The Federal Reserve System

Even before the creation of the Federal Reserve, banks were used by the public just as we use them today. Deposits were made into savings accounts. Loans were taken out to mortgage a home or finance a new business. Banknotes were issued and spent when the public borrowed from the banks. Borrowers spent these banknotes just as paper money is spent today. These bank notes were valued as money since they were backed by the promise that they would be exchanged on demand for either gold or silver.

There was the occasionally belief on behalf of the public that banks would not be able to, or outright refuse to honor their banknotes. This fear, if held by enough of a community, could lead to a run on the banks. In a single day, demands for exchange of banknotes for gold and silver would be made by a majority of the people if there was doubt concerning the ability of a bank to redeem its notes. This problem would be compounded when this fear spread to other banks. Runs on a single bank would escalate and spread from one bank to another causing financial panic (http://www.dallasfed.org).

Another problem prior to the establishment of the Federal Reserve System was the inelasticity of bank credit and the supply of money. Small banks placed their excess reserves in large central reserve banks. Whenever a bank's depositors wanted their funds, the smaller banks would be covered by the central banks. The system worked well during normal conditions. Some banks would draw down on their reserves as other banks would be building up their reserves. In times of excessive demand, however, the problem became quite serious. When the public wanted large amounts of currency, the

demand for funds quickly became powerful and widespread. During these periods of high demand, banks from across the nation called on the central banks to supply the funds (Federal Reserve System 5th ed pp. 10-11).

At the time, there were not adequate facilities available to meet the demand for additional funds. Bank's reserves of money were stored around the nation at 50 locations. The reserves were not able to be shifted quickly to the areas that were experiencing increases in withdraw demand. The immobility of reserves only added another element to the financial panic (Schlesinger pp. 41). The credit situation would become tense. Since the banks could not get the funds from their central banks, the smaller banks had to take more drastic measures. Banks would have to sell securities, call in loans, refuse to renew loans, and decline any new loans. These actions led to the fall in prices of securities. Loans were liquidated and borrowing from banks and other lenders became difficult. Interest rates would rise rapidly and sharply. This type of financial hardship led to the liquidation of bank credit. Over a long enough span, this liquidation would lead to money crises (Federal Reserve System 5th ed pp. 10-11).

These periods of financial panics along with the inelastic money supply had long beleaguered the country. Bank failures, business bankruptcies, and unstable economic development were results of the lack of a central banking system (Federal Reserve System 8th ed. pp. 6-7). The Panic of 1907 was a bank run of epic proportions that exacerbated the problem. Depositors withdrew their savings from the second and third largest banks in the country. These banks were not able to generate enough funds to cover the demand and subsequently closed their doors. Their closings rapidly spread fear across the country leading to one of the largest runs on the banks the nation had ever witnessed (Schlesinger pp. 41).

Fortunately, J.P. Morgan, the exorbitantly rich New York businessman came to the aid of the financial system. He organized a group of bankers who shifted their funds to the failing banks. Depositors were assured their savings were protected and could be withdrawn whenever they wanted. The demand subsided and deposits were allowed to remain in the banks. Although the panic had successfully ended, bankers and politicians knew they needed a stable agency that worked like a central bank (Schlesinger pp. 41-43).

The first step toward a solution was the Aldrich-Vreeland Act of 1908. During times of financial crises, the act authorized the emergency issue of new currency. Additionally, it provided for the creation of the National Monetary Commission. This commission was established to review the nation's banking and money systems. It was also tasked to formulate a long-term solution to a banking system prone to panics and an inelastic currency that was unresponsive to changes in demand (Schlesinger pp. 41-43).

The recommendations, named after the commission's chairman, Senator Nelson Aldrich, became known as the Aldrich Plan. It called for the formation of a central institution to be known as the National Reserve Association. The plan included setting up 15 branch offices across the country while all gold reserves would be kept at a central repository. This new body would also be given the power to issue a central currency and establish a national interest rate for borrowing. The plan faced the same criticism that led to the demise of the first two U.S. banks. It was argued that the country could not safely place control of nation's money and baking with too few powerful bankers.

Still, the money supply was unstable. Wide-ranging speculation existed in the stock and commodities markets. Banking activities were remained unregulated. The problems were identified but there was not a simple solution. (Federal Reserve System 5th ed pp. 11-12).

Although the need for banking reform was undisputed, the problem was finding a balance between national and regional interests. Nationally, the central bank had to facilitate the exchange of payments among regions and improve the U.S. standing among world economies. Regionally, it had to respond to varying local liquidity. Another critical balancing act was that between the private interests of banks and the centralized responsibility of government (http://www.stlouisfed.org/publications/pleng/history.html).

By 1912, newly elected President Woodrow Wilson knew changes in the nation's banking system had to be made. The recurrence of bank panics along currency instability demonstrated the necessity of major reform. President Wilson, who was not thoroughly competent in the technicalities of banking, worked closely with advisors during the drafting of reform plans. Representative Carter Glass and Senator Robert Owen, along with prominent economist, H. Parker Willis drafted what became known as the Glass-Willis proposal. This plan was similar to the Aldrich plan but had some significant differences. It was more of a regional, rather than fully centralized, approach to banking reform (http://www.u-s-history.com/pages/h1052.html).

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