History of central banking in the United States

This article is about the history of central banking in the United States, from the 1790s to the present.

1791–1836: The First and Second Bank of the United States

First Bank of the United States

In 1791, Alexander Hamilton, the Secretary of the Treasury, made a deal to support the transfer of the capital from Philadelphia to the banks of the Potomac in exchange for southern support for his Bank project. As a result, the First Bank of the United States (1791-1811) was chartered by Congress in that same year. The First Bank of the United States was modeled after the Bank of England and differed in many ways from today's central banks. For example, it was partly owned by foreigners, who would share from its profits. It was also not solely responsible for the country's money supply; its share was only 20%, while private banks accounted for the rest. The Bank was bitterly opposed by several founding fathers, including Thomas Jefferson and James Madison, who saw it as an engine for speculation, financial manipulation, and corruption.

econd Bank of the United States

After a five-year interval, the federal government chartered its successor, the Second Bank of the United States (1816-1836). It was basically a copy of the First Bank, with branches over the country. Andrew Jackson, who became president in 1828, denounced it as an engine of corruption that benefited his enemies. His destruction of the bank was a major political issue in the 1830s and shaped the Second Party System, as Democrats in the states opposed banks and Whigs supported them.

1837–1862: Free Banking Era

In this period, only state-chartered banks existed in a free banking system. They could issue bank notes against specie (gold and silver coins) and the states regulated their reserve requirements, interest rates for loans and deposits, the necessary capital ratio etc. The Michigan Act (1837) allowed the automatic chartering of banks that would fulfill its requirements without special consent of the state legislature. This legislation eased creating unstable banks even further, lowering the supervision by the states that adopted it. The real value of a bank bill was often lower than its face value, and the issuing bank's financial strength generally determined the size of the discount. By 1797, there were 24 chartered banks in the U.S., while with the beginning of the "Free Banking Era" (1837), there were 712.

The banks were unstable in terms of longevity compared to today's commercial banks. The average lifespan of a bank was five years; about half of the banks failed, a third of which because they couldn't redeem their notes (how they went out of business). During the free banking era (also see "Wildcat Banking"), the value of gold and silver was very stable. Price stability and changes in price are two different things. When monetary bases (such as gold or silver) are allowed to stay relatively constant, that allows for all other prices to adjust quickly. If a price is quick to adjust (a.k.a. NOT 'sticky') it is said to be a stable price.

During the free banking era, some local banks appeared that took over the functions of a central bank. In New York, the New York Safety Fund acted as a deposit insurance for its member banks. In Boston, the Suffolk Bank guaranteed that bank notes would trade at near par value and acted as a private bank note clearinghouse.

1863–1913: National Banks

The National Banking Act, besides providing loans in the Civil War effort of the Union included provisions:

* To create a system of national banks. They had higher standards concerning reserves and business practices than state banks. The office of Comptroller of the Currency was created to supervise these banks.
* To create a uniform national currency. In order to achieve this, all national banks were required to accept each other's currencies at par value. This eliminated the risk of loss in case of bank default. The notes were printed by the Comptroller of the Currency to ensure uniform quality and prevent counterfeiting.
* To finance the war. National banks were required to back up their notes with Treasury securities, enlarging the market and raising its liquidity.

As described by Gresham's Law, soon bad money from state banks drove out the new, good money; the government imposed a 10% tax on state bank bills, forcing most banks to convert to national banks. By 1865, there were already 1,500 national banks. In 1870, 1,638 national banks stood against only 325 state banks. The tax led in the 1880s and 1890s to the creation and adoption of checking accounts. By the 1890s, 90% of the money supply was in checking accounts. State banking had made a comeback.

Two problems still remained in the banking sector. The first problem was the requirement to back up the currency with treasuries. When the treasuries fluctuated in value, banks had to recall loans or borrow from other banks or clearinghouses. The second problem was that the system created seasonal liquidity spikes. A rural bank would have deposit accounts at a larger bank that it withdrew when the need for funds was highest, e.g. in the planting season. When the combined liquidity demands were too big, the bank again had to find a lender of last resort.

These liquidity crises led to bank runs, causing severe disruptions and depressions, the worst of which was the Panic of 1907.

1913: Creation of the Federal Reserve System

Panic of 1907 Alarms Bankers

Early in 1907, New York Times Annual Financial Review published Paul Warburg's (a partner of Kuhn, Loeb and Co.) first official reform plan, entitled "A Plan for a Modified Central Bank," in which he outlined remedies that he thought might avert panics. Early in 1907, Jacob Schiff, the chief executive officer of Kuhn, Loeb and Co., in a speech to the New York Chamber of Commerce, warned that "unless we have a central bank with adequate control of credit resources, this country is going to undergo the most severe and far reaching money panic in its history." "The Panic of 1907" hit full stride in October. [Herrick]

Bankers felt the real problem was that the United States was the last major country without a central bank, which might provide stability and emergency credit in times of financial crisis. While segments of the financial community were worried about the power that had accrued to JP Morgan and other 'financiers', most were more concerned about the general frailty of a vast, decentralized banking system that could not regulate itself without the extraordinary interventions of one old man. Financial leaders who advocated a central bank with an elastic currency after the Panic of 1907 include Frank Vanderlip, Myron T. Herrick, William Barret Ridgely, George E. Roberts, Isaac N. Seligman and Jacob H. Schiff. They stressed the need for an elastic money supply that could expand or contract as needed. After the scare of 1907 the bankers demanded reform; the next year, Congress established a commission of experts to come up with a nonpartisan solution.

Aldrich Plan

Rhode Island Senator Nelson Aldrich, the Republican leader in the Senate, ran the Commission personally, with the aid of a team of economists. They went to Europe and were impressed at how well they believed the central banks in Britain and Germany handled the stabilization of the overall economy and the promotion of international trade. Aldrich's investigation led to his plan in 1912 to bring central banking to America, with promises of financial stability, expanded international roles, control by impartial experts and no political meddling in finance.

Regional System

Aldrich asserted that a central bank had to be (contradictorily) decentralized somehow, or it would be attacked by local politicians and bankers as had the First and Second Banks of the United States. His solution was a regional system. In Congress, Rep. Carter Glass of Virginia picked up Aldrich's core ideas; to be able to claim Democratic authorship, he made numerous small revisions such as headquartering a region in the financial backwaters of Richmond, Virginia. President Woodrow Wilson added the provision that the new regional banks be controlled by a central board appointed by the president.

Agrarian Demands Partly Met

William Jennings Bryan, by now Secretary of State, long-time enemy of Wall Street and still a power in the Democratic party, threatened to destroy the bill. Wilson masterfully came up with a compromise plan that pleased bankers and Bryan alike. The Bryanites were happy that Federal Reserve currency became liabilities of the government rather than of private banks - a symbolic change - and by provisions for federal loans to farmers. The Bryanite demand to prohibit interlocking directorates did not pass. Wilson convinced the anti-bank Congressmen that because Federal Reserve notes were obligations of the government, the plan fit their demands. Southerners and westerners learned from Wilson that the system was decentralized into 12 districts and thus assured that this design would weaken New York City's Wall Street influence and strengthen the hinterlands. The key legislators in this compromise plan were Representative Carter Glass, a Democrat from Virginia and Chairman of the House Committee on Banking and Currency, and Senator Robert Latham Owen, a Democrat from Oklahoma and Chairman of the Senate Committee on Banking and Currency.

After much debate and many amendments Congress passed the Federal Reserve Act or "Glass-Owen Act," as it was sometimes called at the time, in late 1913. President Wilson signed the Act into law on December 23, 1913.

1913 – Present: Recent Changes

The Fed's power developed slowly in part due to an understanding at its creation that it was to function primarily as a reserve, a money-creator of last resort to prevent the downward spiral of withdrawal/withholding of funds which characterizes a monetary panic. At the outbreak of World War I, the Fed was better positioned than the Treasury to issue war bonds, and so became the primary retailer for war bonds under the direction of the Treasury. After the war, the Fed, led by Paul Warburg and New York Governor Bank President Benjamin Strong, convinced Congress to modify its powers, giving it the ability to both create money, as the 1913 Act intended, and destroy money, as a central bank could.

During the 1920s, the Fed experimented with a number of approaches, alternatively creating and destroying money and, in the eyes of many scholars (notably Milton Friedman), helping to create the late-1920s stock market bubble. In 1928, Strong died. He left a tremendous vacuum in Fed governance from which the bank did not recover in time to react to the 1929 collapse (as, for instance, the Fed did after 1987's Black Monday), and the Fed adopted what most would consider today to be a restrictive policy, exacerbating the crash.

After Franklin D. Roosevelt took office in 1933, the Fed became subordinated to the Executive Branch, where it remained until 1951, when the Fed and the Treasury department signed an accord granting the Fed full independence over monetary matters while leaving fiscal matters to the Treasury.

The Fed's powers have not significantly changed since 1951, though it has frequently adopted different policy approaches.

Recent activities

* August 2007: Injection of funds to stabilize the 2007 Subprime mortgage financial crisis.

References

Part of this article is based on an excerpt of [http://odur.let.rug.nl/~usa/E/usbank/bankxx.htm A Brief History of Central Banking in the United States] by Edward Flaherty
* J. Lawrence Broz; "The International Origins of the Federal Reserve System" Cornell University Press. 1997.
* Vincent P. Carosso, "The Wall Street Trust from Pujo through Medina," Business History Review (1973) 47:421-37
* Milton Friedman and Anna Jacobson Schwartz, "A Monetary History of the United States, 1867-1960" (1963)
* William Greider, "Secrets of the Temple: How the Federal Reserve Runs the Country" (1989), on the 1980s
* Myron T. Herrick "The Panic of 1907 and Some of Its Lessons", "Annals of the American Academy of Political and Social Science", vol. 31 (Jan.-June 1908)
* Charles P. Kindleberger "Manias, Panics, and Crashes" (4th ed.).
* Gabriel Kolko, "Triumph of Conservatism: A Reinterpretation of American history, 1900-1916" (1963) pp 230-54.
* Arthur Link, "Wilson: The New Freedom" (1962)
* James Livingston, "Origins of the Federal Reserve System: Money, Class, and Corporate Capitalism, 1890-1913" (1986).
* Allan H. Meltzer. "A History of the Federal Reserve, Volume 1: 1913-1951" (2004)
* Murray N. Rothbard. "" (2002)* Frank G. Steindl, "Monetary Interpretations of the Great Depression." (1995).
* Shull, Bernard. "The fourth branch : the Federal Reserve's unlikely rise to power and influence." (2005) Westport, Conn.: Praeger.
* Donald R. Wells. "The Federal Reserve System: A History" (2004)
* Robert Craig West, "Banking Reform and the Federal Reserve, 1863-1923" (1977)
* Elmus R. Wicker, "A Reconsideration of Federal Reserve Policy during the 1920-1921 Depression," "Journal of Economic History" (1966) 26: 223-238
* John H Wood. "A History Of Central Banking In Great Britain And The United States" (2005)
* Bob Woodward, "Maestro: Greenspan's Fed and the American Boom" (2000) on the 1990s.

External links

* [http://www.mises.org/journals/qjae/pdf/qjae2_3_1.pdf The Origins of the Federal Reserve] by Murray N. Rothbard
* [http://www.minneapolisfed.org/centralbankhistory/bank.cfm A History of Central Banking in the United States] published by the Federal Reserve Bank of Minneapolis
* [http://www.bos.frb.org/about/pubs/begin.pdf Historical Beginnings... The Federal Reserve] from the Federal Reserve Bank of Boston
* [http://fraser.stlouisfed.org/historicaldocs/rboc/download/31338/ReserveBankDecision1914.pdf Decision of the Reserve Bank Organization Committee Determining the Federal Reserve Districts and the Location of Federal Reserve Banks under the Federal Reserve Act Approved December 23, 1913, April 2, 1914; With Statement of the Committee in Relation Thereto, April 10, 1914.] 27 pages. Government Printing Office, Washington, D.C., 1914.