America’s Bank: The Epic Struggle to Create the Federal Reserve

Throughout its storied history, the U.S. Federal Reserve has been touted as the single most important institution in the country, setting monetary policy to maximize employment and control inflation and acting as the banks’ lender of last resort. Wall Street closely monitors the Fed’s every move and usually works itself into a frenzy, especially now as the central bank is poised to raise interest rates this month for the first time in nearly a decade.

But many people don’t have the foggiest clue about the ‘epic struggle’ involved with launching the Federal Reserve in the early 1900s. This history is critical to understanding the tensions that have surrounded the Fed since its formation and show how far America’s financial system has come.

[email protected] chatted with Fed expert Roger Lowenstein about the central bank’s colorful background on Wharton Business Radio on Sirius XM Channel 111. Lowenstein is an author and former reporter for The Wall Street Journal who most recently published his book, America’s Bank: The Epic Struggle to Create the Federal Reserve.

[drizzle]An edited transcript of the conversation appears below.

[email protected]: Congratulations on the new book and congratulations on the glowing review in The New York Times. Once you get a solid Times review, you’re really on the high road.

Lowenstein: That was a very nice review. Thanks.

[email protected]: Let’s discuss the historical context from the late 1800s and the early 1900s when there was a real want and need to create a central bank. There had been an attempt to create a central bank even earlier, but the plan was squashed in mid-1800s. Explain the background to us.

Lowenstein: The first decade of the 1900s was a time of visible transition. The economy was industrializing, factories were sprouting up and people were moving from farms to the cities. Immigrants were swelling the population and you suddenly heard all sorts of new languages on the streets. Democracy in the country, which had once been a very elitist affair, was changing.

But we had a very archaic financial system that was still designed for a primarily agrarian, less developed, early 19th century farming country. This was holding the country back. Plus, all other industrialized nations in the world had a central bank, but we did not?Twitter . We had no central place that could lend out money to banks when society was short of credit, or hold excess reserves. This meant we would frequently have money panics where people would run to the banks, take out their money, the system would freeze up and there would be no credit. People in Europe couldn’t believe that this otherwise modern industrial country was, frankly, so primitive. But that was the context.

“We had a very archaic financial system… This was holding the country back.”

[email protected]: The year 1907 was particularly important for this process because there was so much concern about the banking industry at this time.

Lowenstein: That’s right. There had been warnings about the American system, particularly from a fellow named Paul Warburg, who is featured in my book. He was a banker and an immigrant from Germany, and he recognized how deficient America’s system was compared to the European systems. But no one really paid attention to his comments until 1907 when there was a terrible banking panic. In many ways it was suggestive of the financial panic in 2008. But the bank runs in 1907 weren’t bank runs at a computer screen. They were real bank runs where people ran down the sidewalk carrying satchels with which they hoped to retrieve their money. And when the bank ran out of money, you were done. That was it.

The other big difference of course was there was no lender of last resort. No Ben Bernanke. No Federal Reserve to make decisions and say, “the pain’s got to start somewhere. Someone’s got to start lending because none of the private banks are lending.” So at this time, many people became convinced that we had to reform the system.

[email protected]: What was it that Warburg noticed that made him encourage change? Certainly Europe was a little bit different than the U.S, but were the systems so completely different in terms of their entire operations?

Lowenstein: Yes, they really were different.

Although English was Warburg’s second language, he was a very vivid, powerful writer and he used a metaphor to make his point. He compared the U.S. system to a town with a water reservoir, and each town had its own little well. But this system isn’t adequate for drinking needs because some streets could run dry or a fire could be very damaging to a small town. He explained that the system needed a centralized reserve. But he was largely ignored, and completely ignored by the political system, until the panic of 1907.

Then people began to take note and various congressmen along with a powerful senator, Nelson Aldrich, went on an expedition to Europe to see if Warburg was correct. They investigated the central banks of England, France and Germany. They interviewed over 50 bankers. In each city they asked, “what happens when there’s a bank panic?” All the countries said, “we don’t have them. Our banks feel confident. They don’t have to shut down. They have the central bank when they need surplus credit.”

[email protected]: The interesting thing is that this wasn’t the first time that the United States tried to put together a central bank. They had done this earlier in the 19th century, but it didn’t last.

Lowenstein: That’s right. There was a reason why it didn’t last and a reason why America endured so long without a central bank. This really goes back to the birth of the country — we’re a nation that rebelled against the far-off central power of an English king. And the very first political debate we had in this country between Alexander Hamilton and Thomas Jefferson focused on whether we should have a strong central government or not. The specific issue they clashed over was whether to have a central bank or not.

In those days it was called the Bank of the United States. Hamilton convinced President Washington to establish this central bank despite vehement objection from Jefferson. After 20 years it was disbanded because Americans from farming districts and areas far from the East Coast felt that a strong federal banking power was going to be similar to the powers they had rebelled against in England. But things didn’t work very well without a central bank and we had a very bad episode of inflation, so we formed a second bank. That was the one you referred to in the 1830s that was undone by President Andrew Jackson.

“All other industrialized nations in the world had a central bank, but we did not.”

When he came to the U.S., Warburg noted that Americans abhorred power, whether on Wall Street or in Washington. You can still see that today. This is a debate we’ve had since the beginning. We had it in the early 1900s and we still have it today.

[email protected]: Is it surprising that what happened back in the early 1900s seems to have similar overtones to what we saw roughly seven years ago?

Lowenstein: Warburg used to say that he felt

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