Essay/Term paper: Federal reserve act

Essay, term paper, research paper:  Humanities

The Federal Reserve: A Knight in Shining Armor



"To suffer either the solicitation of merchants or the wishes

of government, to determine the measure of the bank issues,

is unquestionably to adopt a very false principle of conduct."

-Henry Thornton, 1802



The banker was frantic. A large mob was gathering outside his bank and the people were clamoring for their money. The banker called the Federal Reserve Bank in Minneapolis and warned that unless this "mad run" were stopped, he would soon be out of currency. With the bank nearly two-hundred miles from Minneapolis, a small plane carrying two Federal Reserve Bank officials and a half-million dollars in cash were quickly flown into town. Upon approaching the town the pilot guided the plane low over the main street in a sensational arrival and then landed. From there, the money was carried ceremoniously into town and stacked along the bank's teller windows. The sight of the money calmed the customers fears and saved the bank from failing.

Stories of bank runs- tales of people running to withdraw all their cash from their accounts- may seem dramatic, almost theatrical to people today. But to people living in an economically unstable society, like the early twentieth century, they were an expected occurrence. The banks were independent rivals, the amount of currency in circulation was fixed, and there was no element of trust between the depositor and the bank. Abram P. Andrews, secretary of the National Monetary Commission in 1908 provided a vivid description of the banks' quandary at the time:

"[The banks] were so singularly unrelated and independent of each other that the majority of them had simultaneously engaged in a life and death contest with each other, forgetting for the time being the solidarity of their mutual interest and their common responsibility to the community at large. Two-thirds of the banks of the country entered upon an internecine struggle to obtain cash, had ceased to extend credit to their customers, had suspended cash payments and were hoarding such money as they had." (Born...,12).



The banks, in an attempt to avoid bank runs, were hoarding their money. However in order to hoard the money, they did not lend any out, bringing the economy to a standstill. The credit system of the country had ceased to operate, and thousands of firms went into bankruptcy (Born...,.12). Something had to be done that would provide for a flexible amount of currency as well as provide cohesion between banks across the United States. (Hepburn, 399) This knight in shining armor, as described in the story of the bank run, was the Federal Reserve. The Federal Reserve Act of 1913 helped to establish banks as a united force working for the people instead of independent agencies working against each other. By providing a flexible amount of currency, banks did not have to hoard their money in fear of a bank run. Because of this, there was no competitive edge to see who could keep the most currency on hand and a more expansionary economy was possible.



The evolution of the Federal Reserve did not begin on December 23, 1913 with the passage of the Federal Reserve Act. Rather, it began with the Banking Panic of 1907, the most severe of the four national banking panics that had occurred in the precious thirty-four years.

In response to this panic, a committee was established to find the flaws of the current banking system. This committee, the National Monetary Commission, found there were two main flaws dominating the system. First, the currency was not responsive to changes in demand. (Born...13). This meant that the bank had a fixed amount of currency, regardless of the demand for it. If people wanted to withdraw more money than the bank carried, then the bank had no way of providing the extra money . This led into the second problem of the bank, the fact that it was prone to panic. If people could not get their money out, then they panicked, and these panics drove banks out of business.



The Commission could agree on the problems, but not the remedy. They agreed something had to be done, but solutions were often looked down upon due to their political affiliation. A prime example of this was the proposal of a National Reserve Association by republican senator Nelson W. Aldrich of Rhode Island. Senator Aldrich was seen as the embodiment of the "eastern establishment"-- the perception by southern and western states that the wealthy families and large corporations of the northeast ran the country. (Born...13) Hence, the National Reserve Association was derided as giving too much power to the banking industry of the northeast. Aldrich's bill proposed one central bank with fifteen regional branches. The main bank would control the issuance of currency, the distribution of currency and the discount rate. Voting power would be in proportion to stock subscriptions, and the governor of the entire operation would be appointed by the President of the United States and serve a ten year term. (Clifford 46.)

Aldrich's plan was rejected by democrats like Carter Glass, chairman of the House Banking and Currency Committee. Glass dismissed the proposal for several reasons. First, Aldrich's plan did not allot adequate government or public control of the bank. It gave voting control to the larger banks already in the system. Its currency reform was inflationary and its organization was clumsy. (Clifford, 47.) In the end, opposition to Aldrich's plan was based on opposition to control by private banks. Former Secretary of the Treasury, Leslie M. Shaw, wrote that Aldrich's National Reserve Association was:



"...the same central bank which Mr. Aldrich and all the interests, Wall Street in the lead, have favored for years...Is anyone credulous enough to suppose that Wall Street will be able to control each and all of the fifteen groups?...Such an institution, whatever its name, puts the business of the United States of America absolutely and irretrievably in the hands of Wall Street. (Clifford 48).



With neither party controlling both houses of Congress, and with Aldrich unable to muster up enough support in the republicans alone, his banker-oriented plan was politically impossible.



The election of 1912 which ushered democrat Woodrow Wilson into the presidency, as well as a Democratic Senate, allowed for progress in finding a solution. President Wilson was not well-versed in banking reform, but did believe in many of the same ideas as William Jennings Bryan, a populist politician (Born...14). Wilson used populist rhetoric when talking about the banks, saying things like, "The greatest monopoly, in this country is the money supply," and how he would not accept, "any plan which concentrates control in the hands of the banks." (Born...14)

Wilson relied on the advice of Carter Glass to shape the new reform policy. Glass leaped at this opportunity and began working with the president before his term even began. ( Page, 19) Glass, like other Democrats, was for decentralized power. Too much power in one bank would be a return to Aldrich's proposal. Instead, the Democrats looked to the government to hold the power. What resulted was the Federal Reserve Act of 1913.

The act divided the country into twelve districts, each district with its own banking "center." The banks within each district were then divided up with respect to size, so that small banks, medium banks, and large banks all have the same voting power. An appointed board of governors would oversee all bank operations within their respective districts, and the Federal Reserve would control the distribution of all currency (Hepburn 412). The Federal Reserve Act also required that all nationally chartered banks must be members of the Federal Reserve System. Many private banks were opposed to this idea because it reduced the banks' influence. (Born...14)

The bill passed through Congress with little difficulty, thanks to the Democratic stronghold in both houses, and President Wilson passed the act into law December 23, 1913. However, it was not met without criticism. An editor of the New York Times wrote, following the passage of the Federal Reserve Act: "[The Federal Reserve Act] reflects the rooted dislike and distrust of banks and bankers that has been for many years a great moving force in the Democratic party...The measure goes to the very extreme in establishing absolute political control over the business of banking." (Born...,14) Despite these strong words, both Glass and Wilson insisted that although the Act was of necessity a party measure, it was not a partisan measure. In fact, they argued, the Act was to provide an arrangement that would remove partisan influences from the nation's banking system. Though government influence would be present, it was designed to be free from personal or party politics (Clifford, 40.) The Act was accepted quickly by the public, much quicker than Wilson had anticipated, and he described the Act as a "constitution of peace" for the private businesses of the nation (Clifford, 41.)



The Act was not perfect, however, and the last sentence of the Act states: "The right to amend, alter, or repeal this Act is hereby expressly reserved." (Born...15). In fact, an overlying theme of the Federal Reserve Act was one of uncertainty; and many of the provisions used language like "under the rules and regulations to be specified by the Federal Reserve Board," and "subject to review and determination of the Federal Reserve Board." (Born...15) The rules had to be developed as the game was learned. President Wilson even said himself,

We shall deal with our economic system as it is and as it may be modified, not as it might be if we had a clean sheet of paper to write upon, and step by step we shall make it what it should be." (Born...16.)





John Rich, an agent at the Minneapolis Fed said in January of 1915 that:

"[The Federal Reserve Act] is not perfect. There are here and there defects which will undoubtedly be remedied, but they are of minor importance and in no way detract from the achievement of establishing at last, after sixty years of argument and debate, a discount market in the United States, and the mobilization of banking reserves."





Mr. Rich was right. Though not an ideal system, the Federal Reserve Act did solve the problem of a flexible currency. The Federal Reserve Act helped to stabilize the volatile banking system by providing an elastic currency, affording means to distribute the currency, and allowing for government supervision of banking operations. No longer were banks independent organizations working against each other. Now they were secure, interrelated operations. The Federal Reserve Act worked because it eliminated the competition to hoard money between the banks and put the power into the hands of the government. Now, credit could be made available to expanding businesses, jobs could be created, and the banks would no longer have to worry about bank runs "running" them out of business. Because of the Federal Reserve Act, the economy could once again become expansionary with confidence.









Bibliography



"Born out of Panic." (1998, August) The Region, pp 14-16.





Clifford, A. Jerome. The Independence of the Federal Reserve System. Philadelphia: University of Philadelphia Press, 1965.



Hepburn, A. Barton. A History of Currency in the United States. New York: August M. Kelley Publishers, 1915.