Politics and Banking: Ideas, Public Policy, and the Creation of Financial Institutions

Published by EH.NET (June 2003)

Susan Hoffmann, Politics and Banking: Ideas, Public Policy, and the Creation of Financial Institutions. Baltimore: Johns Hopkins University Press, 2001. xii + 304 pp. $45 (cloth), ISBN: 0-8018-6702-9.

Reviewed for EH.NET by Michael R. McAvoy, Division of Economics and Business, SUNY College at Oneonta.

In Politics and Banking, Susan Hoffmann traces the role of ideas in shaping financial institutions, legislation and regulation in the United States. Specifically, she studies the ideas that formed the basis for regulating commercial banks, savings and loans and credit unions. Indeed, her analytic method is ambitiously applied to a broad swath of depository institution legislation, from the First Bank of the United States to the Financial Services Modernization Act of 1999. Do ideas drive regulation or does self-interest? Hoffmann observes that different types of depository institutions operate under different regulatory frameworks. Ultimately, she concludes that the banking frameworks remain separate due to their different initial public philosophies. History does matter, just as do ideas.

Chapter 1 observes that depository institutions have three separate regulatory frameworks, each the result of a different institutionalized public philosophy: commercial bank regulation and utilitarianism; savings and loans and progressivism; and credit unions and populism. For each public philosophy, Hoffmann examines the relevant legislative debates for the respective regulatory framework to answer the questions, “What did its advocates conceive as (the depository institution’s) purpose?” and “Given that purpose, what design did they propose to achieve it?”

The development of the Bank of the United States (BUS) is examined in Chapter 2 and the history of the Second Bank of the United States (BUS2) is studied in Chapter 3. Hoffmann observes that in the early republic, banking was part of the conflict between those who favored either strong or weak central power. Chapter 2 introduces an organizational design model for financial institutions whose principle categories are Ownership, Capital, Assets and Governance, since financial institutions’ effectiveness depends on their organizational design. In the example of the BUS, Congress intended that it provide an adequate money supply; however, the BUS regulated the money supply through its business with the state banks, an unintended consequence. Those who favored state interests successfully opposed the renewal of the BUS charter in 1811. While the existence of the BUS led to an increase in the number of state banks, ironically, the five year absence of the BUS led to a greater number of state banks with corresponding abuses and prompted Congress to create the BUS2. The purpose of the BUS2 was to provide a uniform currency and manage the economy. Andrew Jackson, an “ideologue” who favored strict separation between public and private interests, prevented the BUS2 from achieving its public purpose when he vetoed the renewal of its charter in 1832 and removed federal government deposits in 1833.

Chapter 4 examines the transition from state banking to national banking. The development of national banking was largely based upon the state free-banking models in which bank charters provided credit, currency and tax revenues and promoted local development. The states introduced financial regulation innovations such as reporting, capital and reserve requirements and deposit guarantee, while private interests developed payment system services. After 1837, states increasingly adopted free-bank charters rather than legislative special charters. The free- banking charter model sought to protect note holders through bond backing and note redemption at par in specie on demand. The purpose of national banking provided the nation with a uniform currency backed by United States bonds and capitalized the issuing banks. Yet, national banking failed to fulfill its purpose due to institutional designs of pyramiding reserves (to New York City in particular), population-based capital requirements and lending restrictions for commercial purposes, so it provided neither adequate currency nor credit. The system failed to provide the public with enough currency when it was demanded during unpredictable yet regular phases of the seasonal or business cycle, and made individual banks responsible for their own reserve positions. Thus the money supply did not respond to the natural requirements of trade.

The Federal Reserve Board’s formation is studied in Chapter 5. Hoffmann states that the traditional interpretations for the Fed’s founding are debates between private and public control and between centralized and decentralized systems. She offers a different interpretation for the Fed’s existence: nature versus construction — the creation by government of a public institution designed atop a government-designed private institution. The money supply debate revolved around whether it should be determined by the “natural” gold standard or “artificial” bimetallic gold and silver standard and was resolved politically during 1896 and reaffirmed during 1900 in favor of gold by the election of William McKinley over William Jennings Bryan, a populist silverite. The Panic of 1907 shifted the political tide with legislation that authorized a National Monetary Commission, which recommended a central bank and the institutionalization of the real bills doctrine. A shift to Democratic Party control of the national government occurred in 1912 with Woodrow Wilson’s election. Carter Glass, progressive Democratic representative from Virginia, shepherded the Federal Reserve Act, which institutionalized the real bills doctrine and the private provision of credit in a regional rather than a central administrative structure, through the House during 1913. Hoffmann discusses further changes to the Fed through the New Deal reforms and after.

The savings and loan framework is the focus of Chapter 6. Just as a progressive, Carter Glass, promoted the Federal Reserve legislation, President Herbert Hoover, another progressive, established the S&L framework to serve the public purpose of home ownership. In fact, much of the S&L framework was based upon the Federal Reserve System legislation. The Home Loan Bank Board legislation had its origins in the liquidity crises of the Great Depression to solve the maturity mismatching of mortgage lenders, as well and their losses suffered from bankers’ deposits due to the era’s failed banks.

In Chapter 7, Hoffmann covers credit unionism, a movement in which populism is the animating philosophical idea. The populist philosophy is one of economic democracy — the provision of access to necessary productive resources. In the populist view, the private ownership of the financial system is an economic flaw since the concentration of wealth subverts economic democracy. A natural money supply is unacceptable if it reduces the economic freedom of “ordinary” persons. Ordinary persons are those who have small amounts of savings and few borrowing needs. Since commercial banks did not provide services to ordinary people and savings and loans accepted small deposits but did not make small loans, credit unions arose as a means through which members could gain control of their resources to meet their small savings and borrowing requirements. Credit unionism continues to be separate from other depository institution regulation since its public philosophy promotes self-help for both its members and credit unions. While the government bailed out other types of depository institutions during the 1980s, credit unions have relied primarily on each other and have innovated institutions to cope with modern challenges including share insurance for member deposits and corporate credit unions that provide member credit unions with liquidity and other bankers’ services.

Chapter 8 concludes, arguing that government failure is the cause of economic growth below potential GDP, and suggesting solutions. Although the “neoliberal” reforms first suggested by Nixon’s 1971 Hunt Commission have been promoted by Republican and Democrat administrations alike since, Hoffmann faults the public philosophy of the approach for its lack of populist basis and its philosophical opposition to national involvement in public education, government bureaucracy, urban problems and environmental regulation. Hoffmann reasons that as money is allocated by the government so should credit — the populist public philosophy should also extend to credit allocation. Thus, if the market shifts the exchange medium to bank credit then households must have access to free checking and no-fee ATM’s.

Hoffmann’s idea and approach is different from much financial history research. Hoffmann rejects the argument that an efficient allocation of the money supply exists and does not consider economic history research useful since “mainstream economics” fails to explain the institutional development of banking policy. The primary evidence for the thesis is the documents, committee hearings and debates published by Congress. Thus there is no reference to work by J. Van Fenstermaker, Hugh Rockoff, Howard Bodenhorn or Jane Knodell on antebellum banking, Roger White on Treasury monetary policy prior to the Fed or Eugene White on competitive deregulation during 1900-1930. There is no acknowledgement for relevant ideas of Douglass North on the role of institutions in history or Paul David on path dependence. The lack of economics makes use of the book’s chapters alone weak without additional readings for courses in Economic History. For instance, Hoffmann ignores more recent discussion of the role of asymmetric information and the role of financial institutions. She does not inquire into what makes banks special. While corporations exist, Hoffmann determines that corporations are provided by the market, yet economic theory argues that corporations are human associations in which resources may be combined to avoid market transactions costs and risks may be managed better — populist notions even if corporations are legal persons with special privileges. Money is referred to repeatedly as a resource while economics principles texts would disagree.

The categories of Ownership, Capital, Assets and Governance are rarely used to discuss contemporary issues such as solvency, liquidity, investment limitations, or private financial innovations. One gets the impression that Hoffmann was forced to include some sort of model in this work, yet the model is used to provide neither much analysis nor prediction. In addition, Hoffmann’s definition of capital lacks clarity. It confuses bank capital with the initial funds used to purchase ownership shares. For instance, initial Second Bank of the United States shares could be purchased with promissory notes of individuals in addition to specie and United States government debt. All of these assets would become reserves or investments of the bank, yet Hoffmann is critical of promissory notes as a basis for capital investment. Presumably, specie was engaged in commerce so not readily available for use in speculation. If the bank required specie reserves, the notes acquired initially could have been called at expiration and not renewed. Markets may not have existed to readily transfer earning assets to the bank without serious price disruptions, even if exchanges unlikely existed for promissory notes.

Further, the populist public philosophy is promoted although little, if any, evidence is presented to suggest that wealth inequality is increasing or that such is harmful to “ordinary” persons. The populist idea of ensuring economic democracy is accepted uncritically. Is improvement in living standards for the median or even upper 80 percent (“ordinary” persons perhaps?) acceptable if there is increasing wealth inequality? I suspect populists would not accept increasing economic inequality even if almost everyone were better off, but I would like to know whether or not Hoffmann accepts this economic outcome when populism is promoted as a basis for modern policy. Hoffmann believes that the Community Reinvestment Act of 1977 is a great success and an example of legislation promoted by populism, yet that the law might prevent transfers of credit or be abused by community groups affecting efficient money allocation is not discussed and would seem to lack populist outcomes if arbitrarily enforced.

While Hoffmann’s approach has weaknesses, the book illustrates effectively that both history and ideas matter. I recommend it to readers in historical political economy, depository institution regulation history or the history of credit unionism. There is much repetition in each of the chapters so any chapter of the reader’s particular interest may be read with the short preface. In particular, I most enjoyed the credit unions chapter and the history of populism in affecting their continuing history.

Michael McAvoy is an assistant professor of economics at SUNY College at Oneonta. His research interests are in the area of economic history, financial history and the economics of financial institutions.