1. The Origins of the Federal Reserve: The Dissatisfaction of New York Bankers

The Federal Reserve did not replace a system of free banking. On the contrary, an approach to free banking existed in the United States only in the two decades before the Civil War. Under the cover of the wartime emergency, the Republican Party put through changes that had long been proposed by the Republicans’ ancestor, the Whig Party. The National Bank Acts of 1863–65 replaced the hard-money free banking of pre-Civil War days with the quasi-centralized regime of the national banking system. By levying a prohibitive federal tax, the national banking system in effect outlawed state bank notes, centralizing the issue of bank notes into the hands of federally chartered national banks. By means of an elaborate set of categories and a structure of fractional reserve requirements, entry into national banking in the big cities was limited to large banks, and bank deposits were encouraged to pyramid on top of a handful of large Wall Street banks. Furthermore, an expansion of any one bank in the pre-Civil War era was severely limited, since the free market would discount the notes of shaky banks, roughly proportionate to the distance of the circulating notes from the home base of the bank.[2] The national banking acts removed that restraint by forcing every national bank to accept the notes and demand deposits of every other national bank at par. Genuine redeemability of notes and deposits was also restrained by the continued legal prohibition of interstate or even intrastate branch banking, which severely hobbled the efficiency of clearing systems where one bank presents the obligations of another for redemption. Redemption was also curtailed by a rigid statutory maximum limit of $3 million per month by which national bank notes could be contracted. Furthermore, although private national bank liabilities were of course not legal tender, the federal government conferred quasi-legal tender status upon them by agreeing to receive all national bank notes and deposits at par in dues or taxes.

The banking system of the United States after 1865 was, therefore, a halfway house between free and central banking. Banking was subsidized, privileged, and quasi-centralized under the aegis of a handful of large Wall Street banks. Even at that, however, the large national banks and their financial colleagues were far from satisfied. There was no governmental central bank to act as the lender of last resort. The banks could inflate more readily and uniformly than before the Civil War, but when they got into trouble and bank-generated booms turned into recessions, they were forced to contract and deflate to save themselves. As we will see further below, the bankers’ drive for fundamental change was generally couched in terms of an attack on the “inelasticity” of the national banking system. Translated into plain English, “inelasticity” meant the inability of the banking system to inflate money and credit, especially during recessions.[3]

The big banks’ turn to the idea of a central bank came after the beginning of the 20th century. The increased dissatisfaction with the status quo was prompted particularly by the rising competition of state banks and private banks outside the direct purview of the national banks of Wall Street. State banks had recovered from their initial shock and, after the 1860s, grew rapidly by pyramiding loans and deposits on top of national bank notes. These state and other non-national banks provided increasingly stiff competition with Wall Street for the banking resources of the nation. State banks were free of the high legal capital requirements for entry into the national banking business, and banking laws, especially in such important states as Michigan, California, and New York, became more lenient during the 1890s. As a result, the proportion of non-national bank deposits to national bank notes and deposits, which had been 67% in 1873, rose to 101% in 1886 and to 145% in 1901. To make things worse for cartelization, New York City lost its monopoly of designated “central reserve city” status—the base of the nation’s banking pyramid—to St. Louis and Chicago in 1887. As a result, the total bank deposits of St. Louis and Chicago, which had been only 16% of the combined total of the three major cities in 1880, rose sharply to 33% by 1912. Banking in the smaller reserve cities rose even more rapidly in this period: the bank clearings outside of New York, 24% of the national total in 1882, rose to 43% by 1913.[4] The major New York banks were understandably perturbed at the rising competition of non-New York and non-national banks. They were upset, too, by the fact that they had to compete with each other for the deposits of the burgeoning state banks. As one New York banker put it: “We love the country bankers, but they are the masters of the situation. We dance at their music and pay the piper.”[5]

The New York national bankers were also particularly perturbed at the mushrooming growth of private trust companies in New York, which were gathering the major share of the new and profitable trust business, when national and most state-chartered banks were prohibited by law from handling trust accounts. At the behest of the national banks, the New York Clearing House, a private organization for the clearing of notes and deposits, tried to impose reserve requirements on trust companies to hobble their competition with banks. In reply, 17 of them walked out of the Clearing House for a decade. Finally, the House of Morgan formed the banker-owned Bankers’ Trust Company in 1903 to compete with the private trust companies.[6]

J.P. Morgan & Co. was the most powerful financial grouping in Wall Street and hence in the country. An investment bank that came to own or control the bulk of the nation’s important railroads, the House of Morgan controlled such leading Wall Street national banks as Guaranty Trust Company, the First National Bank of New York, and, before the 1930s, the Chase National Bank. Despite (or perhaps because of) its mammoth size and influence, Morgan was doing poorly in the gales of competition after 1900. In addition to the factors mentioned above that weakened New York banks, railroads, in which the Morgans had concentrated their forces, began to enter their long secular decline after the turn of the century. Furthermore, virtually all the mergers in the 1898–1902 period that tried to achieve monopoly control and monopoly profits in various industries collapsed with the entry of new firms and suffered major losses. Some of the most egregious failures—including International Harvester, United States Steel, and International Mercantile Marine—were Morgan creations.

J.P. Morgan had long favored corporatism and government cartelization where competition proved inconvenient. After decades of abject failure of Morgan-created railroad cartels, Morgan took the lead in establishing the Interstate Commerce Commission in 1887 to cartelize the railroad industry. Now, after slipping badly in the free market after 1900, Morgan joined other big business interests, such as the Rockefellers and the Belmonts, in calling for the compulsory cartelization of the American economy. This alliance of powerful big business interests, professionals who sought power and place constituted what is now known as the Progressive Era (approximately 1900 to 1918). The Federal Reserve Act was a “progressive” Wilsonian reform that, as Edward Hurley and others pointed out, “did for” the bankers what the other reforms had done for other segments of industry.[7]