The Washington Post Sunday
Contentious birth of the Fed
In recent years, as it has stepped in to deal with the worst economic crisis since the Great Depression, the Federal Reserve has become remarkably politicized. That’s not altogether surprising. Almost exactly a century ago, America’s central bank emerged from the muck of the nation’s immature, crash-and-depression-prone financial system. As Roger Lowenstein tells it in “America’s Bank,” an illuminating history of the Fed’s unlikely origin story, the central bank represented an ambitious — and not entirely successful — effort to resolve several long-standing tensions at the heart of the American experiment in self-government: East Coast vs. the interior, urban sensibilities vs. rural ones, mercantile vs. agrarian interests, Wall Street vs. Main Street. It is still working out the kinks.
The language used to describe the working of the central bank — Fedspeak, as it is known — is famously obfuscatory. But Lowenstein, a financial journalist and author of books on the financial crisis and Warren Buffett, has a great facility for constructing highly readable narratives about complex financial topics. In his telling, America’s central bank came about through political and intellectual horse-trading among a German-Jewish immigrant banker, a patrician Republican from New England and a states-rights Democrat from rural Virginia.
In 1914, the United States stood alone among industrialized nations in eschewing a central bank. Andrew Jackson had famously allowed the charter of the Second Bank of the United States to expire in the 1830s. With only loose regulation, the financial system was decentralized and rudderless. Banks issued their own notes. When conditions turned sour, banks, which were required to hold large reserves, called in loans and withdrew credit — at the same time. And so the industrializing United States “suffered a continual spate of financial panics, bank runs, money shortages and, indeed, full-blown depressions.” The Panic of 1873 turned into a six-year depression. In London, by contrast, the Bank of England — where banks pooled a small portion of their reserves to be used in an emergency — lent freely at times of crisis. As a result, Britain’s 19th-century downturns were far less severe than those of its former colony.
The effort to reconcile a functioning European tradition with the dysfunctional U.S. system started with Paul Warburg. The scion of a German banking family with the “soul of a poet,” Warburg arrived in the United States in 1902 to join the bank run by his in-laws, Kuhn, Loeb & Co., and was “shocked by the primitiveness of American finance.” In January 1907, Warburg wrote a New York Times op-ed, titled “Defects and Needs of Our Banking System,” in which he argued for a central bank. Nine months later, the market illustrated his point perfectly. Thinly capitalized New York-based trusts (institutions that were like banks but held very little reserves) suffered a series of depositor runs. The panic quickly spread to the nation’s largest banks. With federal agencies powerless to act, the banker J.P. Morgan single-handedly engineered a bailout, deciding which institutions would live and which would die. The Panic of 1907 was, Lowenstein notes, “the worst breakdown in the history of the National Banking system.”
Congress, controlled by Republicans, responded in a predictable way: by forming a commission and plotting a European junket. Warburg had sent his plans for a central bank to Sen. Nelson Aldrich, a well-connected Rhode Island Republican who chaired the Senate Finance Committee. When Aldrich led a group of senators on a tour of European capitals, “at each central bank, the Americans were given to feel like the representatives of a primitive system, one barely above contempt,” Lowenstein writes.
Aldrich returned home a convert to the notion of a central bank. In November 1910, he, Warburg and several leading bankers sneaked off to a plutocrats’ resort on Jekyll Island, off the Georgia coast, under the ruse that they were going duck hunting. “Warburg, feeling faintly ridiculous, obtained a hunting rifle and cartridges that he had not the slightest idea how to use.” They hammered out a general plan for a central bank that would serve their interests: owned by private banks, operating with minimal government oversight, and intent on providing a more flexible and resilient currency.
The plan for a central bank, concocted by elitist, moneyed Republicans, was launched into a Washington that was changing; in 1910, the House flipped in favor of the Democrats, and control of the Senate passed from Republicans to Democrats after the 1912 elections. But it found an unlikely champion in Virginia Democrat Carter Glass, the son of a Confederate veteran and a former newspaper publisher, who chaired the House Banking Committee.
You can tell this book is a work of history, because the legislative process actually worked. In June 1913, President Woodrow Wilson, whose contribution was to insist on a powerful board in Washington that would oversee the proposed network of regional reserve banks, presented his plan. The next day, Glass and Sen. Robert Owen (D-Okla.) introduced identical bills in their respective chambers. “Far from a radical manifesto, Glass-Owen struck a sensible middle ground,
with power shared between the center and the regions and between the public and private domains,” Lowenstein writes.
The narrative bogs down as it enters the legislative arena: hearings and lobbying efforts, alternate proposals and last-minute amendments. Competing bills that passed the House and the Senate were finalized in conference the week before Christmas. In the middle of the night on Monday, Dec. 22, at the request of bankers, a provision for deposit guarantees was knocked out. (Then, as now, bankers had no clue as to what public policy was good for them.) Wilson signed the Federal Reserve Act into law on Dec. 23, 1913.
The timing was fortuitous. As war broke out in Europe in 1914, the new Federal Reserve kept America’s banks relatively stable. Gold poured across the Atlantic, the dollar strengthened, and New York surpassed London as the world’s financial capital. Warburg, who had become a U.S. citizen in 1911, was appointed to the Fed’s board of governors. But with two brothers still in Hamburg, he resigned from the post.
Lowenstein notes, correctly, that the establishment of the Federal Reserve was “less an ending than a truce.” Battles over banking regulation, the gold standard and the appropriate way to conduct monetary policy continued to rage. (They still do!) The lines of authority over who would run the Fed — regional banks or the central board, bankers or political appointees — were not resolved for many years. (They still aren’t!) The Fed’s mission constantly shifted. “No onlooker in 1913 could have predicted that one day the Fed’s most well-advertised duty would be setting interest rates,” Lowenstein notes.
Few would have predicted, either, the success the Federal Reserve has had in ironing out business cycles — the U.S. economy has been in recession for only 26 months since July 1991. But few would have foreseen its stunning failures. Warburg died in 1932, three years after the stock market crash and a banking crisis far worse than the Panic of 1907 that the Fed had failed to avert. The serial debacles of 2008, from subprime through Lehman Brothers, AIG and TARP, represented an even greater failure by the Fed (and other institutions).
You can blame the architecture. But the Federal Reserve, like all government institutions, has been beset from its outset by the biases, failings and quirks of the people who run it. As Lowenstein notes, “The Federal Reserve Act did not guarantee sound monetary policy any more than the establishment of Congress could guarantee good laws.”
Daniel Gross is executive editor at Strategy+Business. His most recent book is “Better, Stronger, Faster: The Myth of American Decline and the Rise of a New Economy.”
No one in 1913 could have predicted that the Fed’s most well-advertised duty would be setting interest rates.