The Genesis of the Fed

The New York Chamber of Commerce established a currency commission to report on the problems associated with an insufficient supply of money. The commission reported their findings in October 1906 and concluded the nation needed a central bank to eliminate currency instability the danger of an inelastic currency. Currency instability refers to the purchasing value of the currency being reduced as a result of inflation. Inelastic supply, to an economist, means that supply does not increase when the demand increases. Another means to describe this lack of money is to call it a liquidity crisis, in which insufficient amounts of money are available to meet an increasing demand. Bankers saw this lack of liquidity as a potential loss of profit as they were unable to issue the loans that were being demanded. There is no sound economic rationale for simply increasing the money supply to relieve a liquidity crisis.

Note: under normal economic laws, when the demand exceeds supply, the price rises. Since interest rates represent the price of money, an increase in demand for money should cause the interest rate to rise. This is a good thing. An increasing interest rate ensures that money will not be borrowed for frivolous reasons; but instead will only be borrowed for purchases that make sound economic sense like buying new capital equipment that can be used by businesses to make more “widgets” on a more economical scale and sell them for a lower price!

This commission report began a series of events that led to the enactment of the Federal Reserve Banking Act in 1916. The panic of 1907, which was the result of inflation stimulated by the President Theodore Roosevelt’s Secretary of the Treasury Leslie Shaw over the previous two years, resulted in the big bankers coming together in agreement that a central bank, as a lender of last resort, was required to stabilize the economy. Shaw was attempting to run the Treasury as if it were a central bank by making open-market purchases; the infusion of Treasury money into the economy resulted in inflation.

The big bankers co-opted the academics into presenting a series of lectures during 1907-1908 that called for the economic reasons for a central bank. In January 1908, Senator Nelson W. Aldrich took the lead in banking reform by establishing a National Monetary Commission (NMC) that was to investigate the currency question of instability and suggest proposals for banking reform. The NMC was a sham; its real mission was to overwhelm the public with supposed academic experts and take the financial issue out of politics by putting the non-elected academics and experts at the forefront.

In September 1909, Chicago banker George M. Reynolds delivered a presidential address to the American Bankers Association calling for a central bank. On September 14, 1909, President Taft suggested the nation seriously consider a central bank during his address in Boston. On September 22, 1909, the Wall Street Journal began a fourteen-part series of front-page editorials entitled “A Central Bank of Issue”. These unsigned editorials were actually written by Charles A. Conant, who was the chief paid propagandist for the NMC.

1910 saw numerous public speaking events and printed materials all in support of a central bank and all by non-elected, supposedly non-political types. Every one of them was careful to make this appear to be grassroots movement without ties to any elected official. These behind- the-scene tactics were totally effective in spreading the word (quite a bit of it lacking facts) and thereby educating the general public for the need to support a central bank movement in America.

On November 22, 1910, a secret meeting was held at Jekyll Island, Georgia. Senator Aldrich and five businessmen representing the largest banking interests in the world at the time, traveled under assumed names in complete secrecy, to the private resort co owned by J.P. Morgan to spend a week in drawing up the bill that would eventually become the Federal Reserve Act. Aldrich presented the bill to his NMC with only minor revisions, and it officially became known as the Aldrich Plan in January of 1911. The elections of 1912 brought a change in party to the White House which required dropping the Aldrich name in favor of a more centrist politician. The bill took the name of Representative Carter Glass from Virginia. The bill underwent numerous revisions but was passed by an overwhelming majority in both houses in December 1913. Even with the changes, it was still virtually the same as the original draft written at Jekyll Island.

Now that the central bank was in place, bankers had no reason to hold gold in their vaults. They could, and did, deposit their gold with the Fed and receive reserves upon which they could make loans. They were able to pyramid their credit and thereby expand the supply of money and credit from coast to coast in a coordinated fashion. This was in inverse pyramid with the bank deposits as the base and an expanding succession of upper layers that represent the effects of that lending through successive lending. Economists refer to these successive layers as compounding or the multiplier effect. Coordination was necessary so that inflation was maintained at a low enough level so as to not upset the people and call for government intervention. In short, bankers had created a goose (the Fed as a central bank) that was laying golden eggs for them to harvest on a daily basis.

The inverse pyramiding of bank credit thus created was three layers deep; the Fed pyramided its notes and deposits on top of the newly centralized gold supply; the national banks pyramided bank deposits on top of their reserves on deposit at the Fed; and the state banks who chose not to join the Federal Reserve System could keep their deposit accounts at national banks and pyramid their credit on top of those deposits.

The Fed sat at the base of the pyramid and could coordinate and control inflation by determining the amount of reserves in their member banks. Prior to the Federal Reserve Act, the reserve requirement for national banks was 20 percent reserves to demand deposits. This meant that banks had to set aside 20 percent of demand deposits while making loans with the remaining 80 percent. That resulted in a money multiplier of 5 since 100 percent divided by 20 percent equals 5; meaning the ratio of demand deposits to new credit creation was 5:1. One of the first acts of the new Fed was to cut the reserve requirement in half to only 10 percent of demand deposits, thereby increasing the credit creation ration to 10:1.

I should note that issuing credit and loans on the demand deposits is not necessarily a bad thing under economic law. The new loan is essentially converting a piece of paper that serves as the loan agreement into checkable deposits. This act of monetizing is known as money creation. Money is created when a loan is issued and then money is destroyed when the loan is paid back. Since the temporary increase in the money supply, or monetary base, is offset by the destruction of money when the loan is repaid it does not result in a permanent increase in the money supply. That borrowed money will be spent to buy goods and services that should help the economy grow. This is only valid because the loans are based on deposits that have actual value. When the Fed creates money out of thin air with nothing to back it other than the full faith and credit of the United States, the increase in the money supply, or monetary base, is not temporary; it is permanent since the Fed never takes the closing position of destroying the money at some time in the future. I will discuss the money supply at length in part III.