Wednesday, April 22, 2009

Two Centuries of American Banking by Elvira and Vladimir Clain-Stefanelli

Book Review by Teresa Friedlander, copyright 2009

It is a fact: the United States is a nation of debtors, both individually and collectively. Recently some of our largest financial institutions have imploded seemingly because of too much debt, but the truth is more complicated. When it appeared our economy was on the verge of collapse, the federal government responded by incurring a staggering amount of debt in order to provide credit (i.e., short-term debt) to businesses, governmental entities, and individuals. Even though progress has been slow, almost to the point of imperceptibility, without that infusion of massive amounts of money, our nation quite likely would have fallen into economic chaos. What that might look like is this: scarcity of food, diapers, gasoline, and electricity leading to rationing and possibly rioting in the streets. So, as unimaginable as the amount of debt we will be leaving to future generations is, at least our country continues to function. Meanwhile we grapple with rising unemployment, falling property values, a failing automobile industry, and reinventing our industrial base.

There is plenty of blame to go around as to why we are in this economic crisis, but probably the most important reason is that banking and investment practices became more about betting that real estate prices would continue to rise than about creating real wealth. At the bottom of the pyramid was the actual real estate, the land and houses. As long as demand for housing continued at a fever pitch, everyone with investments prospered, at least on paper. When suddenly it became hard to sell real estate at hyper-inflated prices, the bottom fell out of the financial house of cards and investments backed by mortgages lost much of their face value. Only a lucky (or shrewd) few cashed out before the fall. The rest of us who were hoping to educate children or retire on our savings are having to rethink those life goals.

Elvira and Vladimir Clain-Stefanelli were curators of numismatics (i.e., currency) at the Smithsonian Institution’s National Museum of History and Technology, and in 1975 published a “pictorial essay” of the history of American Banking. This book Two Centuries of American Banking is rich with engravings, photographs, reproductions stories of the evolution of banking in the United States. It concludes with the advent of electronic banking (a major factor in the current crisis) and covers everything from counterfeiting to bank robbery. While not comprehensive in scope, Two Centuries of American Banking gives a concise tutorial on the fundamentals of the nation’s banking system and provides some cautionary notes which in retrospect we should have heeded.

Economies depend on banks to keep trade going. And because of how interlinked the world’s economies are, the current financial crisis in the United States is global in scope. To understand why the world’s banking systems are in a shambles requires a basic knowledge of banking and how it came to be an abstract form of trade. In ancient societies, people traded what they grew, made, or mined at marketplaces and negotiated each trade based on supply, demand, real value, and relationships. In small agrarian societies, this system worked well because the goods didn’t have to travel far and strangers were few. As trade routes made the world both larger and smaller and transactions became more complicated, banks emerged and became vital to trade.

Banks originated in Mesopotamia sometime between 3000 and 2000 BC as a way of securing things of value. Temples and palaces served as bank buildings and initially were used to store grain, the first form of currency. After a time, these banks became safe houses for cattle, tools, precious metals, and other items. Writing, it is thought, was developed by the Mesopotamians as a way of keeping records of ownership. Precious metals were melted into coins and could be exchanged for the value of items on deposit, simplifying trade. Counterfeiting was a problem until the Babylonians established a formal economic system and standard weights and measures under their Code of the Hammurabi. Banking matured and many currencies came into common use, creating the need for money changers. As centuries passed and the ancient Greek and Roman empires rose and fell, many disputes arose about the relative values of different currencies. The Roman Emperor Augustus Caesar (30 BC – 14 AD) introduced the first integrated system of monetary policy and taxation.

Money lending dates back to around 400 BC in Greece where ten per cent interest was normal for business loans and twenty to thirty per percent for shipping loans. According to the New Testament of the Bible, Jesus cast the money changers and lenders out of the temples because they were making a profit by charging entry fees to those who wished to hear the word of God. It is important to remember that at that time, temples functioned as banks which is why money changers and lenders coexisted with priests and rabbis. While his reasons were philosophical and spiritual, what Jesus did, in effect, was to demand the separation of banking and religion in Palestine, and that marked the beginning of a new church.

Meanwhile, on the Italian peninsula, the Romans became increasingly powerful and expanded their control across Europe, the Middle East, and northern Africa. After Jesus’ death, around 30 AD, Christianity gained ground as a religious movement because Christians refused to worship the Roman Emperors as gods. This led to persecution and martyrdom, which in turn inspired more people to become Christians. Despite this resistance, the Roman Empire continued to swell, eventually reaching Britain. Maintaining such a vast empire caused great economic problems. In order to increase the money supply, Rome began circulating coins made of less than pure gold, silver, or bronze, causing runaway inflation. By 270 AD, the silver content in Roman coins was, according to some historians, about four per cent. It wasn’t until the reign of Constantine (306-337 AD) that the Romans developed a standard for coinage which stabilized the world’s economy. Constantine also decided to make Christianity the official religion of the Roman Empire, thereby founding the Roman Church. When Rome fell to the Visigoths in 410 AD, banking ceased and did not resume until the Crusades, some 500 years later. Funding an effort as sweeping as the removal of rival religions such as paganism, Judaism, and Islamism, required tremendous amounts of money in liquid form. Resurrected banks provided the means.

Fast forward to the original thirteen colonies of the north American continent. The New World was rich in natural resources and the colonists produced valuable crops such as tobacco, corn, and cotton which they sold at a profit. The King of England, believed in taxing the colonies’ earnings on exports as well as their purchases of imports, such as tea. The Parliament also passed a law, the so-called “Bubble Act” of 1720, which terminated all banking functions in the colonies, severely limiting the colonists’ ability to prosper; without banks it was virtually impossible to borrow money for new business ventures. In 1776, the colonies had had enough of Britain’s strangle hold and declared independence.

By 1780, the Continental Army was in sorry shape: the soldiers were hungry, poorly clothed, and often barefoot. It seemed likely that the war of independence would be lost, according to Thomas Paine, “from the want of money, means, and credit.” A group of Philadelphians met at The Coffee House on June 8, 1780, and pledged their assets as a way of securing loans to keep the army going. This inspired additional citizens to pledge property and that led to the formation of the Pennsylvania Bank which provided the Continental Army with the vital resources for the war effort.

With the British defeated, the new United States of America was deeply in debt and needed a more sophisticated means of managing the economy than the Pennsylvania Bank could provide. Alexander Hamilton, the first Secretary of the Treasury, proposed to Congress in 1790 the formation of a national bank to centralize the finances of the nation: specifically repaying the debts incurred during the war, keeping tax revenues on deposit, and funding congressionally approved expenditures. Hamilton argued that a central, national bank with no ties to a particular state’s charter was critical for the smooth functioning of a federal government. Despite opposition from Thomas Jefferson and some others, President George Washington signed the law which created the Bank of the United States in 1791. The initial stock offering was immediately over-subscribed and the stock price soared.

The idea of local banking as a way of helping merchants manage their money and providing loans to farmers, artisans, and settlers caught on soon thereafter. Banks earned money by charging interest on loans, depositors earned money from interest the banks paid. The use of bank notes representing the cash on deposit came into fashion, although there were problems with counterfeiting and forgery. A more fundamental problem with the bank notes was that each bank had its own engraver and printer and so there was no uniform currency. Moreover, there was no regulatory function to ensure that a bank only printed notes for the amount of capital it had on deposit. The uncertainty this caused meant that bank notes were often “worth less than the paper they were printed on.”

Of particular interest in the Clain-Stefanellis’ book is the chapter on “Crisis and Recovery, 1920-1935.” In the 1920’s, “city people felt prosperous…and sales of consumer goods increased enormously…the stock market became an interesting game…” and banks lent money to people to buy stocks. Then as now, a frenzy of speculation pushed the limits of the stock market, and when the bubble burst, fortunes disappeared as the value of stocks plummeted. Then as now, the crisis was global and banks failed in great numbers. Then as now a newly elected president took drastic steps to quell the financial panic that gripped the nation in an attempt to restore confidence. The Clain-Stefanellis’ book explains how market speculation with too little regulation and oversight can create phantom wealth, which has a nasty habit of disappearing.

Once upon a time, wealth was measured in gold, land, and other things of real value. In the modern world, very few of us keep bags of gold at home as a way of safeguarding our treasure, rather we opt to deposit our paychecks into bank accounts and calculate our net worth based what we own minus what we owe. Keeping money under the mattress, so to speak, is not and never has been a good investment strategy. Even though investments carry risks, the potential for reward can often be great. Our fatal mistake this time was to assume there would be no end to demand for real estate, we bought more expensive houses than we could afford, purchased investment properties, and took out loans that depended on our ability to make a profit in the future. When the demand for real estate abruptly ended, too many of us lost everything, and as a result our country almost did too. Will we learn from this experience? Only time will tell. Meanwhile, as citizens, we all have a responsibility to become better informed. In the words of George Santayana, “those who fail to learn from history are destined to repeat it.”