This exact phenomenon — elevating new financial interests because they cheapen government borrowing during moments of fiscal uncertainty — has a long precedent in US history.
In 1863, during the Civil War, financing government spending was a matter of life and death for the Union. Running out of money and increasingly frustrated with the inflationary effects of printing fiat money (“greenbacks”) to finance the war, the Union desperately looked for a way to get more people or businesses to lend to the federal government. The existing banking system — often called the Free Banking system (1837–1863) — with its patchwork of state regulations and no national currency, was not a productive source of borrowing for the federal government. This was because states did not always require banks to hold federal debt on their balance sheets.
Looking to fill the Treasury’s coffers in ways other than printing money, Secretary of the Treasury Salmon Chase proposed a new “national” bank system. Not to be confused with First or Second Bank of the United States, the proposed system would enable new nationally licensed (but entirely private) banks to deposit federal bonds with the government to back their banknote issuance. Like today, Chase looked to incentivize new financial institutions to lend to the government through regulatory changes.
Despite opposition to the plan from the existing state banking system, Republicans in 1863 had no other choice. The fate of the Union was at stake. In a vote that relied heavily on partisan loyalty, the national bank system was passed in early 1863, stabilizing the bond market and decreasing the country’s borrowing costs so the Union could fight the Civil War. The federal government’s need for cheap borrowing encouraged a fundamental redesign of the country’s banking system that legally incentivized investors to lend to the government.
What are the implications of building a banking system on the back of government debt as Republicans did with the national bank system? While it is not as safe as today’s Federal Deposit Insurance Corporation (FDIC) system, in which bank deposits are federally insured up to $250,000, it is not the worst option. Nowadays Treasuries are considered to be very safe and highly liquid, meaning that few would question the quality of the banks’ underlying assets, diminishing the chances of a run on the bank.
Yet there are clear dangers as well. By connecting the fiscal with the financial, policymakers tied the fate of the national bank system to the vicissitudes of public finance. What happens, for example, to the banking system when the total quantity of public debt changes? History again provides a guide.
After the huge deficits of the Civil War, during Reconstruction policymakers raised taxes and cut spending, producing a federal government surplus. While federal government surpluses are often thought of as an unqualified positive, they can have undesirable economic effects. Because of the surplus, the Treasury began to retire debt instead of issuing more, decreasing the total quantity of public debt in existence.
Yet because financial regulation dictated that national banks were required to purchase federal debt to issue banknotes, as federal debt became less available, banks began to adapt: they began to change their monetary instruments entirely, relying more and more on bank deposits rather than notes. The issue here was that, unlike banknotes, bank deposits were not required to be backed by public debt and could instead be backed by private debt.
This ensuing deposit-based banking system backed by private debt, encouraged by the government’s fiscal changes, turned out to be very fragile. This deposit-based system in the late nineteenth and early twentieth centuries saw frequent banking panics, culminating in the worst banking crash in US history in the Great Depression.
The creation of the national bank system was not the only time the federal government redesigned the financial system to encourage cheap borrowing with disastrous consequences down the line. As I have detailed elsewhere, the “repo” market — a key component of the shadow banking system that crashed in the great financial crisis of 2007–8 — was created to help cheaply finance government debt during the Cold War. Public debt was again allowed to be used as collateral in a new form of banking to push investors to lend to the government. Yet when the Clinton administration in the 1990s ran a federal government surplus for the first time in nearly thirty years, these “shadow banks” began to replace public debt with private debt as their collateral — mortgage-backed securities (MBS) in particular.
The usage of private housing debt to underpin the monetary system proved highly unstable. When the housing bubble burst in 2007, it affected not only real estate but spilled over into the financial system, producing bank runs and an economic catastrophe.
