Was the Fed Created by a Conspiracy? by Steven Horwitz, Foundation For Economic Education
No, Just Typical Progressive-Era Politics
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.
There Was No Free Market before the Fed
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:
- Limits on the ability of banks to operate branches;
- Minimum reserve requirements;
- 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.
Intervention Creates Crisis, Crisis Drives Intervention
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.
Bootleggers and Baptists and Banks
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,