The History of The Federal Reserve
The Monster From Jekyl Island
The US was late to the central banking game because of the cultural opposition and constitutional barriers to the creation of a national bank. Sweden’s Sveriges Riksbank is considered the oldest central bank, having been founded in 1668, followed by the Bank of England in the same century. Scotland, Spain, and Ireland founded central banks in the 1700s. In the 1800s, the concept caught on and practically all countries founded one. By the time the US Federal Reserve was created in 1913, the only countries that didn’t have a central bank other than a small grab bag of countries (eg Canada, Mexico, Argentina, India) were small countries that used foreign currencies as their primary medium of exchange, including basically all of Africa.
In the early 1900s, the US was tired of the financial panics from the era of the National Banking Acts, which I talked about in the previous article. The Panic of 1907 was the last straw, also known as the Knickerbocker Crisis (presumably where everyone got their knickers in a twist). Trust companies were ineligible to join bank clearing houses, so when there was a run on the Knickerbocker Trust Company, it had no emergency support to provide liquidity. It decided to suspend operation. In response, Congress passed the Aldrich–Vreeland Act which established the National Monetary Commission to study monetary reform, headed up by Senator Nelson Aldrich.
Aldrich was initially opposed to centralized banking because he believed a concentrated national bank would be susceptible to corrupting influence of banks and believed in the power of markets to fix issues. But during his decade-long role as Finance Committee chair, the handful of financial crises he saw had eroded some of this confidence. After being impressed by the rescues orchestrated by J.P. Morgan, the German-born banker Paul Warburg convinced him to go to Europe and observe Germany’s banking system. This convinced Aldrich that central banking was a better approach because it could allow the government to step in for financial rescues rather than relying on private bankers, or so the story goes.
In 1910, Aldrich organized an infamously secret meeting on Jekyll Island at what Munsey’s Magazine had described in 1904 as “the richest, the most exclusive, the most inaccessible” club in the world. While the meeting was arranged to look like a duck hunt and was kept so secret that who exactly attended is still in question, those in attendance likely included Wall Street financier JP Morgan, retail mogul Marshall Field, railroad tycoon William Vanderbilt I, oil baron John D. Rockefeller, venerated banker Benjamin Strong, and other Wall Street connected elites.
After a little over a week of intense work on the island, Aldrich presented a plan to the National Monetary Commission which was then proposed to congress. The plan included a completely privately controlled single central bank they called the National Reserve Association with share-weighted votes for election of directors (viewed as favoring larger banks), governance by a board of directors made up primarily of bankers with only 4 directors representing the public out of 46 total directors, currency backed by commercial bonds, voluntary membership of national banks in the new system, and issuance of banknotes at the National Reserve Association’s discretion (rather than the government’s). The plan also would have allowed banks to continue to pyramid their reserves, perpetuating one of the major weaknesses of the prior system.
Many were suspicious of Aldrich and his well-known ties to wealthy bankers that he had gained in the last 3 years. The Aldrich plan was rejected by congress, but most of its provisions were adopted in the final Federal Reserve Act, with the primary changes being that a much smaller board of governors would be chosen by the president with some requirements as to what professions must be represented (this was changed in 1935), that currency would be backed by gold, and that some of the decentralized nature of the previous system would be kept. While the bankers criticized the change of director selection, to this Woodrow Wilson asked “which of you gentlemen think the railroads should select the members of the ICC?”
When Woodrow Wilson presented the bill to Congress, a number of Democratic congressmen demanded that the “Money Trust” be destroyed, by which they meant they didn’t like the plan to have the boards of the regional reserve banks be partially elected by the share holders of private Federal Reserve member banks. They objected to the idea that these private banking interests would enjoy the special government granted benefits of the member banks that state banks would not have the advantage of. They didn’t get their demands met and the “Money Trust” exists to this day.
Before the Federal Reserve existed, private bank clearing houses had acted as de facto lenders of last resort, sometimes pooling resources in emergencies and issuing emergency currency certificates during panics. In the years after the Federal Reserve was formed, The Fed took over more and more of the traditional functions of private clearing houses, so by the late 1920s most banks were no longer part of a clearing house. This would have significant repercussions at the end of the 1920s.
The Monster’s Depression
The roaring 20s included a roaring stock market. Many people actually believed that the market would rise forever without ever crashing. In hindsight, it was a bubble full of speculation that inevitably had to burst.
But why was there such a spectacular bubble in the 1920s? Here again, The Fed played a role. Shortly after The Federal Reserve was created, WWI broke out. When the US entered the war, the government borrowed massive amounts of money, increasing federal debt (as a percentage of the GDP) by a factor of 10. This caused price inflation not seen at such high levels since the civil war 60 years prior. However, what was unprecedented is that price levels never returned to the long term term price levels, because government debt never back down to pre-war levels. This had never before happened in US history, not even after the Revolutionary War or Civil War. This experience destroyed people’s confidence in the dollar, leading people to look for other ways to safeguard the value of their life savings. Many turned to the stock market for the first time. This unprecedented influx of money into the stock market drove stock prices way up, and the new investors were not as savvy as stock investors in prior decades.
The Federal Reserve nearly doubled the discount rate in the second half of the 1920. The discount rate (at which banks could borrow from The Fed) strongly influenced the rate at which banks were willing to lend to each other, since if they made loans for a lower rate, that both increased their risk of needing to borrow from The Fed and they would need to pay a higher rate to do so.
When The Fed changes policy, it takes time for these signals to propagate thought and change bank policy. This might be a day or two for short term loans, but several weeks for commercial loans, and months for longer term loans like mortgages. In the late 1920s, a substantial portion of banks assets were in these longer term illiquid forms.
After the stock market crashed in 1929, an economic slump followed. Unemployment rose from around 2% to 4% in the next 10 months as the Federal Reserve did little more than supply some extra reserves to banks in New York City to keep the stock market functioning. The Fed did finally reduce the discount rate in January of 1930, but it wasn’t until 1931 that rates were lowered below what was seen in the mid 1920s.
Unemployment skyrocketed to 12% by the end of 1930 in no small part because foreign trade was reduced by the Smoot-Hawley Tariff Act passed in June of that year, exacerbating unemployment in industries that depended on it. The M2 money supply dropped by about 3% from 1929 to 1930, which made cash scarce enough to cause further difficulties in furnishing liquidity. Hundreds of small rural banks failed in the year after the crash, many being agriculture-focused banks that were already weakened by the low crop prices in the 1920s due in part to European WWI demand for food imports dropping off after the war.
When the US economy declined (and because of the Smoot-Hawley tariffs), fewer imports were bought which shifted the balance of trade such that less money was leaving the country than before, which meant more net money was coming in. This money came in to the US in the form of gold. But as gold flowed into the US from abroad, The Fed did not create more money from this gold. The Fed had increased the monetary base by about 2% per year between 1918 and 1929, but between 1930 and 1931 it instead reduced the monetary base by about 4%, exacerbating the already sudden monetary deflation. The Fed’s balance sheet did increase in 1931, but it was mostly gold and modest loans to the federal government. Loans on the books to banks actually decreased during this time as the Federal Reserve became stricter about enforcing collateral rules.
In December of 1930 there was a run on the Bank of the United States (a large private bank). Since it wasn’t part of a clearing house, like most banks by that time, the Bank of the United States had only The Fed to act as lender of last resort in its time of need. However The Fed declined to do so. A plan to guarantee deposits for the bank and merge it with some other bank was repeatedly proposed to the Federal Reserve, but other banks on the board of The Fed refused to subscribe to the plan despite the fact that the bank was likely quite solvent, in part because the Bank of the United States was not well liked among other banks. This resulted in the bank going out of business. Although it was not the first bank closure in The Depression, its closure precipitated widespread market panic. Over 600 banks closed in a span of about a month.
The M2 money supply shrank by 1/3rd from 1929 to 1933 despite The Fed eventually increasing monetary inflation to about 8% per year starting in 1931. Real GDP fell by 30%. One third of all US banks failed during the ensuing years.
Depression Fallout
The Great Depression was a pivotal event in world history. It changed everything.
It ushered in the era of the welfare state with welfare spending increasing from 1/1000th of the GDP before the depression to 20 times as much afterward, more than the entirety of federal non-defense spending 20 years prior. The democratic party began dominating politics as public attitudes towards government aid shifted, with 4 out of 6 elected presidents being democrats after the depression started vs 1 out of the prior 6 presidents in the early 1900s. Unemployment support, farm subsidies, and make-work jobs became normalized. Social Security was created in this wake and used payroll tax withholding for the first time. Union membership shot up from 7% in 1930 to over 25% by 1945.
The Great Depression and Franklin Roosevelt inaugurated the era of big government. Keynesian economics was used as a political tool to justify massive government deficit spending during The Depression with the initial stated intention of solving the economic crisis, but which has instead turned into perpetual deficit spending regardless of good times or bad that has only gotten worse over time. Non-defense spending was about 1.5% of the GDP before the great depression and more than quintupled to 8% by 1935s. FDR signed the most executive orders in US history by almost double the second place president (Woodrow Wilson), more executive orders than all presidents that followed him in the rest of the century combined.
The widespread fear of deflation stems from the events of the Great Depression as well. The money supply dropped by about 30% from 1929 to 1933, and this very sudden, substantial, and unexpected monetary deflation caused havoc as the price system struggled to reset amid enormous uncertainty. Anyone holding debt found the burden far more difficult to pay off than they planned for, which caused numerous bankruptcies for farmers, mortgage holders, and businesses. Irving Fisher came up with his debt deflation theory that became well known in popular discourse as the “deflationary spiral”, tho economists have never really taken the theory seriously because the economic fact of the matter is that value is not truly destroyed in such a situation, but merely redistributed and such redistribution “should not have significant macroeconomic effects.” Never the less, the fear of deflationary spirals has convinced the public that the Federal Reserve’s inflationary policy over the last 100 years is good economics, even as the problems of inflation have become ever present.
While the mainstream view is that perpetual “low” inflation is a good thing, many disagree including myself. However, I plan to write a future article detailing the arguments for why sustained monetary inflation is so extraordinarily harmful, so I’ll leave that concept at that for now.
The Dust Bowl was exacerbated by financial problems caused by The Depression, leading to farms over planting and under investing in sustainable land techniques (like erosion-control) in an attempt to make up for financial shortfalls. While I have seen it said that this caused an influx of rural people in urban areas, the reality is that it didn’t significantly affect the broader trend towards urban living.
The Federal Home Loan Bank Act of 1932 started a legacy of special favorable treatment towards home loans that has contributed to America’s addiction to keeping housing prices (and costs) high. The Banking Act of 1933 established the FDIC and the Glass-Steagall provisions that prevented banks and securities firms from dealing with several categories of non-governmental and “non-investment-grade” securities. The FDIC was the first national deposit insurance system in the world, with much of the world following suit over the rest of the century. Also in 1933, the Emergency Banking Act gave Franklin Roosevelt the power to confiscate nearly all the country’s gold and end domestic gold convertibility of the dollar. The FSLIC was established in 1934, basically an FDIC for savings and loan institutions (bank-like firms specialized in home mortgages).
The Gold Reserve Act in 1934 gave FDR the power to set the value of the dollar in gold and required the Federal Reserve to surrender all of its gold to the US Treasury, much of which went to Fort Knox. These actions sounded the death knell of backed currency not only in the US but worldwide.
Did they do it?
Is it fair to say that the Federal Reserve caused the Great Depression?
The dollar devaluation that pushed so many people into the stock market was certainly something The Fed was complicit in, since they were creating the conditions for monetary inflation. Perhaps the federal government would have found some other way to maintain unprecedented debt without The Fed. However, it seems likely that The Fed fulfilled its purpose in making it easier for the federal government to take on and retain debt, and seems likely to be a big cause of the inflation that drove people into the stock market.
Even so, the severity and length of the downturn was also unnatural. Milton Friedman believed The Fed turned what would otherwise have been a mere recession into the disaster it became. Fed Chair Ben Benanke’s famous statement agreed with him: “You’re right, we did it. We’re very sorry.”
The Fed’s manipulation of interest rates and slow response to the economic crash likely made the crash substantially worse as more otherwise-solvent banks and businesses failed than would have in the previous monetary regime of the National Banking Acts, including the disastrous failure to help the Bank of the United States. When previously clearing houses would have quickly shored up banks in trouble, The Fed failed to step in.
But the short sighted Smoot-Hawley tariffs also clearly played a part. So did the Agricultural Adjustment Act of 1933 that levied enormous taxes on agricultural products, like wheat and hogs, likely exacerbating the Dust Bowl before being struck down by the supreme court (and then being re-passed in 1938). Numerous other taxes made for a particularly unpredictable tax environment in the 1930s. The Dust Bowl itself clearly also had an impact, but certainly wasn’t a primary factor.
The gold standard is often blamed for the Great Depression by making the money supply inflexible. However the reality is that The Fed’s excess gold reserves increased until 1933 and in any case gold reserves were never a hard limit on the amount of money that could be created, since standard practice during the entirety of the gold standard didn’t require full gold reserve backing of the entire monetary base. Not to mention the M2 money supply can generally flex up and down regardless of hard money. The myth of the inflexible and chaotic gold standard is simply a fiction told by those who don’t understand how the monetary system works.
Really when people say that the gold standard was too inflexible, what they really mean is that it prevented the government from running unlimited deficits during financial crises. This is true, so if you think its a good thing for a government to be able to create unlimited money in financial crises, then you probably the gold standard was too inflexible. In my opinion, this limit is a very good thing. It kept both banks and governments from recklessly manipulating the economy. Without it, we’re on a path toward financial ruin of the country as the governments spends an unsustainable amount of the nation’s wealth.
I believe the biggest reason for the sheer length and depth of the depression was the unwillingness for the federal government to cut back during Herbert Hoover’s presidency and the gargantuan increase in the size of the federal government during FDR’s New Deal, which sucked the life out of a drowning economy. While the economy shrank by 30%, President Hoover’s government increased federal spending by 40% and funded this increased spending with his disastrous Revenue Act of 1932 which more than doubled individual income tax rates among a myriad of other taxes and caused enormous economic contraction of an already depressed economy. FDR increased how much of the GDP spent by the federal government to almost 3 times what it had before the depression.
While the economy is positive-sum over time, the resources available for spending in any given moment is zero-sum, and every additional dollar spent by the government was a dollar that couldn’t be spent for food, salaries, or loan repayments by the people. Even when government projects “create” jobs, the money that ends up in the hands of the workers of those jobs is siphoned off by the deadweight losses of taxes, the cost of project materials, loan interest, administration, and the opportunity cost of what those workers could have otherwise done with their time. For every $1 spent by government on an employee, at least $2 is taken from the people. This reduces the money that can be put to good use and invested in projects that can lead to a better economy. This would be ok if the government’s investments were more efficient than the private economy, but they are generally far less efficient for well-understood reasons.
A bad economy is like a leaky boat, if you focus only on bailing out the water, you’ll be bailing out water forever. You need to patch the boat so bailing out is an achievable task. The sudden increase in peacetime government spending was unprecedented before or since, and its no coincidence that the increase coincided with the longest and deepest economic downturn in history.
So in conclusion, The Fed itself is partially complicit on all fronts: the cause of the depression, its length, and its severity. The roaring 20s stock market bubble may not have happened without The Fed. The initial severity of the depression was substantially exacerbated by the existence of and actions/inactions by The Fed, which would have not happened had the previous monetary regime been in place. But the primary reason the Great Depression happened and went on for a whole decade rather than a mere year or two was because of the massive government manipulation of the economy during that time with tariffs, taxes, high spending, and persistent deficit spending both before and after the ending of the gold standard. While this is not a mainstream view, I’m far from the only person that believes this.
Post-war Monetary Policy
The independence of the federal reserve was paused during WWII when they were pressured to keep interest rates on government debt artificially low. The Bretton Woods Agreement in 1944 substantially affected international monetary systems, making the Federal Reserve practically a central bank for nearly the whole world. It even sometimes intervened in foreign exchange markets to trade foreign currencies against the dollar to maintain the peg values of those currencies. Over time this drained the hard assets of The Fed, most importantly gold.
The Employment Act of 1946 established the goal of promoting maximum employment as a responsibility of the federal government. In 1951, the Treasury-Fed Accord formally restored independence of The Fed to set monetary policy regardless of the US Treasury’s financing needs.
During the 1960s, the strains on the Federal Reserve in trying to manage the Bretton Woods system drained gold reserves to a historically low point. I was surprised to find out that gold reserves almost never covered the value of gold-backed paper notes in circulation, except in the 10 years after the legislated dollar devaluation 1934.
Why would a dollar devaluation mean an inflow of gold? The reason is that price information takes time to flow through the market. When the dollar was devalued, its perceived value didn’t decrease all at once, but decreased over a number of years. Buying dollars with gold at this time takes advantage of this mismatch, where converting your gold to dollars allows you to buy more things than doing so before the legislated devaluation.
But this effect is temporary, and by 1960 gold reserves plummeted as foreign countries redeemed their dollars for gold. France hit US gold especially hard, converting all their dollar reserves over a number of years to gold and shipping it back to France in ocean liners that could carry 25 tonnes of gold per trip. The gold France repatriated amounted to about 15% of the reduction in US gold supply from that time.
In 1971, Nixon ended gold convertibility even for foreign banks using the same powers FDR used in 1933. But not before the French could take one more load of gold on the decommissioned naval cruiser Suffren. The “Nixon Shock” completely disconnected the dollar from gold backing, making the dollar into pure fiat currency. Until 1971, only Eastern Europe, China, and a smattering of Latin American countries had retained an unbacked fiat currency system. The nearly 40 year ban on significant private gold ownership was finally ended in 1974.
In 1977, the goal of maximum employment eventually evolved into the Federal Reserve’s “dual mandate” with the Federal Reserve Reform Act. The Humphrey-Hawkins Full Employment Act in 1978 set specific targets of 3-4% for unemployment and a 4% price inflation target. This evolved down over time to today’s 2% price inflation target due to efforts by Paul Volcker and Alan Greenspan, and success with lower inflation targets at other central banks (a 0% price inflation target was never tried because of lingering hysteria around deflation, and I’m sure pressure from bankers benefiting from the seigniorage). The runaway price inflation in the late 70s was met with Volcker raising the discount rate which lead to a recession but restored price stability.
In the 80s, The Fed innovated on the tools it used. It started emphasizing the use of M1 and M2 measures of the money supply over the prior emphasis on interest rates. Open market operations became its primary policy instrument to push the federal funds rate (the interest rate at which banks are willing to lend to each other) toward their target as inter-bank lending became favored over the use of the discount window. The favorite means of doing this in the 80s was in the “repo market” – ie the market for repurchase agreements of securities, which are basically loans that use a financial security as collateral. To satisfy their urge to manipulate rates in this way, it refined its open market operations, increasing their frequency and precision.
The Fed’s high profile bailouts in the prior decade, including bailouts of insolvent companies like Franklin National and Continental Illinois, lead to a “too big to fail” mentality that contributed to the Savings & Loans crisis throughout the 1980s and into the 90s that wiped out a third of US thrift institutions (savings and loans associations, mutual savings banks, and credit unions). About a third of those merged with existing thrift institutions, marking an enormous market consolidation as companies chased the favored treatment given to larger institutions by the FSLIC and then, when the FSLIC itself became insolvent, the FDIC. Larger thrift institutions were given better asset guarantees, more favorable loss-sharing, and were allowed to operate for longer before cutting off bailouts, which taught corporations and investors that big companies were safer and their risky behavior would have fewer consequences.
The bond market crisis in 1994 was precipitated when The Fed under Alan Greenspan suddenly started raising their targeted federal funds rate, and continued to double the target over the next year. The given reason was to reduce inflation, which seems like an odd reason to double interest rates when inflation was already falling at the time and was already at about 3%. Despite what seems like an economic crisis obviously caused by The Fed’s negligence, they still trumpeted their victory when reducing the federal funds rate target to 5.3% (from 6%) was followed by a period of economic stability.
This was called a “soft landing”, but it seems to me they caused a crisis by suddenly disrupting the price system, and then when the price system stabilized on its own, The Fed took the credit and pretended they didn’t cause the problem in the first place. This kind of discretionary economic wizardry is not something to be celebrated as a one-man genius stabilizing force, but decried as a force of chaos.
The Great Recession
When the Great Recession hit in December of 2007, the Federal Reserve embarked on the largest and most aggressive interventions in history. The Fed increased its balance sheet more than it did during the Great Depression and quite a lot faster.
The Fed was already reducing their interest rate target and quickly reduced it to 0% for the first time in history. The Fed started paying interest to member bank on their deposits with the Emergency Economic Stabilization Act of 2008, which allowed it to set a de-facto floor on the interest rate despite abundant excess bank reserves during the crisis (which has remained true to this day other than briefly in 2019). They lent to non-bank institutions for the first time since the Great Depression. It gave overnight loans to Wall Street companies, traded T-bills for illiquid collateral, bought up corporate debt, and lent money to failing money market funds.
The Fed bailed out specific companies like AIG, Bear Stearns, Citigroup, and Bank of America that was tailored specifically to them, with unprecedented special-purpose vehicles created to isolate risky assets. It traded dollars for foreign currency with foreign central banks (“swap lines”) to shore up foreign banks that owed debts to the US. It bought trillions of dollars of long-term treasuries and mortgage-backed securities in order to stimulate the economy for the first time in history. The assets of the Federal Reserve more than doubled in less than 6 months and have moved in a historically unprecedented volatile upward direction ever since. It loosened its requirements on collateral for loans, accepting mortgage-backed and asset-backed securities, as well as short term corporate loan notes (“corporate paper”).
The Great Recession was an enormous shift in Federal Reserve behavior. The Fed inflated the monetary base an average of 30%/year for 6 straight years. It shifted it from being an occasional manipulator of the market to being a constant force that kept interest rates the lowest in history for almost 2 decades.
Pandemic Hysteria
When Covid-19 hit in 2020, The Fed snapped into action, cutting interest rates back to 0 again and nearly doubling its balance sheet in the span of a few months. It bought long-term corporate bonds, municipal bonds, small-business loan notes for the first time ever. It reintroduced lending to money markets, buying of commercial paper, and swap lines with foreign central banks. The Fed increased its balance sheet as a fraction of GDP more than twice as much as it did during the Great Recession, and quite a lot faster. Reserve requirements were also completely eliminated, tho they already hadn’t had any significant effect for decades.
All of this kept the aggressive growth of the monetary base and the broader M2 money supply on an ever more aggressive growth rate, fueled unprecedented government debt, and gave us the worst period of price inflation in 40 years, which by some measures was the highest inflation in US history.
Today
As the century continues on, it seems likely that economic volatility will only increase. The monster from Jekyl Island isn’t the savior that was promised and its not done stomping around yet. It achieved its purpose of helping the federal government spend more than it should, at the expense of creating a highly distorted, inefficient economy that has destroyed the value of the dollar and financial security of the American people. Its only saving grace is that other countries have done an even worse job.