Clearing house currency.

• Author: Timberlake, Richard H.
• Position: Report

The Federal Reserve System is no longer just an unconstitutional monetary institution promoting a continuing inflation; it has also become, with quantitative easing, an unauthorized fiscal agent for the U.S. government. The fiat currency and equally fiat bank reserves it creates are much in contrast to the private currency and bank reserves that die commercial banks' clearing house associations provided in the latter half of the 19th century. It is that episode I review here.

The Structure of Commercial Banking after the Civil War

The commercial banking world of the 19th and 20th centuries in the United States had many unstable characteristics, most of them the results of misguided government regulations, both state and federal. Civil War financing added to die problems, most notably, prohibition of bank-note currency issues by state banks. State laws had already restricted state banks' sizes and branching freedom. The National Banking Acts, passed in 1863 and 1864, aggravated many of the problems--one example being the imposition of legal reserve requirements for national banks. Some states had adopted this ill-advised measure even before the Civil War. All told, state and federal laws resulted in a two-tier system, national and state, with built-in rigidities that severely limited all banks' abilities to respond to changes in the demand for money and credit (Dowd 1995, McCulloch 1986). Especially, in the latter half of the 19th century and into the 20th, an unusual demand for bank credit could so deplete bank reserves that the supply of bank credit and bank-issued deposits would decline. This perverse elasticity emphasized the system's instability: an increase in the demand for credit and money could result in a decrease in the supply of both. No other industry faced such a problem (Timberlake 1993: 207-9). Bank suspensions and the restriction of cash payments became the standard response to these unusual liquidity demands.

During the period 186.5-1910, influential bankers, politicians, and many economists described the banking system's instability as a "currency problem" rather than as a deficiency in the man-made policies governing the commercial banking framework. This judgment substituted symptom for cause. Nonetheless, the system-wide restrictions and regulations on credit activities stimulated the banks to devise an effective defense: clearing house associations operating as lenders of last resort. The associations worked remarkably well and could have endured. However, in 1913-14, the Federal Reserve System replaced the clearing house system.

The Appearance of Clearing House Associations

State and national banking laws--and the widespread practice of demand deposit banking (i.e., the use of checks) after the prohibition of state bank notes--resulted in a large number of relatively small banks. The superfluity of banks stimulated the development of clearing house banks and, subsequently, clearing house associations to economize the humdrum work of check clearing. These institutions first appeared in New York City and then in other large cities. A prominent bank in the financial district would assume the role of a clearing center for all the banks that chose to belong to the local association. Representatives from each bank would then congregate at the clearing bank with similar clerks from all the other banks. Upon a signal, the clerks would carry out their claims and payments from and to each other and strike a balance for the difference.

This practice became so widespread that banks in many cities constructed jointly owned clearing houses. To expedite the daily clearing operation, many banks kept a balance of specie and greenbacks, or some other form of lawful money, as a reserve deposit in their clearing house accounts. National bank notes served as lawful reserves for some state banks, but not for national banks. When a bank needed to transfer large amounts of dollars, it would withdraw clearing house certificates (CHCs) in the form of certificates of deposit in large denominations, often $5,000 and $10,000, from its reserves to satisfy bank creditors in other cities (Timberlake 1993: chap. 14).

Bank panics prompted the clearing house managers to add a lending function to their clearing operations. A member bank facing demands for payments that threatened its reserves could apply for a loan to the clearing house loan committee. If the committee determined that the applying bank was sound, it would arrange for a bank with plentiful reserves to lend, usually at 6 percent annual interest, some of its excess reserves to the needy bank. Today, the fed funds market operates similarly. The borrowing bank conventionally secured its loan with its own collateral paper worth 133 percent of the dollar value of the amount it borrowed. It then used the clearing house loan certificates (CHLCs) it had acquired from the loan to clear its deficiencies at the clearing house, and subsequently paid off the loan when it received remittances for its own outstanding loans. Most of this activity came during the spring and fall of the year when new money was most needed for crop financing, but it became especially important during panics.

Clearing Houses Become Lenders of Last Resort

Each successive panic from 1857 to 1907 saw an extension of clearing house currency issues. More important, the clearing house itself became a fractional reserve lending institution. Clearing house managers, with the approval of their loan committees, began making short-term loans to...