Myth #1: The Federal Reserve Act of 1913

Discussion in 'Financial Cents' started by Quigley_Sharps, Aug 15, 2006.


  1. Quigley_Sharps

    Quigley_Sharps The Badministrator Administrator Founding Member

    Myth #1: The Federal Reserve Act of 1913 was crafted by Wall Street bankers and a few senators in a secret meeting.




    BY: Edward Flaherty, Ph.D. Department of Economics College of Charleston, S.C.

    On the Georgian resort hideaway of Jekyll Island (which has some excellent golf courses, by the way), there once met a coalition of Wall Street bankers and U.S. senators. This secret 1910 meeting had a sinister purpose, the conspiracy theorists say. The bankers wanted to establish a new central bank under the direct control of New York's financial elite. Such a plan would give the Wall Street bankers near total control of the financial system and allow them to manipulate it for their personal gain.
    G. Edward Griffin lays out this conspiratorial version of history in his book The Creature from Jekyll Island. His amateurish take on history is highly suspect, however. Gerry Rough, in a series of well- researched essays on U.S. banking history, reveals many historical inaccuracies, inconsistencies, and even contradictions in Griffin's book and others of its genre. Instead of reproducing Rough's work here, I offer the reader a substantially more accurate view of the events leading up to the creation of the Federal Reserve System in 1913. To get a proper historical perspective, the story of begins just prior to the Civil War...

    The National Banking Acts of 1863 & 1864

    Prior to the Civil war there were thousands of banks in operation throughout the Union, all of them chartered, that is, licensed by the state governments. Banking regulations were virtually nonexistent. The federal government had no meaningful controls on banking practices, and state regulations were spotty and poorly enforced at best. Economic historians call the era leading up to the Civil War as the 'state banking era' or the 'free banking era.'

    The problems with state banking were numerous, but three were conspicuous. First, the nation had no unified currency. State banks issued their own bank notes as currency, a system which at worst invited severe bouts of counterfeiting and at best introduced additional uncertainty in the task of determining the relative value of each bank note. Second, with no mitigating influence on the issuance of bank notes, the money supply and the price level were highly unstable, introducing and perhaps causing additional volatility in the business cycle. This was due in part to the fact that bank note issuance was frequently tied to the market value of the bank's bond portfolio which they were required to have by law. Third, frequent bank runs resulted in substantial depositor losses and severe crises of confidence in the payments system.5

    The National Banking Acts of 1863 and 1864 were attempts to assert some degree of federal control over the banking system without the formation of another central bank. The Act had three primary purposes: (1) create a system of national banks, (2) to create a uniform national currency, and (3) to create an active secondary market for Treasury securities to help finance the Civil War (for the Union’s side).5

    The first provision of the Acts was to allow for the incorporation of national banks. These banks were essentially the same as state banks, except national banks received their charter from the federal government and not a state government. This arrangement gave the federal government regulatory jurisdiction over the national banks it created, whereas it asserted no control over state-chartered banks. National banks had higher capital requirements and higher reserve requirements than their state bank counterparts. To improve liquidity and safety they were restricted from making real estate loans and could not lend to any single person an amount exceeding ten percent of the bank's capital. The National Banking Acts also created under the Treasury Department the office of Comptroller of the Currency. The duties of the office were to inspect the books of the national banks to insure compliance with the above regulations, to hold Treasury securities deposited there by national banks, and, via the Bureau of Engraving, to design and print all national banknotes.5

    The second goal of the National Banking Acts was to create a uniform national currency. Rather than have several hundred, or several thousand, forms of currency circulating in the states, conducting transactions could be greatly simplified if there were a uniform currency. To achieve this all national banks were required to accept at par the bank notes of other national banks. This insured that national bank notes would not suffer from the same discounting problem with which state bank notes were afflicted. In addition, all national bank notes were printed by the Comptroller of the Currency on behalf of the national banks to guarantee standardization in appearance and quality. This reduced the possibility of counterfeiting, an understandable wartime concern.5

    The third goal of the Acts was to help finance the Civil War. The volume of notes which a national bank issued was based on the market value of the U.S. Treasury securities the bank held. A national bank was required to keep on deposit with the Comptroller of the Currency a sizable volume of Treasury securities. In exchange the bank received bank notes worth 90 percent, and later 100 percent, of the market value of the deposited bonds. If the bank wished to extend additional loans to generate more profits, then the bank had to increase its holdings of Treasury bonds. This provision had its roots in the Michigan Act, and it was designed to create a more active secondary market for Treasury bonds and thus lower the cost of borrowing for the federal government.5

    It was the hope of Secretary of the Treasury Chase that national banks would replace state banks, and that this would create the uniform currency he desired and ease the financing of the Civil War. By 1865 there were 1,500 national banks, about 800 of which had converted from state banking charters. The remainder were new banks. However, this still meant that state bank notes were dominating the currency because most of them were discounted. Accordingly, the public hoarded the national bank notes. To reduced the proliferation of state banking and the notes it generated, Congress imposed a ten percent tax on all outstanding state bank notes. There was no corresponding tax of national bank notes. Many state banks decided to convert to national bank charters because the tax made state banking unprofitable. By 1870 there were 1,638 national banks and only 325 state banks.5

    While the tax eventually eliminated the circulation of state bank notes, it did not entirely kill state banking because state banks began to use checking accounts as a substitute for bank notes. Checking accounts became so popular that by 1890 the Comptroller of the Currency estimated that only ten percent of the nation's money supply was in the form of currency. Combined with lower capital and reserve requirements, as well as the ease with which states issued banking charters, state banks again became the dominant banking form by the late 1880’s. Consequently, the improvements to safety that the national banking system offered were mitigated somewhat by the return of state banking.5

    There were two major defects remaining in the banking system in the post Civil War era despite the mild success of the National Banking Acts. The first was the inelastic currency problem. The amount of currency which a national bank could have circulating was based on the market value of the Treasury securities it had deposited with the Comptroller of the Currency, not the par value of the bonds. If prices in the Treasury bond market declined substantially, then the national banks had to reduce the amount of currency they had in circulation. This could be done be refusing new loans or, in a more draconian way, by calling-in loans already outstanding. In either case, the effect on the money supply is a restrictive one. Consequently, the size of the money supply was tied more closely to the performance of the bond market rather than needs of the economy.5

    Another closely related defect was the liquidity problem. Small rural banks often kept deposits at larger urban banks. The liquidity needs of the rural banks were driven by the liquidity demands of its primary customer, the farmers. In the planting season the was a high demand for currency by farmers so they could make their purchases of farming implements, whereas in harvest season there was an increase in cash deposits as farmers sold their crops. Consequently, the rural banks would take deposits from the urban banks in the spring to meet farmers’ withdrawal demands and deposit the additional liquidity in the autumn. Larger urban banks could anticipate this seasonal demand and prepare for it most of the time. However, in 1873, 1884, 1893, and 1907 this reserve pyramid precipitated a financial crisis.5

    When national banks experienced a drain on their reserves as rural banks made deposit withdrawals, new reserves had to be acquired in accordance with the federal law. A national bank could do this by selling bonds and stocks, by borrowing from a clearinghouse, or by calling-in a few loans. As long as only a few national banks at a time tried to do this, liquidity was easily supplied to the needy banks. However, an attempt en masse to sell bonds or stocks caused a market crash, which in turn forced national banks to call in loans to comply with Treasury regulations. Many businesses, farmers, or households who had these loans were unable to pay on demand and were forced into bankruptcy. The recessionary vortex became apparent. Frightened by the specter of losing their deposits, in each episode the public stormed any bank rumored, true or not, to be in financial straights. Anyone unable to withdraw their deposits before the bank’s till ran dry lost their savings or later received only pennies on the dollar. Private deposit insurance was scant and unreliable. Federal deposit insurance was non-existent.5

    The 1907 Banking Panic

    The 1907 crisis, also called the Wall Street Panic, was especially severe. The Panic caused what was at that time the worst economic depression in the country’s history. It appears to have begun with a stock market crash brought about by a combination of a modest speculative bubble, the liquidity problem, and reserve pyramiding. Centered on New York City, the scale of the crisis reached a proportion so great that banks across the country nearly suspended all withdrawals -- a kind of self-imposed bank holiday. Several long-standing New York banks fell. The unemployment rate reached 20 percent at the peak of the crisis. Millions lost their deposits as thousands of banks collapsed. The crisis was terminated when J.P. Morgan, a man of sometimes suspicious business tactics and phenomenal wealth, personally made temporary loans to key New York banks and other financial institutions to help them weather the storm. He also made an appeal to the clergy of New York to employ their Sunday sermons to calm the public’s fears.

    Morgan’s emergency injection of liquidity into the banking system undoubtedly prevented an already bad situation from getting still worse. Although private clearinghouses were able to supply adequate temporary liquidity for their members, only a small portion of banks were members of such organizations. What would happen if there were no J.P. Morgan around during the next financial crisis? Just how bad could things really get? There began to emerge both on Wall Street and in Washington a consensus for a kind of institutionalized J.P. Morgan, that is, a public institution that could provide emergency liquidity to the banking system to prevent such panics from starting. The final result of the Panic of 1907 would be the Federal Reserve Act of 1913.

    The Federal Reserve Act of 1913

    Following the near catastrophic financial disaster of 1907, the movement for banking reform picked up steam among Wall Street bankers, Republicans, and eastern Democrats. However, much of the country was still distrustful of bankers and of banking in general, especially after 1907. After two decades of minority status, Democrats regained control of Congress in 1910 and were able to block several Republican attempts at reform, even though they recognized the need for some kind of currency and banking changes. In 1912 Woodrow Wilson won the Democratic party’s nomination for President, and in his populist-friendly acceptance speech he warned against the "money trusts," and advised that "a concentration of the control of credit ... may at any time become infinitely dangerous to free enterprise."3

    Also in 1910, Senator Nelson Aldrich, Frank Vanderlip of National City (today know as Citibank), Henry Davison of Morgan Bank, and Paul Warburg of the Kuhn, Loeb Investment House met secretly at Jeckyll Island, a resort island off the coast of Georgia, to discuss and formulate banking reform, including plans for a form of central banking. The meeting was held in secret because the participants knew that any plan they generated would be rejected automatically in the House of Representatives if it were associated with Wall Street. Because it was secret and because it involved Wall Street, the Jekyll Island affair has always been a favorite source of conspiracy theories. However, the movement toward significant banking and monetary reform was well-known.3 It is hardly surprising that given the real possibility of substantial reform, the banking industry would want some sort of input into the nature of the reforms. The Aldrich Plan which the secret meeting produced was even defeated in the House, so even if the Jekyll Island affair was a genuine conspiracy, it clearly failed.

    The Aldrich Plan called for a system of fifteen regional central banks, called National Reserve Associations, whose actions would be coordinated by a national board of commercial bankers. The Reserve Association would make emergency loans to member banks, create money to provide an elastic currency that could be exchanged equally for demand deposits, and would act as a fiscal agent for the federal government. Although it was defeated, the Aldrich Plan served as an outline for the bill that eventually was adopted. 5

    The problem with the Aldrich Plan was that the regional banks would be controlled individually and nationally by bankers, a prospect that did not sit well with the populist Democratic party or with Wilson. As the debate began to take shape in the spring of 1913, Congressman Arsene Pujo provided good evidence that the nation’s credit markets were under the tight control of a handful of banks – the "money trusts" against which Wilson warned.1 Wilson and the Democrats wanted a reform measure which would decentralize control away from the money trusts.

    The legislation that eventually emerged was the Federal Reserve Act, also known at the time as the Currency Bill, or the Owen-Glass Act. The bill called for a system of eight to twelve mostly autonomous regional Reserve Banks that would be owned by the banks in their region and whose actions would be coordinated by a Federal Reserve Board appointed by the President. The Board’s members originally included the Secretary of the Treasury, the Comptroller of the Currency, and other officials appointed by the President to represent public interests. The proposed Federal Reserve System would therefore be privately owned, but publicly controlled. Wilson signed the bill on December 23, 1913 and the Federal Reserve System was born.6

    Conspiracy theorists have long viewed the Federal Reserve Act as a means of giving control of the banking system to the money trusts, when in reality the intent and effect was to wrestle control away from them. History clearly demonstrates that in the decades prior to the Federal Reserve Act the decisions of a few large New York banks had, at times, enormous repercussions for banks throughout the country and the economy in general. Following the return to central banking, at least some measure of control was removed from them and placed with the Federal Reserve.

    References:

    1. Davidson, James West, Mark A. Lytle, et al, (1998), Nation of Nations, New York: McGraw-Hill.

    2. Galbraith, John K. (1995), Money: Whence it Came, Where it Went, Boston: Houghton Mifflin.

    3. Greider, William (1987), Secrets of the Temple, New York: Simon & Schuster.

    4. Griffin, G. Edward (1995), The Creature from Jekyll Island, Appleton: American Opinion Publishing, Inc.

    5. Kidwell, David S. and Richard Peterson (1997), Financial Institutions, Markets, and Money, 6th edition, Fort Worth: Dryden Press.

    6. "Wilson Signs the Currency Bill," New York Times, pages 1-2, December 24, 1913
     
  2. Seacowboys

    Seacowboys Senior Member Founding Member

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