The British attack on Washington in 1814 unnerved the public’s confidence in a banking system that had overextended itself in the issuance of bank notes. Banks in the Washington area suspended payments on their obligations to redeem bank notes, touching off a round of payment suspensions that spread to every region except New England.
In the early banking system individual banks issued their own bank notes, which they were obliged to redeem in gold and silver coin (specie). Bank customers received bank notes instead of a checking account and checkbook, and each bank held reserves of coin to redeem bank notes, just as a modern bank holds vault cash and other reserves to redeem checking accounts. A suspension of payments meant that banks no longer redeemed their bank notes with specie, putting the United States on an inconvertible paper standard. An inconvertible paper standard is a monetary system based on paper money that cannot be converted into precious metal at an official rate.
The War of 1812 contributed only part of the pressure on the banking system that preceded the crisis. From 1799 until 1811 the First Bank of the United States oversaw the banking system and made sure that individual banks could redeem their bank notes in coin. In 1811 the First Bank lost its charter from the United States government, substantially removing what regulation there was of state-chartered banks. From 1811 to 1815 the number of banks increased from 88 to 208, and the value of bank notes in circulation rose from $23 million to $110 million. The capitalization of the banking system only doubled during the same time, and most states allowed banks to issue bank notes without regard to capital or reserves. The circulation of bank notes had outgrown the supply of gold and silver, leaving the banking system floating on a thin film of public confidence. After the suspension of payments these bank notes circulated at discounted values, usually between 10 and 20 percent, but some notes from Kentucky banks were discounted 75 percent.
The United States government encountered difficulty financing the war because its bonds not only sold at a discount, but it received payment in depreciated bank notes. In addition to interest-bearing bonds, the Treasury issued $5 noninterest-bearing notes that were not legal tender but were acceptable as payment of taxes.
Congress soon regretted its decision not to renew the First Bank’s charter, and in 1816 granted a charter for the Second Bank of the United States. The bank opened for business on 17 January 1817 and by February had negotiated agreements with state banks in major cities to resume redemption of bank notes in of gold and silver coins.
The suspension of payments put the United States on an inconvertible paper standard for over two years, a rather short time considering that England from 1797 until 1821 was on an inconvertible paper standard. Just as England avoided the excesses of the paper money of French Revolution, the United States during the War of 1812 avoided the excesses of paper money that arose during the American Revolution. Today, virtually all countries are on an inconvertible paper standard.
Chown, John F. 1994. A History of Money.
Hepburn, A. Barton. 1924. A History of the Currency of the United States.
Meyers, Margaret, G. 1970. A Financial History of the United States.
Timberlake, Richard H. 1978. The Origins of Central Banking in the United States.