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Why Did the United States Congress Change Its First National Banking System?
When the Civil War erupted, Congress had no way to pay for the war. It tried taxes and it tried bills of credit (i.e. greenbacks). Each worked to an extent. But Congress realized it needed a more permanent form of credit on which to wage large-scale war. So, they passed the National Banking Act to satisfy these requirements.
Most importantly, it created a system by which the Federal government could pay for the Civil War. For Congress, this Act accomplished many goals. However, there were serious defects.
For many years, the banking system under state regulation had suffered seasonal fluctuations as bank funds moved to New York to take advantage of Wall Street's call-money market. Instead of correcting such fluctuations, the National Banking Act encouraged them by permitting national banks to keep a considerable amount of their reserves as credits with authorized banks in New York and other reserve cities.
In the summer and winter, when loan demand was slack, country banks deposited part of their reserves in New York City banks, receiving interest on the deposits. The New York banks counted money (i.e. gold and silver) deposited by country banks as part of their own reserves, which allowed the New York banks to expand security loans in the call-money market. When country banks needed funds for making agricultural loans in the spring and fall, they withdrew deposits from New York and put pressure on the money market.
In most years, the banks managed to survive the temporary credit stringency. But, when the economy was expanding rapidly and the volume of security loans in New York City was large, the scramble for liquidity often created a money market panic. In turn, this caused an economic recession.
Another deficiency (in the eyes of Congress and the banks) of the banking structure under the National Banking Act was the inelasticity of the currency supply. The act limited the volume of national bank notes to $300 million, originally divided among the states in proportion to population. The supply of currency could not be increased in response to variations in demand.
Moreover, the actual amount of national bank notes in circulation depended on conditions in the Government bond market, since the notes had to be secured by a deposit of Government bonds equal to their face value. When bond yields fell relative to the return on other investments, banks were less willing to hold bonds as security and the amount of bank notes outstanding tended to decline.
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