“Ideas shape the course of history.” – John Maynard Keynes
Last week’s Insight was the first in a series we are posting on the Federal Reserve in which we reviewed some of the historical context of the US banking system leading up to the creation of the Federal Reserve. In this week’s post we will continue our walk through history by taking a closer look at the period of time directly before and after the Federal Reserve's creation in 1913.
National Bank Era (1863 – 1913)
In 1863, in response to the myriad of bank failures the country experienced during the free bank era, the National Banking Act was passed to assert some level of federal control over the banks, create a uniform national currency, and help finance the Civil War efforts for the Union. Although the act was largely successful in achieving these three goals, it made no attempt to address the issue of an inelastic currency which was the heart of the problem behind the plethora of bank failures from before.
At the time the US was still very much an agrarian society, so the natural cycle of a planting and harvesting season would strain the banking system. Cash/reserves would leave the banking system in the spring when farmers need their capital to purchase seed and other materials for planting crops and then return in mass after the fall harvest when the crops had been sold. This cycle put pressure on banks who were most vulnerable in the spring when reserves were at their seasonal low point. The embedded political cartoon tries to illustrate this point by having President Teddy Roosevelt explain to a sharp dressed man wearing a top hat labeled “Congress” as to why a forlorn Uncle Sam is unable to bend over to move the crops with his inelastic suspenders labeled “US currency” for fear of putting excessive strain on his suspender buttons labeled “financial centers.”
Although the National Banking Act did bring some stability to the banking system, the lack of an elastic currency meant that bank runs and financial panics were still very much the norm. Financial panics in 1893 and 1907 led to severe economic depressions, which were only eradicated after J.P. Morgan intervened as a lender of last resort.
Creation of the Federal Reserve (1907 – 1913)
After the financial panics of 1893 and 1907, it became very clear to policy makers that the United States needed a lender of last resort with to provide liquidity and stability to the banking system through the management of an elastic currency. At the time, the US was the last major country in the world without a central bank. Rhode Island Senator Nelson Aldrich was commissioned to travel to Europe to study their central banking system and propose a plan for the US. He left a critic of the idea but returned a supporter. In 1910, he and several prominent bankers met in secret at the now infamous country club on Jekyll Island to write the first draft of a Federal Reserve charter which would later be known as the Aldrich Plan.
The Aldrich Plan, which was based on the idea that the Federal Reserve would be owned and operated by privately owned banks, did not have bipartisan support because many of the Democratic constituents in rural America did not like the idea of so much power being given to an elite group of east coast bankers. Williams Jennings Bryan who was a populist from Nebraska and widely considered a man of the people was quoted as saying, “They [the east bankers] will then be in complete control of everything through the control of our national finances.”
Without bi-partisan support, the Aldrich Plan never gained much traction. Then in 1912, Democratic nominee Woodrow Wilson was elected President. Wilson worked with Senator Carter Glass and others in revising the Aldrich Plan to address the concerns of rural Americans. The key alteration was changing the Federal Reserve from a privately owned institution into an independent government agency overseen by a board whose chairman would be appointed by the President with the advice and consent of the US Senate. This structure ensured that different parts of the country had equal say in how the Fed would be run vs. an elite group of east coast bankers. With this alternation, the plan gained bipartisan support and The Federal Reserve Act of 1913 was passed.
US Federal Reserve Era – Act I (1913 - 1929)
The newly created Federal Reserve was successful in adding stability to the banking system. Having an elastic money supply meant that the Fed could smooth out the interest rate cycle by taking counter cyclical measures. Going back to our farming example, the Fed could expand the money supply in the spring when reserves were being drained out of the banking system and contract it in the fall after reserves were added back after harvest. This made it easier for banks to lend money, which was a blessing and a curse.
The ease of credit led to the speculative bubble and asset price inflation now known as the Roaring 20’s. Eventually the Fed decided they needed to do something to stem the speculation so they raised interest rates in order to make it harder for speculators to borrow money and invest in the stock market. The unintended consequence of this move was that it worked a little too well and money quickly fled out of the stock market causing the now infamous Crash of 1929. Higher interest rates and the swift shift in sentiment led to less spending in the “real economy” which created a recession that later turned into a depression. This in turn led to financial panics and bank runs. The newly formed Federal Reserve was in prime position to provide liquidity as lender of last resort, but at the time, policy prohibited the Fed from making loans to distressed member banks that lacked sufficient collateral. As such, cash-starved banks failed by the thousands.
The Fed’s first foray into being a lender of last resort to quell financial panics was a complete failure, but all was not lost as lessons were learned and the Fed was given even more power to fight the next crisis. This pattern of expanding the Fed’s reach in response to market turmoil has been a common theme over the Fed’s century long history and is the topic of next week’s Insight.
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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