk’s initial objective had been to increase the circulation of city banks, this did not happen. In fact, by having their notes redeemed at par, country banks gained a new respectability. This came, naturally, at the expense of the number of notes issued by the worst former inflationists. But at least in Massachusetts, the percentage of city bank notes in circulation fell from 48.5 percent in 1826 to 35.8 percent in 1833.

The biggest, most powerful weapon Suffolk had to keep stability was the power to grant membership into the system. It accepted only banks whose notes were sound. While Suffolk could not prevent a bad bank from inflating, denying it membership ensured that the notes would not enjoy wide circulation. And the member banks that were mismanaged could be stricken from the list of Suffolk-approved New England banks in good standing. This caused an offending bank’s notes to trade at a discount at once, even though the bank itself might be still redeeming its notes in specie.

In another way, Suffolk exercised a stabilizing influence on the New England economy. It controlled the use of overdrafts in the system. When a member bank needed money, it could apply for an overdraft, that is, a portion of the excess reserves in the banking system. If Suffolk decided that a member bank’s loan policy was not conservative enough, it could refuse to sanction that bank’s application to borrow reserves at Suffolk. The denial of overdrafts to profligate banks thus forced those banks to keep their assets more liquid. (Few government central banks today have succeeded in that.) This is all the more remarkable when one considers that Suffolk—or any central bank—could have earned extra interest income by issuing overdrafts irresponsibly.

But Dr. George Trivoli, whose excellent monograph, The Suffolk Bank, we rely on in this study, states that by providing stability to the New England banking system, “it should not be inferred that the Suffolk bank was operating purely as public benefactor.” Suffolk, in fact, made handsome profits. At its peak in 1858, the last year of existence, it was redeeming $400 million in notes, with a total annual salary cost of only $40,000. The healthy profits were derived primarily from loaning out those reserve deposits which Suffolk itself, remember, did not pay interest on. These amounted to more than $1 million in 1858. The interest charged on overdrafts augmented that. Not surprisingly, Suffolk stock was the highest priced bank stock in Boston, and by 1850, regular dividends were 10 percent.

THE SUFFOLK DIFFERENCE

That the Suffolk system was able to provide note redemption much more cheaply than the U.S. government was stated by a U.S. comptroller of the currency. John Jay Knox compared the two systems from a vantage point of half a century:

"[I]n 1857 the redemption of notes by the Suffolk Bank was almost $400,000,000 as against $137,697,696, in 1875, the highest amount ever reported under the National banking system. The redemptions in 1898 were only $66,683,476, at a cost of $1.29 per thousand. The cost of redemption under the Suffolk system was ten cents per $1,000, which does not appear to include transportation. If this item is deducted from the cost of redeeming National bank notes, it would reduce it to about ninety-four cents. This difference is accounted for by the relatively small amount of redemptions by the Treasury, and the increased expense incident to the necessity of official checks by the Government, and by the higher salaries paid. But allowing for these differences, the fact is established that private enterprise could be entrusted with the work of redeeming the circulating notes of the banks, and it could thus be done as safely and much more economically than the same service can be performed by the Government." - John Jay Knox, A History of Banking in the United States (New York: Augustus M. Kelley, [1900] 1969), pp. 368–69.)

Bank capital, note circulation, and deposits, considered together as “banking power,” grew in New England on a per capita basis much faster than in any other region of the country from 1803 to 1850. And there is some evidence that New England banks were not as susceptible to disaster during the several banking panics during that time. In the panic of 1837, not one Connecticut bank failed, nor did any suspend specie
payments. All remained in the Suffolk system. And when in 1857 specie payment was suspended in Maine, all but three banks remained in business. As the Bank Commission of Maine stated,

"The Suffolk system, though not recognized in banking law, has proved to be a great safeguard to the public; whatever objections may exist to the system in theory, its practical operation is to keep the circulation of our banks within the bounds of safety."

THE SUFFOLK'S DEMISE

The extraordinary profits—and power—that the Suffolk had by 1858 attained spawned competitors. The only one to become established was the Bank for Mutual Redemption in 1858. This bank was partially a response to the somewhat arrogant behavior of the Suffolk by this time, after 35 years of unprecedented success. But further, and more important, the balance of power in the state legislature had shifted outside of Boston, to the country bank areas. The politicians were more amenable to the desires of the overexpanding country banks. Still, it must be said that Suffolk acted toward the Bank of Mutual Redemption with spite where conciliation would have helped. Trying to force Mutual Redemption out of business, Suffolk, starting October 8, 1858, refused to honor notes of banks having deposits in the newcomer. Further, Suffolk in effect threatened any bank withdrawing deposits from it. But country banks rallied to the newcomer, and on October 16, Suffolk announced that it would stop clearing any country bank notes, thus becoming just another bank.

Only the Bank for Mutual Redemption was left, and though it soon had half the New England banks as members, it was much more lax toward overissuance by country banks. Perhaps the Suffolk would have returned amid dissatisfaction with its successor, but in 1861, just over two years after Suffolk stopped
clearing, the Civil War began and all specie payments were stopped. As a final nail in the coffin, the national banking system Act of 1863 forbade the issuance of any state bank notes, giving a monopoly to the government that has continued ever since.

Read History of Money and Banking in the United States free here.

1 Comments – Post Your Own

#1) On May 02, 2012 at 1:36 PM, Jbay76 (< 20) wrote:

nice read, thanks!

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