[Global Finance History] The Birth of the Federal Reserve System as a 'Decentralized Central Bank'

After the 1907 US Economic Panic
Need for a Modern Banking System
June 1910: Six Members Gather to Discuss
1913: Birth of the Federal Reserve Act

In 1913, JP Morgan passed away, and in the same year, the Federal Reserve System (Fed) was established by an act of Congress. A true central bank was created to replace Morgan, who had effectively served as the ultimate lender of last resort. After President Andrew Jackson dismantled the second central bank of the United States in 1832, the American economy operated without a central bank. Not only was there no central bank, but due to President Jackson's general antipathy toward banks, the National Bank Act and most state laws strongly prohibited the establishment of branches. Under the political influence of the late President Jackson, the U.S. banking system existed as thousands of small banks scattered across the country. It was difficult for banks to reach an efficient scale or diversify their loan portfolios.

The inherently vulnerable unit banking structure and inelastic currency were susceptible to crises. However, finding a political solution was also difficult because the interests of large city banks clashed with those of small town and rural banks. Additionally, there was a long-standing conflict over states' rights versus the federal government's authority to regulate the banking system. In the 1860s, most of the national currency consisted of banknotes issued by national banks (commercial banks chartered by the federal government). The amount of banknotes a national bank could issue was determined by the amount of U.S. government bonds it held. Especially in cases of unexpected events or news causing bank customers to rush to withdraw cash, panic was inevitable. Although the problems of the U.S. banking system were widely recognized and studied throughout the first half of the 19th century, systemic reform did not occur. Investors were uneasy about America's backward and fragmented financial system. The Panic of 1907 ended relatively quickly due to Morgan's intervention, but the aftermath was severe. Sound banks and businesses collapsed, and many people lost their jobs. Above all, a flexible money supply was needed. A modern banking system that could benefit people of all classes and sectors was necessary.

In November 1910, six commissioners including Aldrich finally gathered at the Jekyll Island Club off the coast of Georgia to discuss ways to reform the nation's banking system. The meeting and its purpose were kept strictly secret. Participants did not acknowledge the meeting's existence until the 1930s. Those who met on Jekyll Island believed the banking system was facing serious problems. The views of the Jekyll Island participants on this issue are well known. Some spoke publicly before and after the gathering, and others published extensively on the topic. They comprehensively summarized their concerns in the plan drafted on Jekyll Island and the Monetary Commission report.

Like many Americans, the participants were concerned about the financial panics that periodically disrupted U.S. economic activity in the 19th century. Nationwide panics occurred on average every 15 years. These panics forced financial institutions to cease operations, triggering long and deep recessions. American banks held large amounts of cash reserves, but these reserves were dispersed across thousands of bank vaults nationwide. In times of crisis, the cash was frozen in bank vaults and could not be used to alleviate the situation. During booms, banks' excess reserves flowed to large cities, especially New York. Intermediaries lent funds to stock market investors, whose stock purchases served as collateral for the transactions. This American system immobilized bank reserves and destabilized the stock market. It was a structure that inevitably caused financial instability. In contrast, European banks lent most of their portfolios short-term to merchants and manufacturers. These types of notes directly financed commerce and industry and could be quickly converted to cash in times of bank crises.

The Jekyll Island meeting participants were concerned about the inelastic money supply in the U.S. The dollar's value was linked to gold, and the amount of available currency was tied to the supply of a series of special federal government bonds. Seasonal changes in cash demand, such as fall harvests or holiday shopping seasons, did not lead to expansions or contractions in the money supply, causing interest rates to fluctuate significantly each month. The inelastic money supply and limited gold supply also caused long-term and painful deflation. As a result of the meticulous analysis and debate by the six participants, the Federal Reserve Act was created in 1913. The plan drafted on the isolated island eventually laid the foundation for the central bank, the Fed.

Since then, the Fed has continued to evolve in form and function. Paradoxically, it has strived to become a “decentralized central bank.” One of the Fed's most important goals is to make the U.S. banking system more stable. Bank panics, which often resulted in widespread bank suspensions and failures, were frequent throughout the first half of the 19th century. Such panics were caused by the nation's “inelastic currency.” Reformers focused on ways to rapidly expand the supply of banknotes to meet public demand for liquidity. The desire for an “elastic” currency was ultimately realized with the creation of the Federal Reserve Banks and a new form of currency, Federal Reserve notes. Federal Reserve notes are the primary form of U.S. currency today and are supplied in amounts necessary to meet demand.

Through the efforts of the six-member commission, the Aldrich-Vreeland Act was enacted. Based on this law, the National Monetary Commission was established. Subsequently, the Federal Reserve Act was created in 1913 to establish the Fed. In December of the same year, Congress passed the bill, and President Wilson signed the Federal Reserve Act. Finally, a political solution for a central bank was achieved. This also became a new but long-standing source of conflict over states' rights and the federal government's authority to regulate the banking system.

When attempts were made to improve the nation's chaotic banking system, the Panic of 1907, which occurred in an already weakened economy, was not effectively addressed. Had financial titan JP Morgan not intervened, the situation would have been much worse. Despite Morgan's efforts, the financial contagion spread nationwide, causing many banks to fail.

To find solutions to the crisis and how to respond, a substantive review of the American financial system was conducted. In 1908, Congress passed a law to establish the National Monetary Commission. The commission's mission was to assess the recent panic and provide a systematic analysis of currency and banking reforms. Senator Aldrich, a Republican from Rhode Island and a leading reformer, explained the panel's mission in a 1909 speech at the New York Economic Club: “To adopt the best system for the American people, free from past political prejudices or the ghost of the great figure Andrew Jackson, who passed away years ago.”

Baek Youngran, Director of History Journal

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