An Early History of The Federal Reserve of the United States
Established in 1913 through the Federal Reserve Act as a response to the perceived instability of the American financial apparatus, the Federal Reserve System was initially charged “to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking, and for other purposes”, such as “improving the payments system through more efficient collection and clearing of checks and with the provision of fiscal services to the U.S. Treasury” (Parthemos 25).
However, when faced with the crisis that was the Great Depression, the Federal Reserve System failed to meet its stated goals, and according to many economic experts, actually worsened and prolonged the effects of the economic downturn. By examining the circumstances that led to the creation of the Federal Reserve System, the policy itself and the economic theory that guided it, and the final outcome of that policy in regards to the Great Depression, one may be able to draw insight into the efficacy of the banking regulatory system in the United States at that time.
Background Economic Conditions
There were several perceived deficiencies in the national monetary system in the United States that the Federal Reserve Act was supposed to address. Chief among these deficiencies was the perceived inelasticity of the currency supply. This inelasticity could be traced back to the Civil War, as when the Union created a national bank note backed by a 2 percent government bond issue (Mehrling 207) in order to fund the war effort. Additionally, fixed reserve requirements limited the use of bank deposit increase and decrease as an artificial monetary elasticity producer (Mehrling 208).
Also, the modicum of elasticity present in the system was achieved by “pyramiding” reserves, with cash deposits in New York banks viewed as reserves in the rest of the country (Mehrling 208). The San Francisco earthquake and subsequent fires in 1906 started the chain of events that would expose these weaknesses in the financial system at the time and be the catalyst that would spur the nation into adopting a centralized monetary management system.
One of the most devastating natural disasters to ever happen in the United States, the San Francisco earthquake caused “between $350-500 million, or 1.3 to 1.8 percent of U.S. GNP in 1906” (Odell, Weidenmier 2). Since it was the case that British insurance companies had underwritten the majority of fire insurance claims in San Francisco, a direct result of the earthquake was a large movement of capital across the Atlantic, which threatened the stability of the pegged exchange rate between the dollar and the pound Sterling.
In response to this threat, the Bank of England increased by 2 and a half times its discount rate, attracting massive imports of gold into England and precipitously decreasing the movement of gold into the United States. Actions by the Bank of England and other European central banks to keep their domestic gold supplies at acceptable levels resulted in decreased liquidity in the U.S. and plunged the American economy into an extremely severe recession, beginning in May of 1907 as “industrial production fell 40 percent in the next three months” (Odell, Weidenmier 14), and set the stage for the Panic of 1907, “a major financial crisis to erupt from circumstances that in other times might not have sparked concern” (Tallman, Moen 7).
The Panic of 1907 began with an attempt by F.A. Heinze, a former mine operator from Montana turned Wall Street banker, and some of his associates to buy out the stock of United Copper. Upon failing in his scheme, Heinze was forced to resign from his position as president of Mercantile National Bank, prompting a bank run by depositors. The New York Clearing House, a “consortium of New York banks” (Tallman, Moen 4) contained this initial run, along with smaller, related runs at banks operated by Heinze’s associates. A run on the Knickerbocker Trust Company, whose president was implicated in Heinze’s corner attempt, began days later.
This particular run was compounded by the National Bank of Commerce’s decision to no longer clear checks from the Knickerbocker Trust. Furthermore, another trust company, the Trust Company of America soon found itself to also be the victim of a run, as it shared its president with the Knickerbocker Trust. In order to have funds on hand to meet the influx of withdrawals, the trusts had to “liquidate their most liquid assets, call loans on the stock market” (Tallman, Moen 11) at a time that the New York Stock Exchange was finding call money, which was money that was lent out to facilitate the purchase of equities, harder and harder to come by. The large scale liquidation of the call loans by the trust companies would have depressed stock prices even further, making the Panic even more severe than it already was at that point.
Without the power of a central bank to manage this financial crisis, the responsibility to work towards a healthy resolution of the matter fell onto the shoulders the Wall Street banking elite, most notably J.P. Morgan and J.D. Rockefeller (Tallman, Moen 8). Throughout the entire Panic, Morgan and Rockefeller were maneuvering behind the scenes, forming coalitions among banks and trusts to lend out money to their distressed counterparts, with the knowledge that letting the Panic spread wider could affect the entire financial system. However, the Wall Street bankers found themselves with very few options as to how to resolve the Panic, as there was no legal mechanism in place to increase the money supply in the United States.
Policy & Economic Theory
To attempt to fix the monetary system in the United States, Congress passed the Federal Reserve Act in 1913. Spearheaded by Democratic Representative Carter Glass, the Act broke up the country into between 12 and 8 Federal Reserve Districts, each with its own Reserve Bank. Each Reserve Bank had a Board of Directors of 9 people, broken down into three spheres of representation: stock-holding member banks; commercial, agricultural, and industrial interests; and the public at large. A Federal Reserve Board was set up to oversee the activities of all of the regional banks, advised by a Federal Advisory Council made up of elite bankers (Parthemos 25). The two main drawbacks of the old monetary system were addressed as well.
Elasticity was created in the system via the issuance of Federal Reserve Notes as the new national currency, backed by a blend of gold and commercial paper. And because bank reserves would now be held at the regional Federal Reserve banks who had the “authority to rediscount each other’s paper … the banking system’s reserve base could quickly be mobilized to meet extraordinary banking pressures” (Parthemos 26). Finally, the Reserve Banks were also positioned to be collectors of interbank claims and serve as clearinghouses.
The economic theory behind the implementation of the Federal Reserve System is based on two different yet compatible economic theories. In the language of the Federal Reserve Act, the rhetoric of a modified “real bills doctrine” is used. This doctrine, elucidated at the time by J. Laurence Laughlin, believed that the “monetary liabilities of the banking system should ideally be backed by holdings of short-term, self-liquidating commercial bills” (Mehrling 209). This approach was thought to have several advantages. Most prominently, a system built upon the “real bills doctrine” would be much more elastic than the status quo, as it would be able to react to changing credit needs in the economy because of its being based on commercial paper.
Laughlin believed that the best way to implement such a system was to mandate that “certain types of business credit could always be converted into bank reserves” (Mehrling 209). Banks making business loans would not have to worry about the level of bank reserves they hand on hand, as the act of making the loan was implicitly increasing the bank’s reserves at the same time.
Conflicting with Laughlin’s analysis is that of Paul Warburg, a German Wall Street banker who wanted the United States to have a central bank similar to those of Europe. Under Warburg’s plan, elasticity would be created through the inception of a national bill market. The theory behind this approach was that “bank bill holdings could serve as a secondary reserve, salable in times of stringency to move reserves where they were most needed” (Mehrling 212). Additionally, Warburg wanted the bills to be privileged at the discount window, such that the Federal Reserve System could use its influence over the discount rate to try and steer the market interest rate in the direction it desired.
In the end, while Laughlin’s language of the “real bills doctrine” found its way into the wording of the Federal Reserve Act, it was Warburg’s vision of how the Federal Reserve should go about influencing monetary policy that prevailed in practice.
Originally conceived as a decentralized network of regional banks who would work together to achieve more stability in the financial system, the Federal Reserve took on a much more active and centralized role in its management of the American economy very soon after its creation. Under the leadership of its first president, Benjamin Strong, the Federal Reserve responded to its first crisis fairly well.
Abandoning the primacy of commercial paper and the “real bills doctrine”, the Federal Reserve followed a monetary policy whose goal was to support the government debt financing of World War I (Mehrling 214). The peacetime following the end of the war found the Federal Reserve attempting to reintroduce the gold standard internationally and trying to manage credit cycle fluctuations (Mehrling 214). The biggest change in the Federal Reserve’s direction however occurred with the legitimization of open market operations in its Tenth Annual Report.
Still constrained by the language of the Federal Reserve Act which seemed to limit its scope, “in a stroke of rhetorical genius the report presents open market operations not as an activist policy intervention, but merely as a way of testing the legitimacy of credit needs by altering the need for discounts” (Mehrling 214). This offered the Federal Reserve an entirely new method of controlling the money supply, through controlling the cost of reserves.
Unfortunately, the inability of the Federal Reserve to deal correctly with the monetary issues surrounding the Great Depression cast great doubt on the efficacy of the central banking model as set up by the Federal Reserve Act and modified by Benjamin Strong. The Great Depression in the United States ended the era known as the “Roaring Twenties”, as increases in the availability of consumer-level debt along with the rise of consumerism fostered the growth of the money supply by an annual rate of 5.7 percent between 1922 and 1928 (Bordo, Choudhri, Schwartz 488).
The Federal Reserve’s policies during the late 1920’s was of that of contraction in response to a rapidly rising stock market and a move of gold to France as it reinstated the gold standard. As the Great Depression began, the supply of money started to contract, slowly at first with a 2.2 percent decline, but “beginning in October 1930, with the onset of a series of banking panics, [the monetary supply] began a plunge whereby m (ln M2) fell by 12.4 percent at an annual rate” for the next 3 years (Bordo, Choudhri, Schwartz 488). This contraction in the money supply plunged the American economy into the deepest recession in its history, the ripple effects of which affected the entire international economy. The Federal Reserve attempted to use its newfound powers of open market operations to try and stop the economic decline that was occurring.
Between February and August of 1932 the Federal Reserve undertook more than $1 billion in open market purchases. However, this policy of purchasing stopped in August of 1932 and the Federal Reserve stood idle as the rate of bank failures reached a fever pitch in the spring of 1933 and the financial system collapsed, with 35 states declaring bank holidays in the fall of 1933 (Meltzer 11). This inaction as the situation worsened caused the effects of the Great Depression to be much more severe than they would have been if the Federal Reserve had engaged in a stable money policy (Bordo, Choudhri, Schwartz 503).
In conclusion, the Federal Reserve System was created as a response to the perceived weaknesses in the American financial system, some of which dated back to the Civil War era issuance of blackbacks and national bank notes. The inelasticity of the money supply, and the “pyramiding” of bank reserves, along with issues of national check-clearing and interbank claim collection were all issues that the creation of the Federal Reserve was supposed to address.
The economic foundation of the Federal Reserve Act was twofold: the “real bills doctrine” of J. Laurence Laughlin was found in the language of the Act while the influence of the European central banking model was felt through the influence of Paul Warburg. While the nascent Federal Reserve dealt well the financing troubles causes by World War I, it failed to respond adequately to the Great Depression; in fact, the actions undertaken by the Federal Reserve might have succeeded in worsening the effects of what might have otherwise been simply a bad recession.
FRB Richmond Economic Review, vol. 74, no. 4, July/August 1988, pp. 19-28Kerry Odell, Marc D. Weidenmier (2001). Real Shock, Monetary Aftershocks: The San Francisco Earthquake and the Panic of 1907 Claremont Colleges Working Papers in EconomicsTallman, Ellis W., Moen, Jon R.. "Lessons from the Panic of 1907. " Economic Review - Federal Reserve Bank of Atlanta 75.3 (1990): 2.Perry Mehrling. "Retrospectives: Economists and the Fed: Beginnings. " The Journal of Economic Perspectives 16.4 (2002): 207-218.Allan H Meltzer. "Financial collapse: 1933. " Atlantic Economic Journal 29.1 (2001): 1-19.Bordo, Michael D, Choudhri, Ehsan U, Schwartz, Anna J. "Could stable money have averted the Great Contraction? " Economic Inquiry 33.3 (1995): 484.