JOURNAL

The Creation of the Federal Reserve


2019/05/10 - Monocle Journal

On the eve of 19 October 1907, financier J.P. Morgan – then in his seventies – was compelled to abandon his plans for a quiet cigar on the porch of the house he had rented in Richmond, Virginia, and race back to New York on the next available train. Although he had been looking forward to his visit to Richmond for the triennial meeting of the Episcopal Church, an urgent call from his partners in the city had alarmed him enough to interrupt his plans for religious debate and countryside outings. Panic had broken out on Wall Street and the commercial centre of America needed captaining. In lieu of a central bank or a president – President Theodore Roosevelt was reportedly away on a hunting trip in Louisiana at the time – the plutocrats took charge. 

Federal Reserve

Several events occurred in the lead up to the Panic of 1907. In 1906, the San Francisco earthquake had triggered significant insurance pay-outs from British insurers, and to stem the flow of money from the UK into the US, the Bank of England raised its discount rate. As money started to flow back to the UK, the US stock market fell, and by May 1907, the US was in a recession. Later that year, monetary conditions tightened even further, when the US experienced its customary surge in demand for currency and credit from farmers over the autumn period, as they harvested and shipped their crops. As there was no central bank to provide any alleviation during this seasonal rise in demand, it was common practice for banks to individually increase interest rates. Then, on 16 October, a final blow was dealt to the financial system. Two bankers, Charles W. Morse and F. Augustus Heinze, tried and failed to corner the stock of copper mining company United Copper, and incurred a heavy loss. As news of the loss circulated, there was a run on the banks and trusts that were associated with Morse and Heinze. 

Fortunately, the panic was quickly contained in the banking sector, thanks to the role of the New York Clearing House Association. Before 1853, banks operating in New York would have to perform their clearing process manually – that is, a bank would record its exchanges with corresponding banks and then send porters to these banks to settle all transactions and exchange checks for cash on a weekly basis. However, with the number of banks growing rapidly between 1849 and 1853, bookkeeper George Lyman proposed the idea of a centralised clearing house, where certificates could replace the use of actual cash in the exchange process. And so, in 1853, the first clearing house in the US, the New York Clearing House Association, came into being.

For over fifty years, the Clearing House acted as a central bank and played a key role in preventing financial panics. It issued loan certificates that were backed by bank notes held by member banks, thus creating a quasi-currency that helped to stabilise the monetary system. When financial panic hit Wall Street in 1907, the New York Clearing House Association vouched for the solvency of its members and bank runs were quickly halted. However, in the case of trusts, no alleviation could be provided, because trust companies were excluded from the Clearing House’s membership. Instead, the panic intensified when two days later news broke that Morse had been associated with Charles T. Barney, the president of Knickerbocker Trust – the second-largest trust in the country. 

Trust companies emerged in the US in the late 1800s, acting as executors and trustees for funds owned by individuals and companies. However, they quickly found that there was insufficient demand for these services and in order to survive, trust companies began to engage in more general financial activities – taking deposits, providing loans, and making investments. Trusts essentially acted as commercial banks, although they were far less regulated than banks and often significantly more leveraged. This had both positive and negative effects for the economy. Trusts played a key role in providing liquidity by routinely extending short-term loans to New York equity markets, such as the New York Stock Exchange. At this time, nationally chartered commercial banks were prohibited from making uncollateralised loans or guaranteeing payment of checks written by brokers on accounts with insufficient funds. 

Unlike banks, trusts did not require collateral for the loans they extended in equity markets, which were repaid by the end of the business day. Brokers used the loans to purchase securities, the securities were then used as collateral for an overnight call loan from a bank, the call loan was used to purchase stock, and finally, the proceeds of the call loan were used to pay back the initial loan to the trust. This process supported daily transactions at the NYSE. 

However, whilst trusts played an important role in the financial system, unlike banks, trusts generally had a low volume of check clearing and consequently, held much lower cash reserves relative to deposits than banks did. The problem with this was that, like banks, trust company deposit accounts were demandable in cash, making these institutions vulnerable to runs on deposits. And where banks had the additional safety net of the Clearing House in these events, trusts found themselves in freefall. 

By 1907, J.P. Morgan was well-established as one of the wealthiest and most powerful bankers in the world. Early in his career, he had partnered with various other prominent bankers in America to form his own company, which was initially called J. Pierpont Morgan & Co., then Dabney, Morgan & Co., and later Drexel, Morgan and Co., before finally becoming J.P. Morgan & Co. in 1895. During this time, Morgan had been instrumental in reorganising and consolidating many railroad companies in the US, gaining control of a large portion of their stock in the process. By 1902, it was estimated that J.P. Morgan controlled a third of the country’s railroads. In 1892, he had also arranged the merger of Edison General Electric and Thomson-Houston Company to form General Electric, which would become one of the largest and most diversified corporations in the world. Morgan also gained enormous influence in the steel industry, buying Federal Steel in 1898 and Andrew Carnegie’s steel enterprises in 1901. He merged these companies into the United States Steel Corporation and in doing so, created the first billion-dollar corporation in the US. Morgan had also played an important role in reinstating order after the Panic of 1893, in which there had been a run on gold in the US Treasury. And fourteen years later, his influence was required once again. 

Upon arriving back in New York from Richmond, Morgan immediately assembled at his home the presidents of the largest banks, together with other prominent financiers. In his private study, he convinced them that there was only one thing to do: they had to provide credit to those trusts deemed solvent by Morgan’s specialised team, which was already investigating each of the trusts in trouble. Knickerbocker, however, was not one of them, and the trust was forced to close on 22 October after over $8 million had been withdrawn. Rather than containing the potential damage of the panic, the decision to let Knickerbocker close had the opposite effect. With the public’s confidence in trusts further eroded, a second wave of panic was ignited as depositors tried to access their money. 

Led by Morgan, the bank presidents, the US Treasury, and the Clearing House worked together to implement further emergency measures that saved the remaining trusts. However, significant damage had been done – and the US remained stuck in a recession until June the following year. And although it was the take-charge attitude of the leaders of the financial sector that had saved it from collapse, rather than applauding their efforts, these men became the subject of great suspicion following the bailout during the Panic of 1907. 

For many, the fact that the bankers – and J.P. Morgan, in particular – had possessed the power to rescue Wall Street from panic, ignited concerns that the small, elite group of leaders of financial institutions had altogether too much influence over the US financial system. Rumours began to circulate that a secret group of bankers and financiers called the “Money-trust” existed, who were colluding to take full control of the nation’s finances. Louisiana congressman and chairman of the House Committee on Banking and Currency, Arsene Pujo, was charged with investigating the Money-trust allegation in 1912. Although the investigation found no evidence of an actual secret society called the Moneytrust, the committee’s report did highlight the fact that a relatively small group of individuals had gained control over some of the biggest markets in the US, including the manufacturing sector, the transportation sector, mining, and telecommunications, and that several of the largest financial corporations were under the control of an even more concentrated group of financiers. Morgan was individually named in the report, together with other prominent bankers including Paul Warburg, Jacob H. Schiff, Felix M. Warburg, Frank Peabody, William Rockefeller and Benjamin Strong Jr. 

These findings spurred public support for a wave of policy changes that would reform the financial system and go some way to limiting the degree to which wealth and power could collect among such a small pool of beneficiaries. These changes included the approval of the Sixteenth Amendment – which authorised Federal Income Tax – and the Clayton Antitrust Act of 1914. Perhaps most importantly, they also resulted in the passing of the Federal Reserve Act in 1913. 

In the wake of the Panic of 1907, it was clear that the US financial system needed to be revised, but a solution was not immediately forthcoming as the idea of centralising banking powers had been met with strong opposition ever since the US was founded in 1776. In fact, some of the Founding Fathers regarded England’s desire to place the monetary systems of its colonies under the supervision of the Bank of England as an act of oppression that contributed directly to the American Revolutionary War. Others were strongly in favour of a central bank and attempts to establish such an institution succeeded in 1782, 1791, and 1816. However, in each case, the central bank only operated for a relatively short period before being closed by those who opposed the idea. Lawmakers in the agricultural South were particularly suspicious of a central bank, which they believed would disproportionately benefit the urban commercial hubs in the North. The major banks in the North, however, wanted to ensure that they were supported by a lender of last resort – and they wanted to take charge of this entity, rather than leaving it in the hands of government. Although the American Civil War had ended in 1865, tension between the North and the South would renew when it came to the issue of banking. Arguments raged with no clear way to appease all parties. 

However, the necessity of having a central bank to prevent repeated bank failures in the US became undeniable after the Panic of 1907. If depositors attempted to withdraw more cash from a regional bank than it had available, the bank would fail. And bank failures had a way of inciting panic – so if one bank failed, depositors would frantically try to withdraw their money from other banks as well, causing a domino effect of failures across the country. This inevitably led to a decrease in lending, and subsequent economic depression. 

Immediately after the Panic of 1907, the Aldrich- Vreeland Act was enacted, enabling national banks to establish national currency associations to issue emergency currency. The Act also established the National Monetary Commission, which was led by Senator Nelson Aldrich – chairman of the Senate Finance Committee – and comprised of members of Congress who travelled to Europe to observe the banking systems there. The Commission was impressed with how well the central banks in European countries operated, however, the difficulty of trying to implement such a system in the US was only amplified upon their return. 

By 1910, lawmakers were still stuck in a stalemate on the issue of a central bank. Aldrich decided to gather some of the most influential government officials and bankers together at a secret conference that was held at Jekyll Island – off the coast of Georgia – in the hopes of developing a solution that would compromise between the clear necessity for a central bank, and the deeply ingrained distrust of such an institution that had persisted since America’s independence and had only been amplified after the Civil War. A. Piatt Andrew, Henry Davison, Arthur Shelton, Frank Vanderlip and Paul Warburg were invited to attend the secret meeting, and were advised to tell their wives, servants and anyone they met along the way to Jekyll Island that they were going on a social duck-hunting trip, so as to avoid suspicion. Specifically, they did not want to be seen together. It was at this meeting – which the attendees would deny ever took place for at least thirty years after the fact – that the foundations for the Federal Reserve system were laid. Instead of a single central bank, the Jekyll Island group decided that the solution was to create a network of central banks, which would accept assurances of future customer payments to businesses as collateral for cash. A bank in the South that found that its cash supplies were running low when farmers made withdrawals during the harvest season could, for example, then go to its central bank and gain access to cash with a loan to a farmer serving as collateral. A national board of directors would be appointed to set the interest rate, and therefore have some control over credit for the entire country. 

Aldrich presented the plan to Congress, but it was not as well-received as he had predicted. The idea that a new set of powerful institutions would be created and managed by the banks was met with great suspicion. However, the first draft of the plan had provided a base from which a more agreeable system could be developed. Lawmakers agreed that there was a need for a central bank to provide stability to the US banking system, that the idea of decentralised banks was the only way forward, and that the governance of these banks had to be shared between politicians and bankers, who would take into account both business and agricultural interests. Plans for the Federal Reserve system were modified several times, with lawmakers finally agreeing that between eight and twelve reserve banks should be created in areas that were deemed to be of economic or political importance. Furthermore, a board of directors would be appointed, made up of three groups: local bankers, businessmen appointed by those bankers, and a group of representatives for the public. The Board of Governors in Washington would also include both the Treasury secretary and Federal Reserve governors appointed by the president and approved by Senate. 

Arriving at the final version of the Federal Reserve Act, however, was not an easy process, with a long and aggressive battle fought between the banks and government for control over the new system. Nonetheless, in December 1913 the Federal Reserve came into being, providing a key source of stability to the American banking system, which quickly became the dominating centre of the global financial system. As history would show, the Federal Reserve would not be an impenetrable defence against financial failure, however, it became a powerful tool for minimising the damage caused during times of financial crisis, from the Great Depression, to the 1980s recession, and the 2008 financial crisis.

 



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