by Robert E. Wright, Augustana University and Museum of American Finance

Introduction: Throughout history, banking and finance have played important roles in the development of society. Academics and economists have only recently begun to appreciate the banking system’s value to the economy.

Once upon a time, not so long ago, most economists and even many leaders of the nation’s financial services companies believed that the financial system – banks, insurers, mortgage and securities markets, and sundry subsidiary industries – did not matter much to the “real” economy. The end of the Bretton Woods system of fixed exchange rates and capital controls in the early 1970s, the subsequent deregulation of the stock market and commercial banks, and advances in economic theory changed that thinking. Today, most academics, financiers, politicians, and regulators concede that the financial system provides the real economy with vital services, ranging from efficient intermediation and asset allocation to the reduction of transaction costs and asymmetric information. That belief explains why during the financial crisis of 2008 the federal government redirected billions of dollars from angry taxpayers/voters to support financial institutions and reanimate frozen financial markets.

Although widespread appreciation of the role that the financial system plays in the nation’s economic well-being is relatively new, the financial system itself is not. It originated, in largely modern form, during Alexander Hamilton’s tenure as the new nation’s first treasury secretary between late 1789 and early 1795. In those few years, the United States created a stable unit of account based on the value of gold and silver, a central bank that acted as a lender of last resort during financial panics, a commercial banking sector, a property and casualty insurance sector (life insurance came a little later), and securities markets for derivatives, commercial paper, government bonds, and corporate equities (with bonds soon to follow). Although much maligned then and since, Hamilton’s financial system, with appropriate additions and modifications, has driven America’s impressive record of economic growth, which is depicted in the chart on the next page, ever since. (Note: the data is presented on a logarithmic scale so that the business cycle and the overall trend, real per capita growth averaging 1.72% per year, is readily observable.)

Steady economic growth alone might be considered sufficient evidence that the financial system aids all Americans, but French economist Thomas Piketty, in his recent blockbuster Capital in the Twenty-First Century, argues with great fervor that finance exacerbates income and wealth inequalities by aiding the rich much more than it helps the middle class and poor. His main claim is that the rate of return on investments (r) generally exceeds the rate of economic growth (g), so rich investors grow wealthier faster than non-rich workers do. Piketty offers scant evidence (nine data points over a millennium) that r regularly exceeds g, however, and he explicitly excludes capital losses from his analysis (p.354). Worse, perhaps, is Piketty’s assumption that only the wealthy earn r. I don’t know what the situation is in France, but in the United States the financial system has always served all major social groups, rich and poor alike, within the constraints imposed upon it by government regulators and nature.

The Working Poor 
Mutual funds date from the early 19th century. Then called mutual savings banks (MSBs), the funds were managed by trustee-philanthropists who aimed to provide the working poor with a safe way to earn returns as good as those accruing to “the Wealthy and Capitalists” (Constantine Rafinesque to Elijah F. Pennypacker, Jan. 18, 1836, Society Collection, Historical Society of Pennsylvania). Economies of scale and restrictions against withdrawal allowed savings banks to achieve both good security and good returns. Scale kept transaction costs low, while the illiquidity of deposits allowed the funds to remain nearly fully invested in long-term securities. Inaccessible deposits were extolled as a virtue because this prevented depositors from drawing on their savings to finance drinking binges or other “excesses.” (No joke – many early Americans loved to get sauced). To prevent wealthy investors from muscling in, MSBs capped deposits at low levels. The Savings Bank of Baltimore even periodically purged its depositor base of those not considered to be among the “frugal poor.”

Between 1827 and 1842, at least 778 of the depositors in the New Orleans Savings Bank were illiterate. Because they signed with “marks” that were not as readily distinguishable as true signatures, the bank’s clerks jotted down notes about their physical appearance. For that reason, we know that depositor William Hall was a young man with no whiskers, James Scott was a tall young man, John Kinney was a full-size man in middle age, Paul Monneron was short with a fresh round face, and Katherine Lahey struck the clerk as a rather stout young woman, not tall.

Savings banks were wildly successful at attracting the savings of “mechanics, tradesmen, laborers, servants, and others living upon wages or labor” (Historical Society of Pennsylvania). By 1830, New York City savings banks alone boasted of almost 15,000 depositors with over $2 million on deposit. The average deposit was just shy of $140.50, or about $3,500 in today’s dollars. Early savings banks filled an important niche because the poor had few other opportunities for safekeeping their earnings at interest, a point made in a short parable published in the Eastern Argus on Sept. 9, 1825: 

Tom. – I say, Jack, where can a body come athwart the Savings Bank, as they call it?

Jack. – Savings Bank, do you say? Faith, that’s past my reckoning. What would they be at there, ship mate?

Tom. – Harkee Jack, as our Captain was paying us off, says he, Tom, what will you do with all this money? Says I, that’s something more than I have thought about; but between sky larking and jolly boys, I’ll soon be rid of it. Well, says the Captain, and how will you manage to make the pot boil when you are sick or old? Would not it be better for you to lay by whole or a part of the money, which you have earned by so much hard duty, to make yourself comfortable when you are on your beam ends. Aye sire, says I, but if one gives it to our owners, ten chances in one but they break. If we lend it to a mess-mate, or leave it with our landlady, it’s all one, we never get any good out of it. True enough, Tom, says our Captain, but if you put it into the Savings Bank, you are sure of getting it again when wanted, and that too with interest. …

Jack. – Why, Tom, a body has something to work for now. Money at interest, and as safe as a ship in dry dock.

Of course Tom, Jack, and other depositors could not borrow from their savings banks anymore than we can borrow from our mutual funds today. MSBs invested in public securities, equities, commercial mortgages, and the like, not risky, small loans. To borrow, the working poor had recourse to other institutions. Those who ran small businesses could obtain short-term loans from commercial banks. Artisans in Boston and Philadelphia could get small loans from microfinance funds established by Benjamin Franklin in his will. In the latter city, and in Baltimore, artisans, construction contractors, and others could buy land for development on so-called ground rent, an early form of perpetual, interest-only mortgage.

People with physical, personal property to post as collateral could find relief at pawn shops. Those without collateral could borrow from “note shavers,” so called because they discounted promissory notes at unlawfully high rates. Much lending had to be done “in the street” or “out of doors,” as the expression went, because state usury laws typically capped interest rates too low, often at just 6% to 8%, to allow commercial banks to lend profitably to numerous, small, risky borrowers. So the banks, which had capital to protect, lent to the shavers, who, in turn, made the riskier, higher-interest loans.

By the Civil War era, what we today call payday lenders had appeared, though they were not much of a force until the early 20th century. To combat the rise of payday and other high cost lenders, whom Progressives castigated as bloodhounds, charlatans, leeches, and evil predators (hence the shark analogy), the Russell Sage Foundation advocated the creation of alternative lenders. To make the alternatives viable, states had to first ease usury strictures, at least on small loans of short duration. The foundation’s efforts led to the passage of small-loan laws that stimulated the formation of credit unions, charitable loan societies, for-profit loan societies, and small-loan departments at commercial banks. Such alternative lenders managed to “exterminate” loan sharks in many jurisdictions.

Between its formation in 1913 and 1941, for example, the for-profit Provident Loan Society of Rochester, N.Y., made more than 88,000 loans to more than 20,000 families, every one for less than $300 (Provident Loan Society Annual Report, 1941). Interest rates varied somewhat, but the society usually charged 2% per month, which it considered a “fair rate” that had saved “a large number of borrowers” from the “clutches of loan sharks” who charged much higher rates and resorted to morally dubious collection methods. Stockholders, the society’s managers claimed, earned fair returns as well: nothing until 1918, then 4% percent per year until 1929, then 6% percent per year after that (Provident Loan Society Annual Report, 1935).

The working poor also had access to insurance. While the Barbary pirates still roamed the sea lanes, enslaving Christians in Algiers, Tripoli, and other North African ports, some sailors purchased ransom insurance. Artisans who owned their own shops often purchased fire insurance from one of the more than 700 fire insurance companies that formed before the Civil War. By then, some life insurers were beginning to sell policies, called industrial policies, that allowed the working poor to insure against burial costs and other final expenses in weekly installments. Such policies were extremely popular because one of the biggest fears of poor families was being forced to bury loved ones in so-called potter’s fields or pauper cemeteries. 

Another fear of working families was unemployment. Private accident, sickness, and disability insurance policies were available well before the New Deal began to dismantle the system of “Private Security” that had developed over the 19th and early 20th centuries to help alleviate life’s many risks. People with middling and upper incomes tended to purchase coverage from incorporated insurers, either mutual (owned by policyholders) or joint-stock (owned by stockholders). The working poor relied heavily on the benefits provided by nonprofit fraternal organizations or group insurance policies provided by their employers as a fringe benefit. Unemployment and workers compensation insurance (for injuries sustained on the job) became increasingly widespread in the 20th century.

Homeowners
Insurance also helped homeowners, directly by insuring houses and their contents and indirectly by insuring homeowners’ credit in the event of premature death or other income shocks, ranging from slip-and-fall lawsuits to unemployment. Borrowing costs would undoubtedly have been higher in the absence of the risk-sharing and risk-reduction services provided by insurers.

Peer-to-peer mortgage lending is as old the country itself. In the 18th century, most private mortgage lenders were wealthy individuals or the property sellers themselves. As an example of the latter, in 1792 a land owner north of Philadelphia offered for sale a stone farmhouse, smokehouse, carriage house, poultry house, horse and sheep stables, and barn on 222 acres for £3,600 Pennsylvania currency ($9,600), “£1000 down – 500 p annum afterwards on Interest” (New Jersey, Delaware, and Pennsylvania Real Estate Listings, 1792-1793, Historical Society of Pennsylvania). 

Several colonial governments, including Massachusetts, New York, and Pennsylvania, formed loan offices that lent fiat paper money called bills of credit directly to homeowners in exchange for mortgages on their properties. Most loan offices functioned properly but later attempts by various state governments to replicate the institutions typically failed. Missouri, for example, lost money in the 1820s trying to run its own loan office, which made the mistake of issuing colonial-style bills of credit more than three decades after the U.S. Constitution banned the states from issuing paper money. A century later, the state of South Dakota lost $57 million by lending taxpayers’ money to farmers without properly screening them or accurately ascertaining the value of their lands.

Peer-to-peer lending persisted into the 19th and 20th centuries but gradually lost market share to institutional lenders including insurers, savings banks, credit unions, commercial banks, mortgage companies, and building and loan (B&L) associations, the direct ancestors of the savings and loan (S&L) associations that made such a ruckus in the 1980s. Most B&Ls were local, intimate affairs, much like the fictional institution run by George Bailey (played by James Stewart) in the classic movie It’s a Wonderful Life. Even without Donna Reed providing them with (honeymoon savings) liquidity, B&Ls and S&Ls were remarkably stable until pummeled by shocks like the Great Depression of the 1930s or the Great Inflation of the 1970s. Stability reigned because they represented the pooled savings of average homeowners. Recall George Bailey’s admonition to panicked depositors: 

“No, but you … you … you’re thinking of this place all wrong. As if I had the money back in a safe. The, the money’s not here. Well, your money’s in Joe’s house … that’s right, next to yours. And in the Kennedy House, and Mrs. Macklin’s house, and, and a hundred others. Why, you’re lending them the money to build, and then, they’re going to pay it back to you as best they can. Now what are you going to do? Foreclose on them?”

Many B&Ls eventually did foreclose during the Depression because their members could not keep up with their scheduled payments. Other types of mortgage lenders also foreclosed on defaulting borrowers during the Depression but also found themselves forced to foreclose on borrowers in good standing. That was because most non-B&L mortgages were interest-only loans, the principal of which came due every five or 10 years (or even annually earlier in the nation’s history) in so-called “balloon payments.” When the principal fell due, few homeowners could make the balloon payment, which was expected, or find refinancing given the depressed state of real estate prices, which was not. At least the modern, 30-year amortized mortgage emerged out of the mess.

Consumers
Consumer credit arrived with the Pilgrims, not the 1920s or 1950s as sometimes claimed. What changed was the credit provider. In the 17th, 18th, and 19th centuries, private merchant or commercial banks provided credit to wholesalers, who provided it to their retail customers, who in turn provided it to individual consumers in exchange for their patronage. Consumer credit was ubiquitous, not hoarded for the benefit of a privileged few. According to one estimate, 90% of the retail transactions made in late colonial Philadelphia were done on credit, simply by the retailer recording in an account book who took what and when. In the colonial period, accounts were settled up periodically, sometimes years after purchase. By the early 20th century, most retailers expected monthly settlements. In both periods, retailers asked delinquent customers to sign interest-bearing promissory notes or even mortgages that could be sold to third parties or sued upon more easily than book accounts.

Consumers liked buying on credit because it allowed them to enjoy something today and pay for it later. Retail credit may also have appeared free to them, but of course it was not as retailers (and wholesalers) charged higher prices for goods sold on credit than for cash. Prices were not posted like today but rather interested customers asked clerks what the price of some item was, to which the clerk would ask, “How do you pay?” By the 1920s, many retailers had too many customers to continue offering credit to just anyone, yet they knew from experiments that moving to a cash-only basis was not a surefire formula for success. So larger retailers established credit departments that screened and ranked customers according to their credit risk. The store charge card, a formalization of centuries-old customs, was the direct result.

Modern consumer credit emerged when retailers no longer desired to bear the risk of lending to their customers themselves but wanted to retain the business of consumers who wanted the convenience of credit. Finance companies began to fill this need in the first half of the 20th century. General Motors was an early mover, establishing the General Motors Acceptance Corporation (GMAC) in 1919 to help its dealerships finance automobile purchases. Another early finance company, Commercial Investment Trust (now CIT Group), formed in 1908 to help businesses to factor their accounts receivable. After World War II, CIT moved into the consumer finance business and began lending directly to consumers who wanted to buy washing machines, televisions, and other consumer durables.

In 1949, Diners Club began offering a charge card (with traditional monthly pay-offs) that could be used to make purchases at any participating retailer. Just two years later, it boasted 20,000 cardholders. American Express began issuing charge cards in 1959 and did well with them, but in the 1960s credit cards with revolving monthly balances that could be used at a large number of retailers appeared. With Visa or MasterCard credit cards, consumers could charge goods sold by huge networks of retailers and maintain balances indefinitely. Some consumers borrowed too much, at too high a rate of interest, and ended up bankrupt as a result. Millions of others, however, enjoyed the flexibility of buying now and paying later, sometimes much later. Some big retailers kept their charge cards, but most were happy to pay a small percentage of each transaction to rid themselves of the credit risks posed by their customers. Interestingly, some nanobusinesses offer discounts to customers willing to pay in cash, effectively reviving the question, “How do you pay?”

Entrepreneurs
Most Americans realize that entrepreneurs are the lifeblood of the economy. Most startups soon fail, but those that survive often thrive, generating large numbers of quality jobs as they transform markets and sometimes entire economies. Today, an intricate system of angel investors, venture capitalists, and investment banks help to move startups through various milestones culminating in private sale or initial public offering (IPO). In the 18th and 19th centuries, many startups went directly to IPO. That seemingly unlikely procedure worked because corporate governance rules were tighter then, and the shares sold were essentially call options, with payments due in installments, called scrips. Secondary markets for scrips told managers how investors perceived their company’s performance. Startups that failed to achieve milestones found their capital dry up as scrip prices dropped and stockholders refused to pay further installments. 

Entrepreneurs in early America also received short-term funding, typically from suppliers-wholesalers and the commercial paper market, but also from savings and commercial banks. Before branching restrictions were loosened in the last few decades of the 20th century, most American banks were small, local affairs. Many had no branches at all, while others had just a few branches, all located in the same city or county as the headquarters or “main branch.” Bankers were more interested in building long-term relationships than turning profits on individual transactions. They often took pride in helping to build their local communities over the long term. 

Art Dahl, longtime president of the Rapid City National Bank of western South Dakota, was a poster boy for relationship banking. He refused to interrogate applicants harshly or to exact excessive collateral from borrowers on the notion that “if you treat one customer well, he sends more business to the bank” (Banker Dahl of South Dakota, p. 90-91). He gloated, “Many of the prominent people in Rapid City were small borrowers of small means. … We extended credit to many of them and it was profitable for them and for our bank” (Banker Dahl of South Dakota, p. 121).

Young people often start in the personal loan department,” he explained, “and grow to where they have large credits in our commercial loan department.” Interestingly, Dahl’s bank also lent to the poor, even if the probability of them ever becoming large borrowers was remote. “Many people with low incomes,” he believed, “are better credit risks than others with large incomes who have a spending appetite beyond whatever they make” (Banker Dahl of South Dakota, p. 178).

Taxpayers
Today, the financial system allows taxpayers to obtain their tax refunds faster by essentially discounting the receivable due from the IRS, although usually at rates that seem too dear to many. Much more importantly, the financial system has, since the Revolutionary War, allowed governments to spread tax burdens over time. The U.S. government could not have purchased the Louisiana Territory or defeated England (twice), Mexico, the Confederate States, Spain, and Germany (twice, once while simultaneously defeating Japan), let alone the Soviet Union (in the arms race and various proxy wars), if the only resource at its disposal was current taxes because taxpayers and the economy could not have borne the strain. To fund land acquisitions and wars, the government raised taxes a bit but also borrowed heavily.

The same revenue smoothing takes place on a more modest level every day as states and municipalities borrow to fund construction of new roads, bridges, schools, sewage treatment plants, and so forth. Even if such improvements could be funded out of current taxes, it would not be fair to tax people alive today for the total cost of assets that will last for decades or even centuries. The humble municipal bond, a product of the early 19th century, is, then, a benefit to all.

Problems
Of course, some government borrowing is pernicious because it burdens future generations with the living generation’s operating expenses. Finance, like any other tool, can be used for good as well as for evil. Consider slavery. The financial system provided slaveholders with credit and risk-reduction services via slave mortgages and slave life insurance. Those same products, however, also helped slaves by reducing the need for masters to sell them and break up their families. (Insurance did not induce masters to kill insured slaves, as some historians have presumed, because insurers covered only a portion of each slaves’ market value, generally about half.)

Individual financial services companies can make mistakes. Sometimes they behave in a predatory fashion, insuring or lending to those they should not, in order to expropriate resources from them. Sometimes they discriminate or refuse to insure or lend to people they should. Such mistaken practices are best eradicated by fostering competition, not ramping up regulations, much the way that states following the advice of the Russell Sage Foundation checked loan sharks by easing usury caps on small loans. Fraud is a different story. Typically, the financial system produces winners on both sides of the transaction because parties that freely enter into contracts are presumed to benefit. When one party lies about a product, however, clear winners and losers emerge. Once proven in court, fraud was dealt with severely in early America and ought to be again, by increasing fines on corporations and holding more executives’ individual fortunes and persons responsible for blatant wrongdoing.

Finally, the entire U.S. financial system has been implicated, usually correctly, in a number of economic disturbances starting with the Panic of 1792, through the many banking panics of the 19th century, to the Great Depression (1929-33), to the Great Recession (2008-09). Crises impose large costs on most Americans, rich and poor, rewarding only the smart or, some say lucky, few. Crises, however, may represent the price of progress. Little wonder, then, that a key goal since Alexander Hamilton, who masterfully handled a panic in 1792 by implementing what would later be called Bagehot’s Rule, has been to minimize the severity of crises without strangling growth.

Conclusion
The U.S. financial system has never been perfect and never will be. Since the financial revolution led by Treasury Secretary Alexander Hamilton in the nation’s first years, however, the U.S. financial system has adapted to changing economic conditions and rebounded from shocks ranging from wars to recessions to regulatory guffaws. Throughout all, the financial system has stimulated growth while directly and indirectly aiding the working poor, homeowners, consumers, entrepreneurs, and taxpayers. That’s a much more important message than Piketty’s overly simplistic and empirically unverified claim that r > g.