Review: Fed founders wouldn’t recognize their baby

October 30, 2015

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The Federal Reserve’s influence is so pervasive that we cannot imagine a world without it, writes Roger Lowenstein in his new book, “America’s Bank: The Epic Struggle to Create the Federal Reserve.” Yet Americans have always blown hot and cold about their own central bank.

Its first two incarnations were short-lived. President Andrew Jackson shuttered the Second Bank of the United States in 1836 – a move which reflected the public’s distrust of an over-mighty and centralizing institution. Given the Fed’s modern role as supreme arbiter of global monetary policy and its capacity to foster financial calamities, such concerns appear remarkably prescient.

The political impetus that led to the Fed’s establishment in 1914 derived from the financial panic seven years before. This crisis followed a run on New York’s trust companies – deposit-taking institutions, which were lightly regulated, highly leveraged and more speculative than the mainstream national banks that dominated in this era. The trusts resembled in no small measure the shadow banking system which sprouted up prior to, and since, the Lehman Brothers bust. A century ago, however, there was no Ben Bernanke at the ready to open up the monetary spigots.

Instead, the august figure of John Pierpont Morgan was called upon to perform the role of chief financial firefighter. After runs on the trust companies started, Morgan corralled the bankers, sent his men to check the books of failing trusts, allowed the insolvent ones to fail but provided funds for others. The panic soon passed, leaving many with a sense that the U.S. financial system was in dire need of reform.

Paul Warburg, a scion of the influential Hamburg banking family and partner at Kuhn Loeb, argued vociferously for the establishment of a central bank like those operating at the time in Europe. The country’s banking reserves, he complained, were scattered around the country which meant they couldn’t adequately provide liquidity in times of panic. Warburg proposed a central reserve, a “modern central bank” run by “our best trained business men.” Besides, the aged Morgan might not be around during the next financial conflagration. No other private individual could conceivably assume the mantle of America’s greatest banker.

The powerful Republican senator for Rhode Island, Nelson Aldrich, a crony of big business whose daughter had married a Rockefeller, took up Warburg’s proposal. Aldrich headed the Senate’s monetary commission and travelled to Europe to find out how things were ordered there. In late 1910 he secretively gathered together at a country club on an island off the coast of Georgia a small cabal comprising some leading bankers (including Warburg) and a Harvard University economist to fashion proposals for a new central bank. The Aldrich Plan, as it became known, became the blueprint for the Federal Reserve Act that President Woodrow Wilson signed into law a couple of years later.

The eventual bill to establish the Fed was sponsored by two Democrats, Senator Carter Glass of Virginia and Congressman (later Senator) Robert Owen of Oklahoma. By that date, Aldrich had retired from the Senate. His role in the gestation of the Fed was downplayed. Bitter disputes later emerged between those seeking the credit. “Asked once about the identity of the Fed’s father,” Lowenstein writes of Warburg, “he replied that he didn’t know but that judging from the number of men who claimed the honor, ‘its mother must have been a most immoral woman.’”

Lowenstein doesn’t question for a moment the pressing need for a central bank. In his view, the country’s banking system was “antiquated, disorganized and deficient.” The national banks were too conservative – they held reserves equivalent to a quarter of deposits. Consumer credit was undeveloped. The farmers cried out for funding and squealed loudly when agricultural prices fell. Panics on Wall Street were frequent.

Reading the argument of “America’s Bank” it is easy to forget that the United States rose to become the world’s dominant industrial nation without the assistance of a central bank and that by 1900 New York had overtaken London as the world’s financial capital. Lowenstein glosses over the fact that the panic of 1907 was quelled without public funds and followed by a rapid economic recovery without any long-lasting ill effects.

He also shares former Fed Chairman Bernanke’s loathing of deflation, despite the fact that declining prices in the late 19th century were a sign of rising productivity and posed no danger to economic health.

James Stillman, the deeply conservative head of National City Bank, the corporate forerunner of today’s Citigroup, decried Warburg’s central bank plans. “Why not leave things alone?” he asked the German-born technocrat. Stillman, according to Lowenstein, “regarded panics as natural and worthy rituals which cleansed the markets of excesses that he himself studiously avoided.” Perhaps he was right.

In retrospect, there appears a historical inevitability to the creation of the Fed. At the turn of the 20th century, America could just about do without a central bank since the currency was backed with gold, whose ebb and flow automatically dictated monetary policy. But by 1914, the international gold standard was about to become a victim of world war.

The subsequent history of the century was of the spread of fiat currencies, rising government profligacy, intermittent bouts of inflation, and ever-increasing debt burdens. A society intent on living beyond its means, and kicking the can of financial consequences forever into the future, is liable to resort to the central bank’s printing press.

The founders of the Fed did not exactly foresee any of this. Their aim was simply to create an effective lender of last resort to act during market panics. There’s no doubt that the Fed has fulfilled this role. But the unforeseen consequences of Fed interventions continue to this day – as lender-of-last-resort operations encourage risk taking, while the Fed’s ultra-low policy rate facilitates leverage and leads to deteriorating credit standards. Furthermore, the Fed doesn’t consider properly its global influence, directing monetary policy solely to domestic conditions. A century after the founding of America’s central bank seems as good a time as ever to reconsider these failings.

(This item has been corrected in paragraph seven to make clear Owen was a congressman at the time of the bill.)

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