The Federal Reserve System (the Fed) was created in 1913, and apparently America has been going downhill ever since. I was born in 1976, and I let almost 30 years go by before I ever even found out about the Fed’s diabolic plan to destroy the dollar’s value and inflate the US into economic oblivion, using illegal, unethical, secret, and systematic manipulation of our currency. I started getting interested in the Fed, an entity I only vaguely knew about, around 2005, after seeing a documentary called Monopoly Men, and reading about the Fed on the internet, and for a while, the more I learned, the most disturbed I became. After reading The Creature from Jekyll Island, a conspiracy oriented study of the Fed, by G. Edward Griffin, and discovering Congressman Ron Paul, I was telling everyone I knew that America desperately needed to “End the Fed”. I have since come to recognize that the primary reason for my belief that the Fed was evil and needed to go, was due to my acceptance of certain revised accounts of history. Incorrect accounts of history.
The Myth of the Federal Reserve is an amazing attempt at historical revision, and rather than being just one conspiracy theory, weaves many of them together in a conspiracy tapestry. The myth is all over the internet and independent documentaries, and the accounts of the conspiracy differ a bit in their scope, so I can’t possibly address all of the issues in my limited time and space. However, it is my hope that by exposing a couple of the conspiracy oriented conceptions of the Fed as myths, I will have ripped enough of the fabric that weaves the Fed conspiracy tapestry together, that I will have demonstrated its lack of credibility. I will focus on the reason Americans created the Federal Reserve, and some of the mechanics of how the Fed is governed, and how it implements policy. My coverage below will illuminate two conspiratorial myths surrounding the creation of the Fed, that the Panic of 1907 was engineered by wealthy bankers, and that the Fed is a for-profit banking cartel that controls the US money supply in order to enrich itself. Neither of these suppositions is grounded in fact.
The Panic of 1907
Myth: The Panic of 1907 was orchestrated by wealthy financier J.P. Morgan in order to bring about the creation of the Fed, so that future generations of private bankers could control the money supply of the US for their personal profit.
I have read the entire book, The Panic of 1907: Lessons Learned from the Market’s Perfect Storm, and there was nothing remotely resembling this conspiracy within its pages of thorough coverage. John Pierpont Morgan was a prominent figure on Wall Street, and was an instrumental player in resolving the panic. However, he certainly did not create the panic. The authors of the book on this, Robert F. Bruner and Sean D. Carr, provide a detailed historical analysis of the panic and its causes, illustrating quite vividly how it was a true financial storm. Events were set in motion in April 1906, not by a shadowy tycoon, but by the catastrophic earthquake in San Francisco. Because the city was the West Coast’s financial center and regional location for the US mint, and its insurance underwriting was based in New York and Europe, the massive destruction caused an immediate stock sell off at the New York and London exchanges. The earthquake eventually accounted for a 12.5% loss of value at the NYSE, as gold and currency flowed from the large global financial centers to San Francisco for claims and rebuilding.
After a more stable summer, the seasonal loans needed in the agricultural areas of the US for fall crop harvests put too much strain on liquidity, and stock markets dropped 7.7% between September 1906 and February 1907, and in the month of March alone the indexes fell another 9.8%. This prompted the Secretary of the Treasury, George B. Cortelyou, to deposit $15 million in government holdings at Wall Street banks in order to provide liquidity and confidence, and this seemed to work for a little while and markets stabilized. The summer would bring another huge shock to the US financial system when the Bank of England, in an attempt to control their sovereign British gold reserves, quit taking US financial bills in exchange for the precious metal, causing US gold reserves to plummet 10% between May and August 1907, with stocks declining 8.1% between June and September, for a 24.4% total decline on the year. Liquidity was so scarce that the City of New York was not able to auction off enough bonds to meet its needs in August.
The last straw, the one that spurred the tumultuous financial events, came on Tuesday, October 15th 1907, when Otto Heinz, of Otto Heinz & Company, after thinking he had cornered the market on United Copper stock, attempted a short squeeze. This bold move proved a disaster, because Otto had misestimated the amount of United Copper shares in circulation, and when he went to call in the stock, he thought that the short sellers would have to pay him for not being able to produce their shares, and he was surprised to find that those short sellers still had plenty of shares they could redeem. Otto could not come up with the cash needed for these redemptions of the stock he had called for, so he suspended purchases, causing his attempted short squeeze to turn into a collapse of the stock price, which fell from $60 a share to $15 a share in two days. Otto Heinz & Company, as well as the brokerage house he had used to make his trades, Gross & Kleeberg, the State Savings Bank of Butte, Montana, a holder of United Copper stock, all folded by October 17th. The Panic of 1907 officially launched with a classic bank run on October 22nd at the Knickerbocker Trust Company, in which fearful depositors withdrew $8 million dollars within 2 ½ hours. After this the panic spread like a wildfire through the trust companies, fueled by rumor and worry, which escalated into self fulfillment.
There was no Federal Reserve System to act as lender of last resort in the Panic of 1907, and the next best thing, the New York Clearing House (NYCH), which had the liquidity producing and panic stopping tools of loan certificates and reserve pooling, was virtually useless in 1907. Part of the problem was that the banking runs started in the trusts, which were new financial innovations that had started out somewhat like insurance for the wealthy, but by 1907 were essentially investment banking operations. The trusts, being outside the regular banking system, were not officially protected by the NYCH, and the clearing house members were reluctant to risk their reserves with banking entities they did not trust (no pun intended), and they refused to support the Knickerbocker in the beginning. This was a huge gap in leadership, and a left the financial crisis without a true lender of last resort, and thus could not calm the markets.
President Theodore Roosevelt provided erratic and poor leadership during the panic as well, even if you disregard his previous antagonism to Wall Street and trust busting endeavors. The President was hunting in Louisiana at the outbreak of the crisis, and his first statement about the problem on October 22nd, was a fierce leveling of blame at stock speculators, not a good idea if you want to stop a financial panic while it’s underway. After that he listened to Secretary Cortelyou, took a back seat to the mechanics of dealing with the panic, and publicly expressed confidence and support for the bankers and J.P. Morgan.
The one person to demonstrate actual leadership in the Panic of 1907, was J.P. Morgan himself, and his wherewithal likely came from a unique combination of wealth, wisdom, immense local prestige and power on Wall Street, panic all around him, pressure for him to help, an understanding of what to do, an understanding of the stakes, a no nonsense approach to wielding all of his influence when it mattered the most, and a large deal of going concern. J.P. Morgan organized long late night meetings with the bankers, and the heads of the trusts, in order to bailout too-big-to-fail institutions like the Trust Company of America, the New York Stock Exchange, and the City of New York, amongst others. Morgan fronted tens of millions of his own money, and money he controlled through his banking operations, recruited other bankers to pool liquidity, brokered loans with hard terms for struggling institutions, and at one point forced negotiations by locking other wealthy bankers in a room until they reached a deal (too bad Obama couldn’t do that to Congress over the debt ceiling). J.P. Morgan personally filled the role of lender of last resort, a function that is absolutely necessary in modern financial systems, in order to prevent the spread of financial fire, because the longer a financial crisis lasts, the deeper the damage to the economic infrastructure, and the longer the recession that inevitably follows. While J.P. Morgan came out on top in the Panic of 1907, he certainly did not create it, or appear to any of those involved to be enjoying the situation, and as an old man of about 70 at the time he often fell asleep in his chair from exhaustion during the ordeal.
The Federal Reserve Act of 1913
Myth: The Federal Reserve System is a for-profit private banking cartel, is as unrelated to a government agency as Federal Express, and is being used by private bankers to devalue the American currency for their own gain.
The Panic of 1907 contributed significantly to a change in perspective for the American electorate and their representatives, who were historically opposed to central banking. The Federal Reserve Act was passed on December 22nd, 1913, had relatively popular support in Congress, with the House voting 298 in favor, 60 opposed, and 70 abstentions, and the Senate voting 43 in favor, 25 opposed, and 27 abstentions. Federal Reserve Conspiracy Theorists often suggest that the attempt at passage so close to Christmas was orchestrated in order to pass the bill with minority support, which might have merit in the case of the Senate, except those truly opposed would have actually stayed in D.C. to cast their vote if it were as dramatic and controversial as the conspiracy implies. The infamous Jekyll Island meeting, which was a secret affair between the most powerful bankers and important members of Congress, most certainly represents a secret conspiracy to craft a central bank. However, the actual Federal Reserve Act was crafted in the light of day and debated on the Congressional Record, and its actual creation was a compromise between public and private interests, with a clear and uncontroversial purpose of regulating the private banking system, and giving the public official authority as lender of last resort.
The governance structure of the Fed is a mixture of public and private power, and like much of American political innovation, it has a unique composition compared to the central banks of other nations. To understand why, consider that prior to 1913 Americans had been strongly opposed to the idea of a central bank, having been without one since 1836, after President Andrew Jackson vetoed renewal of the charter of the Second Bank of the United States in 1832. Americans were, and are, suspicious of centralized governing power, and did not, and do not, trust the moneyed interests, symbolized by bankers. With the causes and implications of the Panic of 1907 fresh in the public’s mind in 1913, the impetus for establishing a central banking authority, which would act as a regulator and lender of last resort, had been gaining strong support. The debate was focused on whether the central bank should be a private conglomerate or a public institution, with the advocates of a private authority concerned there would be more government intervention in markets, and the advocates of a public authority concerned about the potential for the moneyed interests to use a central bank to enrich themselves at the public’s expense.
As with the US Constitution, a grand compromise was struck, resulting in the public and private structure of the Fed, established by the Federal Reserve Act of 1913. In order to decentralize power regionally, in the Federal sense, the Fed is organized into 12 regional banks, currently with 25 branches, with the country partitioned geographically, so that local interests will share power in the same sense that the US Congress is composed of regional interest that share power. There are around 2,800 member commercial banks, and these banks must deposit a certain proportion of their bank reserves, called the required reserve ratio, with a Federal Reserve branch bank. Each of the 12 regional banks is managed by 9 directors, with 6 of the 9 directors in each region selected by the 2,800 member banks, and the other 3 directors in each region being appointments by the Board of Governors. The Board of Governors is comprised of seven individuals who control and coordinate Fed activities. A new Fed Governor is appointed every other year by the US President, and must be confirmed by the US Senate, to serve out a 14-year term, without the possibility of reappointment. This gives the Fed Governors a degree of political autonomy, which is needed in order to prevent monetary policy from being driven by populist sentiment. The Chairman of the Board of Governors, currently Ben Bernanke, is only appointed to 4-year terms, but the term for this position can be renewed, unlike the other Fed Governors.
Important policy decisions are made by different parts of the governance structure, such that power over policy is diffused between public and private hands. The Board of Governors has sole discretion over the required reserve ratio and the discount rate, giving complete authority over these important policy tools to the publicly appointed civil servants. The other important policy body within the Fed, the Federal Open Market Committee (FOMC), is responsible for making policy by performing Open Market Operations (OMOs). There are 12 members on the FOMC, the 7 Federal Reserve Governors, the New York regional President, plus 4 other seats filled by the other regional Presidents by rotation. The reason the New York region President is a permanent member of the FOMC is because OMOs are physically carried out at the Federal Reserve Bank branch in New York. This structure weights the authority over America’s central bank to the publicly appointed Board of Governors. So although the private sector banks are members of the Federal Reserve System, the policy decisions are primarily controlled by public officials, who have no private financial interests in the institution.
The Fed is mandated with the implementation of monetary policy, and has six long term goals: high employment, price stability, economic growth, interest rate stability, financial market stability, and foreign exchange market stability. Some of these goals are positively related like economic growth and employment, because as the former increases, so will the latter. However, an overheated economy can also lead to inflation with price and interest rate instability, which brings the Fed’s policy goals into inherent conflict at times. The aforementioned goals are not actually under direct control by the Fed, so it must use its policy tools with the intention of affecting operating targets, such as the various bank reserve aggregates or the federal funds rate, which it has relatively good control over. By hitting specific operating targets the Fed hopes to, in turn, influence intermediate targets, like the monetary aggregates, or short and long term interest rates. The movement of intermediate targets then pushes macro-goals, like the Fed’s current aspirations to reverse the negative trends in employment and growth. It is like calling a difficult bank shot in pool, where one must shoot the Q-ball (OMO purchases) at the right spot on the 8-ball (reduction of the federal funds rate), in order to knock it against the table’s bank at the perfect angle (reduction of short and long term interest rates), so that when it careens away it drops into the intended pocket (economic and employment growth). Except monetary policy is much trickier than billiards.
The Fed can increase aggregate demand by increasing the money supply and lowering interest rates, or suppress aggregate demand with the opposite action. The Fed employs three policy tools in order to affect interest rates and the money supply. They set reserve ratio requirements, which are the percentages of demand deposits that banks must hold on reserve, controlling the amount of money banks can lend. The Fed rarely changes reserve ratio requirements, and these can vary depending on the type of bank deposit. The Fed also have the ability to act as a lender of last resort directly to banks, controlling the amount of interest they charge, called the discount rate, and this is a way that they can influence the money supply directly. The most common policy instruments used by the Fed are OMOs performed by the FOMC. By buying and selling government securities, they can once again affect bank reserves and therefore the money supply.
To understand the extent to which monetary policy tools can be used to expand or contract the amount of dollars in circulation, it is helpful to understand the role that fractional reserve banking plays in the creation of money. The Fed classifies assets within different money aggregates based on their relative liquidity, or the swiftness at which they can be transformed into cash. The most liquid forms of money, like cash and demand deposits, fall within the M1 aggregate. Other money supply aggregates, like M2 and L, hold progressively less liquid assets. Fractional reserve banking allows banks to grow M1 by letting them make loans for any deposits that they hold above and beyond the required reserve amount set by the Fed. Those loans will generate additional deposits, of which a portion can again be loaned out, thus continuing the cycle of money supply growth.
For example, say a $100 deposit is made to a bank, and the reserve ratio is set by the Fed at 10%. The bank can loan out $90 of the original deposit, which will likely be deposited at a second bank, who can then loan everything but 10% of the second deposit, or $81. This process will theoretically continue indefinitely, so the simple money multiplier can be used as a short cut to calculate the total theoretical increase in M1 spurred by the original $100 deposit. The formula to calculate the ultimate change in demand deposits is the quotient of 1 divided by the required reserve ratio, all multiplied by the initial deposit amount. Theoretically, a $100 deposit could grow the money supply by $1,000, with a required reserve ratio of 10%, but this is a simple estimate that does not take into account other factors that can constrain this growth. Monetary policy has known limitations, like lagging results, uncertainty in the exact effect of the money multiplier, and persistent risk aversion at banks that tempers their lending even with historically low interest rates. Regardless, any action taken by the Federal Reserve to increase demand deposits increases M1, and through the money multiplier process of fractional reserve banking this increase in the money supply can continue to grow by some factors independent of the Fed’s initial action.
The federal funds rate, or overnight rate, is the interest rate on loans that banks charge other banks, and all three of the Fed’s policy tools can be utilized for the purpose of changing this benchmark rate. For example, the FOMC can lower interest rates by purchasing government securities. To do this, the committee issues a buy order to the Federal Reserve Bank of New York, who in turn notifies bond dealers of the order through the Open Market Desk. After settling on a price, dealers sell bonds to the Fed, who pays the dealer by electronically crediting the dealer’s bank’s Federal Reserve account. As explained previously, the increase in demand deposits adds to the excess reserves that banks can loan out. In this example, there is an inverse effect on short term interest rates, like the federal funds rate, pushing them down when more liquidity enters the system.
Since the Fed is currently targeting low interest rates, in fact with interest rates at the 0% bound, they are targeting quantitative amounts of liquidity injections over time, in a policy called Quantitative Easing, which is expansionary as opposed to contractionary. The intention is to grow GDP by increasing the money supply and holding down interest rates. When the Fed, through its policy tools, adds liquidity to the banking system, the banks will hopefully respond by loaning their excess reserves, and to attract and compete for borrowers they will lower interest rates. As deposit creation multiplies M1, money makes its way into the hands of businesses and consumers, who increase their spending and demand for products and services. This leads to an increase in hiring, and therefore a reduction in unemployment as businesses expand production to meet demand and boost their profits. Rising profits bring more investment into the stock market, and fixed rate debt instruments like bonds become less attractive when interest rates are down. The increase in aggregate demand, and subsequent growth of GDP, is followed by upward pressure on prices as supply inventories are diminished.
If this inflation rises too high, or the economy appears to be overheating, this can instigate the Fed into changing to a contractionary policy stance, which means forcing an economic slowdown, by selling Treasury bonds rather than buying them, thus removing liquidity from the financial system. This is what former Fed Chairman Paul Volcker did in the late 1970s and early 1980s, when inflation reached double digits. The autonomy of the Fed is justified in large part for this reason, so that it can make unpopular policy decisions like raising interest rates and contracting the money supply, at exactly the moment when the markets, business, and the people want no such thing due to the psychology of investment booms. I think that the need for decision making independent of politics, and the need to initiate counterintuitive policy measures, contributes to the conspiracy tinted charge that the Fed is unanswerable to the people, and must therefor be working solely for the interests of bankers. However, this frequent accusation disregards the real need for this independent decision making, free from political considerations which are often self-serving. Just like the Supreme Court has to make unpopular rulings while honoring the letter of the law, the Federal Reserve Board of Governors must make unpopular rulings while balancing economic trade-offs.
A common strategy for the Fed’s monetary policies is to lean against the wind. Former Fed Chairman William McChesney Martin, a man who served under five Presidents from 1951 until 1970, said his job was to “take the punch bowl away as soon as the party gets started”. The Fed’s worst historical failures have come when they did not follow this edict. In the late 1920s, Chairman Roy A. Young’s easy money policies, lax regulation, and weak leadership contributed greatly to the Great Crash of 1929, just as a similar philosophy championed by Chairman Chairman Alan Greenspan contributed to the recent housing bubble and Panic of 2008. During the Great Depression, Fed Chairman Eugene Meyer made the opposite mistake as his predecessor, and did not work to expand the money supply, which proved unhelpful in the least during a time of scarce liquidity. In 1933 President Franklin D. Roosevelt replaced Meyer with the Chairman Eugene Robert Black, head of the Federal Reserve Bank of Atlanta, due to his recommendation that open market purchases be used to increase bank reserves. I rank our current Fed Chairman Ben Bernanke along with Black, Martin, and Volcker, as one of good Fed Chairman, who follows the correct policy at the right time.
Some economists believe that expansion of the money supply generates many problems, such as inflation expectations, which become self fulfilling as higher wages and prices are demanded. Supply does not keep up with demand and the effects of growth versus inflation are a net negative for the economy. Economists, such as Milton Friedman, have advocated a fixed rate of increase in M1, rather than discretionary policies that expand and contract the money supply based on macroeconomic factors. Other schools of economic thought, such as the Austrian school, believe that central banking is itself the source of the business cycle, and should be replaced with the gold standard, or a free market determined currency system. I did not focus on these theories and policy choices here, since my purpose is to argue against certain scenes in the Federal Reserve Conspiracy Tapestry and its revisionist history, but it is helpful to know that there are legitimate economic arguments against the Fed, at least in its current form. To Ron Paul’s credit, he is against the Fed because he follows the Austrian school, and he argues more from theory and historical example, rather than charges of a grand conspiracy. But I am also opposed to the “End the Fed” agenda on real economic theory, not just conspiracy theory, and the correct historical account of the Panic of 1907 is only a small part of this justification, in that it demonstrates the value of a lender of last resort.
I hope I have shown, at the very least, that the Federal Reserve System was not created under a veil of conspiracy for specifically nefarious or greedy purposes. By explaining the historical events that provided the impetus and forged the will to create a central bank, along with the unique structure and function of the Federal Reserve as an American style central bank, I hope that any worries one might have had, that the Fed is a shadowy cartel controlling the money supply, can now be recognized as overly simplistic and paranoid. What I have not done is exhaustively shot down all of the myths surrounding the Fed. What I have also not done with this article is demonstrate the value of central banking in a deeper theoretical sense, which would be needed in order to completely dismiss the Austrian school arguments against central banking. This would be a much bigger endeavor, and it will have to wait until I can give it the time it deserves. In the meantime, in past articles I have covered other theoretical topics relating to monetary policy, such as inflation, deflation, and the fallacies surrounding the recent Fed policy of Quantitative Easing.
Jared Roy Endicott
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Bruner, Robert F., and Sean D. Carr. The Panic of 1907: Lessons Learned from the Market’s Perfect Storm. Hoboken: John Wiley & Sons, Inc., 2007. Print.
Mishkin, Frederic S..The Economics of Money, Banking, and Financial Markets. Eighth Edition. Boston: Pearson Addison Wesley, 2007. Print.