I haven’t written on anything political on this blog for a long time but I think a post on the Federal Reserve is a worthy topic of discussion since it’s not much understood even if what I have to say isn’t what people want to hear. I know this isn’t a favorite institution among Americans who sometimes think that it’s corrupt or doesn’t have much transparency. Some like to think that it’s been involved in a lot of conspiracies such as the Kennedy assassination (which it certainly wasn’t, nor has the CIA). Many view the Fed There are libertarians like Ron Paul and his son Rand who want to end the Fed thinking that it’s unconstitutional and that there’s no need for such system since they believe the economy could regulate itself on its own (I’ll get to this later). Then you have people in the Occupy movement who think that the Federal Reserve exists as a private corporation with too much power in the federal government and only serves the interests of large corporations led by people with too much power and too much money already (it’s actually an amalgamation of a government agency-corporation but with 12 privately owned district banks, yet all profits and central authority belongs to the federal government). However, while many of the anti-Fed movement don’t realize (or ignore) is that the Federal Reserve plays an essential role in the American economy which most Americans take for granted. And while it’s not a perfect system or one a lot of people like, we need to understand that to abolish the Federal Reserve would be absolutely insane.
Now you don’t have to be a financial genius to know that abolishing the Federal Reserve would be a catastrophically stupid idea. In the United States the Federal Reserve functions as a central bank to manage the nation’s money supply through monetary policy, deter bank panics, providing financial services for the government as well as private banks (particularly as a lender of last resort), strike a balance between privatization and government involvement, and create a stable economic environment for businesses, investors, and consumers alike. All these are extremely important for a national economy as well as in our daily lives. Still, while many do blame the Fed for the country’s economic woes, many don’t understand that if the Fed wasn’t around in the first place, the US would’ve been in much worse economic shape than it has been since its creation in 1913. Yet, even Founding Father Alexander Hamilton knew that establishing a centralized national bank was necessary to stabilize and improve the nation’s credit as well as to improve handling of the US government’s financial business. While this idea was controversial for years (even in his own time), history would later vindicate Hamilton’s views on finance, particularly that of a centralized national bank and the Federal Reserve is living proof of this from its inception to its 100 year existence.
When it comes to understanding why we need the Federal Reserve, we need to remember that the Fed was created in 1913 after the US had spent 76 years without a central bank (giving us a good window into what would happen if we actually ended the Fed.) Now unlike what many free-market libertarians would want you to believe and Ron Paul’s gold standard nostalgia, these weren’t great economic times to be honest. Of course, the reason why the US went through a period with no centralized banking system during this time had to do with a few factors. For one, the First and Second Banks of the United States were privately owned (and had foreigners share in the profits), shared only 20% of the nation’s currency supply while state banks accounted for the rest, and ran on 20 year charters which both expired before they could be renewed (all based on Hamilton’s ideas by the way save for the expiring bit). Nevertheless, the fatal flaw with Hamilton’s central banking system was that it provided a way for business interest and greed to usurp power from the federal government and common citizens. Second, a lot of Americans didn’t like a centralized banking system which they saw as undemocratic, corrupt, and favoring the interests of big business. They particularly distrusted centralized financial authority which undermined both banks, which was particularly personified in Andre Jackson who was more than happy to help the Second Bank of the United States along its demise in 1836 even to the point of vetoing congressional attempts to renew its charter to usher an era of laissez faire economics and de-centralized American banking. Unfortunately financial anarchy didn’t go so well.
Of course, running a country without a central bank empowered to issue paper money led to more than a few problems, well, more like large systematic financial fuck ups between 1837 and 1913. During this time the dollar supply was tied to private banks’ holdings and government bonds, which would’ve been fine if the need for dollars was fixed over time. Unfortunately it wasn’t the case. Since there was no central, government-backed bank able to create money on demand, the American banking couldn’t provide it nor was there a for a bank’s money supply to adjust with demand either. When people would try to withdraw more money from one bank that it had available, the bank would fail leading to other people trying to withdraw their funds from other banks. Such activities would create a vicious cycle later snowballing into widespread bank failures and contraction of lending across the economy resulting in economic depression. This happened every few years. Another reason for bank failures being so common before 1913 was the tendency of huge fluctuations in the money supply. Often the US economy would alternate between too much money in circulation and not enough causing all sorts of economic chaos.
The American banking system was particularly unstable during the Free Banking Era between 1837 and 1862 when banks had no federal oversight whatsoever. During this time, banks were short lived with an average lifespan of 5 years with half of them would failing (due to fraud, incompetence, or bad economic conditions) and a third going out of business because they couldn’t redeem their notes. You also have a practice called wildcat banking in which many banks would issue nearly worthless currency backed by questionable security (like bonds or mortgages) since the institution’s real value would often be lower than its face value. Some bank currency was more valuable than others depending on the bank you received the banknote and the quality of its assets, your state’s banking regulations, the quality of your state’s bonds if your state required such banknotes to be backed by them, and the likelihood of fraud. Not only that, but there was no transparency at all so you couldn’t tell whether your neighborhood bank’s assets were wildcat money. And if that weren’t enough, you had to deal with the fact that there were over 30,000 different currencies floating around in the United States at this period, which could be issued by almost anyone even drug stores and steakhouses. A lot of problems also stemmed from this including the fact that some currencies were worth more than others whether backed by silver, gold, or government bonds. Then you have the Panic of 1837 that caused a major recession that lasted until the mid-1840s, eight states either wholly or partially unable to pay their debts, and 343 of the nation’s 850 banks closing their doors resulting in a shock from which the system of state banks would never recover.
The National Bank Era of 1863-1913 was not much better. Though it did establish a uniform US banking policy, established a series of national banks with higher standards than many state ones, created a national currency, and basically helped put an end to the wildcat banking practices. National banks were required to use government issued bills and back them with US government issued bonds as well as accept each other’s currency at par value. The federal government’s 1865 issue of a 10% tax on state bank bills would not only give rise to a uniform national currency by forcing all non-federal issued currency out of circulation but also the creation of checking accounts by the state banks which became the primary source for most banks’ revenue by the 1880s. Yet, despite the reforms, a lot of problems still remained. For one, while the US finally had a uniform currency, it was required to be backed up by treasuries. When such treasuries fluctuated in value, banks had to either recall loans or borrow from other banks or clearinghouses. Second the banking system of the National Bank Era created seasonal liquidity spikes particularly in rural areas during planting season when demand for funds was the highest. When the combined liquidity demands were too big, the bank would again have to find a lender of last resort to borrow from so it could pay its depositors and escape from financial ruin. Unfortunately, the responsibility would usually fall to other banks and financial institutions yet they weren’t always willing to bail out a troubled entity since doing so could put them in financial risk. This led to a string of financial panics which caused serious economic damage. Because there was a chance that you wouldn’t be able to access your bank account during an economic meltdown, Americans didn’t have much faith in their banking system.
The worst of the financial meltdowns to occur during the National Bank Era that helped facilitate the creation of the Federal Reserve was the series of events that helped lead to the Panic of 1907, the period’s worst. Now there are a variety of factors that contributed to this financial crisis that happened to converge all it once. It all began with the devastating San Francisco Earthquake of April 1906 not only developing an urgent need for cash to fund the recovery efforts and contributing to market instability but also made the survivors unable to access their cash for weeks mainly because it had been locked in bank vaults so hot from broken gas line fires that opening them would’ve caused their money to burst into flames. Not only that, 1906 was also a bumper year for crops which brewed a possible economic boom so companies nationwide wanted more cash to invest in new ventures like rebuilding San Francisco. Both of these events made dollar demand uncommonly high at a time when the money supply couldn’t increase much resulting in rising interest rates and withdrawals. Before long, the high number of withdrawals would soon put banks across the country on the brink of failure. In October of 1907, a copper miner turned banker F. Augustus Heinze and his stockbroker brother Otto tried to take over the United Copper Company’s market by buying up its shares. They failed and United Copper’s stock price tumbled causing investors to rush to pull any deposits out of any bank even remotely associated to F. Augustus Heinze. Banks and financial institutions began to fail, particularly the huge Knickerbocker Trust Company, the third largest trust in New York, which had its depositors withdrawing $8 million of its funds in less than 3 hours. Knickerbocker’s failure led banks and financial institutions nationwide to hoard their cash unwilling to lend to other banks, especially in New York. Though undisputed Wall Street king J. P. Morgan managed to bail out some of the troubled banks due to his immense wealth and his ability to get rich guys and bankers to do what he wished, he was unable to solve the systemic failures of the US finance system caused the crisis in the first place. The Panic of 1907 would spark one of the worst recessions in US history as well as similar crises in much of the world as well as would lead to the creation of the Federal Reserve four years later.
Of course, the Federal Reserve doesn’t prevent bank panics it just serves as a better tool to deal with them as a lender of last resort as well as regulating money supply. Thanks to the Fed, the United States has experienced fewer major financial panics and the money supply is mostly under control with huge fluctuations being few and far between. Because of the Federal Reserve, the United States has become a much more stable economy which has helped create a better climate for capitalist enterprise than any US banking system has ever had in its existence. Sure the Federal Reserve isn’t a perfect institution and has problems that need corrected. Yet, we need to understand that when the US tried to do without centralized banking, the economy was much less stable and much more unpredictable while banks weren’t always places you could put your money in. No American wants to live at the time when they’d have to worry whether their bank ran out of money, loan their money to someone else who didn’t pay them back, or issued currency notes of questionable value. Nor do Americans want to live at a time of dramatic fluctuations in the money supply either or frequent bank panics and financial meltdowns. Sure there have been accusations that the Fed serves the interests of wealthy bankers and corporations but it also serves in the best interests of all Americans by making sure that the public retained confidence in the nation’s money and where it’s held. It also helps keep our economy system moving and minimize financial disturbances threatening economic stability. Our ancestors in the 19th century didn’t have such system nor did they have as much trust in the American financial system as we do nowadays. While there were plenty of financial institution running to Washington for bailouts during the 2008 meltdown, there were very few Americans running to the banks to withdraw their life savings before they ran out of money. Thus, while the Federal Reserve may have its flaws and critics, at least it’s a viable system that has worked quite well in its 100 year existence playing a crucial role in the US economy and performing services the American people just can’t live without. So perhaps when people talk about possibly ending the Fed, you might want to remind them that our financial system before the Federal Reserve was much worse and much less accountable. Nevertheless, to say that the Fed does more harm than good is simply not the case at all.