An Analysis of the Factors Surrounding the First Bank of the United States

The first case of the use of paper money in the colonies came from a series of events that unfolded in the colony of Massachusetts. Colonial Massachusetts had often times plundered the French colonies of Canada for wealth and commodities. Usually the expeditions were successful in bringing back significant returns, but one of the expeditions returned unfruitful. As a result the soldiers demanded compensation from the Massachusetts government. The colony attempted to borrow funds from local merchants, but it did not have a sufficient credit rating and thus, acquired little borrowed funds to finance the debt. The Massachusetts government proceeded to print up paper money and give it to the soldiers. Fearing that their paper money would not be accepted to pay off the outstanding debt, the colony promised to pay the debt in full at a later date with tax revenue. The soldiers accepted the paper money, but it was not until forty years later that Massachusetts attempted to redeem only a fraction of its initial promise.

Then in 1691, Massachusetts proceeded, once again, to print up large amounts of paper notes to pay off its outstanding debt. The market quickly devalued the newly issued paper money to forty percent of its declared value. As a response, the colony declared the paper certificates as legal tender; as a result all individuals would have to accept it to pay off any debts. Soon after, a larger number of Spanish silver dollars began to move out of the colony due to a phenomenon known as Gresham's law. Consequently, nearby colonies followed suit with their own paper currency. The colonies then began to inflate the amount of paper currency in the economy to finance the French and Indian War and any other debts the colonies had incurred. As a result, inflation was rampant and soon the schilling depreciated over eighty percent versus silver specie. The effects of these inflationary tactics by the governments led to the familiar boom and bust cycles. A boom present soon after the introduction of newly issued paper currency into the market and a bust when the money supply would contract. In 1751, the British government demanded that all American colonies halt the issue of supposedly redeemable paper currency and return to a market of totally gold and silver coinage. After a rough transition period, the market began a much more prosperous trend and stimulated the export markets of the colonies.

After the American Revolutionary War, the states had accumulated a significant amount of debt from the conflict. Some states, like Virginia, were quite conservative in their spending habits during the war and were firmly against the acquisition of the wartime debt by the Federal Government. The Federal Government taking responsibility for the debt on behalf of the states signified, for example, that Virginians would have to pay off some of the bill of other member states and vice-versa. This was a real problem for the states that spent very little during the war, for they would have to be paying for the debt of other states, expenditures they were not involved in. The newly ratified Constitution of the United States allowed the Federal Government to acquire the debts of the states and use differing methods in order to pay off the debt. Taxation and tariffs were common methods of generating government funding but what was often overlooked was the establishment of a central bank that could inflate the currency supply in order to fund government expenditures.

Alexander Hamilton, Secretary of Treasury under President Washington, was the main proponent of a central bank that could not only pay off the accumulated debt of the states but also spur economic growth by handing credit over to businesses at cheap rates of interest. Monetary inflation allows the central bank to give money, through loans and credit transactions, to individuals that desire these loans. This increase in the outstanding quantity of loanable funds pushes the market rate of interest below the natural rate of interest. The natural rate of interest is the interest rate existent before the artificial inflation of the money supply. Through the inflation of credit, business ventures that would have not seemed profitable before the fall in the rate of interest now seem profitable and that way the economy is spurred by increased yields. Therefore, Hamilton believed that you could use the central bank to accomplish multiple tasks and through paying off the national debt, the economy could be allowed to enjoy increased yields. In addition to allowing businesses “easy money” to initiate what would have otherwise been risky ventures, the government could directly fund investment opportunities and finance various government programs. In this manner infrastructure could be simpler to fund and any government expenditures could be easily paid for.

This proposed central bank would still use gold and silver specie to back up the bank notes but the notes would be more “elastic.” Money would be more readily available in case of a bank run and for investment opportunities. All notes would still be backed 100% by gold or silver specie, this would allow for an objective check on the amount of bank notes the central bank could inflate. These inflated notes, of course, would be deemed legal tender and would be payable for all debts public or private. This was necessary because it was a coercive measure in order to induce individuals to accept these notes versus simply accepting the notes of private banks or simply gold or silver specie.
Hamilton often times tried to persuade President Washington into signing a bill allowing the establishment of a central bank. Thomas Jefferson, who was then Secretary of State under President Washington, advised President Washington to turn down the establishment of any central bank for it would stagnate the economy and allow the Federal Government to instantly receive funding in order to expand its boundaries, something the Anti-Federalists constantly feared. The national media mainly consisted of Anti-Federalist supporters and printed various articles with opinions opposed to central banking. With both Thomas Jefferson and a large portion of the media against him, Hamilton pleaded to President Washington to endorse and sign a bill establishing a central bank. President Washington, after reading a detailed opinion by Hamilton on the subject, accepted, and with Congress, established the First Bank of the United States in 1791.

The Jeffersonian position on the existence of the First Bank of the United States is a very important one and an argument that gives much insight into the early politics of Federal finance. The Anti-Federalists at the signing of the Constitution had many doubts as to the workings of the new document and the possibility that the wording would be skewed in favor of a more oppressive government. In order to curb any absurd growth of government, the Anti-Federalists demanded that their be a Bill of Rights instituted into the document to insure that certain inalienable liberties were protected. That said, there was much in the Constitution already that could give the Federal government leeway and abilities unforeseen by the Anti-Federalists. Thomas Jefferson opposed the First Bank of the United States as an entity destructive to property rights and that its constitutionality was ill-founded. The First Bank of the United States was approved on the premise that the Constitution allows for the coining of money and the regulation of its value. By this measure, the First Bank of the United States was instituted but this seemed to be a large step outside of Constitutional bounds. For instance, the power to coin was given to Congress and was not a power that Congress could transfer to a quasi-private entity, such as in the case of the First Bank of the United States.

In addition, Article 1 Section 8 of the Constitution states that “the Congress shall have the power to coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measure.” This idea of “weight and measure” and “the value thereof” refers to the common practice, in that era, of bimetallism in which different metal monies such as gold and silver had fixed exchange rates against one another. Also, the act of coinage is simply the branding of quality of a coin and not the creation of fiat money or credit out-of-thin-air. In all reality, Congress was simply given the right to take part in bimetallism and fix the exchange rate of metallic currencies, not create paper money without an increase in specie reserves. Timberlake states that “this stipulation presumed a simple, self-adjusting specie standard, and it limited the power of Congress to setting the legal tender value of monetary metal” and that the Constituion emphasizes “the exclusive legal tender properties of the precious metals.” In addition, the Jeffersonians attacked the institution of fiat money on principle. This attack on fiat money had to do with the fact that an inflation of the money supply via fiat money devalues the coins on the market and transfers purchasing power from one person to another. Jefferson and the Anti-Federalists understood that hen government inflates the money supply it was systematically taking money from society and giving it to whoever received the additional credit or fiat money. In essence, fiat money is a system in which government can transfer wealth either to itself or to select individuals. Gregory Christainsen is in agreement and states that “the Founding Fathers did not give the U.S. Government the legal authority to issue fiat money” on the basis that the coinage of money and the regulation of value does not signify the creation of money but instead the minting of coins. That said, Jefferson, during his presidency, made no moves against the First Bank of the United States mostly due to his Treasury Secretary Albert Gallatin who “thought the Bank convenient for the management of government finances.” Though the Jeffersonians where fundamentally against a fiat money issuing banking system, when the time came, few did anything about it.

The First Bank was to reign for twenty years and was given monopoly privilege to release banknotes and credit to the populace. The First Bank inflated on two million dollars in specie. By 1796, the First Bank lent to the public in excess of $6.2 million and had printed notes to pay off any outstanding debts the government had incurred. During the inflationary period, prices rose 72 percent in wholesale markets and by 1796, the First Bank had grown to 18 branches.

Jeffersonians argued that there was no constitutional right that allowed the Federal government to print and distribute paper money. The Federalists on the other hand, predominately Hamilton, argued that the constitution implied that those powers could be used. Before the First Bank's expiration in 1811, the Democratic-Republicans failed to seriously promote a rejection of the First Bank's rechartering; this was mostly due to the presence of Federalist sympathizers within the Democratic - Republican Party. The number of First Bank branches rose from 28 in 1800 to 117 in 1811. In 1804, the banking institutions had inflated twice over specie and were causing turmoil within the economic structure of the United States. The First Bank of the United States had a pyramid ratio of 2.57 to 1; over a two-fold increase on the amount of specie available to the United States Treasury. When the date came for rechartering, the bill was rejected by a slim one-vote margin both in the House of Representatives and the United States Senate. There were many attempts to reestablish the First Bank of the United States including a petition by 150 New York citizens that made its way to the United States Federal House of Representatives Ways and Means Committee.

It is the opinion of the author that inflation, in artificial forms (i.e. forms that do not evolve the laboring for money such as mining for precious metals), has a negative effect on the economy. For certain reasons, individuals could easily argue that inflation is an unethical act- as the Anti-Federalists did- but instead what will be analyzed are the physical effects on the economy with respect to an inflation of the money supply. It is only through proper banking and free markets that prosperity and the production of wealth can take place. Once government gets involved in the market there is always a distortion. This is evident in the use of central banking as a method of spurring economic growth and creating wealth. When there is an inflation of the money supply there is a transfer of wealth that occurs from one group to another. Inflation, through an increase in the supply of loanable funds, signals entrepreneurs of higher order goods- those goods farthest away from consumer’s goods- to produce more capital than desired by the market. Additional artificial credit signals economic actors to engage in production processes that will not turn out profitable due to the existence of the social rate of time preference. Whenever the government uses an inflation of the money supply to bring down the market rate of interest below the natural rate of interest, it creates a misallocation of resources that winds up in a boom and bust cycle.
This fall in the market rate of interest wrongly signals entrepreneurs to be more “future-oriented” and produced with a more long-term strategy in mind. These production processes soon fail as the rate of interest is bid up by the market closer to the natural rate of interest. In an effort to keep the market rate of interest down the banking system can either continue inflation (risking hyperinflation ) or it can cease the creation of new money and allow a depression to reset the economy. It is money and credit that lend to an explanation of the business cycle and it is by following the "money trail," so to speak, that von Mises and von Hayek were able to structure the Austrian theory of the business cycle.

In summation, the establishment of the First Bank of the United States seems to have tested the political workings of the early United States republic. It came quite promptly after the establishment of the Constitution and as the brain-child of Alexander Hamilton. There were many problems present with the First Bank of the United States, both practically and ideologically, but in time it was eventually dismantled by a slim margin on the part of Jeffersonian Democrats. Probably the most interesting part of this paper was analyzing the Jeffersonian position and the lack of initiative Jefferson made during his presidency to disband the First Bank of the United States. That said, the Anti-Federalists were well aware as to the dangers of inflationary money and believed it to be a negative source of finance for the government. The Federalists saw it as an efficient way to finance the Federal system and spur economic growth within the country. In the end it seems that the Federalists have won the battle but only time can tell if fiat money, with its boom and bust cycles, will continue to reign in the financial markets of the United States.

Works Cited

1. Bradford, Frederick A. Money and Banking. Longmans, Green, & Co., 1935.
2. Christainsen, Gregory B. Constitutional and Ideological Influences on State Action: The Case of the First Bank of the United States. George Mason University Press, 1995.
3. Cowen, David J. The Origins and Economic Impact of the First Bank of the United States, 1791-1797. Garland Publishing, 2000.
4. Dowrie, George W. Money and Banking. John Wiley & Sons, Inc., 1936.
5. Groseclose, Elgin. Man and Money. University of Oklahoma Press, 1977.
6. Rothbard, Murray N. A History of Money and Banking in the United States. The Ludwig von Mises Institute, 2005.
7. Timberlake, Richard H. Monetary Policy in the United States. University of Chicago Press, 1993.
8. von Hayek, Friedrich. Prices and Production. George Routledge & Sons, Ltd., 1935.