Hardly anyone noted last week that Monday was the centennial of President Woodrow Wilson’s signing of the Federal Reserve Act. Perhaps that is as it should be.
The media take little notice of anniversaries of agencies like the Food and Drug Administration or Census Bureau and a nation’s central bank should not be any more controversial than such bread-and-butter organizations.
Nevertheless, the central bank is the center of economic attention now, so thinking about its past and future may be useful. Is the Federal Reserve, as currently structured, the central bank we need? If not, how should it be changed? To answer that, one needs to know how it came about.
Let’s be clear that a modern economy needs a central bank to regulate its money supply and act as a lender-of-last-resort in times of financial crisis. We fought over the politics of that question for the first 120 years of our nation’s history, but by 1913, a majority of Americans believed in the need for a central bank.
Over the preceding half century, U.S. households had paid a high price for a deflationary monetary policy indirectly set by Congress and for the lack of any public institution that could stabilize the economy in times of financial panic. That had been particularly true in the harsh Panic of 1893, which caused five years of above 11 percent unemployment together with the bankruptcy of more than 15,000 businesses and closing of some 500 banks. The Panic of 1907 was even worse.
The scars from those two episodes motivated a willingness to bridge the political divide over a central bank, which dated from the 1780s. But that compromise also gave us a Fed with an ungainly structure that confuses many and furnishes fodder for demagoguery by cranks and charlatans.
The divide was between the ideas of two of the nation’s founders.
Alexander Hamilton, a self-made New York attorney who had suffered illegitimacy and poverty as a child, favored a strong role in the economy for the proposed new federal government, including establishing a private national bank endowed by Congress with monopolistic powers and modeled on the Bank of England.
Thomas Jefferson, born into the wealth of Virginia planters but a spendthrift who passed his whole life in debt, hated the business and banking classes of London, Boston, New York and Philadelphia. He upheld an ideal of the small farmer and small town businessman, even though his own lifestyle was sumptuous.
Jefferson opposed any bank that would be given power, or even influence, over the national economy.
The fight between the Hamiltonians who favored an economic role for the federal government and some form of central bank and the Jeffersonians who opposed these measures went on for decades.
Indeed, we see elements of this dispute in contemporary politics, whenever the interests of “Wall Street” are contrasted with those of “Main Street.”
Yet this is what logic teachers call a “false dichotomy.”
While the interests of all economic sectors don’t always coincide, nearly everyone, consumers and producers, big business and small, finance, industry and commerce, all benefit from a stable financial system that effectively channels funds from savers to borrowers, and that provides safe avenues for people to store value, together with reliable and convenient ways of making payments.
In a modern economy, all these hinge on a system of commercial and investment banks and the stability of such institutions depends on a central bank.
Voters realized this after 1907. The problem was finding a political compromise that alleviated their fears.
Households and small businesses had the Jeffersonian fear of a financial system dominated by a small cadre of plutocrats located in New York and a few other large cities.
They did not want a central bank like the Bank of England, located in the nation’s financial center and owned and directed by the very bankers a central bank should regulate.
Businesses did not want a politically controlled central bank located in Washington and run by whatever party controlled Congress or the presidency.
The solution was a decentralized system of “reserve banks,” so called because they held a stipulated fraction of the deposits of private banks that served households and businesses. These reserve banks were to be private corporations, owned by the banks in each district in proportion to their size.
No Wall Street interest could buy up control of the whole system and locally-owned banks in towns like Parkers Prairie, Minn., and Bowbells, N.D., would have at least a small stake in the action.
The federal government would have no say in the day-to-day operations of these district banks. Hamilton’s “monied men” would have influence, but not control.
And there was a board in Washington, D.C., that included the secretary of the treasury and comptroller of the currency as members; but this had little power.
On the whole, the compromise was a good one, though the Fed has made many mistakes.
Events leading up to and including the Great Depression proved that the original board was inadequate and reforms in 1935 created today’s Board of Governors, named by the president and confirmed by the Senate, but with a high degree of autonomy.
There also is the policy-making Federal Open Market Committee that includes the presidents of the 12 district banks, though only five vote in any year.
The role of these officials, who answer to no political body, is anathema to some liberals, but they have proven key to thorough debate over policy alternatives.
There is enough confusion over the structure and history of the Fed that conspiracy theorists and fringe politicians will always find material from which to “distill their fury,” and they will always find eager listeners.
There certainly are instances in which the Fed did not do a good job, including 1919, several years after the 1929 crash, the 1970s and the decade leading up to the debacle that began to unfold in mid-2007.
And there certainly are questions about whether we still need 12 district banks and the other administrative rigmarole that was needed to quell political fears a century ago.
But it is impossible to have a modern economy without a central bank, and the Fed remains a sound model for our nation.