How the Federal Reserve came into being

In 1907, there was a Panic and a financial crisis which saw stocks cut in half.

The crisis was triggered by the failed attempt in October 1907 to corner the market on stock of the United Copper Company. When this bid failed, banks that had lent money to the cornering scheme suffered runs that later spread to affiliated banks and trusts, leading a week later to the downfall of the Knickerbocker Trust Company—New York City’s third-largest trust. The collapse of the Knickerbocker spread fear throughout the city’s trusts as regional banks withdrew reserves from New York City banks. Panic extended across the nation as vast numbers of people withdrew deposits from their regional banks.

– Panic of 1907, Wikipedia

Many saw the US tipping toward a Great Depression. And the government seemed helpless in trying to avert this awful economic plague, a repeat of what was then called the Great Depression, which had begun in 1873 after a similar panic. The financier and merchant banker J.P. Morgan used his preeminent status on Wall Street to strong arm his colleagues into shoring up the banking system by pledging their own capital. But, the world seemed to have just narrowly escaped disaster. Two books that give a full accounting of the period are The Panic of 1907 by Robert Bruner and The House of Morgan by Ron Chernow.

The question after the frightful period in 1907 was what to do to prevent another panic from causing a severe depression. Money center banks based in New York had a plan. Benjamin Strong, a senior executive at Bankers Trust and later the first President of the Federal Reserve Bank of New York, played the prominent role for the bankers in the creation of the Fed and in its expansionary credit policy that led to the second Great Depression.

His policy of maintaining price levels during the 1920s through open market operations, or purchases and sales of government securities, and his willingness to maintain the liquidity of banks during panics, have been praised by monetarists and harshly criticized by Austrian economists

Strong was also involved in the establishment of the Federal Reserve System. After the Panic of 1907, leading bankers believed a private central bank should be created to issue money. The public was adamantly opposed to the establishment of a central bank. Strong, who was Vice President of Banker’s Trust of New York, was JP Morgan’s emissary to the secret Jekyll Island (Georgia) expedition in 1910—one of the selected members who stayed at the luxurious Jekyll Island Hunt Club retreat in November for a private ten-day conference. Also in attendance were Paul Warburg, a recent immigrant from a prominent German banking family who was a partner in the New York banking house of Kuhn, Loeb & Co.; Senator Nelson Aldrich (Nelson Rockefeller was named after Aldrich, his maternal grandfather); A. Piatt Andrew, Assistant Secretary of the Treasury and Special Assistant to the National Monetary Commission (the only other NMC member besides Aldrich); and other bankers including Frank A. Vanderlip, president of the National City Bank of New York; Henry P. Davison, senior partner of J.P. Morgan & Co.; and Charles D. Norton, president of the Morgan-dominated First National Bank of New York.

What came to be known as the Aldrich Plan was drafted by these men during their conference at Jekyll Island. The plan was written in secrecy, as the public would never approve of a banking reform bill written by bankers; much less of a plan for a central bank. The Aldrich Plan was introduced in the U.S. Congress, and followed by much debate, but never came to a vote, because the party in favor of it was voted out, and the Glass-Owens Bill was introduced instead.

The general outline of the Aldrich Plan did eventually serve as the model upon which the Federal Reserve System was created with, however, significant changes that placed control into political hands (via the Board of Governors, selected by the President of the United States), and limited the role of professional bankers in its operation to that of the 12 branches. It met with Warburg’s satisfaction, as he said that minor changes could be adjusted administratively later. The term Central Bank purposely was kept out of its name, as Warburg and others warned it would not be passed otherwise.

Three years later, after months of hearings, drafts, and debates, a bill creating the Federal Reserve System was approved by Congress as the Federal Reserve Act and signed into law by President Wilson on December 23, 1913. The Federal Reserve System has many similarities to the National Reserve Association proposed by the Aldrich Plan, but with vastly differing management and control.

Strong became President of Banker’s Trust in 1914, and shortly thereafter was appointed Governor of the Federal Reserve Bank of New York the same year, which position he maintained until his death in 1928.

Economic historian Charles P. Kindleberger states that Strong was one of the few American policymakers interested in the troubled financial affairs of Europe in the 1920s, and that had he not died in 1928, just a year before the Great Depression, he might have been able to maintain stability in the international financial system.

–Benjamin Strong, Jr., Wikipedia

I am with the Austrians on this. Austrian economist Murray Rothbard is good on the 1920s here:

Great Britain might well have been able to return to the original form of gold standard at a new, realistic, depreciated parity of $3.50 to the pound. But it was not willing to do so. For the British dream was to restore, even more glowingly than before, British financial preeminence, and if it depreciated the pound by 30 percent, it would thereby acknowledge that the dollar, not the pound, was the world financial center. This it was fiercely unwilling to do; for restoration of dominance, for the saving of financial face, it would return at the good old $4.86 or bust in the attempt. And bust it almost did. For to insist on returning to gold at $4.86, even on the new, vitiated, gold-exchange basis, was to mean that the pound would be absurdly expensive in relation to the dollar and other currencies, and would therefore mean that at current inflated price levels, Britain’s exports—its economic lifeline— would be severely crippled, and a general depression would ensue. And indeed, Britain suffered a severe depression in her export industries—particularly coal and textiles—throughout the 1920s. If she insisted on returning at the overvalued $4.86, there was only one hope for keeping her exports competitive in price: a massive domestic deflation to lower price and wage levels. While a severe deflation is difficult at best, Britain now found it impossible, for the new system of national unemployment insurance and the new-found strength of trade unions made wage-cutting politically unthinkable.

But if Britain would not or could not make her exports competitive by returning to gold at a depreciated par or by deflating at home, there was a third alternative which it could pursue, and which indeed marked the key to the British international economic policy of the 1920s: it could induce or force other countries to inflate, or themselves to return to gold at overvalued pars; in short, if it could not clean up its own economic mess, it could contrive to impose messes upon everyone else. If it did not do so, it would see inflating Britain lose gold to the United States, France, and other “hard-money” countries, as indeed happened during the 1920s; only by contriving for other countries, especially the U.S., to inflate also, could it check the loss of gold and therefore halt the collapse of the whole jerry-built international monetary structure.

–A History of Money and Banking in the United States, Murray Rothbard

The British tried “internal devaluation”, a severe cut to wage and price levels (much as the euro countries are forced to do by their ‘gold standard’ system). This was rebuffed politically. It was only because the British went on gold at an unrealistically elevated conversion rate and convinced the Americans to inflate in Britain’s stead that credit spiralled out of control, creating an unsustainable boom. This same experiment was repeated in the 1980s after the Louvre Accord to halt the collapse of the US dollar, with the US in the position of Great Britain and Japan in the position of the US. The result was not a global depression, but it was a severe recession with a property, savings and loan and high yield bond bust in the US, a residential property crisis in Britain and Scandinavia as well as two lost decades for Japan after it hyperinflated a credit bubble with the inevitable disastrous consequences.