The Creation of the Federal Reserve

Podcast Transcript

In 1913, the United States created its third national bank.

Unlike the previous two, this bank was organized in a completely different manner. Its structure was designed to avoid the problems of the previous national banks.

Also, unlike the previous national banks, this one was not subject to open and lengthy public debate. There was a fair amount of secrecy involved.

Learn more about the creation of the Federal Reserve and the very odd way it was created on this episode of Everything Everywhere Daily.

If you remember back to my previous episode on the subject, America had not one, but two different national banks in the 19th century.

The First Bank of the United States was established in 1791 and lasted for 20 years until its charter expired and wasn’t renewed.

The Second Bank of the United States was established in 1816 and fell victim to the same fate after 20 years, when its charter wasn’t renewed.

After the demise of the Second Bank of the United States, the country entered a period known as the Free Banking Era. During this period, banks were chartered by individual states, each issuing its own banknotes backed by varying assets. Notes circulated at discounts depending on the perceived soundness of the issuing bank, and bank failures were common, especially during panics.

The Civil War led to partial nationalization, as the National Banking Acts of 1863 and 1864 created federally chartered “national banks” that issued a uniform national currency backed by U.S. government bonds. However, there was still no lender of last resort, no coordinated monetary policy, and no central authority to manage liquidity. Seasonal interest rate spikes, recurring bank runs, and major bank panics exposed the system’s instability.

Bank panics became a major problem after the Civil War. There were panics in 1873, 1884, 1890, 1893, 1896, and finally one in 1907.

The Panic of 1907 was a major financial crisis triggered by a failed attempt to corner the stock of the United Copper Company, which led to runs on New York trust companies, causing widespread bank withdrawals and a collapse of credit. With no central bank to supply emergency liquidity, the crisis was halted only after J. P. Morgan personally organized private rescue funds.

The Panic of 1907 was the straw that broke the camel’s back for the banking industry. The crisis convinced many political and business leaders that the country needed a permanent lender of last resort and a more flexible money supply.

So, once again, the idea of a central bank was seriously considered.

However, there was a problem. The reason the previous two banks never had their charters renewed was that deep-seated suspicions about banks and bankers had permeated American culture since its founding.

Many Americans in the late eighteenth and nineteenth centuries believed that concentrated financial power posed a threat to individual liberty and republican self-government. A national bank, by definition, centralizes credit and currency in a single institution.

To Jeffersonian and later Jacksonian thinkers, this looked like a re-creation of the British financial system, which they associated with aristocracy, corruption, and undue influence by wealthy creditors.

Another objection was constitutional. The Constitution never explicitly granted Congress the power to charter a bank, so strict constructionists argued that such an institution was unconstitutional. Alexander Hamilton defended the First Bank of the United States by invoking the “necessary and proper” clause. Still, opponents, such as James Madison and Thomas Jefferson, insisted that the federal government was limited to enumerated powers and that banking was a state-level function.

Farmers, small merchants, and debtors worried that a central bank, typically controlled by urban financiers, would pursue tight-money policies that favored creditors over borrowers. The First and Second Banks of the United States could, by redeeming state-bank notes for gold or silver, force local banks to contract credit.

Regional and sectional politics added another layer. The early United States was economically diverse, and many states jealously guarded their own banks and currencies. A national bank headquartered in Philadelphia or New York appeared to give the Northeast disproportionate power over the South and West.

It was in this environment that bankers and politicians who sought to establish a new central bank had to work.

The National Monetary Commission was a bipartisan body established by Congress in 1908, following the Panic of 1907, to examine domestic and international banking and currency systems and recommend reforms to prevent future financial crises.

It was led by Senator Nelson Aldrich of Rhode Island.

In November 1910, Aldrich and the National Monetary Commission secretly met with a small group of leading bankers and financial experts at the Jekyll Island Club off the coast of Georgia.

Among the attendees were the Assistant Secretary of the Treasury, representatives from J.P. Morgan & Co., National City Bank of New York, and Bankers Trust Company of New York.

This meeting has become infamous because of the secrecy surrounding it.

The attendees traveled under assumed names, avoided the media, and told even the club staff only that they were on a “duck hunt.” The secrecy was intentional; if it became public that top Wall Street bankers were designing the country’s monetary system, the plan would be politically doomed.

Over the course of roughly a week, they drafted what became known as the Aldrich Plan, which envisioned a single, privately controlled central banking institution called the National Reserve Association, with regional branches.

Although the Aldrich Plan never became law, it served as the intellectual foundation for the Federal Reserve Act.

When Democrats won the 1912 election, they rejected Aldrich’s proposal as too dominated by Wall Street. Still, they kept its key architecture: a central banking system with regional reserve banks coordinated by a national board.

The Democrats, led by Representative Carter Glass of Virginia and Senator Robert L. Owen of Oklahoma, rewrote the plan to shift control from private bankers to a public board appointed by the federal government.

President Woodrow Wilson personally guided the compromise, insisting on what he called a “decentralized central bank”. That being a bank with public oversight in Washington, but with regional Reserve Banks reflecting local interests.

The final bill created a new institution that consisted of a Board of Governors in Washington appointed by the President, a new elastic currency called Federal Reserve Notes, and a lender-of-last-resort “discount window”.

There were other unique elements of this new institution. The Twelve regional Federal Reserve Banks were to be owned by member commercial banks in that region.

This is something that most people don’t realize. The regional Federal Reserve banks, which do most of the actual banking and work with individual banks, are not technically government institutions.

Also, the system would be funded outside the federal budget to insulate it from political pressures.

Once the House and Senate reconciled their versions, Wilson pressed Congress to pass the bill before the holiday recess. After intense debate, the Senate approved the Federal Reserve Act on December 19, 1913. The House followed on December 22. Wilson signed it into law on December 23, 1913, just before Christmas, noting that the country finally had a central banking system that balanced public authority with regional representation.

The timing was not accidental. Wilson and the Democratic leadership wanted the bill passed before opponents could regroup in the new year. Some members complained that the vote was being rushed in the final days before Christmas, but the political momentum, plus the lingering memory of 1907, carried it through.

The Federal Reserve Board began operations in December 1914, just months after the outbreak of World War I in Europe. The new institution immediately faced extraordinary challenges.

As European powers liquidated American securities to finance the war, gold flowed into the United States in unprecedented quantities. The Fed had to manage this influx while maintaining domestic financial stability and helping to finance American participation in the war after 1917.

During these formative years, the Fed’s role and authority was poorly defined. The regional Reserve Banks exercised considerable autonomy, sometimes pursuing conflicting policies.

The Fed also struggled to establish its relationship with the Treasury Department, which had traditionally managed government finances and influenced monetary conditions through its handling of federal deposits and bond sales.

Benjamin Strong, who served as Governor of the Federal Reserve Bank of New York from 1914 until his death in 1928, emerged as the system’s most influential figure during this period.

Strong pioneered the use of open market operations, the buying and selling of government securities, as a tool for influencing credit conditions. He also worked to establish the dollar as a key international currency and collaborated with European central bankers to stabilize the international monetary system during the 1920s.

However, the 1920s also revealed the Fed’s limitations and misjudgments. As stock prices soared in the late 1920s, Fed officials debated how to respond. Some worried about speculative excess and advocated tighter monetary policy, while others argued that stable commodity prices should dictate appropriate policy.

The Fed ultimately pursued a middle course that proved inadequate to prevent either the stock market crash or the subsequent economic catastrophe.

The Great Depression represents the darkest chapter in Federal Reserve history. Between 1929 and 1933, the American economy contracted by roughly one-third, unemployment soared above twenty-five percent, and nearly half of all banks failed.

The Federal Reserve was created to prevent the panics that occurred in the late 19th century, and now, under its watch, the country experienced the greatest panic ever.

The actual mechanics of what happened during the Great Depression will be the topic of a future episode, as it is a pretty involved subject.

However, it became obvious that reforms to the Federal Reserve were necessary.

The end result of the Banking Act of 1935.

One of the core changes was to the governance and internal organization of the Federal Reserve System. Prior to 1935, the Washington-based board was called the “Federal Reserve Board”.

The Act renamed it the Board of Governors of the Federal Reserve System and reorganized leadership titles so that the chief executive became the Chairman of the Board of Governors, the second in command became the Vice-Chair, and the other members were titled “Governors”.

It removed from membership of the Board of Governors the Secretary of the Treasury and the Comptroller of the Currency, who had previously sat on the Board. With their removal, the Board gained greater independence from the executive branch.

The Act also formally established the terms and appointment of Governors. They would be nominated by the President and confirmed by the Senate for staggered, long-term appointments, with the intent of insulating them from direct political influence.

Another major reform was the re-organisation of the Federal Open Market Committee or FOMC, the body responsible for coordinating openmarket operations (buying/selling government securities) and thus influencing credit and money in the economy.

The Act established the FOMC in its modern form, comprising all seven members of the Board of Governors, plus five regional Reserve Bank presidents, on a rotating basis, as voting members.

The Act also gave the Board of Governors explicit power to set reserve requirements for member banks.

In the 1970s, Congress clarified the goals that monetary policy should pursue. Amendments in 1977 articulated the now familiar mandate to promote maximum employment and stable prices.

There is a lot more to be said about the Federal Reserve. They are unquestionably the most important economic organization on Earth.

The adjustment of interest rates on the world’s reserve currency, the ability to establish bank reserve limits, and conducting open market operations have profound implications for everything.

Stock markets, real estate, inflation, unemployment, and many other factors, for better or worse, are all dependent on decisions made by the Federal Reserve.

An institution created in the years preceding the First World War, which was the latest iteration of a national bank first established in the 18th century.