President Reagan famously said that the closest thing to eternal life on this earth is a government agency. Surely that aphorism applies to the Federal RESERVE. And most especially when you put a Trumpian ALL CAPS focus on the “reserve” part of its title.
That is to say, the purpose of the 1913 act had nothing to do with the Fed’s present-day “goals” with respect to inflation, unemployment, economic growth, housing starts, business capex, or any other aspect of the ebb and flow of commerce on Main Street. Instead, the Federal Reserve Act’s far more modest remit was to fix the badly flawed “reserve” arrangements of the National Banking Act that good old Abe Lincoln and his Treasury Secretary Salmon P. Chase had put into place to finance the civil war.
What the latter actually did was to nearly tax out of existence the honest free enterprise state banks that had prevailed during America’s growth explosion prior to the Civil War in favor of a system of federally regulated “national banks”. But the latter were just thinly disguised servants of the US Treasury. In that capacity, they were required to hold US Treasury bonds as collateral to back the issuance of their own bank notes—the latter being the essence of the 19th-century banking business.
As it happened, during the 50 years after the Civil War, fiscal prudence prevailed in Washington—even as the proceeds from Uncle Sam’s “revenue tariffs” soared owing to America’s booming commerce with the world. The result was that nearly 80% of the Civil War Debt was paid down by 1913, and the remaining debt, at less than 3% of GDP, amounted to barely $10 per US citizen.
So at that point Abe Lincoln’s war debt monetization machine was no longer needed, and the Civil War inflation had also been long-extinguished after the US officially went on the gold standard in 1879. Still, the awkward cantilevered reserve-holding structure of the Civil War banking system had lingered on.
The latter required local or so-called “country” banks to retain roughly 15% of their demand deposits as cash reserves, of which 60% could be placed at a dozen or so regional “reserve city” banks. In turn, these regional reserve city banks were required to maintain an even higher reserve ratio (around 25%)—of which 50% could be deposited with a third tier of “central reserve city” banks located in St. Louis, Chicago, and New York City.
Needless to say, during ordinary times, the central reserve city banks, and most especially the New York money center banks, were awash in the cash that would flow in from the “country” banks of the hinterlands and build up through the pyramid of regional reserve city banks. That sea of cash cascading to Wall Street, Chicago, and St. Louis would then frequently be put to work as overnight margin loans to the nation’s original stock market speculators and “hedge funds”.
Of course, the problem was that at certain times of the year, like the fall harvest, or when business conditions changed due to droughts, trouble in export markets, over-investment in new technologies like railroads or mechanized farm equipment, etc., the cash flows in the cantilevered reserve structure would be thrown into reverse. To wit, country banks would draw down deposits at the regional reserve city banks to meet the withdrawal demands of their customers. In turn, the regional reserve city banks would drain deposits from the central reserve city banks, which would be forced to liquidate their margin loans, sending the stock markets into a periodic crash and tizzy of liquidation.
While these periodic “panics” were claimed to cause severe hardships down the line to Main Street and to subtract from national prosperity, present-day scholars like Professor Wicker of Ohio State have shown otherwise namely, that these 19th century panics were very short-lived and did not much interfere with the relentless rise of industrial production, economic wealth and living standards after the Civil War.
Most especially, these “panics” did not establish in any way, shape or form a case for a modern day “central bank” in the business of macro-management of the GDP and unemployment rates; and most certainly did not remotely suggest need for central bank administered 2% inflation target, which would have been pointless under the gold standard, anyway. The latter actually generated a net zero rise in the general price level in the US between 1879 and 1913.
Thus, the Congressional authors of the 1913 act merely sought to remove the reserve structure rigidities of Lincoln’s banking system and most especially its tendency to drain the nation’s banking reserves into the big central city reserve banks. That was, in fact, the first and foremost objective of the act’s intellectual architect and draftsman, Congressman Carter Glass, who was a financially literate small-town newspaper editor from Virginia.
In brief, Congressman Glass’ scheme centered on the creation of 12 equal regional “reserve banks” that would operate “discount windows” empowered to advance cash loans to member banks. Such discount loans were to be based on solid commercial loan collateral and would bear interest at market rates plus a penalty spread.
The implicit point of the scheme was to make the national bank system more liquid and “elastic” by providing “borrowed reserves” to meet customer withdrawal demands in lieu of liquidating cash balances within the tiered national banking system. This discount window-based mechanism was, in essence, a “money printing” scheme, but its purpose was merely to eliminate the cause of banking “panics” on the presumption that the gold standard and free market capitalism would handle growth, investment, inflation, and prosperity without any help from a monetary Sherpa in Washington.
Indeed, the heart of the system was the decentralized reserve banks spread from Boston to Kansas City, Dallas, and San Francisco. The Board of Governors in Washington, in fact, was more an honorific and largely powerless afterthought to give a “Federal” veneer to the scheme. But Carter Glass wanted the core discount loan-making function of the reserve banks to be domiciled as far from the big Wall Street banks as possible.
In short, the Glassian discount window-based money-printing system did not sever the dollar’s link to gold. Nor did it provide any kind of mandate whatsoever for macroeconomic management of the US economy.
And more crucially still, it did not even recognize US Treasury debt as a valid form of collateral to be used by member banks to obtain discount loans or what amounted to “borrowed reserves” at the 12 regionalized Reserve Banks.
Instead, it tethered the Reserve Bank printing presses to the ebb and flow of commerce on Main Street. That is, the reserve banks could print new central bank credit only after goods had been produced and then pledged as collateral for commercial bank credits, which in turn had been rehypothecated for cash advances at the Federal Reserve discount windows.
In short, there was a double barrier against the modern 20th-century form of peacetime “inflation”. To wit, the gold standard remained intact because dollars created by the banking system and the new Federal Reserve could be redeemed for gold without limit—even at the small denomination level of gold coins.
Secondly, under the Glassian monetary regime known as the “real bills doctrine,” supply always preceded demand per Say’s Law. Production of goods in the real economy came first, followed by spendable commercial bank credit and central bank money.
If we fast forward for a moment to March 2020, however, we get a scintillating glimpse of what the Gipper meant by the eternal life of Federal bureaucracies. To wit, in its capacity as the leading bank regulator in the US, the Fed actually abolished any and all “reserve” requirements in the US banking system, and therefore the entirety of its original reason for existence. The replacement regime based on capital and liquidity ratios has no need for central bank credit at all.
But, alas, the Fed did not put itself out of business in March 2020. To the contrary, in less than 26 months, it generated $4.8 trillion of new central bank credit–or more than it had issued during its first 106 years of operation. That’s because the original narrow liquidity purpose of the Federal Reserve banks had long been surpassed by sweeping mission creep that had finally resulted in today’s form of monetary central planning.
And this “mission creep” started almost from the day the Fed went into operation in November 1914. To wit, 30 months after the Fed opened its doors, Woodrow Wilson took America into a pointless war in Europe and needed massive amounts of cash to fund a two-million-man army that was being mobilized, trained, and deployed to France from scratch.
So he committed the greatest possible monetary sin. Namely, he untethered the Fed’s printing press from the ebb and flow of Main Street commerce, allowing US Treasury debt to become eligible collateral for Discount Window loans.
Needless to say, it was off to the races from there. Self-evidently, politicians have an infinite capacity to spend and borrow on the state’s credit when the discipline of rising yields and “crowding out” in the bond pits is short-circuited by central bank absorption of the government’s debt as “collateral” for printing press credits.
As it happened, financing America’s lurch into the Great War provided the playbook for funding the permanent Warfare State and Welfare State that emerged in the century to follow. But at the time it seemed simple and harmless enough: To wit, the US Treasury sold massive amounts of Liberty Bonds to everyday people in a kind of grand Red Cross blood drive, while the folks who bought the bonds were able to borrow most of the payment from their local national banks.
In turn, they could pledge these Liberty Loans as collateral to obtain discount window advances from the Federal Reserve banks to fund their balance sheets; and, conveniently, at interest rates slightly below the yields on the Liberty Bonds, which were the underlying collateral.
Needless to say, this scheme worked for the short duration of the war because the excess demand created by monetizing the war loans was being dissipated in the bloody trenches of northern France. At length, in fact, the household debts to fund the Liberty Bonds were paid off after the war’s end, and the bloated level of Federal Reserve credit which had enabled them was paid down, as well.
But before long, the commercial banks had what amounted to a hissy fit over dividends from the Federal Reserve. The member banks technically owned the Federal Reserve system and had become accustomed to the dividend flow from the surge in discount window loans that had funded the Liberty Bonds.
When the latter had been liquidated after the war, of course, the dividends dried up. So immense pressure developed within the system to rebuild Federal Reserve balance sheets so that system profits and dividend-paying capacity might be restored. And, as post-war prosperity surged by 1923, a solution was found.
To wit, under the guidance of the newly formed FOMC (Federal Open Market Committee), the reserve banks began to buy bonds in the open market based on newly minted Federal Reserve credit, which in turn generated system profits and dividends.
Nevertheless, what started as a money-making side gig was progressively transformed into an instrument of “national policy”. This famously started at the Federal Reserve Bank of New York under the leadership of ex-JP Morgan Banker Benjamin Strong.
During the Benjamin Strong era, the national policy objective was mainly to help France and England recover from the fiscal calamity of the Great War, but the die had now been cast. Rather than operating the printing presses to service a passive discount window by issuing commerce-based advances to member banks, the printing presses were now taken over by an FOMC that was in the national policy business and able to operate with virtually unlimited discretionary power over the entire financial system and US economy.
It was only a short leap from there to Greenspanian monetary central planning, but two interim steps by Oval Office miscreants Franklin Roosevelt and Tricky Dick Nixon opened the door to today’s inflationary disaster.
In 1933, FDR decreed that citizens could not own or trade in gold to protect themselves from inflationary central bankers. And then in August 1971, Tricky Dick supplied the coup de grâce by closing the gold window to foreign central banks as well.
Now America’s money was all fiat, all the time. And, not surprisingly, since August 1971, the consumer’s dollar has also lost 87% of its purchasing power.
Editor’s Note: The story of America’s banking system is not just history—it’s a warning.
What began as a narrow reserve mechanism has morphed into full-scale monetary central planning, leaving the dollar weaker and your financial security at greater risk than ever. The consequences of this shift are now accelerating, and when the dollar’s global dominance falters, the fallout could be swift and severe.
That’s why we’ve prepared a special report, Guide to Surviving and Thriving During an Economic Collapse. It reveals what’s coming, what it means for your savings, and the steps you can take now to protect yourself and your family. You can access it right here.
Read the full article here