Rothbard and the Suffolk Bank

From Murray Rothbard’s History of Money and Banking in the United States:

Despite the flaws and problems, the decentralized nature of the pre–Civil War banking system meant banks were free to experiment on their own with improving the banking system. The most successful such device was the creation of the Suffolk system (p 114).

It is a fact, almost never recalled, that there once existed an American private bank that brought order and convenience to a myriad of privately issued bank notes. Further, this Suffolk Bank restrained the overissuance of these notes. In short, it was a private central bank that kept the other banks honest. As such, it made New England an island of monetary stability in an America contending with currency chaos (p 115).

The Suffolk ground rules from beginning (1825) to end (1858) were as follows: Each country bank had to maintain a permanent deposit of specie of at least $2,000 for the smallest bank, plus enough to redeem all its notes that Suffolk received. These gold and silver deposits did not have to be at Suffolk, as long as they were at some place convenient to Suffolk, so that the notes would not have to be sent home for redemption. But in practice, nearly all reserves were at Suffolk. (City banks had only to deposit a fixed amount, which decreased to $5,000 by 1835.) No interest was paid on any of these deposits. But, in exchange, the Suffolk began performing an invaluable service: It agreed to accept at par all the notes it received as deposits from other New England banks in the system, and credit the depositor banks’ accounts on the following day.

With the Suffolk acting as a “clearing bank,” accepting, sorting, and crediting bank notes, it was now possible for any New England bank to accept the notes of any other bank, however far away, and at face value. This drastically cut down on the time and inconvenience of applying to each bank separately for specie redemption. Moreover, the certainty spread that the notes of the Suffolk member banks would be valued at par: It spread at first among other bankers and then to the general public (p 117).

How did the inflationist country banks react to this? Not very well, for as one could see the Suffolk system put limits on the amount of notes they could issue. They resented par redemption and detested systematic specie redemption because that forced them to stay honest. But country banks knew that any bank that did not play by the rules would be shunned by the banks that did (or at least see its notes accepted only at discount, and not in a very wide area, at that). All legal means to stop Suffolk failed: The Massachusetts Supreme Court upheld in 1827 Suffolk’s right to demand gold or silver for country bank notes, and the state legislature refused to charter a clearing bank run by country banks, probably rightly assuming that these banks would run much less strict operations (p 117-8).

The biggest, most powerful weapon Suffolk had to keep stability was the power to grant membership into the system. It accepted only banks whose notes were sound. While Suffolk could not prevent a bad bank from inflating, denying it membership ensured that the notes would not enjoy wide circulation. And the member banks that were mismanaged could be stricken from the list of Suffolk-approved New England banks in good standing. This caused an offending bank’s notes to trade at a discount at once, even though the bank itself might be still redeeming its notes in specie. In another way, Suffolk exercised a stabilizing influence on the New England economy. It controlled the use of overdrafts in the system. When a member bank needed money, it could apply for an overdraft, that is, a portion of the excess reserves in the banking system. If Suffolk decided that a member bank’s loan policy was not conservative enough, it could refuse to sanction that bank’s application to borrow reserves at Suffolk. The denial of overdrafts to profligate banks thus forced those banks to keep their assets more liquid. (Few government central banks today have succeeded in that.) This is all the more remarkable when one considers that Suffolk—or any central bank—could have earned extra interest income by issuing overdrafts irresponsibly (p 118).

While it lasted, though, the Suffolk banking system showed that it is possible in a free-market system to have private banks competing to establish themselves as efficient, safe, and inexpensive clearinghouses limiting overissue of paper money (p 122).

A few things to point out:

1) Rothbard refers this bank as a free market central bank, which is not true because such a term is contradictory by definition. A central bank emerges from government policy. Instead this is just an example of a private fractional reserve bank. It is essential to note that fractional reserve banks does not necessarily mean central banks, nor are the problems that are attributed to central banks equal to that of fractional reserves.

2) The last passage is important because even the anti-fractional reservist Murray Rothbard admits that there can be free banking policy where it can be ‘efficient, safe, and inexpensive clearinghouses limiting overissue of paper money.’ Thus, this at least dents (and at most discredits) the Rothbardian theory of fractional reserves being inefficient in the long run. See Rothbard’s article ‘Fractional Reserve Banking’ which is at odds with the last passage I quote from his History of Money and Banking

3) Most of what Rothbard is saying about the Suffolk bank is consistent to George Selgin’s theory on free banking. Also showing that the demise of the Suffolk bank was not due to market processes but to government intervention. This is the basic demise for most successful free banking banks as Selgin notes in his book The Theory of Free Banking

-Isaac Marmolejo

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9 responses to “Rothbard and the Suffolk Bank

  1. Private banks can set up a cartel or create a clearing house supported by one private player acting also like a lender of last resort. That’s not central banking in the modern meaning of the word but relaxing a little bit the notion of central bank I don’t see why a free market central bank is an oxymoron.

    • It is an oxymoron on how Austrian generally define central banking, which the definition includes some sort of government policy to enact a central bank. Of course, if you want to change the definition up a bit, or relax a little bit the notion of a central bank, then yes, a free market central bank is not an oxymoron, but isn’t that just splitting hairs now?

      But regardless, define central bank as whatever you want, this still does not change the fact that Rothbard saw free banking as an efficient way, at least if you consider the passages above.

  2. The Suffolk Bank, if I remember correctly, operated as a sort of clearing house (on top of its other banking operations), and when Rothbard calls it a free market central bank he’s really referring to two important features,

    1. Lender of last resort. Suffolk could, in effect, bail out bank branches which needed quick liquidity.

    2. It had a set of rules for member banks, meaning it restricted banking operations for a number of independent branches that used the Suffolk Bank as a clearinghouse.

    So, true, it was not a central bank in the same spirit as the Federal Reserve System. But, Rothbard calls it that only to bring attention to its central bankesque qualities.

    As per your comment on free banking, I completely agree. That paper was originally published in 1983, though. Rothbard’s critique of White’s Free Banking in Britain was published in 1988. Before that, Rothbard actually came to close agreement with White (it was upon further research that Rothbard wrote his critique). So, this was possibly written when Rothbard more or less agreed with Selgin and White on how a free banking industry would work.

    • Right, but my point is that it is seriously misleading to consider it a central bank, at least I think so, given how Austrians define central banking.

      And it is interesting that you listed the years that the Rothbard criticism was published. I did not look at the dates when I posted this, so you might have a point. But, nevertheless, modern Rothbardians, at least most of them, do not consider free banking as an efficient means and think that in the long run, would only lead to some sort of fraud or scam. They completely overlook what Rothbard had to say about the Suffolk bank.

      • Well, I think “fraud” is a “short-run” criticism. The long-run criticism is that fractional reserve banking is unstable.

        I don’t know if it’s misleading. I think comparing a clearinghouse to a central bank leads to powerful conclusions: a lot of the roles given to central banks can be just as adequately (or even better) preformed by a clearinghouse. In essence, I’m agreeing with you. Maybe Rothbard should have used “like” or “similar to;” but, I don’t think Rothbard ever meant to really compare the two to the degree you are — in short, I think you’re reading too much into what Rothbard wrote here.

        • You’re right in that the Austrian criticism is: short run = fraud and long run = unstable… I am not sure why I wrote long run for the fraud.

          I get your point about reading too much on the topic, your criticism is fair and will be taken into consideration.

  3. Pingback: A Few Critical Notes on Fractional Reserve Banking | Economic Thought

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