American Currency before the Federal Reserve System
The First Bank of the United States (1791) and Second Bank of the United States (1816) were the two precursor banks to the Federal Reserve System in the United States. They were responsible for issuing the small quantity of paper currency that circulated in the early years of the United States. After the Second Bank of the United States closed in 1836, the dominant form of currency became private bank notes issued by state-chartered commercial banks (normally redeemable on demand for gold or silver). The United States did not have a uniform national currency. The system of state-bank issuing of currency notes was confusing and inefficient. By the 1860s, as many as 8,000 different issues of state bank notes were circulating in the United States. With the vast distances to be covered and the lack of efficient means of transportation, banks rarely accepted — at face value — notes issued by banks unknown to them.
During the American Civil War, national bank notes were issued to finance the war and other needs of the different states. Until 1913, these formed the bulk of the nation's paper currency. National bank notes were currency the government gave to nationally chartered commercial banks for them to issue as their own. National bank notes grew out of the government's need to raise money to finance the Union army. Faced with a depleted treasury, and reluctant to raise taxes on northern industry, President Lincoln reluctantly agreed to a plan formulated by his secretary of the Treasury, Salmon P. Chase. Under Chase's plan, the federal government would offer a new type of banking license — a federal, or national, charter. A bank with a national charter would have the power to issue a new form of currency: national bank notes. However, for each note issued, the bank would have to hold a somewhat larger dollar value of government securities as collateral (called a backing requirement). The banks could purchase government securities directly from the U.S. Treasury for gold and silver, which were universally accepted money at that time. In effect, the government would receive gold and silver in return for its liabilities (government securities). Chase's plan was embodied in the National Banking Act of 1863. To enhance the prospect that national bank notes would be successful, and to eliminate the competition from notes issued by state banks, Chase also developed a tax that Congress gradually increased until the state bank practice of issuing currency ended. Because national bank notes had to be fully collateralized government securities, the nation's supply of paper currency effectively depended on the government's debt.
The supply of currency expanded and contracted in direct response to changes in the value of government securities in the nation's bond markets, not in response to the needs of the economy. When the government began repaying its Civil War debt, redeeming and retiring securities issued in earlier years, the supply of collateral available in the banking system for note issuance shrank. Currency was inelastic (incapable of adjusting to the public's changing needs and demands), and this led to the money panics that periodically plagued the economy of the United States.