The American System

Nationalists did not stop with the protective tariff. Henry Clay of Kentucky championed a three-part plan to stimulate economic expansion. He called his plan the American System. The system's three policies included:

• protective tariff
• a national banking system
• internal improvements (roads, canals, bridges, etc.)

Clay maintained that the three components of the American System would work together to spark a rapid economic expansion, benefitting all sections of the country.

As with the tariff, Congress moved quickly to address the issue of national finance. The nation had been without a centralized banking system since 1811, when Congress did not renew the charter for the original Bank of the United States (Hamilton's bank). This absence spawned an increase in state-chartered banks that freely issued credit and placed currency beyond their holdings into circulation. The loose banking practices of these unregulated state banks led to inflation and financial chaos.

What do you think happens when a financial institution prints paper money in excess of its gold and silver deposits?

According to the leaders of the day, if paper money is not backed by gold and silver, it declines in value. As the supply of paper money increases, the value of the notes decreases. That causes prices to increase, a development also known as inflation.

In 1816, Congress chartered the second Bank of the United States (B.U.S.). With a capital of $35 million, the B.U.S. was, by far, the nation's largest and most powerful bank. The federal government owned one-fifth of its capital stock. Private bankers bought the rest of the shares.

The Bank of the United States issued its own notes backed by gold and silver. Like the paper money in your wallet, B.U.S. notes functioned as currency that citizens could use to purchase goods and pay taxes. The Bank also served as a regulatory check on the state banks, since it was answerable to Congress. If a state bank had placed too much of its own paper currency in circulation, the B.U.S. would buy up the state notes and redeem them for gold and silver. This forced the state bank, with its limited hard money (gold and silver), to limit the amount of notes it issued.

Why did banks need to limit the number of paper notes they issued?

Each note could be redeemed at that institution for an equivalent amount of hard money (e.g., a customer could turn in a $10 note to a bank and receive $10 worth of gold). If the total value of a bank's paper notes exceeded the value of its hard money supply, it was vulnerable to a run of customers wanting to redeem their notes at the same time, which the bank could not cover. When a bank ran out of gold and silver, the remaining paper notes held by customers were worthless. Many "wildcat" banks printed notes far beyond their reserves. While this allowed for easy credit during an economic expansion, if economic stress caused people to demand gold or silver, the banking system could be thrown to the "monkeys," as shown in the cartoon.