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| ISBN-13: | 9780691634463 |
|---|---|
| Publisher: | Princeton University Press |
| Publication date: | 04/19/2016 |
| Series: | Princeton Legacy Library , #1436 |
| Pages: | 310 |
| Product dimensions: | 6.00(w) x 9.25(h) x (d) |
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Money and Capital Markets in Postbellum America
By John A. James
PRINCETON UNIVERSITY PRESS
Copyright © 1978 Princeton University PressAll rights reserved.
ISBN: 978-0-691-04218-3
CHAPTER 1
Introduction
The development of an efficient financial structure plays an important role in the process of economic development. The accumulation of capital in itself does nothing to promote growth in income or output if that capital cannot be successfully transferred into a productive use. A financial structure that leads to an efficient allocation of funds is one of the necessary conditions for growth in per capita income. The importance of finance for development in the United States has perhaps never been articulated as well as by J. S. Gibbons in 1858:
Anyone who has travelled among our country villages, out of the immediate influence of cities, has occasionally been struck by the neglect of natural advantages, the lack of energy, the rudeness of life and character, and the almost savage features of the common people. But on visiting the same place after an interval of a few years, he has seen a total change; a larger population, a better class of buildings, an air of thrifty growth, and a manifest increase of comfort. The old lethargy has disappeared; a new life has been infused into everything; even the countenances of the people are softened; a less brutal and more intelligent spirit beams from their eyes. A bank has been the starting point of this new career; the mill-dam has been built across the little streams of capital and the social machinery is brought into play.
The United States in the postbellum period, the period between the end of the Civil War and the establishment of the Federal Reserve system, experienced significant and far-reaching structural changes in both the composition and location of economic activity. The process of industrialization that had begun in the antebellum period continued after the Civil War. From 1869 to 1899 the share of agriculture in total commodity output fell from 53 to 33 percent, whereas the manufacturing share rose from 33 to 53 percent. In addition to this substantial shift in the composition of output from agriculture to industry, there was a regional shift within manufacturing from the East to the Midwest going on as well. Value added in manufacturing in the Northeast amounted to 66 percent of total manufacturing value added in 1870, but fell to 51 percent in 1910; meanwhile, the Midwest share increased from 18 to 25 percent during the period from 1870 to 1910, while the Western share rose from 10 to 13 percent.
These changes in the composition and regional distribution of output were paralleled by shifts in the distribution of the labor force. From 1870 to 1910 agricultural workers as a percentage of the labor force fell from 52.9 to 31.4 percent, that is, from over one-half of the labor force to under one-third, while at the same time workers in manufacturing increased from 19.1 to 22.2 percent. At the same time this sectoral shift was taking place, a westward shift in the distribution of the population was occurring as well. Concomitant with the growth in the relative importance of manufacturing and the relative decline in agriculture was a marked migration into the cities. Between 1870 and 1910 urban population as a percentage of total population almost doubled, rising from 25.2 to 45.7 percent.
The general shift in the composition of output from agriculture to industry, the migration and change in composition of the labor force, and shifts in regional demand for funds, due in part to the shift of industry from East to West and also in part to the increasing capital intensiveness of agricultural production, all marked significant changes in the structure of the American economy. Efficient mobilization of financial resources required a transfer of funds from relatively stagnant to rapidly expanding industries, as well as from relatively capital-abundant areas to relatively capital-scarce areas. Consequently, efficient allocation of financial resources called for both intersectoral and interregional transfers of funds. At the same time the economy as a whole expanded very rapidly during this period, with net national product rising fivefold between 1870 and the beginning of the Federal Reserve period, while real per capita income almost tripled.
These substantial changes in both the quantity and composition of output placed great demands on the financial system. The development of large-scale industry with its increased demands for external financing required the raising of unprecedented amounts of capital. One result was the rapid growth of the open market for funds in the late nineteenth century, especially the New York stock and bond markets, which were no longer limited to railroad issues. Another institutional development that resulted from this need to mobilize large sums was the rise of the investment banker. Private bankers, such as J. P. Morgan, were able to assemble much greater amounts of capital than ever before, as evidenced, for example, in the creation of U.S. Steel. Financial intermediaries, such as mutual savings banks, building and loan associations, and life insurance companies, grew rapidly and played significant roles in the mobilization and transfer of long-term capital from surplus to deficit areas, as also did mortgage companies.
A variety of institutions therefore were instrumental in mobilizing and transferring long-term capital. On the other hand, the market in short-term capital was primarily the province of the banking system, to which it was restricted by both sound banking theory and legal regulations. An open market in short-term funds, the commercial paper market, did spread rapidly during the period, but its principal customers were the banks. Commercial banks were by far the most numerous and important financial intermediaries in the postbellum period. The banking system had two important functions: the creation of the means of payment, and the mobilization and transfer of short-term capital, as opposed to financial intermediaries in the long-term market, which were not allowed to create money, either in the form of bank notes or deposits. The adequacy of the banking system in fulfilling these functions had direct effects on the growth and stability of the American economy, and the postbellum banking system has been severely criticized for its performance in both areas. That record of performance will be examined here.
In the late nineteenth century questions of banking and monetary policy, such as the appropriate type and volume of bank notes to be issued, the proper basis for the currency, the level of rural interest rates and the existence of banking monopolies there, were subject to more public discussion, debate, and outrage than in any other time in U.S. history, with the possible exception of the Jacksonian period. The national banking system was widely criticized as being unsuited to the needs of the country. Detractors pointed to its tendency to concentrate balances in New York and its resulting susceptibility to panics, and also to the unresponsiveness, or "inelasticity" in the word of the time, of the currency to seasonal or cyclical shifts in demand. Indeed, the banking system throughout the nineteenth century has been almost always pictured as a promoter of instability rather than of economic development.
This book will examine the structure and operation of the banking system in the postbellum period. Structure here will encompass not only such quantifiable features as the number of banks and bank density but also the legal framework and constraints under which the banks operated. In addition, the way in which practice frequently differed from legal requirements will be studied. In the process of portfolio selection, for example, banks were often able to evade or sidestep legal restrictions. Consequently, studies of the development of banking legislation, such as Knox's well-known History of Banking, can be misleading as to the actual workings of the financial system.
The National Monetary Commissinnin 1911 complained that "no satisfactory account of the operations of European banks, no penetrating examination of the great credit institutions or of the organization of credit" was available, so its studies were designed to provide "more accurate and concrete information in regard to the actual practice of banking in these countries than has ever been published before." These same criticisms apply equally well to studies of U.S. banking in the late nineteenth century, which have considered only the legal and theoretical constraints under which banks operated.
The demands of the postbellum economy, which was growing rapidly and also changing in composition, spawned a variety of financial institutions to meet its needs, in both the long- and short-term capital markets. The development of the open market in commercial paper represented one response to the need for interindustry and interregional transfers of funds. Several provisions of the National Banking Act established legal barriers to some profitable opportunities of banks. In addition to being a study of institutions, this is also a study of institutional change, in which the process of adaptation of the banking system will be examined. It will be shown that the banking system, through the development of the commercial paper market and the correspondent banking system, adjusted to mitigate the effects of the barriers to the mobility of funds, as the growth of state banks avoided the legal barriers to profitable operations imposed by the National Banking Act.
Just as the postbellum banking system was widely believed to be an accomplice, if not a promoter, of instability, it was also pictured as having been an imperfect and underdeveloped structure for the mobilization and transfer of short-term capital in the face of widespread barriers to interregional capital mobility. Lance Davis, for one, has argued that these pervasive barriers to capital flows were significant in American development, asserting, "In the United States such immobilities distorted the pattern of growth throughout the entire nineteenth century; but they became much more important in the postbellum decades."
Evidence of these barriers to capital mobility was well known in the postbellum period. In an efficient national short-term capital market, interest rates would be equalized across regions and sectors after allowing for differences in risk. Areas with high interest rates, indicating a high marginal product of capital, attract funds from relatively low interest rate regions; capital is thereby transferred into the region in which it may be employed most productively. At the same time, the inflow of funds reduces interest rates and consequently the differential between regions until in a perfect market interest rates are equalized.
Short-term interest rates, however, were not uniform across the United States in the postbellum era. Substantial differences among regional interest rates existed and were taken as evidence of the misallocation of financial resources. Logan Roots, president of the Arkansas Bankers' Association, noted in 1892 that in Little Rock it was often difficult to borrow on good security at 8-10 percent, whereas in Boston it was often difficult to loan at 3-5 percent, and noted, "The condition is well known...." More systematically, in an 1898 Political Science Quarterly article, R. M. Breckenridge compiled average weekly rates of discount from reports from selected cities as reported in Bradstreet's, which are reported in Table 1. These figures were supposed to represent the local discount rate on loans of the same quality — prime, double-name paper. So, to the extent that the quality of loans and discounts was poorer in the interior and thus commanded higher rates there, this table understates the differences in average loan rates between regions. Breckenridge commented that these local differences in discount rates were so wide that "they must seem to many astonishing and inexplicable."
What were the contemporary explanations for these differentials? One popular theory was that the regional differentials were due to the "disinclination of capital to migrate," which an interest rate difference of about 2 percent was necessary to overcome. Breckenridge rejected this argument because the lack of an efficient mechanism to transfer funds between regions seemed to be much more important. The persistence of the differentials must be ascribed to "the failure of the American organization of credit adequately to mediate, with equitable charges, between those who need to borrow and those who are able and willing to lend." In other words, the financial system provided no efficient mechanism of domestic arbitrage to equalize discount rates across regions.
This lack of formal mechanisms to promote interregional transfers of funds was a widely criticized aspect of the national banking system. The National Monetary Commission, charged by Congress to inquire as to what changes were necessary or desirable in the U.S. monetary system, noted that "there is a marked lack of equality in credit facilities between different sections of the country reflected in less favored communities, in retarded development, and great disparity in rates of discount. ... Our system lacks an agency whose influence can be made effective in securing greater uniformity, steadiness, and reasonableness of rates of discount in all parts of the country."
The prohibition of interstate branch banking was often identified as the institutional barrier to an efficient distribution of capital. The Indianapolis Monetary Commission observed: "Bank capital is in nearly every other country distributed largely by means of branch offices. No where save in the United States is there such a multitude of small and unconnected institutions." Branch banking was argued by many to be the solution to the problem of the interregional allocation of capital; an extensive system of branches across areas could efficiently allocate funds to the best advantage in contrast with the actual system of unit banking in which banks were small, isolated entities not participating in national markets.
Extensive studies of the branch banking systems in more than a dozen countries were done by the National Monetary Commission, and the tightly interconnected networks of branches in such countries as Canada, England, and Scotland were often cited with approval. In spite of the low population density, the rate of discount in Canada did not vary more than 1 to 1½ percent across the entire country, in sharp contrast to the United States. These barriers to interregional capital mobility in turn were said to have had serious consequences in the misallocation of resources: "Even the strongest and most flourishing enterprises suffer from the lack of some efficient machinery for simultaneously borrowing in the accumulating, wealthy and investing sections of the country and lending the means thus acquired in the sections where opportunities for investment are more abundant than capital."
However, it will be argued here that just as consideration of legal restrictions alone gives a misleading picture of nineteenth-century bank operations, an erroneous conception of the nature and extent of the short-term capital market will be acquired from examination only of the legal unit banking structure of the national banking system. Notwithstanding the prohibition of interstate branch banking, a complex and extensive network of interrelationships for the transfer of funds did exist among banks; they were not isolated entities. Jonathan Hughes was closer to the truth in observing, "By the end of the 1870s there existed a giant American financial system; virtually a national market for money." Again, the banking system proved to be quite responsive to profit opportunities in spite of legal constraints.
Nevertheless, it is not enough to know that institutions existed for the transfer of short-term capital. In addition, we would like to know how successful these mechanisms of the interregional capital market in fact were in promoting the development of a national market. A study of the structure of financial markets and data on the size of interregional capital flows alone will not reveal the success of these channels in integrating local markets into a national one. One also needs to know what effects those flows had. In other words, the performance of the market, as indicated by interest rate movements, must be assessed as well as the structure.
The postbellum era experienced a remarkable convergence of regional interest rates, indicating the development of a national capital market over a relatively brief period. Our investigation will be confined to the short-term market, although Lance Davis suggests that the same process of interest rate convergence also proceeded in the long-term market at a slower pace. Davis has derived regional series of gross and net returns on earning assets for both country and reserve city national banks for the postbellum period, which have become the standard measures of market performance in this period, serving as proxies for local interest rates. Consider Figure 1, which presents the movements of net returns on earning assets of country national banks by region for the 1870-1914 period. Even though the figures are only proxies for the true interest rates, the trend is evident. Over the postbellum period interregional differentials narrowed substantially and a national market evolved. In Appendix A the construction of a series of local interest rates more precise than both Davis's gross and net return on earning assets and Smiley's recent postbellum regional interest rate series for the shorter 1888-1911 period is described. Figure 2 presents these estimates of regional short-term interest rates for country banks in the period 1888-1911. The regional interest rate series are weighted averages of the average rate on loans and discounts of country national banks by state, the weights being the relative sizes of the loan and discount portfolio.
(Continues...)
Excerpted from Money and Capital Markets in Postbellum America by John A. James. Copyright © 1978 Princeton University Press. Excerpted by permission of PRINCETON UNIVERSITY PRESS.
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Table of Contents
- Frontmatter, pg. i
- Contents, pg. vii
- List of Tables, pg. ix
- List of Figures, pg. xi
- Preface, pg. xiii
- CHAPTER I. Introduction, pg. 1
- CHAPTER II. The Growth of the Banking System, pg. 22
- CHAPTER III. The Individual Bank, pg. 45
- CHAPTER IV. The Correspondent Banking System, pg. 89
- CHAPTER V. Methods of Interregional Transfers of Funds, pg. 149
- CHAPTER VI. The Process of Capital Market Integration, pg. 199
- CHAPTER VII. Summary, pg. 236
- APPENDIX A. Data Appendix, pg. 245
- APPENDIX B. Interest Paid on New York Bankers' Balances, pg. 263
- Bibliography, pg. 268
- Index, pg. 285