Federal Reserve Act

Federal Reserve Act (1913).The Federal Reserve Act had its origins in the Panic of 1907, when the collapse of several loosely managed trust companies sparked a general financial crisis. Depositors frightened by the collapse of trust companies withdrew money from banks, which then called in loans and dumped securities on the market, contributing to a serious recession. Financier J.P. Morgan saved the day, using a fund created by bankers and the federal government to prop up threatened but basically sound financial institutions.

The crisis illuminated severe weaknesses in the American banking system. National banks around the country issued currency backed with U.S. government bonds. They kept their reserves either in cash or on deposit in several designated money‐center banks. The system produced an inelastic currency—since it was tied to the availability of Treasury bonds, it could not expand with the economy. The problem became particularly acute at harvest time, when the demand for money rose as farmers sold their crops. Moreover, because reserves were dispersed throughout the system, mobilizing them during a crisis proved extremely difficult.

The panic inspired Congress in 1908 to create the National Monetary Commission, chaired by Senator Nelson Aldrich of Rhode Island, to study banking reform. A Republican stalwart with personal ties to the John D. Rockefeller family, Aldrich was in no sense a Progressive, yet in this case he was open to change. His commission toured Europe studying continental financial arrangements, but Aldrich made his most important contact in New York. There he met Paul Warburg, a member of the noted German‐Jewish banking family and a partner at Kuhn, Loeb, who combined strong civic responsibility with wide financial experience.

In late 1910, Aldrich, Warburg, and several other leading bankers met secretly to hammer out a plan to create a central bank along European lines, but more decentralized. The group recommended the creation of fifteen regional banks, controlled by local bankers, to handle the issuance of currency. These institutions would issue money in exchange for either gold or “real bills”—short‐term commercial paper backed by goods (inventories, for example). Such a currency would be “elastic,” that is, able to expand with the economy. The regional banks would also hold the reserves of financial institutions in their region, permitting a concerted response to any crisis. Over the regional banks would stand a central board composed largely of representatives of business and finance but also including a few government appointees. Aldrich formally submitted the plan to Congress in January 1911.

Although Aldrich's proposals remained stalled in Congress for almost two years, the election of Woodrow Wilson in 1912 opened the way for financial reform. In December 1912, even before Wilson's inauguration, Senator Carter Glass of Virginia, chairman of the Senate Banking Committee, put forward his own plan. It closely resembled Aldrich's, except that Glass, a states’ rights Democrat, sharply restricted the authority of the central board.

Glass quickly secured Wilson's support, but his plan horrified most congressional Progressives. Deeply suspicious of bankers, who they believed manipulated the financial system for their own ends, Progressives feared that Glass's measure would increase bankers’ power. Fortunately Wilson, who knew little about finance and had few convictions on the subject, made enough concessions to win over Progressive critics. In a key concession, Wilson agreed to strengthen the authority of the central board and to make all of its members presidential appointees, giving Washington a predominant voice in the new system.

The financial community opposed the final version of the bill, which it feared gave the federal government too much authority over the nation's banking system. As a result Progressives rallied around the measure and gave the proposal a radical aura that it did not entirely merit. The bill, authorizing the creation of twelve regional banks and the Federal Reserve Board in Washington, became law in 1913. The Federal Reserve Act had one serious weakness, not rectified until the 1930s: It did not define precisely the relationship between the regional banks and the central board. Nevertheless, the Federal Reserve Act gave the United States a central bank able to pursue consistent monetary policies.
See also Banking and Finance; Business Cycle; Depressions, Economic; Economic Regulation; Federal Reserve System; Monetary Policy, Federal; Progressive Era.

Bibliography

Arthur S. Link , Woodrow Wilson and the Progressive Era, 1954.
Robert C. West , Banking Reform and the Federal Reserve, 1977.
Ron Chernow , The House of Morgan, 1990.
Ron Chernow , The Warburgs, 1993.

Wyatt C. Wells