"Give me control of a nation's money and I care not who makes its laws" -- Mayer Amschel Rothschild
We are excited to be partnering with Liberty Street Films to bring their new documentary, Money for Nothing: Inside the Federal Reserve, to our local community in Colorado Springs (details here). Over the next four weeks we will be doing a series of Insights on the Federal Reserve in the hopes of laying some groundwork for better understanding and appreciation of the material that will be covered in the film. Today we start this series by taking a look at the history of the US banking system and the events leading up to the creation of the Federal Reserve under the Federal Reserve Act of 1913.
The origins of centralized banking activity here in the United States dates all the way back to the American Revolutionary War when the Continental Congress printed paper money known as “continentals” to finance expensive military efforts. Continentals were issued so rapidly that they quickly lost their value and were considered worthless by the end of the war. To address this issue, Treasury Secretary Alexander Hamilton urged Congress to establish a central bank in the United States. In 1791 the First Bank of the United States was created with the charter to “manage the government's money and to regulate the nation's credit” from its headquarters in Philadelphia. The federal government had a 20% ownership stake in the Bank and elected 20% of the Bank’s directors with the remainder being controlled by private investors.
The First Bank was not popular with many Americans who felt it gave too much power to and favored the New England states. Although it successfully carried out its mandate, Congress fell one vote short of renewing its charter upon its expiration in 1811. Without a central bank, the US economy had no governing agency to oversee banking and credit activity. This led to a plethora of private banks issuing their own form of currency and extending credit in a non-uniform way across the country.
By 1816, the political climate had shifted and was once again ripe for the introduction of a US central bank. After several years of economic disruptions and numerous bank runs, Congress decided to charter the Second Bank of the United States. The Second Bank was structured similarly to the First Bank and received the same backlash from Americans who felt that its activities advantaged the elite at the expense of the country’s more rural population. In 1828 Andrew Jackson was elected president on the promise of quelling the banker controlled power being perpetuated by the current system. Many Americans shared in President Jackson’s belief that a central bank created “a concentration of power in the hands of a few men irresponsible to the people." The embedded cartoon shows Jackson destroying the Second Bank to the approval of Uncle Sam with the Bank’s president, Nicholas Biddle, depicted as the Devil. When the Second Bank’s charter expired in 1836 it was not renewed.
Source: Time Magazine
The period that followed was known as the “free bank” era. During this period of time, banks were unregulated and issued their own currencies in the form of banknotes. The value of banknotes would vary based on the credit quality of the issuing bank. Commerce was difficult since both parties had to be comfortable with and agree upon the value of the banknotes being exchanged. In 1863, during the heart of the American Civil War, the National Banking Act was passed to create a national currency backed by the US government. The Act brought stability to the currency system by levying a tax on state bank notes while exempting the national bank notes from the tax, which effectively created a uniform currency for the nation.
Although a uniform currency provided some measure of stability for the emerging US economy, bank runs and financial panics were still very much the norm. Without a centralized banking system or deposit insurance, people’s money was only as safe as their bank’s individual financial state. Whenever a bank was thought to be suffering from a liquidity problem, which was often the case for rural banks whose reserves would be drawn down during the growing season and then replenished after the harvest, people would pull their money out of the bank creating a self-fulfilling liquidity squeeze and eventual bank failure. Because of this, the last part of the 19th century and beginning of the 20th century was characterized by a series of financial panics. Financial panics in 1893 and 1907 led to severe economic depressions, which were only eradicated after J.P. Morgan intervened by effectively acting as a central bank and providing liquidity to the U.S. banking system.
Shortly after the panic in 1907 Congress created the National Monetary Commission to study the nation’s banking system. Senate Republican leader Nelson Aldrich was appointed the head of the commission. He travelled to Europe to study examples of central banking in practice. He left an opponent of central banking but returned in favor of it after studying Germany’s centralized banking system. In 1910, Aldrich and executives from several major banks had a secret ten day meeting at Jekyll Island, Georgia to draft the establishment of a U.S. central bank. What came out of that meeting became known as the Aldrich Plan which proposed a well-capitalized central bank with 15 branches to represent the different regions of the United States. Each branch would then be controlled by their member banks with voting power tied to the size of each member bank. The plan was well supported by banks and most Republicans but lacked bipartisan support to pass through Congress.
The bill lacked bipartisan support because Aldrich was seen as the epitome of the “Eastern establishment,” which southerners and westerners already felt had too much power. Democratic Nebraskan populist William Jennings Bryan said that if the plan passed, large banks would “then be in complete control of everything through the control of our national finances.” (A sentiment shared by Mayer Amschel Rothschild in the opening quote over a century before Jennings Bryan’s time.) Opposition to the “money trust” proposed by the Aldrich Plan and support for protecting the general public from financial panics became the central platform of the Democratic Party in the 1912 election. The campaign was successful and the Democratic Party took control of presidency and both chambers of Congress.
The Chairman of the House Committee on Banking and Currency, Carter Glass, redrafted the Aldrich plan for newly elected president Woodrow Wilson who supported the core tenants of the Aldrich plan. When President Wilson first brought the Federal Reserve Act to Congress it was vehemently opposed by some members of his own party on the basis that smaller, regional banks would not be afforded the same government backing as the larger, centralized banks. It was only after Wilson garnered the support of Jennings Bryan and agreed to pass anti-trust measures after the bill had passed, that the Federal Reserve Act got any traction. After months of deliberation, hearings, and amendments the Federal Reserve Act passed both branches of Congress and was signed into law by President Wilson in December 1913.
The final plan represented a compromise between the competing political parties which created an independent central bank that balanced the interests of private banks and American people. The American Institute of Economic Research provided the following synopsis on the bill.
In its final form, the Federal Reserve Act represented a compromise among three political groups. Most Republicans (and the Wall Street bankers) favored the Aldrich Plan that came out of Jekyll Island. Progressive Democrats demanded a reserve system and currency supply owned and controlled by the Government in order to counter the "money trust" and destroy the existing concentration of credit resources in Wall Street. Conservative Democrats proposed a decentralized reserve system, owned and controlled privately but free of Wall Street domination. No group got exactly what it wanted. But the Aldrich plan more nearly represented the compromise position between the two Democrat extremes, and it was closest to the final legislation passed.
The Federal Reserve Act of 1913 was a monumental piece of legislation in our nation’s history. Some might argue that it is responsible for the current level of prosperity we enjoy in the United States, while others would argue that it was the inflection point where “Big Brother” started down the long path of financial control over its citizenry. Both extremes have merit and as with most things, the truth probably lies somewhere in the middle. Next week we will look at the impact the Federal Reserve has had on the US economy over the past 100 years.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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