The Temple: The Federal Reserve, 1913 to the Great Depression

"I believe… that the Federal Reserve system will materially check undue expansion by making banks conservative as to their loans, because of the knowledge that any departure from strictly commercial transactions will take away their ability to liquidate such investments by rediscounting in the Federal Reserve Banks…"
Charles Hamilton, delivering his initial address as Governor of the newly created Federal Reserve Bank, December 1914.

The panic of 1893, and the land price collapse that brought it on, ushered in the worst depression the US had experienced up until that time. The banking system was accorded much of the blame. However, as the cycles chapters reveal, there was more to it than that. Nevertheless, the national banking system had its problems. Though this system was successful in providing a national uniform currency, it did not prove 'elastic' enough to meet the seasonal demands of the nation and its bank users. It proved eventually that national banks could only issue notes up to the value of the bonds that it had deposited with the Comptroller. Once this limit was hit, no further note issue could be undertaken. This meant in practice that the supply of currency remained seasonally constant throughout the year. This was most unhelpful for the seasonal nature of what was required of the currency. This is pointed out in the relevant cycles chapters. The variation in interest rates reflected this problem and can be seen in the charts of interest rates after 1860 and up until 1913. Rates generally increased in the fall, and often peaked around December / January, though not always.

A second problem arose in how reserves for the system were pyramided. Country banks put reserves with Reserve City Banks, who put reserves into Central Reserve City banks. This was adequate until the possibility of a nation wide bank run presented itself, causing banks to act selfishly, for reasons of self preservation, by calling on reserves, compounding liquidity problems at the very time liquidity in the system was required. In addition, most of the reserves that found their way to New York Central Reserve banks were of course put to work for profit, often as call loans for stock market investment. The system proved a little too unstable in a downturn.

Said one bank historian, Edwin Kemmerer, in his banking study for the National Monetary Commission of 1910: "It has been found that the two periods of the year in which the money market is most likely to be strained are the periods of the 'spring revival', about March, April and early May, and that of the crop-moving demand in the fall; and the two periods of easiest money market are the 'readjustment' period, extending from about the middle of January to nearly the 1st of March, and the period of the summer depression, extending through the three summer months. Of the eight (banking panics of the era), four occurred in the fall or early winter…and these four included two of the three really severe panics of the period (i.e., those of 1873 and 1907); three occurred in May…and one…probably the least important, … extended from March until well along in November. The evidence accordingly points to a tendency for panics to occur during seasons normally characterized by stringent money markets. This does not mean that the seasonal stringencies are the causes of the panics; it does mean that the months in which they occur are the weakest links in the seasonal chain, and that in periods of extraordinary tension the chain breaks at these links."

The panic of 1907 cemented calls for banking change; in particular to provide financial stability and a more elastic currency. The Aldrich-Freeland Act of 1908 established a line of enquiry to find the solution. Wrote one economist, Franklin MacVeagh, a little later in 1911:"It is…extravagant and inefficient to live under a banking and currency system which in the most ordinary and quiet times saturates everybody concerned with a sense of financial uncertainty - a condition that constantly hampers not only the bankers themselves but business in all its branches and forms…This apprehension - this habitual looking forward, especially to the autumn - this customary wondering how the market is going to be one or two or three or four months hence - and this calculation as to how one's own bank is going to be fixed to meet the situations and fluctuations that ought to be immaterial - are all incorporated into the very nerves of bankers and more or less into the nerves or business men in general."

After some years of debate, Congress passed the Federal Reserve Act in December of 1913. The title of this act read: "An Act to provide for the establishment of Federal Reserve Banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes." A key plank of this reform was the ability of some sort of central bank to supply the nation more currency for business if and whenever it was demanded. This, it was reasoned, would go a long way toward solving the perpetual banking crises that afflicted the nation, and along with them the usual seasonal spikes in shorter-term interest rates. Accordingly, the new system of note issue was to be based not on bonds but on commercial assets.

Hence the development of the Fed's rediscounting responsibilities. If a member bank of the Reserve system ran into difficulties, it could, if it wished, on-sell (rediscount) a part of its loan (asset) base to the Fed, in return for immediate cash to satisfy depositors. (Though the assets had to be normal business loans, and not loans made for purchase of stocks, bonds or real estate.) This had the currency representing real transactions and a sounder basis for the future. Noted W. Randolph Burgess, a long time official at the Federal Reserve Bank of New York: "The fundamental change which the Federal Reserve had made…is to shift much of the burden of meeting fluctuations in the demand for credit from the reserves of the member banks in New York City to the twelve Reserve Banks, which through the strength of their holding of pooled reserves and through their power of note issue and deposit expansion can provide almost any extra funds required." (The Reserve Banks and the Money Market, revised edition, 1936.) The interest (discount) rate used to do this is set by the Fed.

Once the Fed got going, it was clearly successful in one of its stated objectives of supplying a more elastic currency to the markets, as is illustrated by the dramatic change in the behavior of short term interest rates after 1914. (After allowing for the uncertain influences of the First World War.) Said Burgess, but quoting this time his 1927 first edition: "In the old days there were rigid and not far distant limits to the reserves available; now the mechanism of the Reserve System provides for a much larger possible expansion. It gives much greater elasticity…" (Page 122.) Importantly, Burgess noted further that: "The presence of the Reserve System gives greater elasticity to the supply of funds and stability of the money market and removes the fear of money panics."
(Page 125.)

Now here is something interesting. Again it was being intimated, at very senior banking levels, the belief that a system had been found to eliminate the (money) panics. A clue to the psychological effects that this may have had in the 1920's is given by noting the following. In Burgess' second edition, the one published in 1936, after yet another banking panic had been witnessed - several panics in fact - the above passages were amended, and the one from page 125 now read: " The presence of the Reserve System gives greater elasticity to the supply of funds - and the control of that elasticity is the central problem of Federal Reserve policy."

Clearly, many professional men and businesspersons had come to believe the creation of the Fed had 'tamed the business cycle' so to speak. Did not the Fed now have 'control' of the money supply, control of money's creation, control of the gold supply, and further, the better regulation of its member banks ? Even the Fed chairman had intimated as much. In an address delivered before students of the Graduate College, Harvard University, on November 28, 1922, Benjamin Strong, in describing for students the prior panics of the national Banking era, said: "These extreme credit condition arose because there was no stretch. When the period of surplus reserves arose, those funds poured into the speculative markets. When the period of deficient reserves arrived, all the banks sought to contract their loans to make good their reserves and we witnessed the extremes of speculation and of business embarrassment. There was neither control of the volume of credit, nor moderating influence as to rates of interest. And, finally, there was no control over the movements of gold in and out of the country."

The Fed solved the monetary panics, but continual failure by our central bankers to admit, or indeed even recognize, the fatal flaw in our fractional reserve system guarentees the continual return of that periodic land-induced, economic downturn.

Follow up references:

Kemmerer, Edwin W., Seasonal Variations in the Relative Demand for Money and Capital in the United States, National Monetary Commission, Senate Document No. 588, 61st Congress 2nd Session, Washington, Government Printing Office, 1910.

MacVeagh, F., Banking and Currency Reform, Journal of Political Economy, 19, 10, pages 809-818.

Strong, Benjamin, Federal Reserve Control of Credit, Federal Reserve Bank of New York, Quarterly Review Special Issue, 75th Anniversary.

Wheelock, David C., Seasonal Accommodation and the Financial Crises of the Great Depression: Did the Fed Furnish and Elastic Currency, Research Department. Federal Reserve Bank of St. Louis.

Print This Page

Home ----- Contact Us