Getting the Federal Reserve right, Part One

By John Steele Gordon

After J. P. Morgan had stopped the financial panic of 1907 by acting, in effect, as the country’s central bank, it was realized that the United States could no longer do without a real one. Since Andrew Jackson had killed the second Bank of the United States in 1836, there had been recurring financial crises—in 1837, 1857, 1873, 1893 and now 1907. They had been made far worse by the lack of a lender of last resort to provide liquidity and keep banks operating until the crisis eased.

The question was how to structure the new bank. The country’s leading bankers wanted a single central bank headquartered in New York City, the nation’s financial center. But the ghosts of bank-hating Thomas Jefferson and Andrew Jackson were still a powerful force in the Democratic Party. Fearing the “Money Power,” they wanted as weak a central bank as possible.

In 1908, Sen. Nelson Aldrich of Rhode Island headed a National Monetary Commission to look into the nation’s banking laws and design improvements. Aldrich was a wealthy conservative Republican, thoroughly comfortable with the money power. His daughter had married John D. Rockefeller Jr. in 1901 and named one of her sons after her father. (The son later became governor of New York and vice president of the United States.)

Aldrich knew that a single central bank located in the nation’s money capital was a political non-starter. So the commission, issuing no fewer than 30 reports detailing national banking systems in Europe and Canada, designed a system of regional bank reserve associations spread across the country and owned by the banks in their territories. Each would be headed by someone with the title of governor, traditionally the title of power in central banking. In Washington there would be a national reserve association headquarters.

Two of the three political platforms that year (the Democratic and the Bull Moose parties) opposed the National Monetary Commission’s proposal. They wanted a central bank owned by the federal government.

When Woodrow Wilson and the Democrats won the election of 1912, they made the establishment of a coherent banking system a priority. To get one, they compromised with the Aldrich plan. There would be twelve regional Federal Reserve Banks, owned by the member banks, but with a controlling interest in the system as a whole vested in a central board in Washington, the members of which would be appointed by the president.

All national banks were required to be members of the Federal Reserve System. Member banks could go to the “discount window” at their Federal Reserve Bank and borrow money on the collateral of their commercial loan portfolios if they needed liquidity. State-chartered banks were allowed to join if they could meet the capital requirements. But the vast majority of the state banks could not do so. So the banks that most needed the protection of the Federal Reserve could not join it. (It was a bit like being able to buy life insurance if you are in robust good health but not if you are frail.) As a result, bank failures averaged over 650 a year, mostly in rural areas, during the 1920s.

Most of the members of the Federal Reserve Board in Washington were political appointees and the governors of the regional banks had very limited experience in banking at the highest level. So they turned for guidance to Benjamin Strong, governor of the New York Fed and the former head of Bankers Trust, who did.

But when Strong died in the fall of 1928, the Fed became rudderless. The result would be a banking catastrophe such as the nation had never known.


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