America's Bank

by Roger Lowenstein

  Prospectively, the most dramatic change would be the replacement of the outmoded system of segregated banking reserves with a series of centrally directed Reserve Banks that would act—especially in an emergency—as lenders of last resort. The Act would also create a more adaptable currency and strengthen the organization and oversight of America’s wobbly banks. That this would make Washington a more prominent player in the monetary system (and the sometime partner of the big New York banks) could not be doubted. Representative Lindbergh said acidly that the new law gave official sanction to the Money Trust. It was also charged that the new institution would be captive to the easy-money theories of Bryan. But the public was weary with the debate and ready to give the Federal Reserve System a try. Editorial reaction was generally favorable. The New York Tribune judged that the new system would be “a great advance upon any which this country has ever had.” The Times, though muted, was thankful that the measure had been improved by the force of public opinion; the paper said the legislative history offered striking proof of the “efficiency of representative institutions.” Even The Wall Street Journal grudgingly allowed that the final measure was better “than business dared to hope.” Banks were also pleased. Although Vanderlip sourly hinted that National City would relinquish its charter in protest, most national banks quickly applied for membership in the Federal Reserve—some on the day the law was enacted.

  Also on that day, Warburg sent a bittersweet note to Glass: “While my heart bleeds at many things that went into the bill, and at many things that were left out, I rejoice at the many good features that, after all, the law will contain.” An incurable reformer, Warburg could not resist, even on the day of triumph, outlining points he had in mind for subsequent amendment. He did, at least, indulge a moment’s pride in “the victory of which some of us have worked for so many years.”

  If Jackson had stood against the supposed evils of centralization, Warburg, more than anyone else, had recognized the weakness in stand-alone banking and crusaded to overcome the Jacksonian view. It was an American prejudice, a parochialism, which he as a foreigner had seen more clearly. Colonel House, long under his spell, wrote to Warburg on New Year’s Day, “It is you that just now deserves the gratitude of your countrymen, and some day I shall tell them when and how you served them.”

  The Federal Reserve’s creation closed the gap between American banks and the developed banking systems that Aldrich had seen in Europe, and readied the United States for financial leadership. It also closed a gap in American history. Since the days of the Founding Fathers, resistance to central authority had been entrenched in the culture; it was the spiritual sword wielded by the colonists in 1776 and by mistrustful populists ever since. But local autonomy had its limits. Notably, the Articles of Confederation had failed to deliver effective government, and so the country had embarked on the compromise of federalism. Only the country’s banks had been left behind. When the subject was money, central authority had always been taboo; it was a demon that terrified the people. Fear of this demon had kept the country without any effective organization of its finances for seventy-five years. Now, three-quarters of a century after Andrew Jackson, the ghost was slain.

  CHAPTER FOURTEEN

  EPILOGUE

  The measure itself was the result of the labors of many men, extending over a long period.

  —AGRICULTURE SECRETARY DAVID F. HOUSTON

  Mr. Wilson experienced no lack of confidence in me.

  —CARTER GLASS

  [Carter Glass] is not the chief author . . . nor is he entitled to the main credit.

  —SAMUEL UNTERMYER

  Mr. Glass himself could not have created such a bill.

  —JAMES L. LAUGHLIN

  A profanation of history.

  —CARTER GLASS

  It was not an “original proposal”. . . . but, on the contrary, it was the digested product of elaborate and careful study of European banking experience as adapted to American necessities and requirements.

  —H. PARKER WILLIS

  Glass and Willis have so falsified the record . . .

  —PAUL WARBURG

  Mr. Warburg has never made any statement regarding the authorship of the act.

  —H. PARKER WILLIS

  Congress should realize that the Federal Reserve System is the child and property of both parties.

  —PAUL WARBURG

  It had little or no relationship in principle to the so-called Aldrich bill.

  —H. PARKER WILLIS

  I feel for it, in a sense, as I would for my child.

  —PAUL WARBURG

  THE ENACTMENT of the Federal Reserve system, although a landmark in American history, was less an ending than a truce. Few of the battles of 1902–1913 were put to rest. The tension between centralism and local autonomy, between the public and Wall Street, and between an inflationary money-printing machine and countinghouse prudence persisted. Congress’s internal quarrel over how much power to vest in the Fed endures to this day. The conflicts continued in part because the framers, not wishing to brook too much controversy, had been deliberately vague. As Frank Vanderlip wrote the week the Federal Reserve Act was passed, “The law is full of indirect and implied powers.” The pressing issue of who would control the system was contested from the start, when William McAdoo ran the agency almost as a Treasury subbureau. It arose again in the 1920s, when the board in Washington battled the Reserve Bank of Chicago over control of the discount rate, and later, in the Truman era, when the White House attempted to impose its will on the board. Later still, Richard Nixon bullied his Fed chairman, Arthur Burns, into an inflationary stimulus policy in advance of the President’s reelection.

  Then, too, the issue of Wall Street influence was never resolved, no matter that the original Act created twelve supposedly equal banks. New York’s was destined to be dominant, and its influence was as bitterly resented in the era of Lloyd Blankfein and Jamie Dimon as it was in 1913.

  The basic federalist structure enacted a century ago remains in force; so does the essential purpose. Then as now, the Fed serves as a banker to other banks and the keeper of their reserves. Along with setting short-term interest rates and supervising the banking system, the Fed is in charge of the nation’s monetary policy. Then as now, the Fed provides liquidity to the system, especially in times of crisis, so that banks may supply the country with adequate credit.

  But the framers had created less a static machine than an organic institution that, inevitably, would be buffeted by presidents and economic cycles and repeatedly amended by Congress. Its charter—“to furnish an elastic currency” while defending the dollar through the mechanism of the gold standard—was fraught with tension. (It was further conflicted by the real bills idea that reserve notes should be printed only to provide for actual commercial activity.) The resolution of these debates was never a fixed point, but rather a range on a continuum that was destined to be fought over again and again. The Fed’s failure during the Great Depression hardly proved that Elihu Root, the tradition-minded New York senator, had been wrong about the risk of inflation—only that he had overlooked the risks in the other direction. In the 1970s, the Federal Reserve vindicated Root when it destroyed the dollar with excessive money-printing.

  Similarly, the framers argued over the proper type of bank paper acceptable for discount because of the risk of being either too liberal or too strict. A century later, Ben Bernanke reignited this debate with his frantic acquisitions of mortgage securities, Treasury bonds, and also the very commercial paper of which Paul Warburg was so enamored. Even the desirability of Wall Street control was a matter of degree. Wall Street, as Vanderlip was fond of saying, was as patriotic as anyplace else; more to the point, it had desirable expertise. In the 1980s, Fed chairman Paul Volcker, formerly of Chase Manhattan, vanquished double-digit inflation by jacking up interest rates, triggering a recession. Congress protested that Vo
lcker was a tool of Wall Street. Representative Henry González (a Texas Democrat, just like the agrarian leader in 1913) threatened to impeach him. Volcker did his job. The New York Fed’s intervention, in 1998, when it organized a rescue of a hedge fund that was scarily entwined with the biggest banks, was further along the continuum—that is, it reeked of Wall Street influence. By then, Congress had amended the Fed’s charter, stipulating more explicitly that its mission was to promote both full employment and stable prices. The Fed’s evolution was neither steady nor direct, but over time its thrust was clear: power shifted toward the center, and its charter was interpreted more broadly—not just the narrow terrain of monetary policy, but to a large extent the economy as well.

  Would Carter Glass or Paul Warburg approve of such things? It has become a commonplace that the founders of the Fed, were they to return to Washington, would scarcely recognize the colossus housed in the Marriner S. Eccles Federal Reserve Board Building. It is just as certain that the veterans, pro and con, of the founding era, would find validation of very disparate views. To Lindbergh, the Fed’s bailouts of banks and of AIG in 2008, as well as the New York Fed’s general coziness with Wall Street, would confirm his fears about the Money Trust. Just as surely, Warburg would applaud that, when the Great Recession came, the United States had a lender of last resort that could provide elasticity (all that “quantitative easing”) so that banks were not forced to desperately hoard their reserves, and so that the meltdown did not become pandemic. In this sense, the debates that shroud the contemporary Fed are a replay of those of 1913.

  America’s abandonment of the gold standard would have shocked the founders, who took for granted that money had to be more than mere paper. More than anything, going off gold (which occurred in stages, culminating under Nixon) expanded the Fed’s charter. It made the agency the supreme arbiter of the money supply. This was a significant departure from 1913. Originalism, however, is not an argument, although it may be a faith. The view that the Fed could have stayed fixed, a fossil from the Wilson era, seems hopelessly naïve. In truth, the Fed was forced to start adapting on the day it came into being, and by the time the founding generation had left the scene, the organization was already appreciably evolved.

  It took some time, in 1914, for the Fed to become operational. Although the Act specified eight to twelve Reserve Banks, McAdoo never considered fewer than twelve, probably because the Banks were hot political plums. He and Secretary of Agriculture Houston embarked on a ten-thousand-mile cross-country trip, where they heard pitches from scores of cities. McAdoo also commissioned a poll, asking bankers to name the city where they would want their Reserve Bank. Political favoritism was said to influence the selections, but there is no evidence of this. McAdoo’s selections closely mirrored the bankers’ poll.* Perhaps this was done to induce banks to join the new system; overwhelmingly, they did. Even at the start, the New York Fed was by far the most powerful, with four times the capital of Atlanta’s.

  Wilson guaranteed a Wall Street presence on the board by nominating Warburg. His appointment was controversial with the Senate Banking Committee, which was nervous about Warburg’s connection to Kuhn, Loeb. Under badgering from senators, Warburg promised to sever himself from the firm (which he was not required to do, since investment banks were not part of the Federal Reserve System). Not until November 1914 was the Reserve system—banks and board, including Warburg—up and running.

  By then, the war in Europe was raging. The founders could scarcely have anticipated the war or its effect on the new system. In many ways, the world for which the agency had been designed ceased to exist. In the United States, the guns of August triggered a financial crisis. As the Fed was not yet operational, McAdoo authorized banks to issue emergency currency. He pressed the New York Stock Exchange to close (to prevent European belligerents from selling American securities and withdrawing gold). And it remained closed until December.

  Even as the Fed got going, it remained under the Treasury’s thumb. Due to the war, McAdoo exercised czarlike powers. He repeatedly clashed with Warburg, who thought the central bank should be independent from the executive, and who attempted to persuade the board to seek greater powers from Congress. A third party emerged in the power struggle: the Reserve Bank of New York, run by Benjamin Strong, the Wall Street insider and intimate of the Jekyl Island group. Because the Act did not make clear exactly where the levers of authority lay, the Fed’s first years were marked by a profound competition among the Reserve Banks, the board, and the Treasury Department.

  Various members of the founding generation did battle to ensure that the Act was implemented according to their designs. Glass warily monitored the Fed from Congress and was often at odds with Warburg, as was H. Parker Willis, who had been appointed secretary to the board. The debate over whether the Fed would be a so-called central bank was replayed in repeated battles for control over the discount rate (the benchmark interest rate). According to the statute, each Reserve Bank was entitled to set the rate in its district, but they were subject to board “review and determination.” This language provided a fertile field for disputes. Glass was active on each side. As a congressional overseer, Glass favored the periphery over the center. Then, in 1918, he was appointed Treasury secretary and evidenced an unseen Hamiltonian impulse when he blocked the Reserve Banks from hiking rates. In 1927, when in the Senate, Glass reverted to Jeffersonian form, protesting that an imperious board was behaving too much like, in his words, a “central bank.”

  After America entered the war, McAdoo leaned on the board to keep rates low and the Fed dutifully complied. The Reserve Banks further assisted war finance by purchasing bank credits backed by Treasury notes and bonds. They also bought government securities on the open market. This tacitly redirected the Fed from its intended method of operation. As the Reserve Banks fell in step with war finance, their assets became concentrated in government securities rather than the bank commercial paper to which the framers had devoted so much energy.

  However, if the war temporarily thrust the Fed into a subservient role, it also broadened its field of action. Many people had envisioned that, apart from emergencies, the agency would play a passive role—as the Act put it, simply “discount[ing] notes, drafts, and bills of exchange arising out of actual commercial transactions.” Harvard’s Oliver Sprague had predicted an extreme degree of passivity, testifying just before enactment, “After the institution has been going ten or fifteen years it will almost run itself.” This would soon seem ludicrous. In fairness, centralizers such as Warburg always wanted a more dynamic agency. Within a year of the Fed’s founding, so did the board. In its first annual report, the board signaled its disposition to be proactive. Its duty, it asserted, “is not to await emergencies but by anticipation to do what it can to prevent them.”

  Just as Wall Street had hoped, the Fed’s emergence, coupled with the war, catapulted America’s standing in world finance. By keeping Britain and France afloat, the United States, long a debtor nation, suddenly became a significant creditor. In return for exports of food, arms, and other supplies, gold poured into American harbors. After America’s entry into the war, Congress fulfilled Warburg’s insistent demands and amended the Act to widen the board’s powers. The amendments greatly increased the Fed’s note-issuing capacity; notes in circulation doubled within months. And the Reserve Banks, by issuing more notes, were able to soak up much of the bullion previously stashed in people’s pockets and in the vaults of member banks. The Fed’s enlarged and unified gold cache elevated the dollar’s status as an international currency.

  However, the war put Warburg in an awkward spot. Given that he had two banker brothers still in Hamburg—one an adviser to the German government—Warburg became an easy target for international conspiracy theorists and closet anti-Semites, groups that would hound the Fed in the future. In May 1918, to spare Wilson the embarrassment of a prolonged renomination battle, Warburg offered his resignation.* H
e stressed his utter allegiance to the United States and indicated he would continue to serve if the President desired. No doubt, Warburg was hoping that Wilson would insist. There was no question of his loyalty, and bankers rallied to his cause. But his tussles with McAdoo had damaged his standing in the administration, and he faced opposition on the Senate Banking Committee, in particular from the mercurial chairman, Robert Owen. After letting Warburg dangle for months, in August Wilson accepted his resignation. For Warburg, it was a devastating, and an irrecuperable, loss.

  For the next decade, the Fed’s most effective leader (and its last connection to the founding generation) was Benjamin Strong. His first task was to nip inflation, which skyrocketed after the war. After a battle with the Treasury Department, Strong hiked the discount rate, leading to a severe but brief depression. Bank failures rose sharply; however, there was no money shortage and no liquidity crisis. The mechanism of 1913 worked.

  In the 1920s, the Reserve Banks shifted their emphasis from making discount loans to individual member banks to so-called open market interventions. Trading by Reserve Banks developed a liquid market in short-term Treasury securities. Such interventions became the Banks’ chief tool for influencing interest rates and credit conditions—and not just on an emergency basis, but as an ongoing ballast to the economy. Significantly, in 1923, the Reserve Banks formed the Open Market Investment Committee, which attempted to conduct monetary policy on a coordinated basis. Although still a good distance from the bureaucratic giant of later years, such concerted action nudged the Fed closer toward being a central bank. Nonetheless, confusion over the board’s and the Reserve Banks’ respective powers persisted. The uncertainty would do serious harm; it contributed to the Fed’s ineffectualness during the Great Depression.