History of Central Banking in the United States
This article is about the history of central banking in the United States, from the 1790s to the present.
1791–1836: The First and Second Bank of the United States
First Bank of the United States
Alexander Hamilton, The Secretary of the Treasury convinced Congress in 1791 that the financial needs and credit of the new government required funding the national debt, and creating a national bank. In 1791 the First Bank of the United States (1791-1811) was chartered by Congress. It was modeled after the Bank of England and differed in many ways from today's central banks. For example, it was partly owned by foreigners, who would share from its profits. It was also not solely responsible for the country's money supply; its share was only 20%, while private banks accounted for the rest. The Bank was bitterly opposed by Thomas Jefferson and James Madison, who saw it as an engine for speculation, financial manipulation, and corruption. However their chief financial advisor, Albert Gallatin, recognized its value. Congress refused to extend its charter in 1811, and as a result Madison's government had great difficulty financing the War of 1812.
Second Bank of the United States
After a five-year interval, the federal government chartered its successor, the Second Bank of the United States (1816-1836). It was basically a copy of the First Bank, with branches over the country. Andrew Jackson, who became president in 1828, denounced it as an engine of corruption that benefited his enemies. His destruction of the bank was a major political issue in the 1830s and shaped the Second Party System, as Democrats in the states opposed banks and Whigs supported them.
In this period, only state-chartered banks existed. They could issue bank notes against specie (Gold and Silver coins) and the states regulated their reserve requirements, interest rates for loans and deposits, the necessary capital ratio etc. The Michigan Act (1837) allowed the automatic chartering of banks that would fulfill its requirements without special consent of the State legislature. This legislation eased creating unstable banks even further, lowering the supervision by the states that adopted it. The real value of a bank bill was often lower than its face value, and the issuing bank's financial strength generally determined the size of the discount. By 1797, there were 24 chartered banks in the U.S., while with the beginning of the Free Banking Era (1837), there were 712.
The banks were very unstable compared to today's commercial banks. The average lifespan of a bank was five years; about half of the banks failed, a third of which because they couldn't redeem their notes. Also, without a central bank responsible for monetary policy, the money supply and price level were much more volatile than today.
During the free banking era, some local banks appeared that took over the functions of a central bank. In New York, the New York Safety Fund acted as a deposit insurance for its member banks. In Boston, the Suffolk Bank guaranteed other banks on-par value of their notes in exchange for reserves. Another private institution that took up work of today's central banks was the clearinghouse. It acted as a lender of last resort when a bank needed liquidity, e.g. in a bank run.
1863–1913: National Banks
Some of the problems of the free banking era were solved with the National Banking Act, besides providing loans in the Civil War effort of the Union. The provisions were:
* To create a system of national banks. They had higher standards concerning reserves and business practices than state banks. The office of Comptroller of the Currency was created to supervise these banks.
* To create a uniform national currency. In order to achieve this, all national banks were required to accept each other's currencies at par value. This eliminated the risk of loss in case of bank default. The notes were printed by the Comptroller of the Currency to ensure uniform quality and prevent counterfeiting.
* To finance the war. National banks were required to back up their notes with Treasury securities, enlarging the market and raising its liquidity.
As described by Gresham's Law, soon bad money from state banks drove out the new, good money; the government imposed a 10% tax on state bank bills, forcing most banks to convert to national banks. By 1865, there were already 1,500 national banks. In 1870, 1,638 national banks stood against only 325 state banks. The tax led in the 1880s and 1890s to the creation and adoption of checking accounts. By the 1890s, 90% of the money supply was in checking accounts. State banking had made a comeback.
Two problems still remained in the banking sector. The first problem was the requirement to back up the currency with treasuries. When the treasuries fluctuated in value, banks had to recall loans or borrow from other banks or clearinghouses. The second problem was that the system created seasonal liquidity spikes. A rural bank would have deposits at a larger bank that it withdrew when the need for funds was highest, e.g. in the planting season. When the combined liquidity demands were too big, the bank again had to find a lender of last resort.
These liquidity crises led to bank runs, causing severe disruptions and depressions, the worst of which was the Panic of 1907.
1913: Creation of the Federal Reserve System
Panic of 1907 Alarms Bankers
Early in 1907, New York Times Annual Financial Review published Paul Warburg's (a partner of Kuhn, Loeb and Co.) first official reform plan, entitled "A Plan for a Modified Central Bank," in which he outlined remedies that he thought might avert panics. Early in 1907, Jacob Schiff, the chief executive of Kuhn, Loeb and Co., in a speech to the New York Chamber of Commerce, warned that "unless we have a central bank with adequate control of credit resources, this country is going to undergo the most severe and far reaching money panic in its history." "The Panic of 1907" hit full stride in October.
J. P. Morgan had single-handedly stopped the Panic of 1907. He did it not with his own control of money, but with the prestige that enabled him to bring all the powerful players together in one room, and keep them until they found solutions to the emergency. Only bankers seemed to appreciate the real problem: the United States was the last major country without a central bank that could provide stability and emergency credit in times of financial crisis, not to mention support for expanded foreign trade in good times. The threat perceived by the financial community was not so much excessive power around Morgan, but the frailty of a vast, decentralized banking system that could not regulate itself without the extraordinary interventions of one old man. Financial leaders who advocated a central bank with an elastic currency after the Panic of 1907 include Frank Vanderlip, Myron T. Herrick, William Barret Ridgely, George E. Roberts, Isaac N. Seligman and Jacob H. Schiff. They stressed the need for an elastic money supply that could expand or contract as needed; more accurately the need was for liquidity. That is, for a central bank that would loan money to banks on the basis of assets that would be hard to sell in a crisis. After the scare of 1907 the bankers demanded reform; the next year, Congress established a commission of experts to come up with a nonpartisan solution.
Rhode Island Senator Nelson Aldrich, the Republican leader in the Senate, ran the Commission personally, with the aid of a team of brilliant economists. They went to Europe and were impressed at how well the central banks in Britain and Germany handled the stabilization of the overall economy and the promotion of international trade. The dollar was a second-rate currency in world trade compared to the pound. Aldrich's impartial investigation in the best tradition of Progressive Era fact-finding led to his plan in 1912 to bring central banking to America, with promises of financial stability, expanded international roles, control by impartial experts and no political meddling in finance.
Aldrich realized correctly that a central bank had to be (contradictorily) decentralized somehow, or it would be ganged up on by local politicians and bankers as had the First and Second Banks of the United States. His solution was a regional system. In Congress, Rep. Carter Glass of Virginia picked up Aldrich's core ideas; to be able to claim Democratic authorship, he made numerous small revisions such as headquartering a region in the financial backwaters of Richmond, Virginia. Glass had once been a fervent silverite; he now accepted the ideas proposed by the experts. President Woodrow Wilson added the provision that the new regional banks be controlled by a central board appointed by the president.
Agrarian Demands Partly Met
William Jennings Bryan, by now Secretary of State, long-time enemy of Wall Street and still a power in the Democratic party, threatened to destroy the bill. Wilson masterfully came up with a compromise plan that pleased bankers and Bryan alike. The Bryanites were happy that Federal Reserve currency became liabilities of the government rather than of private banks - a symbolic change - and by provisions for federal loans to farmers. The Bryanite demand to prohibit interlocking directorates did not pass. Wilson convinced the anti-bank Congressmen that because Federal Reserve notes were obligations of the government, the plan fit their demands. Southerners and westerners learned from Wilson that that the system was decentralized into 12 districts and surely would weaken New York and strengthen the hinterlands. One key opponent, Congressman Carter Glass, was given credit for the bill, and his home of Richmond, Virginia was made a district headquarters. Powerful Senator James Reed of Missouri was given two district headquarters in St. Louis and Kansas City.
Congress passed the Federal Reserve Act or Owen-Glass Act, in late 1913. Wilson named Warburg and other prominent bankers to direct the new system, pleasing the bankers. The New York branch dominated the Fed and thus power remained in Wall Street. The new system began operations in 1915 and played a major role in financing the Allied and American war efforts. Wilson considered the Fed to be a private institution and refused to interfere in its working.
1913 – Present: Recent Changes
The Fed's power developed slowly in part due to an understanding at its creation that it was to function primarily as a reserve, a money-creator of last resort to prevent the downward spiral of withdrawal/withholding of funds which characterizes a monetary panic. At the outbreak of World War I, the Fed was better positioned than the Treasury to issue war bonds, and so became the primary retailer for war bonds under the direction of the Treasury. After the war, the Fed, led by Paul Warburg and New York Governor Bank President Benjamin Strong, convinced Congress to modify its powers, giving it the ability to both create money, as the 1913 Act intended, and destroy money, as a central bank could.
During the 1920s, the Fed experimented with a number of approaches, alternatively creating and destroying money and, in the eyes of many scholars (notably Milton Friedman), helping to create the late-1920s stock market bubble. In 1928, Strong died. He left a tremendous vacuum in Fed governance from which the bank did not recover in time to react to the 1929 collapse (as, for instance, the Fed did after 1987's Black Monday), and the Fed adopted what most would consider today to be a restrictive policy, exacerbating the crash.
After Franklin D. Roosevelt took office in 1933, the Fed became subordinated to the Executive Branch, where it remained until 1951, when the Fed and the Treasury department signed an accord granting the Fed full independence over monetary matters while leaving fiscal matters to the Treasury.
The Fed's powers have not significantly changed since 1951, though it has frequently adopted different policy approaches.