America’s banking system had suffered criticism since the Civil War. It was too elastic. It was not elastic enough. It was too centralized in New York. It was not centralized enough in New York. For twenty years, it had seemed that the colossus J. P. Morgan alone might carry the nation’s banking community on his shoulders like Atlas. He did so in 1893, then again in 1907, at which time he announced that even with support from other syndicate members, including some foreign bankers, the next panic would sink him and the country. Consequently, by the turn of the century most of the so-called bank reformers—including numerous bankers from the Midwest who feared for their own smaller institutions if large East Coast banks got into trouble—agreed on three main principles for shoring up the system.
First, genuine bank reform needed (in their view) to fill the void left by the old BUS as a central bank. Never mind that the BUS had never fulfilled that function. Collective memory inaccurately said that the Bank had restrained the inflationary impulses of the state banks, and thus provided a crucial check on the system in times of stress. The new central bank above all should be a lender of last resort, that is, it should provide cash (liquidity) when there were isolated bank runs.
Second, bank reformers concluded that an elastic money supply was needed in which credit and cash could expand in good times and contract in bad. This was a main complaint about the money supply under the National Bank Act—that the national banks lacked the ability to rapidly issue new banknotes or any mechanism for withdrawing them from circulation. Of course, any elastic powers would centralize even further the money supply in the hands of one source, as opposed to the many national banks who each issued their own notes, providing some tiny measure of competition.
Third, all but a few of the most conservative East Coast bankers wanted to reduce the power of New York’s financial community. A certain element of anti-Semitism accompanied this because the phrase “New York bankers” was really code for “New York Jewish bankers.” It regurgitated the old fears of the Rothschilds and their “world money power,” but even well-meaning midwestern bankers looked suspiciously at the influence eastern banking houses had over affairs in Kansas or Colorado. It seemed unfair to them that an East Coast panic could close banks in Littletown or Salina.
Critics noted another problem, namely, that national banks could not just print money willy-nilly. To expand the number of notes they issued, the national banks had to purchase additional U.S. government bonds, a process that could take several months. Certainly the structure did not enhance elasticity. On the other hand, states permitted branch banking (which enhanced stability and solvency), whereas national banks were denied branching privileges.25
The entire banking structure still relied on gold as a reserve. For gold to effectively police international transactions, all nations had to abide by the rules of the game. If one nation had a trade deficit with another, it would make up the difference in gold. But this meant a decrease in that nation’s gold reserve, in turn decreasing the amount of money issued by that nation’s central bank, causing a recession. As prices fell, the terms of trade would then swing back in that country’s favor, whereupon gold would flow in, and the cycle would reverse.
The difficulty with the gold standard was not financial, but political: a nation in recession always had an incentive to go off the gold standard. However, from 1900 to 1912 most nations faithfully submitted to the discipline of gold in a time of prosperity. Such false optimism cloaked the fact that when the pressure of national recessions began, the temptation would be for each country to leave the gold standard before another. In the meantime, however, it reinforced the desire on the part of American reformers to create a financial system with a central bank along the lines of the European model.
Following the many plans and proposals drawn up by bankers’ organizations over the previous thirty years, in November 1910 five men met in secrecy on Jekyll Island, Georgia, to design a new financial system for the nation. Frank Van-derlip (president of National City Bank), Paul Warburg (a powerful partner in Kuhn, Loeb and Company), Henry Davison (a partner in the Morgan bank), Harvard professor A. Piatt Andrew, and Senator Nelson Aldrich of Rhode Island outlined the plan that became the Federal Reserve System. They presented their completed plan to Congress, where it stagnated. Many viewed it as too centralized, and others complained that it did not deal with the “money power” of New York’s banks.
Meanwhile, the House held hearings in 1912 that dragged J. P. Morgan and other prominent bankers before the Banking and Currency Committee. Morgan was accused of “consolidation” and stifling competition. In fact, Morgan and his contemporaries had strengthened the system and protected depositors by establishing combinations and utilizing clearinghouses, which were private organizations that reduced the likelihood of panics and provided a setting for effective information exchange. House members pontificated about the evils of consolidation—an incredible irony given that in the 1930s, after the Great Depression, another set of congressional investigators would complain that the competitiveness within the securities industry helped cause the stock market crash. Thus, bankers were criticized for competing and criticized for combining!26
Congressional interest in the Jekyll Island proposal revived, but with emphasis on decentralizing the system and in reducing the influence of New York’s banks. The result was the Federal Reserve Act, passed by Congress in 1913. Under the act, twelve Federal Reserve banks would be established across the country, diminishing New York’s financial clout. Atlanta, Boston, Dallas, San Francisco, Minneapolis, Chicago, Cleveland, Philadelphia, and Richmond all received Federal Reserve Banks, and Missouri got two—St. Louis and Kansas City. Each bank was a corporation owned by the commercial banks in its region and funded by their required deposits. In return, the member banks could borrow from the Reserve bank in their region. A separate board of governors, housed in Washington, D.C., consisting of representatives from each bank, was to set policy, but in reality, each bank tended to go its own way. These characteristics allowed the Federal Reserve System to appear to be independent of the government and nonpartisan.
While decentralizing the financial system answered one critical need demanded by the reformers, the Fed (as it became known) also met another in that it served as the lender of last resort. The district banks were to step in during emergencies to rescue failing private banks, but if the crisis grew too severe, one Federal Reserve bank could obtain help from the Reserve bank in another region (or all regions, if necessary). Few really imagined that even under the new system, there might exist an emergency so broad that every Federal Reserve District would come under siege at the same time. But the reformers had ignored the single most important corrective: introducing interstate branch banking.27 This disadvantage kept large branch-bank systems from becoming member banks, especially A. P. Giannini’s powerful Bank of America and Joseph Sartori’s First Security Bank and Trust, both in California. To rectify this problem, Congress passed the McFadden Act in 1927, which permitted national banks to have branches in states where the state laws permitted branching, thus allowing both Giannini and Sartori to join the Federal Reserve System as members. But Giannini’s dream of nationwide interstate banking was never reached, contributing to the collapse of the banking system during the Great Depression.
Contrary to all intentions, the New York Federal Reserve Bank quickly emerged as the most powerful influence in the new Fed system. The creation of the Fed also marked the end of any form of competition in money, since the new Federal Reserve notes eventually replaced money specifically (and legally) backed by gold or silver.
Another pillar of Progressivism came to fruition on Wilson’s watch. The idea of an income tax had long been cherished by socialists, and it was one of the ten planks desired by the Communist Party in Karl Marx’s Communist Manifesto. During the Civil War, the Republicans had imposed a 3 percent tax on all incomes over $800, then raised it twice thereafter. Several utopian socialists called for income tax
es in the postwar years, and both the Populists and the Democrats advocated an income tax in the 1890s. But not until 1894 did Congress pass a 2 percent tax on all incomes above $4,000. Within a year, the Supreme Court struck down the measure as unconstitutional—which it clearly was.28
For several decades, the tariff (and land sales) had provided most of the revenue for running the operations of the government, which was adequate as long as the government remained small. However, tariffs carried tremendous political baggage. They pitted one group of Americans against another, usually by section. Northern manufacturers, who obtained a tariff on manufactured imports, received artificially higher prices for their goods at the expense of all other Americans; southern sugar planters, who obtained a tariff on sugar, could raise prices for all sugar consumers; and so on. While some argued that the tariff burdens balanced out—that in one way or another everyone was hurt, and everyone benefited—each tariff bill focused the debate on specific groups who gained and lost. In this regard, the substitution of income taxes for tariffs “efficiently conserved legislative energies: Life became simpler for Congress [because] the battle against tariffs had always involved direct, urgent, and threatening lobbies.”29 The proposed income tax, on the other hand, only affected a small group of the wealthy.
Proponents also designed the first proposed tax with two features that would reduce resistance to it. The tax rates would be extremely low, even for wealthy groups, and the filing process would be absurdly simple—only a few pages were required for the first income tax. Since people had become convinced that equal taxes meant proportional taxes—which was surely untrue—then the income tax promised to “equalize tax burdens borne by the various classes…and to ensure it was paid by the wealthiest classes.”30 To underscore this fact, the income tax had “little to do with revenue and everything to do with reform.”31
There was one small hurdle—the Constitution. Since income taxes were unconstitutional, imposing the new tax demanded the Sixteenth Amendment, which was ratified in 1913. Reformers gained support using three major strategies: (1) they emphasized the extremely low nature of the tax and the fact that many Americans would pay no tax at all; (2) they stressed its simplicity; and (3) they pointed to the problems and controversies surrounding tariffs. The original tax exempted anyone earning less than $3,000 per year or married couples earning less than $4,000 per year; whereas those earning between $20,000 and $50,000 paid only 2 percent. For the richest of the rich, those earning over $500,000, the top rate was 7 percent. Contrasted with taxes in the twenty-first century, the state tax rates alone in many states exceeds the top rates exacted by the federal government in 1913. Although some liberal historians claimed that the income tax was a “conservative measure designed to placate the lower classes with a form of pretend punishment of the rich,” it certainly did not help the workingman by any stretch of the imagination. By the year 2000 the average American worked until May of every year to pay just his federal taxes; whereas that same American worked only nineteen days to purchase all the food he would eat in a year!32
Income taxes introduced a significant danger to American life, especially through the hidden growth of the federal government. Minor rate changes in the tax would be enacted without any public reaction; then, after World War II, they were deducted directly from workers’ paychecks so that they never saw the damage. Moreover, during an emergency, rate increases became substantial, and even if lowered later, never returned to the preemergency levels. Economist Robert Higgs described this as a “ratchet effect” in which government power grew with each crisis.33 At the end of World War I, the top tax rate would rise by a factor of ten, illustrating the grave danger inherent in the structure.
Wilson’s reduction of tariff rates was inconsequential and irrelevant after passage of the income tax. He was a big-government Progressive, and his inclinations were on display in numerous other policies, especially the creation of the Federal Trade Commission, a group appointed by the president to review and investigate business practices. Ostensibly, the FTC was to prevent the formation of monopolistic combinations, using its cease-and-desist orders, augmented by the 1914 Clayton Antitrust Act. A follow-up to the Sherman Antitrust Act, it prohibited interlocking directorates and tying clauses, whereby a producer could tie the sale of a desired product it made to another product the buyer did not particularly want.
Both the FTC and Clayton, in the truest style of Teddy Roosevelt, targeted big business and trusts. Unfortunately, like taxes, the burden of regulations fell on unintended groups, whereas those usually targeted by the regulations and taxes escaped. Such was the case with the Clayton Act. A study of antitrust laws and their effect on overall business activity revealed that the antitrust actions against large firms coincided with business downturns, suggesting that the downturns resulted from the attacks on a few large firms.34 (These results were repeated in the 1990s when an antitrust suit against Microsoft sparked a massive sell-off in tech stocks, adding support to the argument that antitrust law had done little to encourage competition and had inflicted substantial damage to the U.S. economy for more than a century.)35 While creation of the Fed and the passage of the income tax amendment characterized Progressivism at home, events in Mexico gave a brief glimpse of Wilson’s vision for Progressivism abroad.
South of the Border
Even before Wilson assumed office, in 1910, Mexico had entered a period of constant chaos. That year the Mexican dictator of thirty-three years, Porfirio Díaz, was overthrown in a coup led by Francisco Madero, ostensibly a democrat. Within three years, however, Madero was in turn unseated by General Victoriano Huerta, who promised a favorable climate for American businesses operating in Mexico. Huerta received support from the U.S. ambassador, Henry Lane Wilson. Aside from the protection of American firms’ operations and personnel, the United States really had little interest in the internal affairs of Mexico.
Taft had expressed a willingness to recognize Huerta, but Huerta’s forces killed Madero just before Wilson took over, whereupon the president stated that he would not recognize “a government of butchers.”36 Wilson’s idealism took over as he openly supported Venustiano Carranza and Francisco (Pancho) Villa, two rebel generals who opposed Huerta. In April 1914 a Mexican officer in Tampico arrested American sailors from the USS Dolphin, when they disturbed the public peace on shore leave. When the American naval officers protested, the Mexicans immediately released the sailors, but did not apologize sufficiently to please the admiral.
Wilson saw an opportunity to intervene against Huerta. He dispatched a fleet to Vera Cruz, purportedly to intercept a German vessel delivering munitions to Huerta’s army. Events spun out of control, and American warships shelled the city. Carranza soaked all this in and recognized that an overt alliance with Wilson would taint his regime in the eyes of the Mexican people. From that point on, he continued to buy arms from the U.S. government, but he otherwise kept his distance. When the fighting at Vera Cruz weakened Huerta, Carranza took over in August, then promptly gave the cold shoulder to Wilson’s overtures to assist in forming the new Mexican administration.
Having failed to woo Carranza, Wilson turned to the other revolutionary general, Villa, whose army held much of northern Mexico. By that time, Villa was something of a celebrity in America, gaining notoriety among journalists and filmmakers as the personification of the “new democrat” in Mexico. He was also now Carranza’s enemy, and government troops defeated Villa in April 1915, whereupon the rebel leader lost much of his luster. This victory forced Wilson to reconsider Carranza’s legitimacy. In frustration, he recognized Carranza as the de facto leader of Mexico without offering official recognition, which, in turn, outraged the jilted Villa. Seeing his hopes of running Mexico melt away, Villa launched a series of revenge raids directed at Americans across northern Mexico. He killed eighteen Americans on a train and then crossed the border in 1916 at Columbus, New Mexico, murdering another seventeen U.S. citizens.
The president of Mexi
co lacked the resources (as well as the will) to pursue Villa in his own territory. Wilson did not. He sent American troops under General John “Black Jack” Pershing on a punitive expedition into Mexico to capture Villa. Entering Mexico in the spring of 1916 with more than 15,000 men, armored cars (one commanded by a young cavalry officer named George Patton), and reconnaissance aircraft, Pershing hunted Villa across more than three hundred miles of Mexican desert. Although Patton’s lead units engaged some of the Villistas, Pershing never truly came close to the main body of Villa’s troops, and he finally informed Wilson that the best course of action would be to occupy all of northern Mexico.
The Pershing invasion revived fears of the “Colossus of the North” again marching on Mexican soil, causing Villa’s forces to grow and turning the bloodthirsty killer into a cult hero in parts of Mexico. And while Carranza certainly wanted Villa dead, he did not intend to let the Yankees simply walk into sovereign Mexican territory. In June 1916, Carranza’s and Pershing’s forces clashed, bringing the two nations to the precipice of war. The president considered Pershing’s recommendation for an American occupation of parts of Mexico, and even drafted a message to Congress outlining the proposed occupation, but then scrapped it.
A Patriot's History of the United States: From Columbus's Great Discovery to the War on Terror Page 84