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The History of the Federal Reserve: Its Creation and Role during Tough Times

Is there a more controversial function in finance than the Federal Reserve Bank? From its beginnings, history, and the purpose of what the bank does… There are tons of rumors and theories about what the Fed does, and who controls the Fed.

In today’s craziness surrounding the financial world with the stock market in a frenzy from fears of the Coronavirus and its effects and the overvaluing of the market, I thought it might be useful for us to explore this topic.

What do we know about the Fed besides speculation and theory? The makings of the Fed is interesting and start as early as the beginnings of our own country.

The bank began its birth among quite a bit of criticism and scorn from the beginning. Charles A Lindbergh, Sr., father of the famed pilot, said that:

“This [legislation] establishes the most gigantic trust on Earth…the worst legislative crime of the ages is perpetrated by this banking and currency bill.”

And from Henry Cabot Lodge, Sr., another extremely wealthy individual during the early 1900s:

“seems to me to open the way to a vast inflation of the currency.”

In today’s post we are going to explore these topics relating to the Fed Reserve Bank:

  • What was before the Fed?
  • How did the Fed start?
  • What was Jekyll Island?
  • What is the purpose of the Fed?
  • The Structure of the Fed
  • Monetary Policy of the Fed

What Was Before the Federal Reserve?

To give you a background of the Federal Reserve, I think it is good to look back at history to get an understanding of the events that led up to the creation of the federal reserve bank.

Let’s look through a brief timeline of money in the US at its founding.

  • 1771 – 1791: US Currency – To help finance the fight for independence against the British, the Continental Congress printed the country’s first money, known as “continentals.” Congress printed so much of this fiat currency that it led to inflation which eventually devalued the money to the point of being worthless, or “not worth a continental.”
  • 1791 – 1811: Country’s First Attempt at a Central Bank – Alexander Hamilton led the first charge to create the First Bank of the United States in Philadelphia in 1791. It was the largest corporation in the US at the time and was primarily influenced by big banks and other money interests. The land at the time was mostly agrarian and was against the idea of a large, powerful bank. In 1811 Congress failed to renew the bank’s charter by one vote.
  • 1816 – 1836: A Second Attempt ends in failure – In 1816, the political climate had changed enough that another central bank was established, by a narrow vote. But when Andrew Jackson became president in 1828, he had vowed to destroy the Second Bank of the United States, as he was a central bank foe. And in 1836, the bank’s 20-year charter was not renewed again.
  • 1836 – 1865: Free Banking Era – This era saw the rise of state-charted and unchartered “free banks,” which issued their notes, redeemable in gold or specie. The period also saw the increase in demand deposits and the creation of the New York Clearinghouse Association in 1853 as a way for the city’s banks to clear checks and settle accounts.
  • 1863: National Banking Act – During the Civil War, the National Banking Act of 1863 was passed. The act required that US government securities back nationally chartered banknotes. An amendment later required that taxes be applied on state banknotes, but not national notes. The bill effectively created a uniform currency for the nation.
  • 1873 – 1907: Financial Panics – The National Banking Act created a sense of currency stability for the country, but bank runs and financial panics continued to rock the nation. In 1893, a banking panic triggered the worst recession the country had ever seen. The fear was staved off by the efforts of JP Morgan, then the most powerful man in the country, and with his support was able to prop up the banking system. For more on this moment in history, check this out.
  • 1907: The Beginning of the End – In 1907, Wall Street triggered another severe banking failure with a run of bad speculations. JP Morgan was again called on to change the nation’s fortunes. By this time, most Americans realized there needed to be a better system, but no one could agree upon what was the best route to take. Progressives and conservatives bitterly disagreed, which was the best option, but all decided that something needed to change.

Enter Nelson Aldrich and Woodrow Wilson to the center stage for the creation of the Federal Reserve Bank. 

How Did the Federal Reserve Start?

The Aldrich-Vreeland Act, which was passed in 1908 as a result of the 1907 panic. The act provided for immediate currency relief during a crisis, it also created the Monetary Commission to search for a long-range plan to find a solution to the country’s banking and financial issues.

Guided by Senator Nelson Aldrich, the commission created a banker-led plan. Other progressives led by Jennings Bryan aggressively attacked the program, their goals was to have the central bank under public control, not banker control.

In 1912, when Woodrow Wilson won the election was the death knell for the Aldrich plan. But the stage was set for the creation of a decentralized central bank.

Though Woodrow Wilson was far from an expert in finance, he leaned on advice from Carter Glass, who was soon to become the chairman of the House Committee on Banking and Finance, and from H. Parker Willis, the Committee’s expert advisor.

By 1912, Glass and Willis presented Wilson with the central banking proposal that would become the Federal Reserve act.

During the period between 1912 and 1913, the issue of the central bank was fiercely debated, molded, and reshaped. And on December 23, 1913, President Wilson signed the Federal Reserve act into law.

During 1914 the bank was built from the ground up. Fourteen different sites were chosen to house the regional Reserve Banks, and by November 16, 1914, the banks were open for business.

The opening coincided with the start of the First World War.

Before we continue with some more history, we need to stop a moment and discuss the meeting at Jekyll Island.

The Creature from Jekyll Island

Nothing calls more attention to it than the creation of the Federal Reserve Bank; many rumors and conspiracies are surrounding the creation of the bank.

None more secretive and controversial than the meeting that took place between November 20 thru 30, 1907, on Jekyll Island, which is off the coast of Georgia.

Jekyll Island was during this time, the most exclusive club in the world, and included homes owned by such luminaries as JP Morgan, Marshall Field, and William Vanderbilt I.

It had become apparent to Senator Aldrich and his colleagues that reform was needed in the banking system of the United States. With the most recent banking panic of 1907, it had become necessary for lawmakers to create a solution.

By the fall of 1910, Aldrich decided that a meeting with the most powerful men in the banking community was necessary to create a plan to control the central bank that was coming.

Aldrich knew that the meeting of these banking leaders was likely to lead to suspicion about their motives and threaten the success of the plan they were about to create.

To ensure secrecy, he created a ruse by disguising the meeting as a duck hunting trip and instructed the men to meet one at a time at a train terminal in New Jersey. Once there, they all boarded a private train car. Once aboard, they only used their first names, thus creating the “First Name Club.” The first names were used to help throw off suspicion and prevent any of the staff from learning who the men were.

All in the group recognized the need for an elastic currency supplied by a central bank that holds reserves of all the banks in the system. However, the details were far more challenging to agree to and took many hours of discussion from early morning to late at night.

In the end, they agreed to a plan that included a central bank with fifteen branches across the country. Each branch would be governed by a board of directors who would be elected by the member banks in each district, and with larger banks getting more votes.

The branches would be responsible for:

  • Holding the reserves of the member banks
  • Issuing currency
  • Discounting commercial paper
  • Transferring balances between branches
  • Checking clearing and collection

The national bank would set discount rates for the whole body, as well as buy and sell securities.

By and large, this is approximately what was eventually agreed to as the Federal Reserve Act in 1913.

For controversies about the founding of the Fed, you need to look no further than the book “The Creature from Jekyll Island,” which was written by G.Edward Griffin.

Griffin suggests in his book that evil people with ulterior motives created the Fed.

According to Griffin’s theory, the bank was simple, create something that could create money out of thin air, to the benefit of the bankers. And according to Griffin, is precisely what they did, creating fiat money.

In Griffin’s opinion, that is the exact problem, fiat money, which has no intrinsic value and is the cause of modern monetary issues. The money that the government creates and has a particular value, according to the government, and is also used to control inflation.

According to Griffin, the central bankers of both the US and Britain were the cause of the Great Depression in 1929, but not before the most affluent investors were warned to sell their investments.

Griffin also believes that the central bankers of the world, including the Fed, have been the cause of all major wars since 1694 with the Bank of England. All of this, he believes have profited some of the richest families in the world, including the Vanderbilts, Rothchilds, and Morgans, among others.

His book has inspired political leaders such as Rand Paul to advocate for a more transparent Fed, or for the outright elimination of the Fed. One of the rallying cries of the Tea Party movement has been the elimination of the Fed.

Is the book, right? I will say this; he brings up a lot of interesting points, some of which stretch the imagination, to say the least. The history of the meeting on Jekyll Island took place, but whether the details revealed are accurate or not is under debate.

The book is an entertaining read, and I would recommend it to those who are familiar with the history of the Federal Reserve. I am not a paranoid person by nature, so I thought it read as more fiction than anything else.

For some more controversy, let’s talk about the Fed’s role during the Great Depression.

Fed’s Role in the Great Depression

For those of you not familiar with the Great Depression, this was a period between 1929 to 1941 that was the deepest and longest-lasting downturn in the history of the US.

The Fed’s role in the Depression has been hotly debated among scholars since the time of the Depression. Everyone from Benjamin Bernanke, the former chairman of the Fed, to multiple bloggers have reasons for the Depression and Fed’s role in the period.

During the Depression, industrial production plummeted, unemployment exploded, families suffered, and marriages fell apart. The contraction started in the US and spread around the world.

The Depression began in August 1929, when the Roaring Twenties came to a screeching halt with the contraction of the economic expansion.

A series of calamities sparked the Depression:

  • The stock market crash in 1929
  • The regional banking crisis in 1930 and 1931
  • A series of national and international crisis from 1931 to 1933

The downturn finally hit bottom in March 1933, when the commercial banking system collapsed. During this time, FDR declared a banking holiday to give everyone a break and cool off.

According to Bernanke, there were multiple reasons the Fed failed during the Great Depression. Let’s examine them a little bit.

First, the inefficiency of how the Fed was set up hurt the decision-making process among the various governors. The Fed’s decision making was decentralized and often ineffective, each governer set policies for their districts, but some decisions required the approval of the Board in DC. But the Federal Reserve Board lacked the power and tools to enact any of these decisions and struggled to get all the principal actors to agree to a common goal.

When everyone agreed, then policies could be swift and useful, but often they didn’t, which meant that the governors were left on their own—the indecisiveness leads to independent decisions that were often contradictory to other governors.

Ultimately the governers disagreed on the correct course of action, and no one could agree on the proper course of action, and thus not much was done to help.

Some actions they did try, the policies they did enact that the Fed felt were in the public interest, unfortunately, hurt the economy, and others that would have helped they never adopted.

An example of a policy the Fed tried was the decision to raise interest rates in 1928 and 1929. The Fed did this to end speculation in the stock market, but this action slowed the economy in the US. And globally, because the gold standard was linked to interest rates, this action triggered a recession across the globe. And in 1931, the Fed repeated the same mistake with the same result.

Another action not enacted was the failure of the Fed to act as the lender of last resort during the banking panics that began in 1930 and ended in 1933 with banking holiday. One of the central tenets of creating the Fed was to act as a lender of last resort to help prevent the exact banking runs that occurred during the Great Depression.

Among the governors, there was much disagreement about how to distribute the funds and to which banks do you save. Some believed you should help the most solvent; others thought you tried to stem the tide at the most insolvent.

The disagreement about how to act led to the most severe sin of omission, doing nothing at all to stem the decline in the supply of money. The Fed could have prevented deflation by preventing the collapse of the banking system, but it failed to do so for a couple of reasons.

The big reason, the economic collapse was unforeseen and unprecedented in US history. The decision-makers in the Fed either lacked the tools to determine what was really happening and lacked the authority to take measures to cure the economy.

That’s not all the say that the Fed did nothing to try, several modern economist scholars state that the Fed did try several measures that could have stemmed the tide but were not done with either enough vigor to counteract the deflationary effects of the banking crisis. Overall, the Fed’s efforts to stop deflation and revive the economy, while with good intentions, were too little and too late to make an impact.

I am a firm believer in studying history and that we can discover lessons to learn from during any point in history. The lessons learned from the Great Depression led to decisions made during the Great Recession of 2007 to 2009. More about this in a moment.

History of the Fed and the Gold Standard

Gold has a long history as the currency of choice, beginning with Lydia in 600 BC. In the US, the gold standard was enacted in 1900 and was set as the only metal for redeeming paper money. The price then was set at $20.67 an ounce.

In 1913 when the Fed was established, the gold standard was adopted as the means of the value of money. The gold standard was abandoned during the First World War so they could print enough money to pay for the war. Unfortunately, this caused hyperinflation because the “free” money was tied to the gold standard, which was then modified.

During the Depression, there was a run on gold. As the Fed attempted to print more money to stabilize the economy, people started trading in their dollars for gold, thus hoarding the gold because they didn’t trust the banks.

The hoarding led FDR to close the banks for a week and forced all the banks to turn their gold over to the Fed and decreed that banks could no longer redeem gold for dollars, and no more gold could be exported. Later he ordered all Americans to turn in their gold for dollars and created Fort Knox, the largest reserve of gold in the world at that time.

Because of Roosevelt’s actions, this led to the United States becoming the largest holder of gold, and other countries began to peg their currencies to the dollar, which led to the dollar becoming the de facto world currency.

In 1971, President Nixon, in response to a growing economy and inflation, decided to abandon the gold standard. The elimination of the gold standard allowed nations to print more of their own money, which initially increased inflation, but eventually, this stabilized.

The elimination of the gold standard has allowed the Fed to print more money and put it into the system in times of stress or to reduce the amount of money to stabilized rampant inflation.

Great Recession 2007 to 2009

The Great Recession began with the economic slump as a result of the US housing market going from boom to bust. The bust caused large amounts of mortgage-backed securities to fail, along with derivatives losing a significant amount of money.

The causes of the recession were:

  • Failure by the government to regulate the financial industry, particularly banks.
    • The failure included the inability to stop the toxic mortgages.
  • Next, there were too many financial firms taking on too much risk.
    • “Shadow banking system,” which included investment firms became bigger than depository banks without all the scrutiny. Which led to a collapse of the credit system
  • And finally, too many firms borrowing more money than they could afford.

All of this led to the collapse of firms such as Bear Stearns, Lehman Brothers, and Washington Mutual.

All of this led to extraordinary measures by the Fed to stave all of the collapses off.

The Fed lowered the interest rates to almost zero in an attempt to create more liquidity. They also provided the banks with $7.7 trillion in emergency loans, which was known as quantitative easing.

The US government also injected liquidity into the economy to the tune of $787 billion. Additionally, the Dodd-Frank act was passed in 2010 to help regulate the banking industry. The bill included provisions for the government to intercede in failing financial institutions to either help them recover or allow them to fail. It also included a provision to “stress test” the banks to ensure that they have the liquidity to withstand two years of severe financial distress.

There are critics of all the above, stating that the system has flooded too much liquidity into the system and has allowed politically connected entities to stay afloat despite their financial instability. And that the stimulus has delayed real economic recovery and built a house of cards waiting to fall at the next crisis.

Final Thoughts

The Fed has a long, storied history that is not without its controversies. In today’s market instability, I thought it would be helpful to see where we came from so we can have some insight into where we might be going.

The recovery of the two financial crises in our history has shaped our economy and monetary policy to a great extent. And with the ongoing Coronavirus pandemic and the related collapse of the financial markets, I thought it might give us some insight into how the Fed is trying to react to what is going on.

The balance sheet for the Fed has grown by leaps and bounds since the crisis of 2007, and some fear that this will be our undoing during this time of instability. It also calls into question the continued feasibility of our fiat currency. Some argue that the rise of Bitcoin could be the next currency that rises from the ashes of the subsequent recovery.

One thing we can all learn from history, is that there is always recovery and life will go on, maybe not in the fashion we were used to before, but it will continue.

As always, thank you for taking the time to read this post, and I hope you found something of value for your investing journey.

If I can be of any further assistance, please don’t hesitate to reach out.

Take care and stay safe out there,

Dave