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The Federal Reserve’s
doors have been open for “business” for one hundred years. In
explaining the creation of this money-making machine (pun intended – the
Fed remits nearly $100 bn. in
profits each year to Congress) most people fall into one of two camps.
Those inclined to view the Fed
as a helpful institution, fostering financial stability in a world of
error-prone capitalists, explain the creation of the Fed as a natural and
healthy outgrowth of the troubled National Banking System. How helpful the Fed has been is
questionable at best, and in a recent book edited by Joe
Salerno and me — The Fed at One
Hundred — various contributors outline many (though by no means
all) of the Fed’s shortcomings over the past century.
Others, mostly those with a
skeptical view of the Fed, treat its creation as an exercise in secretive government
meddling (as in G. Edward Griffin’s The Creature
from Jekyll Island) or crony capitalism run amok (as
in Murray Rothbard’s The Case Against the Fed).
In my own chapter in The Fed at One Hundred I
find sympathies with both groups (you can download the chapter pdf here). The actual creation of the
Fed is a tragically beautiful case study in closed-door Congressional deals and
big banking’s ultimate victory over the American public. Neither of these facts
emerged from nowhere, however. The fateful events that transpired in 1910 on
Jekyll Island were the evolutionary outcome of over fifty years of government
meddling in money. As such, the Fed is a natural (though terribly unfortunate)
outgrowth of an ever more flawed and repressive monetary system.
Before the Fed
Allow me to give a brief reverse
biographical sketch of the events leading up to the creation of a monster in
1914.
Unlike many controversial laws
and policies of the American government — such as the Affordable Care Act, the
Troubled Asset Relief Program, or the War on Terror — the Federal Reserve Act
passed with very little public outcry. Also strange for an industry effectively
cartelized, the banking establishment welcomed the Fed with open arms. What
gives?
By the early twentieth century,
America’s banking system was in a shambles. Fractional-reserve banks faced with
“runs” (which didn’t have to be runs with the pandemonium that usually
accompanies them, but rather just banks having insufficient cash to meet daily
withdrawal requests) frequently suspended cash redemptions or issued claims to
“clearinghouse certificates.” These certificates were a money substitute making
use of the whole banking system’s reserves held by large clearinghouses.
Both of these “solutions” to the
common bank run were illegal as they allowed a bank to redefine the terms of
the original deposit contract. This fact notwithstanding, the US government
turned a blind eye as the alternative (widespread bank failures) was perceived
to be far worse.
The creation of the Fed, the
ensuing centralization of reserves, and the creation of a more elastic money
supply was welcomed by the government as a way to eliminate those pesky and
illegal (yet permitted) banking activities of redemption suspensions and the
issuance of clearinghouse certificates. The Fed returned legitimacy to the laws
of the land. That is, it addressed the government’s fear that non-enforcement
of a law would raise broader questions about the general rule of law.
The Fed provided a quick fix to
depositors by reducing cases of suspensions of their accounts. And the banking
industry saw the Fed as a way to serve clients better without incurring a cost
(fewer bank runs) and at the same time coordinate their activities to expand
credit in unison and maximize their own profits.
In short, the Federal
Reserve Act had a solution for everyone.
Taking a central role in this
story are the private clearinghouses which provided for many of the Fed’s roles
before 1914. Indeed, America’s private clearinghouses were viewed as having as
many powers as European central banks of the day, and the creation of the Fed
was really just an effort to make the illegal practices of the clearinghouses
legal by government institutionalization.
Why Did Clearinghouses Have So Much Power?
Throughout the late nineteenth
century, clearinghouses used each new banking crisis to introduce a new type of
policy, bringing them ever closer in appearance to a central bank. I wouldn’t
go so far as to say these are examples of power grabs by the clearinghouses,
but rather rational responses to fundamental problems in a troubled American
banking system.
When bank runs occurred, the
clearinghouse certificate came into use, first in 1857, but confined to the
interbank market to economize on reserves. Transactions could be cleared in
specie, but lacking sufficient reserves, a troubled bank could make use of the
certificates. These certificates were jointly guaranteed by all banks in the
clearinghouse system through their pooled reserves. This joint guarantee was
welcomed by unstable banks with poor reserve positions, and imposed a cost on
more prudently managed banks (as is the case today with deposit insurance). A
prudent bank could complain, but if it wanted to use a clearinghouse’s services
and reap the cost advantages it had to comply with the reserve-pooling policy.
As the magnitude of the banking
crisis intensified, clearinghouses started permitting banks to issue the
certificates directly to the public (starting with the Panic of 1873) to
further stymie reserve drains. (These issues to the general public amounted to
illegal money substitutes, though they were tolerated, as noted above.)
Fractional-Reserve Free Banking and Bust
The year 1857 is a somewhat
strange one for these clearinghouse certificates to make their first
appearance. It was, after all, a full twenty years into America’s experiment
with fractional-reserve free banking. This banking system was able to function
stably, especially compared to more regulated periods or central banking
regimes. However, the dislocation between deposit and lending activities set in
motion a credit-fueled boom that culminated in the Panic of 1857.
This boom and panic has all the
makings of an Austrian business cycle. Banks overextended themselves to finance
the booming industries during America’s westward advance, primarily the
railways. Land speculation was rampant. As realized profits came in under
expectations, investors got skittish and withdrew money from banks. Troubled
banks turned to the recently established New York Clearing House to promote stability.
Certain rights were voluntarily abrogated in return for a guarantee on their
solvency.
The original sin of the
free-banking period was its fractional-reserve foundation. Without the ability
to fund lending activity with their deposit base, banks never would have
financed the boom to the extent that it became a destabilizing factor. Westward
expansion and investment would still have occurred, though it would have
occurred in a sustainable way funded through equity investments and loans.
(These types of financing were used, though as is the case today, this occurred
less than would be the case given the fractional-reserve banking system’s
essentially cost-free funding source: the deposit base.)
In conclusion, the Fed was not birthed from nothing in
1913. The monster was the natural outgrowth of an increasingly troubled banking
system. In searching for the original problem that set in
motion the events culminating in the creation of the Fed, one must draw
attention to the Panic of 1857 as the spark that set in motion ever more
destabilizing policies. The Panic itself is a textbook example of an Austrian
business cycle, caused by the lending activities of fractional-reserve banks.
This original sin of the banking system concluded with the birth of a monster
in 1914: The Federal Reserve.
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