The Real History of the Fed: Why It Didn’t Take a Miracle (Or a Conspiracy!) to Pass
The following is a guest post by Steven Horwitz, Charles A. Dana Professor of Economics at St. Lawrence University.
Perhaps because money and finance are among the most complex and obscure parts of economics, a variety of cranks and conspiracy theorists have historically aimed their arguments against any number of monetary institutions and practices. In the last hundred years, the US Federal Reserve System has been the subject of many wild stories about its origins and ongoing operation. The Fed is believed by some to be part of the supposed international Jewish banking cartel of long-standing legend. For others it is part of the supposed empire of the Rothschilds, and for yet others it is part of a plot by private bankers to control the US government. Even among those who don’t subscribe to the more outrageous of these views, there are many who refer to the Fed as a “private bank” that has inappropriate influence over the US economy.
It is not possible to address every one of these stories about the Fed in detail, but what can be done is to offer a history of the Fed and a brief description of its structure that provides an alternative narrative about its origins and operations. That narrative relies on standard histories of both the US monetary system and the Progressive Era of US history. The result is a story that situates the Fed as just another example of Progressive Era zeal for a larger role for the administrative state, which would remedy the supposed failures of capitalism by relying on well-meaning experts to execute its policies.
Like other legislation of that era, the Fed was a government intervention supported both by ideologically-motivated and well-meaning reformers and by the industry being regulated. Rather than being this as some sort of unique conspiracy to take control of the US monetary system, it was a story very similar to those found in the history of everything from railroad regulation, to meatpacking regulation, to the regulation of monopolies and trusts as historians from Gabriel Kolko onward have documented. Unique historical factors in the monetary system affected the particular form the Fed took, but its broad history places it squarely in the tradition of the Progressive Era. If the Fed is the product of some nefarious conspiracy, so is a whole bunch of other legislation passed around that time.
The Fed emerged not as a response to failures of a free market in banking, nor as the result of shadowy banking conspiracies, but instead as a response to the failures of the National Banking System (1863-1913) that preceded it. The US banking system has never been a free market, as the National Banking System (NBS) was itself a response to pre-existing state-level regulations on banking. Under the NBS, and many of the state systems that came before it, banks were subject to three major regulations: 1) limits on the ability of banks to operate branches; 2) minimum reserve requirements; and 3) requirements that banks that produced currency buy up certain bonds or other financial assets as collateral.
The first and third of these regulations were particularly problematic. The limits on branching varied. During the pre-Civil War years, branch banks of any kind were illegal – banks could only operate one office. During the NBS, interstate branching was illegal, as no state would allow branches of banks chartered in other states to open up in that state, and some states still prohibited banks from opening branch offices within their state. The result was a banking system with few inter-bank institutions and too many banks that were too small and not sufficiently diversified, and therefore overly prone to failure.
The bond collateral requirements were also a problem. Before the Civil War, they often served as a form of crony capitalism as some states required that banks buy the bonds of railroads and other nominally private enterprises instead of, or in addition to, government bonds to serve as collateral. In the NBS, federally chartered banks were required to buy federal government bonds as a way of financing the Civil War. Regardless of whose bonds were required, forcing banks to purchase bonds when they want to expand their issues of currency became a problem as the required bonds were sometimes found to be either worthless or in short supply. One result was periodic currency panics that continued throughout the century.
The use of banking regulation and central banks as a way to finance government expenditures, particularly for war, explains the origins of numerous central banks and other government interventions in banking throughout history. The various conspiracy theories about the Fed do glimpse one important truth: central banking and bank regulation has long been a way for governments to extract resources from the private sector, most often for activities that would be difficult to support through taxation or debt. Central banks such as the Fed do operate in ways that are not especially visible to the public. However, this sort of cost concealment is not unique to central banks. The military draft is another example. As we will see below, none of the activities around the creation of the Fed took place in great secrecy, despite the inordinate attention paid to the meeting on Jekyll Island that helped formulate its final structure.
The result of the NBS regulations was a series of ever-worsening banking panics, culminating in severe panics in 1893 and 1907, both of which resulted in major recessions. After both panics, debate over alternatives heated up. By 1907, the Progressive Era had already produced the anti-trust laws, the Pure Food and Drug Act, and numerous other new regulations. Into this context came the debate over monetary institutions. The dissatisfaction with the National Banking System led to a series of public commissions and debates discussing reform.
After the Panic of 1907, a number of bills came before Congress that would have effectively addressed the problems by removing the bond-collateral requirements and permitting some degree of interstate branching. Ending the bond-collateral requirements was politically acceptable, but opening up branching was strongly opposed by smaller, agricultural states who feared that big city banks, especially New York ones, would enter in and drive them out of business. With each state having two votes in the Senate, these economically wise attempts at reform died a political death.
With good economics making for bad politics, as it often does, a compromise was needed. All along there had been voices supporting some sort of central bank with arguments consistent with the ones made for other Progressive Era reforms. The belief was that the most serious problem was making sure that reserves could be moved to where they were needed rather than being more centralized in New York and a couple of other major cities. Bringing some sort of intentional cooperation to reserve management could be accomplished through a central bank. However, the same rural areas that feared big city banks with the ability to branch also feared a central bank that would be tied too closely to those same banks, or to Washington. The US has a long history of fearing centralized monetary power, whether private or public. All of these debates took place very publicly, in the government, the newspapers, and academia.
Once it seemed likely that some sort of government-run reserve plan would win the day politically, two groups lined up to support it, as was often the case with Progressive Era legislation, much of which parallels the “Baptists and Bootleggers” phenomenon. The original “Baptists and Bootleggers” concept comes from the two groups that supported Prohibition. On the one side were was the temperance movement, with its moral stance against demon rum. On the other side were the bootleggers, who profited mightily from Prohibition, much like modern drug dealers profit greatly from their ability to charge high prices for illegal drugs. This basic scheme can be used to explain a whole variety of government interventions where support comes from both those who support the cause for moral/ethical reasons and those who stand to benefit from the intervention materially. For example, both leftist activists and Walmart support an increase in the minimum wage. The former for ideological reasons and the latter because they generally pay above the minimum and raising it would benefit them by increasing the costs of their smaller competitors.
The creation of the Fed was supported by Progressive Era reformers (the “Baptists”) who generally tended to believe that government-administrative management by experts was the way to solve social problems, including economic ones, and by bankers and economists who saw a new system as a source of profits, power, and prestige (the “Bootleggers”). A variety of professional organizations were involved in support for the creation of some sort of central bank in the US. These organizations included the American Economic Association, but also the American Bankers Association and the American Academy of Political and Social Science. The largest bankers already had some power under the NBS, but a central bank would more tightly link them to the political process as well as giving them an official imprimatur in dealing with foreign governments. Not all economists supported the proposed system, nor did most midwestern bankers, but many did and they saw it as an opportunity to bring principles of scientific money management to public policy in addition to raising their profiles.
This was no “conspiracy.” It was, again, a classic Baptists and Bootleggers story, much like one could tell about a number of other government interventions throughout American history. The problem with the Fed is not that it was the product of a conspiracy by private bankers, but that it was the product of politics. Of course private bankers had an interest in the outcome and participated in the Fed’s creation. They did the same thing with railroad, monopoly, and food and drug regulation. The corporatism that defined the Progressive Era, and continues to define our own times, is not about conspiracies, but about wrongly trusting that politics can solve problems and not understanding the incentives political solutions create for private parties to seek to gain by them.
As negotiations between politicians and bankers continued in the early 1910s, they eventually settled on the Federal Reserve System as a “decentralized central bank.” By carving the US up into 12 districts and putting a regional bank in charge of each one, with all 12 coordinated by a weak oversight board in Washington, the hope was to diffuse the political opposition to the possibility of a “money trust.”
Here is another point at which the conspiracy-minded critics of the Fed turn a nugget of truth into a mountain of misunderstandings. Yes, the Fed is technically “private” in the sense that it is not on the budget of the federal government. The critics claim it is a private bank owned by bankers. But they are asking the wrong question when they ask “who owns the Fed?” The real question is who owns “them,” as the ownership is actually of the 12 district banks, not the Fed as a whole. Each of the district banks is “owned” by the banks that operate in their district. That ownership, however, is not like owning stock in Apple. The shares that each bank has cannot be traded and only provide a limited set of decision-making rights. Even the interest that the district banks would earn on their holdings of government bonds is returned to the Treasury, so this hardly profits “the Fed” or the bankers who supposedly own it.
The district banks are most emphatically not private in the same sense that a corporation like Apple or Ford, or even a local small business, is. Aside from the inability to trade shares, there is the more obvious point that the whole system was created by Congress who also granted it a number of political privileges, including its monopoly over currency issue. Calling the Fed a “private bank” is true only in a very limited sense of the term, and criticisms based on it that claim are extraordinarily misleading and often highly misinformed.
The Fed is no more the product of a conspiracy than is every other piece of legislation passed during the Progressive Era, or since. Yes, private interests played a significant role, but that is the nature of the corporate state. Yes, the Fed is officially a “private” institution, but it is not owned by individual bankers, rather by banks, and those banks cannot trade or profit from their ownership “shares.” The famed meeting at Jekyll Island was no different than the conversations that happen on K Street every day, in which politicians, lobbyists, and businessmen co-design new regulations and institutions. The damage the Fed has done in its 100 years is significant enough on its own. There is no need to invent wild conspiracy theories to explain its history when the same tools that explain the origin and failure of so much of what government tries to do apply equally to the Fed.