War has generally had grave and fateful consequences for the American monetary and financial system.
—Murray N. Rothbard, A History of Money and Banking in the United States
Governments have three ways to tax: direct taxes (the requirement to pay money to the government), debt (present government spending without tax revenue to pay for it with the assumption that it will be paid for in the future), and inflation (“printing money,” or the artificial expansion of money and credit beyond specie [e.g., a commodity like gold, silver, etc.]). Further, history demonstrates a tight connection between the expansion of government power, war, and the expansion of legal privileges and immunities for banks. These realities reinforce one another.
War requires revenue, which is difficult to acquire from citizens in direct taxes, so governments often offer banks the ability to expand money and credit through inflation and then suspend specie payments—that is, refuse to pay clients back their money in gold or silver when demanded. On the other hand, banks are all too happy to be granted legal protection via the government because this allows them to refuse to honor their contractual obligations and expand their businesses artificially without being charged with fraud, all with the promise that the government will save them from the consequences. This has often been the case throughout American history.
The monetary policy followed by the United States government because of the War of 1812 generated several consequences, chief of which was America’s first nationwide boom-bust cycle—the Panic of 1819. During the war, in 1814, the United States abandoned the gold standard to fund the war through the inflationary expansion of money and credit rather than through tax revenue.
While, at this point, America still did not have a modern central bank in “Federal Reserve–like” form, similar monetary policies led to similar results. The United States abandoned the gold standard and allowed banks special legal privilege and immunity to print more fiat currency than was redeemable in gold and to suspend specie payment. In addition to the Panic of 1819, domestic prices increased 25 percent, and imports increased by 70 percent. Describing the role of the US government, Murray Rothbard writes in The Mystery of Banking:
The U.S. government encouraged an enormous expansion in the number of banks and in bank notes and deposits to purchase the growing war debt. These new and recklessly inflationary banks in the Middle Atlantic, Southern, and Western states, printed enormous quantities of new notes to purchase government bonds. The federal government then used these notes to purchase arms and manufactured goods in New England. . . .
. . . By August 1814, it became clear that the banks of the nation apart from New England could not pay, that they were insolvent. Rather than allow the banks of the nation to fail, the governments, state and federal, decided in August 1814 to allow the banks to continue in business while refusing to redeem their obligations in specie. In other words, the banks were allowed to refuse to pay their solemn contractual obligations, while they could continue to issue notes and deposits and force their debtors to fulfill their contractual obligations. This was unfair and unjust, as well as a special privilege of mammoth proportions to the banking system; not only that, it provided carte blanche, an open sesame, for bank credit inflation.
. . . This general suspension was not only highly inflationary at the time; it set a precedent for all financial crises from then on. Whether the U.S. had a central bank or not, the banks were assured that if they inflated together and then got in trouble, government would bail them out and permit them to suspend specie payments for years.
Ironically, to deal with the consequences created by granting legal immunity to banks to expand money and credit and suspend specie payments, the Second Bank of the United States was chartered in 1816. Unsurprisingly, however, the Second Bank too became an engine of inflation rather than curbing it: “The boom therefore continued in 1818, with the Bank of the United States acting as an expansionary, rather than as a limiting, force.”
During that time, Americans did seem to recognize more clearly than today how the Bank of the United States and the government were to blame. John M. Dobson writes, “The bank’s policies fueled inflation, and it was popularly viewed as a major contributor to the Panic of 1819.” Though created after the War of 1812, we start to see here the close connection between national banks and war. These are mutually reinforcing policies.
The long-term monetary and financial consequences of the War of 1812 seem to have been an inoculation to the concept that, during wartime, the government can grant banks legal privilege to inflate the money supply, expand credit, and suspend specie payment. Apparently, during war, governments could give banks special permission to engage in practices that would normally be unsound and illegal (e.g., the inflation of money and credit).
This further prepared the American people for the back-and-forth struggle between legal allowances for banks versus a central bank, which would inform the debate until the creation of the Federal Reserve System. The legally facilitated profligacy of the banks—especially during wartime—had unappreciated economic effects, but this ironically led many to prefer a national central bank, which would do the same things on a greater scale. It also prepared Americans for the idea that governments could employ inflation as a means of taxation to pay for wars (and other government projects).
