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.
Knowledge@Wharton 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.
An edited transcript of the conversation appears below.
Knowledge@Wharton: 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.
Knowledge@Wharton: 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.”
Knowledge@Wharton: 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.
Knowledge@Wharton: 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.”
Knowledge@Wharton: 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.
Knowledge@Wharton: 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 as though he was battling the ghost of Andrew Jackson. These battles don’t go away. I guess it is surprising. It’s also pretty interesting that in 1907, President Theodore Roosevelt wrote a note to his brother-in-law saying that the situation had gotten out of hand. He went on to say that people were acting as if every bank had something rotten in it and, while many banks behaved badly, people went too far to blame them all. I bet bankers today would agree with that sentiment.
It’s interesting that we now have a Federal Reserve that intervened to stop the latest banking panic and got the economy going again. Maybe it’s not the greatest economy ever, but we’re down to 5% unemployment. Regardless, people still hate the Fed and it’s unpopular for doing its job. These old feelings are still fresh and raw with a large segment of the American public.
Knowledge@Wharton: When you go back in time and think about how the central bank was brought forth in the early 1900s, it seems the feelings are just as political then as they are now, correct?
Lowenstein: These were hugely divisive issues. The founders, Warburg, Senator Aldrich and Carter Glass (from the 1933 Glass-Steagall Act) were very aware of how politicized the issue was, particularly the issue of central power. It was such a big issue that when Glass took the first blueprint for what became the Federal Reserve Act to the president-elect, Woodrow Wilson in 1912, it was a plan for 20 reserve banks around the country. The plan didn’t include a Federal Reserve board and there was no Washington angle. It wasn’t going to be central or federal at all; it was going to be a number of banks around the country.
Wilson had been an academic and historian before going into politics. He had studied Alexander Hamilton and knew about the historic central bank debates. He said to Glass, “you’ve got to do something about centralization.” That’s why the act came to have this Federal Reserve System in Washington. The idea was to have reserve banks spread around the country and a reserve board in Washington, very much like the compromise in the Constitution that divides power between the states and the federal government.
“The idea was to have reserve banks spread around the country and a reserve board in Washington, very much like the compromise in the Constitution that divides power between the states and the federal government.”
Knowledge@Wharton: Another individual in your book that was an important character in the early 1900s was J.P. Morgan. This man obviously wielded a lot of power in the American financial sector.
Lowenstein: Yes, when the panic of 1907 occurred, J.P. Morgan was the most powerful banker on Wall Street. By the way, he wasn’t the richest and his bank wasn’t the biggest, but he had a strong reputation. And since there was no federal power to speak of, he called in the other leading bankers and they undertook the job of deciding which of the banks would be rescued with loans and which banks were insolvent and should be let go. Of course, this was the job that Ben Bernanke undertook a century later and he had to answer the question, ‘who’s worthy of a loan and who’s not?’
Morgan was so powerful that, according to a newspaper report, the treasury secretary came up from Washington to New York to meet with the bankers and the report said: “With Mr. Morgan presiding.” Imagine J.P. Morgan’s CEO Jamie Dimon presiding over the treasury secretary! Today, a federal official would be presiding. But there was no federal financial power, so J.P. Morgan took over.
His role was crucial and he helped mitigate the panic, though he didn’t stop it altogether. Though he got letters from people saying things like, “you stand between us and chaos.” But he was already 70 years old and so he told people that this country was too big and too developed to rely on one person to bail out the financial system. He explained how important it was to have a systemic, institutional organization to handle these issues. So, in his way, Morgan’s actions helped further the argument for creating the Federal Reserve.
Knowledge@Wharton: I want to know about conflicts of interest with the Federal Reserve. Who exactly owns the Federal Reserve? Ben Bernanke has said that the Federal Reserve makes money in recessions. So how do we resolve this potential conflict of interest, since the Fed is also supposed to encourage the economy to flourish?
Lowenstein: Let’s separate that into two questions. The Federal Reserve is a network of banks that own assets and it’s a good thing that they make money. Ordinary banks can also make money in recessions if they’re careful. The hope is that the Fed makes loans to solvent entities. Most Fed loans are made to the United States government. But there’s no crime in making money. By the way, a good part of the profits that the Federal Reserve banks earn go back to the taxpayers because they’re sent to the government. I don’t see a conflict there.
The 12 Federal Reserve banks around the country pay dividends to the individual banks that are members. So the commercial banks and other banks in their territories own a share of the profits, which are capped at 6%. Profits above 6% go to the federal government. The idea in having private ownership was about having a compromise. The Federal Reserve was very controversial and the idea of entrusting all this power to the federal government was very controversial. So the founders decided to compromise and say, “we’ll have the hub in Washington, the Federal Reserve System will fully be a government entity, but private banks that are participating and putting up the capital for this system will get a dividend when the system is profitable, up to 6%.” The banks do, after all, have their capital in that institution, so they’re entitled to some return. But they can’t make gobs of money either.
“Right now there’s a terrific tension going on at the Federal Reserve.”
Knowledge@Wharton: Let’s talk about what’s happening right now with the Federal Reserve. People have been waiting for an interest rate move for several years and Wall Street’s ears perk up any time we get close to a meeting between members of the Federal Open Market Committee (FOMC). It’s a bit crazy how the Fed has really taken this front-and-center role with Wall Street over the last several years.
Lowenstein: Yes, Wall Street is terribly on edge about the idea of interest rates going up as much as a quarter of one percentage point. But anyone who has followed the Fed for a few decades knows that the country has lived and prospered when interest rates were at 2%, 4% or sometimes even 7%. I think Wall Street and the rest of the country will discover that they can live with interest rates above this unusually low level near zero, which of course is a residue of the financial crisis. I hope that the Fed chairwoman Janet Yellen and her central bankers get on with it.
Going back to the question about conflicts of interest, a related issue is the independence of the Fed. It’s very important for the Fed to be independent of the executive, the Treasury and the White House. Every administration likes interest rates to be low. In a crisis, the Fed tends to walk in step with the administration. But now that the financial crisis is over, I think it’s time for the Fed to reassert its independence and that may mean lifting interest rates sooner rather than later.
Knowledge@Wharton: Is Janet Yellen the person to do that? In terms of personality, it seems Ben Bernanke would have been the kind of person to lead that push, but I don’t know if Janet Yellen is that person.
Lowenstein: Well, we won’t know until we see her in office for a few more months.
No one expected Bernanke to take on the radical programs that he did. This brings up the age-old question: Does the person create the times or the times create the person? Presumably, some of each. Ben Bernanke responded to his times and did things no one would have expected. Now it’s up to Yellen to respond to these times.
Knowledge@Wharton: Bernanke led us down the path to zero interest rates. When you look at the 1907 banking crisis, do you see parallels and commonalities between the two eras?
Lowenstein: That’s a very good question. When you look at Ben Bernanke’s case, you can see more in common with the Great Depression, which was the Fed’s first testing ground. Of course, it failed at that time.
Bernanke was a scholar for most of his career before he joined the Federal Reserve board as a governor, and then as chairman in 2006. His scholarship focused on how the Federal Reserve failed to respond effectively to the Great Depression. Bernanke promised in a famous dinner honoring Milton Friedman that the Federal Reserve was at fault for the Great Depression, but he said, “we won’t do it again.” He also famously referred to making a “helicopter drop” of cash on Americans to keep the country out of a deflationary cycle, which got him the nickname ‘Helicopter Ben.’
But as Fed chairman he did basically everything short of going up in that helicopter to avoid a repeat of the Great Depression.
Knowledge@Wharton: People that follow the Federal Reserve have widely been expecting that we’ll see a bump in interest rates in December. But it’s expected that further rate rises will be slow and steady. What do you think?
Lowenstein: That seems to be what the Federal Reserve is telegraphing and that happened last time when interest rates were raised in the early- to mid-2000s. But there’s no law that says the Federal Reserve has to be slow and steady. By the way, there’s no law that says the Fed can’t surprise markets if it decides that conditions warrant a surprise.
I think markets are a bit more grown up than the Fed gives them credit for. Fed members shouldn’t worry all the time about market expectations. Let the Fed get policy right and markets will adjust. We’ve endured surprises before. We’ll live through them again.
Knowledge@Wharton: Looking back in time, the banking industry wasn’t in great favor with many people in the United States. It certainly hasn’t been popular lately. This divide between the haves and have-nots has persisted over decades.
Lowenstein: Yes, there’s a natural conflict. People have a tendency to prefer when banks hold a lot of capital so they’re safer from financial shocks. Nonetheless, we want banks to lend. Right now there’s a terrific tension going on at the Federal Reserve about what should happen. Banks have been forced to hold more capital since the financial crisis, but should they be forced to hold even more capital? That really means they’re going to issue fewer loans.
This was also a large problem in 1907 because there was no Federal Reserve. There were rules requiring banks to basically lock up a ton of capital in their vaults, which was therefore not going out into society and generating loans. There’s a tension there, which means you don’t want to go too far in either direction.