The Fed Has Robbed Us Of a Vibrant Private Banking System

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The evolution of currency and banking out of the nineteenth century provides more than a limited glimpse into the concepts and philosophies that we struggle with still. At the outset of the 1800's, the economic foundation in monetary terms was built upon specie, true hard money. To obtain goods and services meant an exchange of property - property in money for property in goods (or services). There were (and are) obvious drawbacks to a system totally dedicated to property, but legal clarity is not one of them.

The evolution of banking had fast appeal on American commerce, so much so that by the middle of the nineteenth century the total of demand balances (deposits) were greater than those of actual specie (gold or silver). That increasingly led to the use of drafts as a form of intermediary payment. Instead of property to property transfers, the system took on this heavier element of finance. Drafts, as with currency, are derivatives and thus subject to different standards and legal classifications and systems.

As the century progressed, drafts themselves became increasingly subverted by the introduction of checking. Once again, it was convenience that drove the penetration of this kind of finance. There is a distinct advantage to being able to place "funds" in a relatively safe bank and then not having to visit the counter every time you wished to engage in commerce. Instead of carrying gold and silver coin all the time, one might instead use paper transfers of gold and silver coin (and eventually transfers of nothing more than currency).

But not all checking was universally accepted or acceptable. Distance proved to be the clearest and severe impediment, closely connected with the pace of communications technology to breach geography. If you received a check drawn on a local bank, payment was easy and without cost. If, however, you ended up with an out of town or out of district draft or check, there were still significant hurdles for you and the bank to receive payment.

In the earliest days of drafts and bank notes, such distance led to discounting. The further you traveled from the paying bank, the greater the discount applied to the draft. Since banks were very much disposed to increasing the checking business, for nothing else other than it permitted greater fractional lending (deposits were more stable), solving the discounting was a primary goal. What developed across the 1800's was a private network of clearing systems, and some that were quite well advanced and adapted.

The Suffolk System in Boston that acted as both a tradegroup network for clearing drafts inside the city, and as a correspondent entity with banks further out in the Massachusetts and New England hinterland. Country bank members would create and hold deposit balances of their own with the Suffolk Bank (or designated member) in which to clear any check that made their way into Boston. The benefits of being a member meant that checks presented by country agents in Boston, where significant trade was carried out, were paid at par (or nearly so). For the check writer, or draftee, it meant that they did not have to open and maintain an account with a Boston city bank in order to gain favorable commercial pricing. For the country banks, then, they could retain more deposits locally regardless of the regional trade structure.

There is, of course, more than trivial liability to the banks running the clearing system. Since they would pay out of their own accounts any drafts or checks presented by country banks, they had a vested interest in trying to assure eventual payment by those same country banks. While deposit balances were instructive about such ability, they were by no means comprehensive. As such, the Suffolk system operated as a systemic regulator, often threatening to eject any bank that conducted itself recklessly (however the system defined it). Removal from the clearing network amounted to near suicide, so country banks (and city members too) were enforced of a very real kind of prudence.

This kind of arrangement became commonplace throughout the United States. Country banks in far-flung locations without the ability to pay drafts or checks at par entered correspondent relationships with city banks. Those city banks, in turn, formed their own networks to function as a de facto national clearing system. Over the course of the century, discounts on drafts, and then mostly checks, fell precipitously, but were never fully erased.

What was also clear entering the first decade of the 20th century was that this organic and dispersed network of loose affiliations fed into a vast and growing interbank market. Country banks maintained deposit balances with their correspondent city banks, who in turn maintained deposit balances with other correspondent banks or clearing networks, with all of it designed to placate depositors with relatively low-cost and pain-free banking. The net result of that was an immense increase in deposit balances, and thus "money" growth - the true aim of any bank or banking system.

As a regulatory matter, given the nature of the interbank market as it related to clearing, correspondent deposit balances were counted as "reserves" for country banks. Certain correspondent banks could also use their correspondent deposits in other places for the same calculation, meaning there was an evident and powerful regulatory leverage applied to this manner of actual banking and finance.

When the Federal Reserve System's creation was being debated, check clearing was not initially believed to be a vital role for the central bank (the system's designers did not want it to be known as a central bank because they knew it would have been rejected as such, and since they were hostile, severely, to public opinion they were careful to make it sound like a private bank rather than government agency). But almost immediately it became clear that the clearing function itself was going to be if not the deciding factor in the successful adoption of the new system, at least a major reason for it.

Under the Federal Reserve Act of 1913, the new reserve requirement would eventually phase out the acceptability of correspondent balances. That meant if a bank joined the Federal Reserve System, it would likely have to transfer all its correspondent deposits to reserve system deposits. This rule was meant to capture as much of the banking system as possible under the agency's discretion and authority. Even with that rule, the new government system would have ended if check clearing had not been added to the list of "services" provided by the Fed banks. If the Fed had not created a parallel clearing system, the cost of maintaining correspondent balances (for check clearing) at the same time as reserve balances with member banks (for satisfying the reserve requirements) would have likely resulted in few actual banks becoming part of the new system.

The first attempt at a Fed clearing system, the voluntary reciprocal plan of March 1915, was a straight failure. Only about a third of member banks signed up for it, meaning that a tremendous aggregation of deposits remained outside the Federal Reserve System in previous correspondent relationships. Part of the reason for that had to do with the charging of transaction fees, particularly at the thousands and thousands of country banks that served the still-relatively rural national landscape. While these country banks were accepting checks at par inside their correspondent networks, the fees they gained offset the costs of doing so.

From the perspective of the country banks, then, the voluntary reciprocal plan meant doing what the country banks largely did anyway, accept checks at par, only now without the offset of revenue. In light of that cost-benefit analysis, the Fed did what any government agency had come to do in the Progressive Era - outlawed the fees entirely.

Circular No. 1, Series of 1916 was basically an act of government coercion against bank clearing competition. By requiring all member banks to pay par and disallowing any fees for the service, the costs of running the check clearing business were shifted to the Federal Reserve System itself. In other words, the Fed as government agency subsidized the Fed's own clearing service at the expense of the privately run system. The reason for that was just as clear - ensure the elimination of the private system so that deposits, the vast interbank network, transitioned inside the new regulatory structure.

The country banks did not go down without a fight. The next almost decade was spent navigating among several groups of litigation. The most decisive was Farmers & Merchants Bank of Monroe, North Carolina vs. Federal Reserve Bank of Richmond, Virginia. The Legislature of North Carolina under Section 2 of Chapter 20, Public Laws of 1921, entitled "an act to promote the solvency of state banks", voided the Federal Reserve's prohibition on transaction fees.

"That in order to prevent accumulation of unnecessary amounts of currency in the vaults of the banks and trust companies chartered by this state, all checks drawn on said banks and trust companies shall, unless specified on the face thereof to the contrary by the maker or makers thereof, be payable at the option of the drawee bank, in exchange drawn on the reserve deposits of said drawee bank when any such check is presented by or through any Federal Reserve Bank, post office, or express company, or any respective agents thereof."

The language used in the act, quoted above, was made necessary, in the eyes of the smaller banks, because Federal Reserve member banks had begun rather extortive tactics to "convince" country banks to give up and join. Reserve banks would accumulate checks for presentation and then travel to the country bank in question (or hire local agents) to present them "over the counter" for currency rather than the far preferable and customary debit of the correspondent deposit account. The country banks rightly, in my opinion, resisted such extraordinary tactics since they represented a very real threat to ongoing business outside the Federal Reserve System.

The Farmers v. Federal Reserve case was argued before the Supreme Court at the end of April 1923, with the decision handed down in early June of that year, upholding the North Carolina law. The Court denied the Federal Reserve's ironic specification that North Carolina had violated the federal Constitution, Art. I, § 10, cl. 1 prohibition against mandating anything other than gold or silver in payment of debts. The Fed's arguments that North Carolina had violated its right to due process and equal protection under the federal Constitution were also rejected by the Court.

Furthermore, the Court found that Congress never "imposed" upon the Federal Reserve a duty to create a national and "universal system of par clearance and collection of checks." The prohibition against the charge of transaction fees by nonmember banks amounted to a bill of attainder against them.

Bills or acts of attainder are so abhorrent to the American conscious that they are specifically prohibited in two sections of Article 1 of the Constitution: Section 9 Limits on Congress and Section 10 Limits on the States.

The Federal Reserve did not, however, give up on its efforts despite such a judicial rebuke. The Fed clearing system continued to give favored monopoly status to Reserve banks in other ways in order to softly "coerce" subjugation under the Board's regulatory authority. Presentment time differentials, for example, remain where private banks are forced to present by 8am to obtain same-day funds while Reserve Banks are afforded an extra six hours, until 2pm. That isn't a large barrier in this current age, but it was not inconsequential particularly in the earlier decades of building the Federal Reserve System.

And by 1923, the damage to the private system had been done. The legal uncertainty and costs of remaining outside the Federal Reserve membership, in both transaction clearing at par and reserve requirements after full adoption in November 1918, were simply too great. By the time Farmers v. Federal Reserve had been adjudicated it was by then too late. The collective actions of compulsion against non-member banks had set in motion the unavoidable capture by centralization.

More importantly, though, this attainder behavior persists throughout modern operations. There is certainly a case to be made for undertaking such a course, where the public derives benefit from having the banking system housed within the agency's grasp. But that is simply assumed as true without debate. The Suffolk System evolved nearly a century before the Federal Reserve was created, and correspondent networks grew and transformed without the "aid" of regulatory rigidity. Banks are inherently risky and risk-taking by nature, but there was a great deal of stability to be gained by making them accountable to each other (certainly in light of recent TBTF regimes).

The growth of the interbank market as well as the sheer scale of depository adoption is testament to market acceptance of the private system (this does not mean it was perfect, only that it carried and crafted capabilities that solved problems flexibly enough to attain more than acceptance). The primary counter-argument against this ad hoc clearing arrangement is the same as the economic argument in favor of soft central planning - bank panics. There is nothing that can be offered, in my opinion, which convincingly makes the case that the clearing system and its interbank behavior contributed to the great panics of the latter half of the nineteenth century. Yet, the coercion toward capture of the greater and full share of banking by the Federal Reserve System is justified on exactly that basis. Bank panics were thought to be diminished in frequency and scale by the government arrangement of interbank relationships now directing "elasticity."

That is highly debatable, not the least of which is its obvious failure in the 1920's, leading to the Crash and Great Depression. In the intervening decades, there is also no reason to suspect that a private clearing and banking system would have fared any worse in maintaining a relatively benign financial climate into the 1960's. But where that is mere counterfactual, and thus difficult to assert on anything other than logical conjecture, the period of the late 1960's and 1970's again offers an obvious counterpoint to the benefits of centralizing - the Great Inflation. And, if anyone needs reminding, it continues into the bubble age of the Great "Moderation" and Great Recession (that doesn't ever seem to want to end).

The goal of bringing the banking system under Federal Reserve authority was not just bank panic prevention, though that was the most visible (intentionally) rationalization. The Progressive Age had released into the government apparatus the belief in centralized control - the enlightened Philosopher Kings of ancient Platonic lore. The ends simply justified the means, as attainder was no real impediment, until at least the Supreme Court interfered in this one instance, toward obtaining just those capabilities. The 1920's was, as even Milton Friedman admitted, the first where central banks began to exercise discretion in the name of economic "steering", ignoring the "rules of the game" of the gold standard system through commandeering sterilization. It was inevitably a disaster, as it was again in more recent times.

In the long line of evolution of banking, not in terms of money but in terms of a policy tool, the clearing/attainder episode is starkly and frighteningly emblematic of the preferred approach. The private banking system held out as long as it did precisely because it was never fully accepted that "elasticity" was an enduring answer to panics. It is certainly more complicated than that, but in raw and general terms that has been borne out by history.

Nowhere is that more evident than right now, as we endure the persistent boot of economic mismanagement. By containing private banking, and then corralling it, central planning in the modern age of interest rate targeting was made possible. It was the worst possible arrangement, where banks were accountable (systemically speaking) no longer to each other but to the government in policy that removed all prudence in the name of "aggregate demand." That it contains the stain of coercion in its base incorporation is unsurprising. Government force does not reason, it exercises power through any expression that it can get away with. If it ends up with a disaster and mess, that was never really the point anyway. People really need to take note how all of this evolved, as it was never intended to be a democratic exercise. With the current policy regime, hostility to private markets has never been greater.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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