History of the Federal Reserve System

National bank currency was considered inelastic because it was based on the fluctuating value of U.S. Treasury bonds. If Treasury bond prices declined, a national bank had to reduce the amount of currency it had in circulation by either refusing to make new loans or by calling in loans it had made already. The related liquidity problem was largely caused by an immobile, pyramidal reserve system, in which nationally chartered rural/agriculture-based banks were required to set aside their reserves in federal reserve city banks, which in turn were required to have reserves in central city banks. During the planting seasons, rural banks would exploit their reserves to finance full plantings, and during the harvest seasons they would use profits from loan interest payments to restore and grow their reserves. A national bank whose reserves were being drained would replace its reserves by selling stocks and bonds, by borrowing from a clearing house or by calling in loans. As there was little in the way of deposit insurance, if a bank was rumored to be having liquidity problems then this might cause many people to remove their funds from the bank. Because of the crescendo effect of banks which lent more than their assets could cover, during the last quarter of the 19th century and the beginning of the 20th century, the United States economy went through a series of financial panics.^[4]

The National Monetary Commission, 1907-1913

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Prior to a particularly severe panic in 1907, there was a motivation for renewed demands for banking and currency reform.^[5] The following year, Congress enacted the Aldrich–Vreeland Act which provided for an emergency currency and established the National Monetary Commission to study banking and currency reform.^[6]

The chief of the bipartisan National Monetary Commission was financial expert and Senate Republican leader

In 1910, Aldrich and executives representing the banks of J.P. Morgan, Rockefeller, and Kuhn, Loeb & Co., secluded themselves for ten days at Jekyll Island, Georgia.^[6] The executives included Frank A. Vanderlip, president of the National City Bank of New York, associated with the Rockefellers; Henry Davison, senior partner of J.P. Morgan Company; Charles D. Norton, president of the First National Bank of New York; and Col. Edward M. House, who would later become President Woodrow Wilson's closest adviser and founder of the Council on Foreign Relations.^[7] There, Paul Warburg of Kuhn, Loeb, & Co. directed the proceedings and wrote the primary features of what would be called the Aldrich Plan. Warburg would later write that "The matter of a uniform discount rate (interest rate) was discussed and settled at Jekyll Island." Vanderlip wrote in his 1935 autobiography From Farmboy to Financier:^[8]

Despite my views about the value to society of greater publicity for the affairs of corporations, there was an occasion, near the close of 1910, when I was as secretive, indeed, as furtive as any conspirator. None of us who participated felt that we were conspirators; on the contrary we felt we were engaged in a patriotic work. We were trying to plan a mechanism that would correct the weaknesses of our banking system as revealed under the strains and pressures of the panic of 1907. I do not feel it is any exaggeration to speak of our secret expedition to Jekyl Island as the occasion of the actual conception of what eventually became the Federal Reserve System. ... Discovery, we knew, simply must not happen, or else all our time and effort would be wasted. If it were to be exposed publicly that our particular group had gotten together and written a banking bill, that bill would have no chance whatever of passage by Congress. Yet, who was there in Congress who might have drafted a sound piece of legislation dealing with the purely banking problem with which we were concerned?

Despite meeting in secret, from both the public and the government, the importance of the Jekyll Island meeting was revealed three years after the Federal Reserve Act was passed, when journalist

The 1911–12 Republican plan was proposed by Aldrich to solve the banking dilemma, a goal which was supported by the American Bankers' Association. The plan provided for one great central bank, the National Reserve Association, with a capital of at least $100 million and with 15 branches in various sections. The branches were to be controlled by the member banks on a basis of their capitalization. The National Reserve Association would issue currency, based on gold and commercial paper, that would be the liability of the bank and not of the government. The Association would also carry a portion of member banks' reserves, determine discount reserves, buy and sell on the open market, and hold the deposits of the federal government. The branches and businessmen of each of the 15 districts would elect thirty out of the 39 members of the board of directors of the National Reserve Association.[10]

Aldrich fought for a private monopoly with little government influence, but conceded that the government should be represented on the board of directors. Aldrich then presented what was commonly called the "Aldrich Plan" – which called for establishment of a "National Reserve Association" – to the National Monetary Commission.^[6] Most Republicans and Wall Street bankers favored the Aldrich Plan,^[7] but it lacked enough support in the bipartisan Congress to pass.^[11]

Because the bill was introduced by Aldrich, who was considered^{[by whom?]} the epitome of the "Eastern establishment", the bill received little support. It was derided by southerners and westerners who believed that wealthy families and large corporations ran the country and would thus run the proposed National Reserve Association.^[11] The National Board of Trade appointed Warburg as head of a committee to persuade Americans to support the plan. The committee set up offices in the then-45 states and distributed printed materials about the proposed central bank.^[6] The Nebraskan populist and frequent Democratic presidential candidate William Jennings Bryan said of the plan: "Big financiers are back of the Aldrich currency scheme." He asserted that if it passed, big bankers would "then be in complete control of everything through the control of our national finances."^[12]

There was also Republican opposition to the Aldrich Plan. Republican Sen. Robert M. La Follette and Rep. Charles Lindbergh Sr. both spoke out against the favoritism that they contended the bill granted to Wall Street. "The Aldrich Plan is the Wall Street Plan ... I have alleged that there is a 'Money Trust'", said Lindbergh. "The Aldrich plan is a scheme plainly in the interest of the Trust". In response, Rep. Arsène Pujo, a Democrat from Louisiana, obtained congressional authorization to form and chair a subcommittee (the Pujo Committee) within the House Committee Banking Committee, to conduct investigative hearings on the alleged "Money Trust". The hearings continued for a full year and were led by the subcommittee's counsel, Democratic lawyer Samuel Untermyer, who later also assisted in drafting the Federal Reserve Act. The "Pujo hearings"^[13] convinced much of the populace that America's money largely rested in the hands of a select few on Wall Street. The Subcommittee issued a report saying:^[14]

If by a 'money trust' is meant an established and well-defined identity and community of interest between a few leaders of finance ... which has resulted in a vast and growing concentration of control of money and credit in the hands of a comparatively few men ... the condition thus described exists in this country today ... To us the peril is manifest ... When we find ... the same man a director in a half dozen or more banks and trust companies all located in the same section of the same city, doing the same class of business and with a like set of associates similarly situated all belonging to the same group and representing the same class of interests, all further pretense of competition is useless. ...^[12]

Seen as a "Money Trust" plan, the Aldrich Plan was opposed by the Democratic Party as was stated in its 1912 campaign platform, but the platform also supported a revision of banking laws intended to protect the public from financial panics and "the domination of what is known as the "Money Trust." During the 1912 election, the Democratic Party took control of the presidency and both chambers of Congress. The newly elected president, Woodrow Wilson, was committed to banking and currency reform, but it took a great deal of his political influence to get an acceptable plan passed as the Federal Reserve Act in 1913.^[11] Wilson thought the Aldrich plan was perhaps "60–70% correct".^[6] When Virginia Rep. Carter Glass, chairman of the House Committee on Banking and Currency, presented his bill to President-elect Wilson, Wilson said that the plan must be amended to contain a Federal Reserve Board appointed by the executive branch to maintain control over the bankers.^[12]

After Wilson presented the bill to Congress, a group of Democratic congressmen revolted. The group, led by Representative

Enactment of the Federal Reserve Act (1913)

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Main article:

The Federal Reserve Act

After months of hearings, amendments, and debates the Federal Reserve Act passed Congress in December, 1913. The bill passed the House by an overwhelming majority of 298 to 60 on December 22, 1913[15] and passed the Senate the next day by a vote of 43 to 25.^[16] An earlier version of the bill had passed the Senate 54 to 34,^[17] but almost 30 senators had left for Christmas vacation by the time the final bill came to a vote. Most every Democrat was in support of and most Republicans were against it.^[12] As noted in a paper by the American Institute of Economic Research:

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.^[7]

Ironically, in October 1913, two months before the enactment of the Federal Reserve Act, Frank Vanderlip proposed before the Senate Banking Committee his own competing plan to the Federal Reserve System, one with a single central bank controlled by the Federal government, which almost derailed the legislation then being considered and already passed by the U.S. House of Representatives.[18] Even Aldrich stated strong opposition to the currency plan passed by the House.^[19]

However, the former point was also made by Republican Representative Charles Lindbergh Sr. of Minnesota, one of the most vocal opponents of the bill, who on the day the House agreed to the Federal Reserve Act told his colleagues:

But the Federal reserve board have no power whatever to regulate the rates of interest that bankers may charge borrowers of money. This is the Aldrich bill in disguise, the difference being that by this bill the Government issues the money, whereas by the Aldrich bill the issue was controlled by the banks ... Wall Street will control the money as easily through this bill as they have heretofore.(Congressional Record, v. 51, page 1447, Dec. 22, 1913)

Republican Congressman Victor Murdock of Kansas, who voted for the bill, told Congress on that same day:

I do not blind myself to the fact that this measure will not be effectual as a remedy for a great national evil – the concentrated control of credit ... The Money Trust has not passed [died] ... You rejected the specific remedies of the Pujo committee, chief among them, the prohibition of interlocking directorates. He [your enemy] will not cease fighting ... at some half-baked enactment ... You struck a weak half-blow, and time will show that you have lost. You could have struck a full blow and you would have won.^[20]

In order to get the Federal Reserve Act passed, Wilson needed the support of populist

Southerners and westerners learned from Wilson that the system was decentralized into 12 districts and surely would weaken New York and strengthen the hinterlands. Sen. Robert L. Owen of Oklahoma eventually relented to speak in favor of the bill, arguing that the nation's currency was already under too much control by New York elites, who he alleged had singlehandedly conspired to cause the 1907 Panic.^[7]

Large bankers thought the legislation gave the government too much control over markets and private business dealings. The

You allowed the special interests by pretended dissatisfaction with the measure to bring about a sham battle, and the sham battle was for the purpose of diverting you people from the real remedy, and they diverted you. The Wall Street bluff has worked.[22]

When Wilson signed the Federal Reserve Act on December 23, 1913, he said he felt grateful for having had a part "in completing a work ... of lasting benefit for the country,"^[23] knowing that it took a great deal of compromise and expenditure of his own political capital to get it enacted. This was in keeping with the general plan of action he made in his First Inaugural Address on March 4, 1913, in which he stated:

We shall deal with our economic system as it is and as it may be modified, not as it might be if we had a clean sheet of paper to write upon; and step-by-step we shall make it what it should be, in the spirit of those who question their own wisdom and seek counsel and knowledge, not shallow self-satisfaction or the excitement of excursions we can not tell. ^[24]

While a system of 12 regional banks was designed so as not to give eastern bankers too much influence over the new bank, in practice, the

Operations, 1915-1951

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Wilson named Warburg and other prominent experts to direct the new system, which began operations in 1915 and played a major role in financing the Allied and American war efforts.

US spending on WWI was massive even before the US officially entered the war. Federal spending increased fifteen-fold from 1916 to 1918, as the US lent an enormous amount of funds to US allies and as the military mobilized.[30] The Federal Reserve offered below-market-rate interest rates to banks who used the funds to buy government bonds and treasury certificates. This "discount rate" was the primary tool the Fed used during this time. Because of these actions, the money supply increased and consenquently prices inflated.

Federal Reserve leaders did not take steps to reduce inflation, however. While the institution was ostensibly created as an independent organization from the government to remove it from political pressures, the political pressure of war nonetheless pressured the Fed to cater to the Treasury's appetite for low-cost war debt financing. At the same time, European gold flowed into the vaults of reserve banks and allowed the dollar to remain backed by gold despite massive monetary expansion, while European countries suspended their gold standards temporarily during the war. The US economy boomed post war as Europe was reliant on US goods their damaged and rebuilding industries couldn't supply for themselves.

In 1923, a recession prompted the head of the New York Fed, Benjamin Strong, to aggressively use open market operations in purchasing government securities to stem the downturn.

After WWII, the Employment Act of 1946 added the goal of maximum employment as a responsibility of the Fed.

Accord of 1951 between the Federal Reserve and the Treasury Department

The 1951 Accord, also known simply as the Accord, was an agreement between the

In 1956, the Bank Holding Company Act named the Fed as the regulator of bank holding companies that owned more than one bank.

Post Bretton-Woods era

In 1978, the

In July 1979, President Jimmy Carter nominated Paul Volcker as Chairman of the Federal Reserve Board amid roaring inflation. Volcker tightened the money supply, and by 1986, inflation had fallen sharply.^[34] In October 1979, the Federal Reserve announced a policy of "targeting" money aggregates and bank reserves in its struggle with double-digit inflation.^[35]

In January 1987, with retail inflation at only 1%, the Federal Reserve announced it was no longer going to use money-supply aggregates, such as M2, as guidelines for controlling inflation, even though this method had been in use from 1979, apparently with great success. Before 1980, interest rates were used as guidelines; inflation was severe. The Fed complained that the aggregates were confusing. Volcker was chairman until August 1987, whereupon Alan Greenspan assumed the mantle, seven months after monetary aggregate policy had changed.^[36]

2001 recession to present

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From early 2001 to mid-2003, the Federal Reserve lowered its interest rates 13 times, from 6.25% to 1.00%, to fight recession. In November 2002, rates were cut to 1.75%, and many rates went below the inflation rate. On June 25, 2003, the federal funds rate was lowered to 1.00%, its lowest nominal rate since July 1958, when the overnight rate averaged 0.68%. Starting at the end of June 2004, the Federal Reserve System raised the target interest rate, and then continued to do so 17 more times.^{[citation needed]}

In February 2006, President George W. Bush appointed Ben Bernanke as the chairman of the Federal Reserve.^[37]

In March 2006, the Federal Reserve ceased to make public M3, because the costs of collecting this data outweighed the benefits.^[38] M3 includes all of M2 (which includes M1) plus large-denomination ($100,000 +) time deposits, balances in institutional money funds, repurchase liabilities issued by depository institutions, and Eurodollars held by U.S. residents at foreign branches of U.S. banks, as well as at all banks in the United Kingdom and Canada.

2008 subprime mortgage crisis

Due to a credit crunch caused by the subprime mortgage crisis in September 2007, the Federal Reserve began cutting the federal funds rate. The Fed cut rates by 0.25% after its December 11, 2007 meeting, disappointing many investors who had expected a bigger cut; the Dow Jones Industrial Average dropped nearly 300 points that day. The Fed slashed the rate by 0.75% in an emergency action on January 22, 2008, to assist in reversing a significant market slide influenced by weakening international markets. The Dow Jones Industrial Average initially fell nearly 4% (465 points) at the start of trading and then rebounded to a 1.06% (128-point) loss. On January 30, 2008, eight days after the 0.75% decrease, the Fed lowered its rate again, this time by 0.50%.^[39]

On August 25, 2009, President Barack Obama announced he would nominate Bernanke to a second term as chairman of the Federal Reserve.^[40] In October 2013, he nominated Janet Yellen to succeed Bernanke.

In December 2015, the Fed raised its benchmark interest rates by a quarter of a percentage point to between 0.25% and 0.50%, after nine years without changing them.^[41]

Key laws affecting the Federal Reserve

Key laws affecting the Federal Reserve have been:^[42]

• Banking Act of 1935
• Employment Act of 1946
• Federal Reserve-Treasury Department Accord of 1951
• Bank Holding Company Act of 1956
  and the amendments of 1970
• Federal Reserve Reform Act of 1977
• International Banking Act of 1978
• Full Employment and Balanced Growth Act
  (1978)
• Depository Institutions Deregulation and Monetary Control Act (1980)
• Financial Institutions Reform, Recovery and Enforcement Act of 1989
• Federal Deposit Insurance Corporation Improvement Act of 1991
• Gramm-Leach-Bliley Act
  (1999)

References