Monday, December 23, 2013

100 Years Ago Today: The Birth of the Federal Reserve

Although President Wilson signed the Federal Reserve Act on December 23, 1913 the more interesting story goes back to November 1910.
The five bankers who joined Senator Aldrich and Treasury Assistant Secretary Andrew were Frank Vanderlip (National City Bank of New York), Henry P. Davison (J.P. Morgan), Charles D. Norton (First National Bank of New York), Paul Warburg (Kuhn, Loeb & Co.) and Benjamin Strong (Bankers Trust).
From Forbes:

Forbes founder B. C. Forbes reported in 1916:
Picture a party of the nation’s greatest bankers stealing out of New York on a private railroad car under cover of darkness, stealthily riding hundreds of miles South, embarking on a mysterious launch, sneaking onto an island deserted by all but a few servants, living there a full week under such rigid secrecy that the names of not one of them was once mentioned, lest the servants learn the identity and disclose to the world this strangest, most secret expedition in the history of American finance. I am not romancing; I am giving to the world, for the first time, the real story of how the famous Aldrich currency report, the foundation of our new currency system, was written… The utmost secrecy was enjoined upon all. The public must not glean a hint of what was to be done. Senator Aldrich notified each one to go quietly into a private car of which the railroad had received orders to draw up on an unfrequented platform. Off the party set. New York’s ubiquitous reporters had been foiled… Nelson (Aldrich) had confided to Henry, Frank, Paul and Piatt that he was to keep them locked up at Jekyll Island, out of the rest of the world, until they had evolved and compiled a scientific currency system for the United States, the real birth of the present Federal Reserve System, the plan done on Jekyll Island in the conference with Paul, Frank and Henry… Warburg is the link that binds the Aldrich system and the present system together. He more than any one man has made the system possible as a working reality....

And from National Public Radio's Planet Money:

A Locked Door, A Secret Meeting And The Birth Of The Fed

J.P. Morgan: Not a pussycat.
J.P. Morgan: Not a pussycat.

In 1907, the U.S. economy was in the grip of a financial crisis. Unemployment was up. The stock market was down.

People started panicking. They were lining up overnight to pull their money out of healthy banks This can be deadly for an economy: Healthy banks have to shut down, businesses can't get credit, they lay people off, and the economy gets worse.

At the time, the U.S. government had no way to deal with the panic. There was no institution that could step in to stop the run on healthy banks. So the job of stopping the panic fell to one man: J.P. Morgan (of J.P. Morgan fame).

He summoned dozens of the leading financiers in New York to his private library on Madison Ave, and essentially ordered them to contribute to a $25 million pool that would be used to backstop the system. Then he locked them in and made them stay there through the night, until they all agreed to his plan.
The plan worked — it essentially ended the Panic of 1907.

But some powerful people in Washington wondered: what about the next panic? Do we really want the fate of the U.S. economy to hinge on one rich guy in New York?

One person in particular decided this was a problem: Senator Nelson Aldrich, chairman of the Senate finance committee. Aldrich knew there was something America could do so that it would no longer have to rely on one guy to end panics. The U.S. could create a central bank.

This was not a new invention. Countries in Europe already had central banks. And, during panics, the central banks basically did what J.P. Morgan did in the U.S.: Act as lenders of last resort for healthy banks. When depositors were lined up out the door yelling for their money, banks that were basically sound could borrow from the central bank.

But just consider that name: central bank. Throughout American history, both of those words — "central" and "bank" — had been deeply unpopular. The thought of a bunch of rich bankers in New York controlling a powerful central bank did not inspire confidence.

Still, Aldrich realized he needed bankers' help to draw up a plan for a central bank. So he came up with a plan to gather in secret.

He told a handful of New York bankers to come on a given night, one by one, to a train station in New Jersey. There they would find a private rail car hitched to the back of a southbound train. To conceal their identities, Aldrich told the bankers to come dressed as duck hunters and to address each other only by first name...MORE including audio (5 min 38 sec)
Benjamin Strong went on to become the first President of the Federal Reserve Bank of New York from October 5, 1914 – October 16, 1928. As head of the most powerful of the regional Fed banks (and in some ways more powerful than the Fed Chairman) Strong was intimately involved in the great bull market of the '20's and the timing of his death, 11 months before the market's top-tick, has led to a lot of alternative and counterfactual histories of what was to come.