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Introduction


“Often, in discussing the notable accomplishments of the federal reserve banking system, I have remarked that a person acquainted with the details could, if endued with a fertile facility of expression, write a history of federal reserve legislation which would read like a romance.” So said the Virginian Carter Glass, one of the authors of the Federal Reserve System, in the first sentence of his book on the same subject.1 Whether or not the typical student would regard the history of the Federal Reserve a romance, there is no question that the 1913 battle to fix the nation’s banking and currency problems, which would finally result in the creation of the Federal Reserve System, had many of the elements of an epic struggle. The story included protagonists and antagonists, plots and sub-plots, and a climax and resolution.
But why was the attention of politicians, bankers, and business leaders turned to the nation’s financial landscape in the first place? In a word, the nation had grown. Since the Civil War, the population and commerce of the nation had increased by leaps and bounds, and by the early years of the twentieth century, it was obvious to many that the banking system currently in place in the United States was inadequate. The Panic of 1907 offered proof. Wilson biographer and scholar Arthur S. Link put it this way: “Men might disagree over method, but no one denied the urgent need for reform of the nation’s antiquated banking and currency systems.” 2
This lesson will explore the need behind the call for a new banking and currency system, the concerns of some of the agitators in the conflict, and the resulting end-product: the Federal Reserve System. It is based primarily upon the letters and writings of Benjamin Strong, Jr., the first governor of the New York Federal Reserve Bank.

Context Information for Teacher and Student


Anyone familiar with one of the great debates of our own time, that of whether government or the free enterprise system should be the primary agent in solving our nation’s ills, should have little difficulty recognizing in this lesson the same pull of competing perspectives. Just as in our own day, the United States in the earliest years of the twentieth century faced dilemmas as big as the nation itself, and the problems were met with a rising cacophony of loud and strident voices, each one seeing in his solution the only way out of the financial fog.
Proposals to modernize the national banking system gathered around two poles: at one end were those who wished to bring the power of the national government to bear on the predicament; at the other end were those who wanted to allow business interests to work according to laissez-faire principles for a better resolution of the problems they had helped to create. This was the classic encapsulation of the two sides of citizen disagreement on the use of power: public or government versus private or free enterprise. Note: For a comprehension of this lesson, it is very important to know that the word public will be used synonymously and interchangeably with the word government, and private with the term free enterprise.
Until 1913, banks operated under the organization set up by the National Banking Act of 1863. This system performed as a three-tier pyramid: thousands of country banks made up the bottom tier; forty-seven reserve city banks comprised the middle tier, and three central reserve city banks in New York, Chicago, and St. Louis topped off the system in the highest tier. Country banks and reserve city banks were required to deposit some of their cash reserves in the next level up. This is how it worked: when a country bank needed more money than it had on hand to lend to customers, it would initiate a withdrawal of its reserves in the reserve city bank. When pressure on a reserve city bank from numerous country banks became sufficient, it would turn to one of the three central reserve city banks to withdraw some of its reserve cash.
One reason why country banks often started the upward push of pressure on the higher banks for cash was because they needed money in the fall to lend to farmers. In the early years of the twentieth century, agriculture comprised a large section of the American economy, and farmers, especially those in the West and South, often needed to borrow money to harvest crops and transport them to market. As all farmers needed money at roughly the same time, the local country banks often found themselves without enough cash to lend and not able to get money moved from the upper level banks quickly enough, if in fact they had enough held there in reserve in the first place.
The situation described above illustrates the two problems that developed within this system as the commerce in the country began to expand: the problems of immobile reserves and inelastic currency. "Immobile reserves" describes the problem of higher-tier banks not being able to shift money or reserves around the country easily or fast enough to help the country banks where the need was the greatest. "Inelastic currency" was the problem of not being able to expand and contract money in the economy to meet periodic, pressing needs.
Sometimes the pressure put on banks would precipitate a crisis. When individual depositors realized that a lot of money was leaving their bank to meet the seasonal demands around the country, they would fear for the safety of their own money and withdraw it. Other depositors would hear that people were lining up to take out their money, so they too would rush to the bank to retrieve theirs. When enough people did this, banks would run out of money and have to close their doors and shut down, sometimes for good. (Banks never hold all of their deposits; they make money in part by lending to customers a sizeable percentage of their depositors' money and charging a fee for its use.) At this time in history, there were no government guarantees or safeguards to protect the money in a bank. If a bank was forced out of business because of a panic, depositors simply lost their money.
In 1907 a banking panic, similar to the one described above, caused several banks in New York to fail. Charges began to circulate that New York City bankers had caused the panic by "hoarding" their vault cash instead of lending it out as the system required. The Panic of 1907 did not cause a nationwide depression as some previous panics had done, but it did draw the attention of many public and private observers to the fact that the banking and monetary situation was no longer adequate for the needs of the nation and that a fix could not be delayed. The nature of the change was to become the question.
Into this financial volatility emerged an additional factor: the political mood of the country was shifting from support for laissez-faire to activist government policies. Called progressivism, this inclination on the part of the citizenry to demand solutions from their governmental representatives began to be felt in the area of banking and finance. Solutions to the banking and currency quagmire became a matter of debate between progressives who favored governmental or public solutions, and conservatives who favored free market or private solutions.
Enter the major contenders included in this lesson. Benjamin Strong, who would later come to embrace the Federal Reserve System and even defend it, at first opposed many features of the Federal Reserve bill (the Owen-Glass bill) as it made its way through Congress. He was a New York banker and favored a private solution. William Jennings Bryan was a progressive Democrat and President Wilson's Secretary of State. A powerhouse in national politics, he threw his considerable political weight behind a public cure. Congressman Carter Glass, chairman of the House Banking Committee, was somewhere in the middle. President Wilson, too, was willing to adopt a new system that had both public and private elements.
In fact, the Federal Reserve System that resulted from this tug of war did actually contain both public and private elements. Carl H. Moore in his book The Federal Reserve System said, "Thus, as President Wilson on that December evening signed the Federal Reserve bill into law, a new ‘creature’ was born. A unique creature, it was neither government nor private but part of both."3 The Federal Reserve Act which established the Federal Reserve System was to consist of 12 regional banks, privately owned by member banks, but governed and regulated by a president-appointed and Senate-confirmed Federal Reserve Board.
The debate between those advocating public and private answers to this nation’s problems has not ceased, thus making this lesson a relevant one for today’s students.


"Federal Reserve Note"

This Note Is Not Legal Tender

One Dollar


"Federal Reserve Note"

This Note Is Not Legal Tender

One Dollar


"Federal Reserve Note"

This Note Is Not Legal Tender

One Dollar




Worksheet I. The Need


Our Banking System Is a Mess!



From Benjamin Strong, Jr.: On a Central Bank vs. Regional Banks, [13 Dec. 1913?]


“This country is confronted with a problem in currency reform, unique in the history of banking and unprecedented in the character and number of complications to the dealt with … The United States has 7,500 banks of issue, operating under Federal charter, twenty thousand odd State banking and credit institutions conducting their business under divergent laws of forty-eight different States, and seven forms of circulating medium: National bank notes, United States gold certificates, United States silver certificates, United States notes, treasury notes, gold coins, and silver coins....The United States has no discount market, 28,000 different rates, as many usury [high interest rates] laws as there are States, as many penalties as there are usury laws ... notwithstanding the fact that this country has the largest store of gold, the greatest natural resources, the largest power of production, and the largest volume of banking capital of any nation of the world. The resources of our banking system are about $25,000,000,000. Our 28,000 banks support the largest credit structure known in history."


Question

Put in your own words the confusion that prevailed in U.S. banking and currency prior to the creation of the Federal Reserve System.






Answer

The Problem of Immobile Reserves and Inelastic Currency:

Money Can't Move Around the Country Fast Enough and There's Not Enough of It!



About the problem of immobile reserves, read what Roger T. Johnson wrote in Historical Beginnings ... The Federal Reserve: "Under the national bank system the bank reserves were spread around the country, but they tended to be immobile where they sat.... Fifty different cities in the nation served as reserve depositories. Even though the total of reserves in the national banking system was very large, the economic value of this reserve was largely mitigated because it was so spread out; it was as if the American army were scattered all over the country, with each soldier assigned to protect his own specific area of several square miles. Such an army would clearly be infinitely less powerful than one whose forces were all gathered in a few strategic locations. The reserves of money could not be shifted easily to areas of the country needing them." 4
In the same book, Johnson wrote about the problem of inelastic currency: "Currency ... grew or contracted in response to the requirements of American business. The amount of currency in circulation, therefore, depended upon the value of bonds which the national banks held rather than upon the needs of the economy. Such inelasticity in the currency tended to aggravate matters rather than alleviate them, causing the economy to gyrate wildly and somewhat uncertainly between booms and busts." 5


Questions

1. What does the word immobile mean and how does it apply to money in the economy at that time?

2. What were some problems that resulted from inelastic currency?



Answers

The Problem of Immobile Reserves and Inelastic Currency:

Our Farmers Need Help!



From Benjamin Strong, Jr.: On a Central Bank vs. Regional Banks [13 December 1913?]
"In the United States we have a number of districts clearly marked in their nature as to the kind of business. All of the banks in certain districts, such as those which grow corn, wheat and cotton, are obliged to borrow money at the same time of the year. A number of other districts have money to loan during this same period. Under our present system, series of banks in one district, say the cotton district, borrow from a series of banks in another district, say the New York district, involving vast transfers of actual cash."
From Benjamin Strong, Jr. to Elihu Root, 6 Dec. 1913:
“… in 1912 … the reduction in cash of the New York banks, from August 15 to December 30, was only $60,000,000., that is, from $379,000,000. to $319,000,000.; that is, such reduction of cash is a natural seasonal movement that occurs in the fall of every year.”


Questions

1. Why did “vast transfers of actual cash” occur every year?

2. In what season of the year did this transfer occur?



Answers

The Problem of Immobile Reserves and Inelastic Currency:

Stop the Bank Panics!



In this excerpt from the Benjamin Strong, Jr. Papers held in the NY Federal Reserve Bank, Benjamin Strong, Jr. in a letter to Sen. Elihu Root on Dec. 13, 1913, defends the New York banks against the accusation that New York banks had caused the Panic of 1907. [To see the actual figures that he refers to as “these figures” and “the enclosed tables”, go to the links http://wwl2.dataformat.com/Document.aspx?doc=32929 and http://wwl2.dataformat.com/Document.aspx?doc=33017 .]
“Instead … of the so-called “big interests”, and particularly the New York bankers, having brought on or purposely caused the panic, as has been so kindly suggested by various members of Congress, these figures show the whole trouble to have been due to actual hoarding of money by country banks in all parts of the United States, particularly in the West and South.

You will notice, in the enclosed tables, that many of the banks in the Southern and Western states carried over 100% more cash in their vaults than the law required. The banks in Georgia held 187% more cash than was necessary; in Alabama 169%, in Texas 145%, in Colorado 164%, in Oregon 159%. These figures clearly show that, while New York was making every effort to protect the rest of the country and live up to its position as a central reserve city, the country banks were all taking more than their share; and, further, that they could have carried an average excess cash reserve of over 50% and still have left enough funds for the central reserve cities to do business without friction.”


From Benjamin Strong, Jr., to Elihu Root, 16 Dec. 1913:
“August 17, 1907, the cash in the Clearing House banks in New York City was $274,000,000. By November 30 this cash had been reduced to $217,000,000.,- this including the worst period of the panic. The greatest reduction occurred in the week at the height of the panic, from October 26 to November 7, when the cash reserve of the New York banks was reduced $30,000,000. The total reduction from August 17 to November 30 was $57,000,000. This represents the net reduction in cash, after figuring in all receipts by the New York banks during that period from every source, including gold from Europe. On such a showing, who can honorably say that New York banks were hoarding money during this period? … The banks of New York City lived up to their every responsibility in 1907, and went far beyond what could reasonably be expected of them, as they not only paid tremendous premiums for bringing gold into the United States for the purpose of supplying it to the country, but paid out $25,000,000. in actual cash …”


Questions

1. Instead of New York banks “hoarding cash”, which banks did Strong say were actually holding it?


2. How does he back up his claim?

3. How do you think a new banking system with more centralized authority could correct this problem and thereby prevent panics?




Answers

An incident given in When Washington Shut Down Wall Street puts a human face on the Panic: “In 1907 depositors had nowhere to turn if their bank closed its doors. The New York Times reported that the demand for cash grew quickly after the Knickerbocker opened at ten o’clock until ‘the line doubled back on itself in a great S ….’ Less than two hours later, after paying out a total of $8 million to hundreds of depositors, the Knickerbocker Trust Company … suspended cash withdrawals. Depositors remained in line for more than an hour after the doors closed. A man from Rahway, New Jersey, said to his neighbor, while they both continued to wait: ‘I know something about the bank in my town. I know the officers and I am going to take my money there.’ He did not get the chance.”6




Question

What happened to the money of the man quoted in the above paragraph? Why?





Answer


Worksheet II: The Concern



Make the New System "Private": The Power to Control Our Nation's Money Must Not Be Placed in the Hands of Biased Politicians!

From Benjamin Strong, Jr.: On a Central Bank vs. Regional Banks, [13 Dec. 1913?]
“In considering the detail of the Owen bill, it will be found that, in general, a possibility of abuse of political power in the case of [12] regional banks [as opposed to one central bank managing several regional banks] is very great and that the one man power placed in the hands of the Secretary of the Treasury is appalling…. How may this system develop, in this country of keen political partisanship [bias], where each [political] party grasps every advantage within its reach to secure the dominant position, or maintain it once secured? May it be expected that a board of control [the proposed Federal Reserve Board], upon which sit officers of the Government whose appointments are partisan and political, which is subject in many important respects to the direction or influence of the officers of the Government, to be free from political influence and from discrimination, particularly having regard to the political complexion of the different sections of the country? … With one President having the power to appoint a majority of a board of control during one term of office, and with one or more members of the Board members of his official family or subject to their direction, it is never impossible that the powers exercised by that board may be used for political or partisan purposes. … Such a system as is proposed instantly interjects sectionalism and partisanship …. The General Fund of the United States at the present time consists of about $90,000,000. on deposit with Government depositaries, and approximately $35,000,000 net in addition … By an extraordinary provision of the Owen bill, the disposition and distribution of this huge sum is placed absolutely within the discretion of one officer of the United States Government …. Is it intended that one officer of the Government shall be the supreme monetary power of the United States? ... No officer of the United States should be empowered to distribute $2000,000,000. at will in any section of this country; and to vest that power in the partisan political member of the Federal reserve board is a serious menace to the financial independence of the people of this country. What may be expected on the eve of a National election?”


Question

Strong raises several concerns about the wisdom of placing monetary power in the hands of elected, biased politicians. List his concerns.




Answer


Make the New System "Public": The Power to Control Our Nation's

Money Must Not Be Placed in the Hands of Greedy Bankers!



From Arthur S. Link's Wilson: The New Freedom: "To Bryan Democrats, the adoption of the Aldrich plan [which favored banker or private control of money] could only mean the perpetuation of Wall Street control of the credit resources and money supply ... The Progressive platform in 1912 not only denounced the plan but went on to say ... 'The issue of currency is fundamentally a governmental function ... The control should be lodged with the government and should be protected from domination or manipulation by Wall Street or any special interests.'" 7
And later in the same book: "The Secretary of State [William Jennings Bryan] was adamant in his opposition [to the Federal Reserve bill, as it was drawn up in May, 1913] ... 'I called his attention to the fact that our party had been committed by Jefferson and Jackson and by recent platforms to the doctrine that the issue of money is a function of government and should not be surrendered to banks,' Bryan afterward remembered telling Wilson... Moreover, Bryan warned, he would have to insist upon exclusive public control of the proposed Federal Reserve Board."8
"Since 1910 Wilson had been slowly evolving in his own mind two basic assumptions that he felt should govern banking and currency reform. The first was that the concentration of credit and money in Wall Street had reached the proportions of monopoly, and that economic freedom could not exist so long as a "Money Trust" had the power to 'chill and check and destroy genuine economic freedom' ... Wilson's second basic assumption ... was that banking was so much a public business that the government must share with private bankers in making fundamental financial decisions. He supported the Federal Reserve bill, he told a reporter, because 'it provides ... for public instead of private control, thus making the banks what they should be- the servants and not the masters of business ... With government control, there is created a force which, while it will not attempt to run the business of the banks, will be clothed with some authority to prevent injustice from the banks to the general public.'"9
Woodrow Wilson consulted the economist Louis D. Brandeis, who advised: "'The American people will not be content to have the discretion necessarily involved vested in a Board composed wholly or in part of bankers; for their judgment may be biased by private interests or affiliation' ... [Wilson decided to] insist upon exclusive governmental control of the Federal Reserve Board and upon making Federal Reserve notes the obligation of the United States ... [Senator Carter] Glass had no recourse but to yield and change his measure as Wilson had directed." 10


Questions

1. What did the Progressive party of 1912 say about the power to issue currency? What did William Jennings Bryan say?


2. What were Pres. Wilson's two basic assumptions about banking and currency reform?
3. Why did Louis Brandeis think the power over money should not be vested in bankers?


Answers


Worksheet III: The Result



The Establishment of the Federal Reserve System

Senator Theodore E. Burton to Benjamin Strong, 23 Dec. 1913:
“Under separate cover I take pleasure in sending a copy of the Conference print of the Banking and Currency Bill [which established the Federal Reserve System]. This is the form in which it finally passed the Senate this afternoon and will become a law by the signature of the President this evening.”
From the 1913 Federal Reserve Act:
T "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.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled, That the short title of this Act shall be the "Federal Reserve Act."


Questions

1. On what date did the Banking and Currency bill become law?


2. What are the 4 stated purposes of the Federal Reserve Act?
3. What government body created the Federal Reserve System?



Answers

From the 1913 Federal Reserve Act:


"The Reserve Bank Organization Committee" shall designate not less than eight nor more than twelve cities to be known as Federal reserve cities...Said organization committee shall be authorized [to determine] the reserve districts and [to designate] the cities within such districts where such Federal reserve banks shall be severally located....[The] Federal reserve bank ... shall include in its title the name of the city in which it is situated, as "Federal Reserve Bank of Chicago.'"
"Every [member bank of the Federal Reserve System] ... shall be required within thirty days after notice from the organization committee, to subscribe to the capital stock of such Federal reserve bank...."
"A Federal Reserve Board is hereby created which shall consist of seven members, including the Secretary of the Treasury and the Comptroller of the Currency, who shall be members ex officio, and five members appointed by the President of the United States, by and with the advice and consent of the Senate.... The Federal Reserve Board shall be authorized and empowered ... to examine at its discretion the accounts, books and affairs of each Federal reserve bank and of each member bank ....[and] to exercise general supervision over said Federal reserve banks."


Questions

1. How many cities were to be designated as locations for Federal Reserve Banks?


2. What would own the capital stock of each Federal Reserve Bank? Would this make the Federal Reserve banks publicly owned or privately owned?
3. Which political members of government would appoint and give consent to five of the seven Board members?
4. What were some powers that the politically appointed Board had over the 12 regional Federal Reserve Banks?
5. To sum up, what were some public (government) features of the Federal Reserve Act, and what were some private (business) features?



Answers

The Federal Reserve System Explained By Benjamin Strong, Jr.

From Benjamin Strong, Jr.: Address to the Tokyo Ginko Club, 24 May 1920:


"But behind this the purpose of the law creating the System is clear. The Reserve Banks to be sure are subject to strict supervision by a Government body the Federal Reserve Board,--but they are owned by the member banks, and their affairs must be administered impartially...."
“All of the Reserve Banks and their branches are connected by their own telegraph and partly their own telephone lines, with each other and with the Treasury in Washington. Collections, payments and transfers are largely made by telegraph, and settlements are effected by changes in the proportionate ownership in a large fund of gold deposited by the Reserve Banks in trust in the Treasury. These settlements are made daily by brief a telegram in code.”
"To meet various requirements of our own situation, such as the size of the country, its varied economic characteristics in the different sections, and in order to avoid too great concentration in New York, a regional system was adopted. The reasons for this are obvious and have, as you know, become completely convincing to me."


Questions

1. Can you discern from the first paragraph why Strong is not too concerned about the publicly appointed Board having supervisory powers over the member banks?


2. How did the banks communicate with each other in 1920?
3. Why was a regional system (12 Federal Reserve Banks instead of 1 big central bank) adopted?
4. Did Strong, who argued against the Federal Reserve System in The Concern worksheet above, ever come to support it? How do you know?


Answers



1 Carter Glass, An Adventure in Constructive Finance (Garden City: Doubleday, Page & Company, 1927) 1.


2 Arthur S. Link, Wilson: The New Freedom (Princeton, New Jersey: Princeton University Press, 1956) 199.

3 Carl H. Moore, The Federal Reserve System: A History of the First 75 Years (Jefferson, North Carolina: McFarland & Company, Inc., 1990) 8.

4 Roger T. Johnson, Historical Beginnings ... The Federal Reserve (Federal Reserve Bank of Boston: Banking and Public Services, 1977), 14.

5 Ibid., 13.

6 William L Silber, When Washington Shut Down Wall Street (Princeton, New Jersey: Princeton University Press, 2007), 44.

7 Arthur S. Link, Wilson: The New Freedom (Princeton, New Jersey: Princeton University Press, 1956), 201.

8 Ibid., 206.

9 Ibid., 211-212.

10 Ibid., 212-213.






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