Remember when central banking was boring? When it was one of those issues, like a house’s wiring, that seemed unimportant so long as it was working as advertised? No longer. When the financial crisis of 2008 was quickly followed by the deepest recession in eighty years, central banking suddenly became important. Whether it’s Federal Reserve head Janet Yellen’s chronic fretting about when to start raising interest rates, or the European Central Bank’s coercion of Greece’s recalcitrant leftist government, understanding central banking is now vital to understanding basic politics.
America’s Bank: The Epic Struggle
to Create the Federal Reserve
by Roger Lowenstein
Penguin Press, 368 pp.
That’s a particularly difficult task in the United States, because of the bizarre structure of our central bank, the Federal Reserve. Its hybrid of private and public institutions is unique in the world, and extremely complicated. America’s Bank: The Epic Struggle to Create the Federal Reserve, a new book by the financial writer Roger Lowenstein about the early legal history of the Fed, is a lively and thought-provoking look at the function of American central banking as well as the politics of the day.
Lowenstein’s story begins back in the glory days of “wildcat” banking after Andrew Jackson killed the Second Bank of the United States in 1836. In those days, there was no federal regulation of banks (though states had their own rules). Just about anyone could start up a bank and begin issuing notes, and as a result there were literally tens of thousands of different currencies. Financial panics were common, and there was a chronic shortage of good currency.
This rickety and erratic system was replaced by the National Banking Act during the Civil War, which established a system of stronger national banks. These would issue a uniform currency, as well as buy lots of government bonds to finance the war. It was a marked improvement from the previous era, but still had many weaknesses.
One problem was that the system had no mechanism to adjust the supply of money to the needs of production. This was particularly bad for farmers (who, in 1900, comprised 38 percent of the labor force), who have to spend a lot of money within a short time to bring in the annual harvest. Without a smooth supply of credit, interest rates would sometimes spike to 100 percent.
Financial stability was an even bigger problem. Bank reserves could be kept in vaults or sent up to the bigger and stronger national banks—but they didn’t want idle cash, so reserves piled up in New York, where they ended up on the stock market. This provided a route by which panics on Wall Street might be transmitted to the broader economy by evaporating bank reserves. Conversely, rural banks calling on their reserves could restrict credit on the stock market and trigger a mass sell-off.
The system’s worst crisis was in 1907, when an attempt to corner the market on United Copper Company shares failed and ruined several major Wall Street players. This infected the trusts—huge quasi-bank institutions basically designed to evade banking regulations—and led to a broader financial panic. It was a disaster, but coordinated action from the Wall Street elite, led by J. P. Morgan, distributed enough liquidity to forestall a total collapse.
It was a stark illustration of the system’s limits: no last-resort lender, no effective control over currency circulation, and ineffective financial regulation, which added up to an extremely fragile and crisis-prone banking sector. That, plus the generally outdated structure of U.S. financial institutions—the payments system was unreliable and laughably inefficient—sparked a drive for reform.
Lowenstein’s description of the protracted, tortuous political negotiations to create a semblance of an American central bank is very thorough, focusing on six protagonists: Paul Warburg, an immigrant German banker and forceful advocate of European central banking principles; Rhode Island Senator Nelson Aldrich, a business-friendly Republican who converted to reform after 1907; Frank Vanderlip, head of the nation’s largest bank; Carter Glass, a conservative Democrat and fanatical racist who nevertheless became a key supporter; and Woodrow Wilson, who eventually shepherded the Federal Reserve through Congress.
The creation that would become the Federal Reserve Act started with a secret meeting in 1910 on Jekyll Island between Aldrich, Warburg, Vanderlip, Assistant Secretary of the Treasury A. Piatt Andrew, and several other Wall Street heavies. The product of their meeting, dubbed the Aldrich Plan, envisioned a decentralized structure of fifteen reserve banks spread around the U.S., owned by an association of local banks, issuing a new national currency backed by gold—most of the functions of a central bank without looking like one, to appease Americans’ crankish fears of banks and government domination. The system would be overseen by the Washington branch—members of which would be mostly bankers or their representatives, save for a small minority of government appointees—with the power to set interest rates nationwide.
Two years of Byzantine political negotiation followed, but Republicans did not manage to pass the Aldrich Plan before Wilson won the presidency in 1912, along with large Democratic majorities in Congress. However, Wilson, influenced by Glass, considered the Aldrich Plan a reasonably good starting point, and the eventual Federal Reserve Act bore a strong resemblance to it. The most important difference was that the overseeing body, the Federal Reserve Board, was made up of all government appointees.
The account of the intrigues and political horse trading is where the book shines. The looseness of political ideology at the time is particularly striking in today’s hyper-polarized days. Aldrich was an arch-conservative Republican and sworn enemy of progressivism, yet his plan was passed with only a few substantive changes by a progressive Democratic president and Congress, backed by William Jennings Bryan himself.
On the structure and function of the Fed, however, Lowenstein is less convincing. He’s fairly clear on what it’s supposed to do but is a little too enthusiastic about the quality of the institution produced. “[I]t was a highly worthy achievement,” he writes as the last words in the book’s epilogue, but glosses over the fact that the Fed as constituted in 1913 failed to achieve any of its major objectives. Just sixteen years later, a banking panic orders of magnitude worse than the one in 1907 destroyed most of the financial system and led directly to the Great Depression. It turned out that the Fed did not properly regulate banks. It did not serve as a lender of last resort. It did not ensure an even supply of money.
It wasn’t until the New Deal, with reforms in 1933 and 1935, that these functions were firmly established as part of the Fed (and in a few other organizations, like the Federal Deposit Insurance Corporation). Ironically, one of the structural changes to the Fed’s governing board was to add some of the private bankers who serve as the regional reserve bank presidents—a move back toward the original Aldrich Plan, though government appointees are still a majority.
Of course, this is nominally a book about a single bill, and I don’t fault Lowenstein for mostly ignoring the later history of the Fed in the main body of his text, which is well worth reading. However, there is altogether too much sense that the Fed was a destined star in the American firmament, and the epilogue, which chronicles the later careers of the era’s protagonists, is a missed opportunity to discuss the Fed’s later trajectory—most critically, whether the institution handed down from 1913 needs an overhaul.
In the 1960s and ’70s, Milton Friedman and Anna Schwartz advanced a thesis that became conservative orthodoxy: to wit, that the Fed bears most of the blame for the Depression, because it could have prevented it with better monetary policy—implying that Keynesian remedies like stimulus spending are unnecessary. In 2002, at an event celebrating Friedman’s ninetieth birthday, the Fed chief Ben Bernanke said, “Regarding the Great Depression, you’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
Bernanke had an opportunity to test this notion as Fed chairman just six years later, when faced with a financial crisis worse than that of 1929. He moved heaven and earth to save the financial system, loaning trillions to troubled financial institutions at rock-bottom rates, and he largely succeeded. However, the broader economy suffered a devastating collapse and weak recovery, and the Fed’s efforts to jump-start growth with unconventional monetary stimulus have not worked well. Total output and employment has not reached anywhere close to where reasonable pre-2007 projections predicted, and shows no sign of catching up. On current trends, by 2026 or so the Great Recession will displace the Great Depression as the most damaging economic crisis in American history.
The assumption underlying the Fed’s actions since the crisis is that all the policy necessary to restore full employment can be funneled through private credit channels. But what eventually broke the Depression for good was the stupendous government spending of World War II. With no such event on the horizon, many economists and writers (including myself) have suggested that the Fed be given the power to bypass the credit channel and put new money directly into the pockets of ordinary citizens. Since the crisis, it has quintupled the monetary base—creating trillions in new money—to little obvious effect. Had a fraction of that money been passed straight to citizens, this recession would likely be over.
Seven years after the 2008 crisis, with no sign of economic stimulus from Congress, and more than a century after the creation of the Fed, it’s worth thinking about whether we might be stuck with a twentieth-century central bank in a twenty-first-century world.