Meanwhile the government, discouraged and an-annoyed at the experience it had had after the discontinuance of the Second Bank of the United States, had established the so-called "independent treasury system." Prior to this an effort had been made to fall back once more upon the state banks, the deposits of the government formerly kept with the Bank of the United States being apportioned or distributed among a number of banks. The panic of 1837 and the resulting suspension embarrassed the government and enforced the necessity of getting some plan that would retain the funds under real and genuine control of the federal administration. After various expedients had been suggested and their adoption had been unsuccessfully sought, Congress created the independent treasury system which assumed substantially its present form in 1846.

The idea of this system was that the government should entirely dissociate itself from the state banks and should pay only coin and receive only coin. Whenever it had a surplus of money on hand, such funds were to be kept in specie in vaults provided for that purpose. It was reasoned that this would keep the government entirely independent of the banks and their vicissitudes. The system was put into operation and was carried on with fair success down to the opening of the Civil War. During that time expenses and incomes were not far from being in a condition of equilibrium, and the system worked with comparative smoothness.

It was evident, however, even at that comparatively early date, that conditions might easily arise under which the subtreasury system would not be feasible. It was seen that, should there be a heavy surplus, it would inevitably operate to draw out of the circulation and out of the banks a substantial percentage of the money of the country, retiring it from use until such time as the government should see fit to pay it out again in the ordinary course of its business. Because the amount of government transactions was not very large, and because taxes were correspondingly light, while a fair adjustment of revenue to expenditure had been obtained, this was not an immediate or pressing question, but every observer closely familiar with the conditions recognized that such a situation might easily develop, and that the subtreasury system would then become an extremely difficult means of managing the fiscal affairs of the government. The Civil War, therefore, found the government with its fiscal system entirely divorced from the banking system of the country and with the banks disorganized and subject to no uniform or joint control.

At the opening of the Civil War it was promptly seen that very definite fiscal expedients would have to be adopted. The customs duties fell off as soon as the war came on, and, as these had been the principal source of revenue, the federal administration was sadly in need of funds. It undertook to borrow money from the banks, and then, although Congress had granted permission to suspend the Independent Treasury Act in certain respects, the administration insisted on drawing out the installments of the loan from the banks which had agreed to make it. The banks had expected that, instead of being compelled by the Treasury to pay coin as they would under ordinary circumstances have had to do, they would be allowed to keep the funds on deposit in their vaults and simply transfer them at the government's order to public creditors. The effect of drawing off the specie from the banks and placing it in the Treasury was to weaken the reserves and finally to lead to a suspension of specie payments, the banks refusing to pay out gold or silver on demand.

Meanwhile the necessities of the government had been mounting very rapidly, and it had been unwisely determined to issue legal-tender Treasury notes (popularly known as "greenbacks")- The first issue of these notes came out in 1862 and was followed by other issues. As the notes were legal tender they could be used in redeeming bank notes. They took the place of gold and silver coin, these metals being retired from circulation and hoarded or exported. The result was that the country was speedily placed on a basis of irredeemable paper. It was now without a metallic circulation, without any large financial institution on which to fall back, without any uniform bank-note currency, and without any substantial control over the banks. The constant and enormous demand for funds with which to carry on the war could not be satisfied by any other means than huge loans on long time, accompanied by heavy taxation designed to supply the funds for paying the interest on the bonds and ultimately redeeming them as they fell due. In endeavoring to sell such bonds the federal government encountered lamentable difficulty and was driven to various expedients for pushing the securities into the hands of buyers.

Among other schemes that suggested themselves to the Treasury authorities was that of organizing a banking system similar to the free banking system of the state of New York. The basic idea of this system was that of allowing the banks to issue notes, on condition that they should deposit with the Treasury securities in proper amount to protect the notes they issued. It was supposed that by requiring them to buy United States bonds to serve in this capacity, the government might create a strong demand for such bonds and that, as a result, it would be found easier to sell the securities, while their price, would probably be proportionately better.

On the other hand, it was argued, this system would be so popular that the state banks would be unable to compete with it. They would rush into the system, and consequently the country would be supplied with a uniform currency, issued by a set of banks directly under the control of the national government, responsible to that government and purchasing its bonds as a basis for the issue of its notes. This was the fundamental idea upon which the present national banking system was based. It was designed primarily as a device of national finance rather than as a service to industry.