December 23, 2011
Ninety-eight years ago today, President Woodrow Wilson signed the Federal Reserve Act into law, creating the Federal Reserve System.
To understand the motivation for the law, it’s first necessary to understand what the Act does.
Broadly speaking, the Act established the U.S.’s central banking system (the Federal Reserve), and also granted the Fed the authority to issue legal tender – Federal Reserve Notes.
Most people today call those Notes “dollar bills,” and prior to the Act’s passing, legal tender was issued by private banks.
The Federal Reserve can also issue additional notes at times of financial crisis to offset the accompanying reduction in market liquidity.
“Reduction in market liquidity” means, essentially, a market freeze; financial transactions such as buying, selling, lending, or paying debts slow or stop altogether.
Liquidity in the banking market mostly refers to banks having enough cash on hand to continue to operate and, in worst-case scenarios, avoid bank runs.
Bank runs are when all of a bank’s customers attempt to withdraw their deposits at the same time for fear that the bank is or will soon become insolvent (think of the scene in It’s a Wonderful Life as an example).
Anyhow, such a financial crisis – the Panic of 1907 – was the primary motivation for the Federal Reserve Act.
Strangely enough, the Act was a product of anti-Wall Street sentiment among the general public, but it took several years to get there.
The initial response by Congress to the 1907 crisis was the Aldrich-Vreeland Act, which was aimed to make the money supply somewhat more elastic during emergency shortages (currency elasticity is a trait that describes a currency’s ability to expand or contract).
The law also established the National Monetary Commission, which was formed to study what changes needed to take place in the U.S. banking system.
Republican Senator Nelson W. Aldrich of Rhode Island, who was largely responsible for the Aldrich-Vreeland Act, also became the Chairman of the Commission.
Aldrich, though, was widely perceived as being closely aligned with big banks and big business.
His 1911 “Aldrich plan” for addressing the woes of the U.S. banking system probably didn’t help this perception, since it called for a central institution (the National Reserve Association) to be privately controlled by bankers.
These events coincided with the rise of the Progressive Movement, which was extremely distrustful of concentrations of power and wealth.
Naturally, Progressive leaders such as William Jennings Bryan were opposed to Aldrich’s plan.*
Amid this climate, the plan had little public support, and, with Democrats gaining control of Congress in the 1910 elections, little political support.
The next year, hearings were held before the House Banking and Currency Committee on the control on the nation’s banking and financial resources.
The hearings concluded that the majority of America’s finances were concentrated in the hands of a tiny Wall Street group, further incensing the public against Wall Street.
The last ingredient in the creation of the Federal Reserve Act was the 1912 election of Woodrow Wilson, who, running on a Progressive platform, defeated Republican William Howard Taft.
Wilson’s election ultimately led to a central banking system that was controlled by the government, not big banks (admittedly, I’m skimming over quite a few details leading up to the creation of the final Act itself).
The Act received overwhelming support from Congress (voted 298–60 in the House, 43–25 in the Senate), and was signed by President Wilson on December 23, 1913.
Although the Federal Reserve is regarded as controversial by some even today (which I really don’t want to get into two days before Christmas), it is nonetheless a mainstay of the U.S. financial system, and looks to continue to be in the foreseeable future.
*Jennings famously declared that if the Aldrich plan were implemented, the big bankers would, “then be in complete control of everything through the control of our national finances.”