A Brief History of Early American Monetary Policy: The Rise and Fall of A Private Solution to A Public Problem

Libertarians love to theorize about how a true free market economy would regulate business sans government. Cynics often write off such conjecture as unrealistic and naïve by claiming libertarian theory has no historical precedent. Detractors assume that in the early history of the United States, there was little government interference in the economy. They point to the many financial panics of the nineteenth century and blame the chronic economic instability on the government’s laissez faire approach towards the issuance of the more than ten thousand types of private banknotes circulating throughout the country. In fact, the financially irresponsible bank behavior that contributed to these panics was indirectly promoted by the policies of President Andrew Jackson.

Detractors of libertarian monetary theory paint an incorrect picture of the early years of the United States and deem our cause hopeless, stopping the debate in its tracks. Here, I hope to show that some historical evidence does suggest that participants in a free market economy could regulate business and that such efforts were rendered ineffective by government interference in the economy.

In the early nineteenth century, the Suffolk Bank of Massachusetts was the ultimate success story of responsible banking. It regulated regional banks by buying up their notes and sending them back for specie redemption, thus forcing the banks to keep permanent reserves. This private solution to a public problem eliminated the uncertainty, risk, and costs created by multiple currencies. Other banks welcomed and encouraged this centralization and the Suffolk was able to curtail the overissue of banknotes and lower the number of bank defaults in the Northeast. They campaigned against counterfeiting by forming the New England Association, which included over half of the banks in New England at its peak. The association created a fund that financed investigations and prosecutions as well as bounties for private agents to make arrests. Their crowning achievement was a massive attack on the counterfeiters’ headquarters in Canada in 1833.

Unfortunately, the New England Association had to suspend specie payments during the Panic of 1837 and gradually fell apart as banks lacked the resources to continue to contribute to the fund. However, their failure rates were much lower than the rates of many regions, when a quarter of all the nation’s banks failed.

What caused the panic? While there were many important international factors, the economic downturn was exacerbated by the policies of President Jackson. He issued an executive order in 1836 to force specie out West in hopes of curbing inflation but actually ending up doing the opposite. His Deposit Act of the same year also had disastrous consequences. While he had the noble goal of dismantling the Second Bank of the United States, his actions were far more indicative of cronyism.

He deposited federal funds in 100 politically motivated pet banks and prevented them from issuing paper money in amounts smaller than $5 in hopes of creating a cash and carry economy. Instead, his efforts hurt laborers who often made less than a dollar a day.

These two policies caused western banks, flushed with funds, to pump credit into the economy. The number of banks doubled in the five years following Jackson’s reelection and rampant land speculation underwrote the wave of bank loans, which increased from $200 million in 1830 to $525 million in 1836. As a result, prices increased while wages stagnated and specie was transferred from the main commercial hubs in the East, forcing Eastern banks to scale back their loans, contributing to the panic.

With horrible timing, the nation’s first free banking laws were passed in Michigan in 1837. Unfortunately, by 1842 all but three of the banks created under these laws failed as a result of market corrections for the inflated real estate prices that had resulted from government-induced speculation through stay laws, which prevented banks from collecting debts.

Most historians don’t even recognize the types of free market regulations exhibited by the New England Association and those that do simply point to its ultimate failure, and the failure of Michigan’s free banking laws, as proof that banks can’t be trusted to operate without government regulation, failing to realize that government regulation actually significantly helped cause their demise. Hopefully, some day historians will learn to look beyond first glance.