Jul 2016

Jefferson’s hatred of centralized banks is why the US still uses checks: The US Regulatory Environment Part 2


While, I admit this title is an exaggeration, it’s more true than you will believe.

Following our last US regulatory system post, we’re taking a deeper look at the anti-federalists, and how their influence created a dual banking system and, ironically, a reliance on checks throughout America.

When it comes to Online Payments, US companies still lag far behind Europe and Asia. In 2012, US companies wrote four times as many checks as European companies. That’s 21 billion checks. Writing a check costs approximately five times the price of an online payment. So why does the US still rely so much on checks? It all starts with Thomas Jefferson, and his hatred of centralized banks.

If you read our last post on the US Regulatory system you might remember it mentioning that Jefferson - one of the founding fathers, the principal author of the Declaration of Independence, and the third president of the United States -  had a famous mistrust of banks and borrowing. He saw them as a cause of long-term debt that enslaved people. He thought they increased speculation, driving market instability. He saw them protecting monopolies. And perhaps most importantly, he saw centralized banks as a threat to the sovereignty of democracy.

His distrust of them was so great that in 1799, Jefferson split from Washington over the creation of the first bank, and created the first opposition party, the Democratic-Republicans. Washington would never speak to him again.

Distrust of centralized banks lead to the United States becoming a nation of small banks.

Mistrust of centralized banks wasn’t unique to Jefferson, though. Many in the US opposed the idea. They saw a centralized bank as an overstepping of government's authority - and a violation of the 10th amendment. The result was that the US lacked a central currency until the late 18th century.

Prior to this, the United States was a nation that made wide use of credit. Credit was used for domestic and overseas goods, and promissory notes become a standard for commerce. Early Americans appreciated these for the ability to defer a payment to a more opportune time.

However, currency was a problem for the union, especially leading up to the American revolution.

During the colonial period, many of the states had produced their own currency. These had been volatile, and difficult to exchange. Between 1775 and 1791 the Continental Congress - hoping to finance the American Revolution - would produce their own paper money, known colloquially as “continentals”. 

The First National Bank (and soon after its closure, the second) would be formed, and granted a monopoly on the production of the American currency. These continentals had been easy to counterfeit and were issued in large quantities, creating so much inflation that the phrase “not worth a continental” would become part of the common lexicon. Alexander Hamilton would eventually declare them an embarrassment. 

An explosion of checks - and banks.

By the expiration of the Second Bank of the United States charter in 1841, the US was left with a hole in its banking infrastructure. With a need for new banks to fill the roles previously handled by the national banks, there was substantial wealth and opportunity for capital.

With no central control of banks, some states would legislate single state banks, others no banks at all. In New York, a laissez-faire model known as “free banking” gained attention, and following its success many states would implement the same, creating what is commonly called “the free banking era”.

The “free banking era” lasted from 1836 to 1865 and permitted banks to open with little restriction. During this period each bank was permitted to issue its own currency, letting a free market control the overall supply and quantity of banknotes. While banknotes might keep value in their state, or even in cooperating states, beyond those lines they frequently sold at a steep discount.

By 1860 the US would have nearly 1400 state-chartered private banks issuing over 30,000 different varieties of bank note, creating confusion, counterfeit problems, and a huge jump in the usage of checks. By 1853 the New York Clearing House was established to provide a way for the city’s banks to formally exchange checks.

The free banking era came with costs. Predatory practices and a lack of systems to support failing banks led to a period of boom and bust for banks. In one case, between 1852 and 1854, 80% of Minnesota’s financial institutions would shut down.

The Creation of the the Dual Banking System

To correct the conditions of the free banking era, the federal government implemented the National Bank Acts of 1863-1866. These laws laid out a national currency plan, backed by government securities. It gave the federal government the power to sell war bonds and securities; it taxed banks; and perhaps as important, it created the national banks and the dual banking system of the United States.

The dual banking system is simply the system of banking where both national banks and state banks exist side by side. These national banks were subject to stricter regulation, and had higher capital requirements than state banks, however they were also free of the taxes levied on state banks, including the 10% tax on all bank notes.

While national banks, and the union’s currency flourished, state bank notes almost immediately fell out of circulation. The state banks soon flipped their charters - becoming national banks - or collapsed entirely. 

With limited options for profitably handling cash, state banks turned to an old form of money transfer: the check. From the 1870s to the 1880s check use boomed. It was revitalizing, causing a resurgence of state banks. 

By 1913 there were over 7000 National banks, but by the same time, the new boom in state banks resulted in over 15000 of them.

The effect of this today 

Today the dual banking system spans 8000 banks in the United States, and around that many credit unions. That’s nearly as many banks as all 28 member states of the EU combined. 

This illustrates the difficulty in changing the banking system in the US. The sheer size of the system alone makes it monstrously hard – like changing every bank in every nation of Europe. But add to that the state level controls, and the separation of power between nation and state, and the task seems impossible. You can see why the check, - that old promissory note that had been relied upon by pre-national tradesmen, guided the wealth of a nation through the obscurity of a 30,000 bank notes, and protected the state banks – remains a cornerstone of American corporate finance.

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