How the Fed Was Born

A book about the birth of the Federal Reserve overlooks the flaws in the system.

Penguin Press

America's Bank: The Epic Struggle to Create the Federal Reserve, by Roger Lowenstein, Penguin Press, 368 pages, $29.95

Conspiracy theories about the creation of the Federal Reserve System abound. Typically they give a prominent place to a now infamous but then-secret meeting in November 1910 at an exclusive Georgia resort on the secluded Jekyl Island (at that time spelled with only one l). Organized and chaired by the powerful pro-business and pro-tariff Sen. Nelson W. Aldrich (R–R.I.), the small conclave included such prominent New York bankers as Frank A. Vanderlip of National City Bank and Paul M. Warburg of Kuhn, Leob & Co. Together the group hammered out a proposal known as the Aldrich Plan. Introduced into Congress with minor modifications in January 1912, the plan become a template for the final Federal Reserve Act, passed in late 1913 with the crucial backing of President Woodrow Wilson.

The actual story is both more complicated and more interesting than the simple conspiracy narrative. Roger Lowenstein, a financial journalist—his previous books include a study of the hedge fund Long-Term Capital Management and its collapse—has now ventured into this historical territory with America's Bank: The Epic Struggle to Create the Federal Reserve. Displaying extensive primary research into the personal papers of all the major players, he provides a readable narrative interwoven with well-sketched background biographies. Unfortunately, Lowenstein renders this narrative as a simplistic morality play, with pro-central bank heroes ("patriotic conspirators," as he styles them at one point) and anti-central bank villains, leaving the book devoid of much economic insight.

The book is divided into two parts. The first covers the efforts, particularly after the Panic of 1907, that led up to the Jekyl Island meeting: A few bankers, economists, and reformers exploited the defects of the prevailing national banking system to persuade influential citizens in business, universities, and the press that a European-style central bank was the only viable path forward. The second part recounts how the Aldrich Plan was translated into legislation that populist politicians who were traditionally hostile to central banking and Wall Street would be willing to embrace.

Andrew Jackson's destruction of the Second United States Bank in the mid-1830s left a legacy of popular aversion to central banking of any sort. Given these inauspicious prospects, several competing factions ended up playing major roles in the Fed's founding.

There were populists, such as William Jennings Bryan, who had given up on their inflationist efforts to remonetize silver but were still a political force to be reckoned with, especially within Democratic ranks. Their ideal system centered around a government-issued paper currency, like the Greenbacks introduced during the Civil War, free from the machinations of Wall Street and bankers.

There were the small country bankers, who emphatically defended the prevailing system of unit banking, with its legal limitations on branch banking. That system protected local rural banks from competition, so they effectively blocked all attempts to bring about interstate branching and even most attempts to permit intrastate branching.

There were the Midwestern city bankers, centered in Chicago, who tended to support what was referred to as the asset-currency reform. This approach would grant banks greater freedom to issue banknotes, especially during periods of financial stringency.

And then there were the major New York bankers, who ultimately came to believe that they could only preserve their financial dominance with a government-sponsored but privately controlled centralized clearinghouse empowered to loan currency to banks in times of stress. This last scheme was essentially what the original Aldrich Plan would have created.

These crosscurrents produced bitter, drawn-out debates about what form, if any, the country's central bank should take. The struggle involved, among other disputes, whether the institution would be privately or governmentally controlled, whether it would be a central organization with branches or a loose federation of regional organizations, and whether the resulting currency would be solely a bank liability or government-guaranteed. On all three of these questions, the second alternative gained critical concessions, thanks to Bryan's influence and Wilson's mediation. When the final act passed, it was a complex brew of compromises. Indeed, by this time Aldrich, no longer in the Senate, was denouncing the act. In light of his extreme unpopularity with progressives, that opposition probably assisted the plan's passage.

Many of the principals in this struggle would subsequently claim primary authorship of the final act or have it claimed for them. The candidates included the banker Paul Warburg, principle drafter of the Aldrich Plan; Rep. Carter Glass, a Virginia Democrat who introduced the initial House version of the act; Sen. Robert Owen, an Oklahoma Democrat, who did likewise in the Senate; H. Parker Willis, an economist who assisted Glass; J. Laurence Laughlin, an economist who was Willis' teacher and advised him as he assisted Glass; and "Colonel" Edward M. House, Wilson's enigmatic intimate. This led Warburg, when asked to identify the Fed's father, to quip that he didn't know, but given how many made the claim, "its mother must have been a most immoral woman."

Lowenstein's account of a few specialized aspects of the Fed's creation is not as detailed as previous scholarly works, and he occasionally ascribes motives beyond what scrupulous attention to sources would warrant. Still, America's Bank provides a good, comprehensive overview to anyone primarily interested in the personal, political, and ideological details of the story. But when it comes to objectively describing the economic background behind the Fed's creation, or to understanding the economic reasoning of its opponents and even some of its proponents, the book is deeply flawed.

The problem is not just that America's Bank unreflectively extols the Fed. It's that this celebratory tone is informed by the author's superficial understanding of monetary theory and history. These weaknesses are clearest in the first few chapters, which offer a vulgar caricature of early U.S. monetary history, sprinkled with more than a few outright factual errors. Contrary to Lowenstein's account, James Madison, as president, did not oppose but supported the rechartering of the first U.S. Bank. The second U.S. Bank, rather than muting the business cycle, presided over and contributed to the Panic of 1819, the first major depression in U.S. history. And when Lowenstein describes America's so-called free banking era as a "monetary babel," he ignores decades of scholarly research finding that the charges of reckless and fraudulent "wildcat" banking are highly exaggerated and that, to the limited extent the phenomenon was real, it was mainly the result of a government-imposed restriction on the issue of banknotes, known as the bond-collateral requirement.

That requirement was later embodied in the post-Civil War national banking system. The new system was therefore hardly the "remedy" Lowenstein claims it was—before he goes on in future pages to contradict himself by overstating its real faults. The depression of 1873 did not last six years but at most 27 months, according to the National Bureau of Economic Research. Nor was the secular deflation from 1867 to 1896 drastic; prices declined about 2 percent per year, accompanied by robust secular growth of real gross domestic product per capita. When Lowenstein writes that "beginning in 1887, there had been serious financial turmoil roughly every three years," his "serious financial turmoil" must mean every spike in interest rates. In fact, between the Civil War and the Fed's creation, major bank panics followed by recessions occurred only in 1873, 1893, and 1907, and none of those events approached the severity of the Great Depression. On the other hand, incipient bank panics in 1884 and 1890 were nipped in the bud by bank clearinghouses issuing extralegal clearinghouse receipts that could serve as currency.

Even worse is the disdainful contempt Lowenstein displays toward opponents of central banking, particularly those who advocated alternative reforms. To be sure, the national banking system did have serious drawbacks. Two were particularly harmful: It fastened the fragile and fragmented unit banking system on the country, and it created what was known as an "inelastic currency." But Lowenstein hardly touches on the ideal solution to the first problem—the legalization of branch banking—and he does not fully appreciate the nature of the second. The term "inelastic currency" does not properly refer to an inelastic money supply but rather to the inability of national banks to freely convert their deposits into banknotes.

The bond-collateral requirement rigidly tied the quantity of banknotes to a shrinking national debt. Despite the increasing importance of bank deposits in the U.S. money stock, many transactions still required currency rather than less liquid and potentially more risky checks. (As late as the Great Depression, most workers, having no checking accounts, were still paid with weekly envelopes of cash.) In a country with a large agricultural sector, there were regular seasonal demands to convert deposits into currency. But because banks could not freely issue banknotes, these seasonal demands drained reserves of gold and Greenbacks from the banks. This inelastic currency became a major source of potential panics.

Hence the asset-currency reform that America's Bank so casually dismisses. It proposed relaxing the restrictions on issuing banknotes, thereby solving the problem of an inelastic currency without creating a central bank. Proponents of this reform repeatedly pointed to the success of Canadian banking, which faced the same seasonal fluctuations in currency demand that the U.S. banks did. But Canada—which had no central bank, had nationwide branching, and allowed banks a nearly unrestricted freedom to issue currency—sailed through this era with no credit crunches, bank panics, or major bank failures. The asset-currency reform movement emerged in the 1890s, and it initially had the support of influential economists such as Laurence Laughlin and many bankers—even Frank Vanderlip. Asset-currency bills were regularly introduced in Congress, but they were inevitably blocked by a coalition of small country and New York bankers. Laughlin, Vanderlip, and others eventually turned to some kind of central bank as the only viable alternative.

Was the Federal Reserve actually an improvement over the flawed national banking system that preceded it, as Lowenstein assumes? Let us look at the record.

Created just before the outbreak of World War I, the Fed helped finance U.S. participation in that war by generating the highest rate of inflation in American history outside of the two hyperinflations during the American Revolution and in the Civil War Confederacy. After the war, it orchestrated the most rapid rate of deflation in U.S. history, so severe that it makes the mild, benign deflation of 1867 to 1896 look like price stability by comparison. During the Great Depression, the Fed presided over the most massive banking panic not just in the history of the U.S. but in the entire history of the world, despite being created to prevent such a catastrophe. It also contributed to the recession of 1937, in the midst of high unemployment lingering from the Great Depression; and it followed that with another bout of inflation during World War II, severe enough to inspire comprehensive wage and price controls. During the postwar period, the Fed was responsible for the Great Inflation of the 1970s, which hit double-digits and was accompanied by the country's first inflationary recessions. And let's not forget the financial crisis of 2007–08.

In fact, there are only three periods during the entire century of the Fed's existence when one can plausibly claim that it performed satisfactorily: during the 1920s, when the price level was stable; during the low-inflation 1950s; and during the two decades beginning in the mid-1980s, a spell whose low inflation and two minor recessions earned the sobriquet "the Great Moderation." Some critics would even question how satisfactory the Fed's record was during those three periods. (The '50s, for example, were punctuated by three recessions.)

If we ignore the most recent panic affecting mostly investment banks and other components of the shadow banking system, bringing on the financial crisis, the period since the Great Depression did see the elimination of contagious bank runs. But the timing suggests that this change owes more to the introduction of deposit insurance than to the Fed. Yet since the Fed's creation, the economy has experienced two periods with significant numbers of bank failures unassociated with panics or depressions: the rural failures of the 1920s and the savings and loan crisis of the 1980s. Indeed, more outbreaks of numerous bank failures occurred in the century under the Federal Reserve than in the century before, with the Fed presiding over the most serious case of all: again, the Great Depression. By any objective measure, the Fed has been an abysmal failure.

Ironically, this makes Lowenstein's book, with all its shortcomings, all the more instructive. It provides valuable insight not just into how a central bank was foisted on the body politic but into how it became an object of superstitious reverence, notwithstanding the overwhelming evidence to the contrary.