Recently I read Money: The True Story of a Made-Up Thing by Jacob Goldstein and I am currently making my way through America’s Bank by Roger Lowenstein. Both touch on one of my favorite topics, the history of central banking in the United States. The origin story of the Federal Reserve is much different than that of other central banks, for quirky and interesting historical reasons. In this issue I’ll explore the reason and story behind the creation of the Federal Reserve, and what we can learn from that history when thinking about the future of the Federal Reserve and the financial services industry.
I. Pre-Federal Reserve Banking
Until the Federal Reserve was created in the early 20th century, the United States had a deeply fragmented banking system with individual state banks issuing their own currencies. It was a completely decentralized monetary policy regime, with little sense of a national macroeconomic management framework. As Goldstein recounts in his entertaining book, America had twice experimented with national banks early in its history, and from an economic policy perspective, both had been quite successful. However, a polity (i.e. Andrew Jackson and his followers) that distrusted centralized power and bankers did not continue the Second National Bank after its charter expired, and we were left with a messy system of state and local banks all trying to independently manage their economies.
Not coincidentally, the pre-Federal Reserve United States was especially prone to disastrous financial crises. A stretch of regularly occurring financial crises concluded with the panic of 1907, where a shadow banking system of trusts led to a run on banks that concluded with unemployment doubling and bankruptcies rising by half. The crisis was only solved when, quoting Goldstein, “J.P. Morgan, the most influential banker in the country, locked a bunch of other bankers in his private library and told them he wouldn’t open the door until they agreed on plan to bail them out…this is what passed for central banking in America in 1907.”
II. Creation of the Modern Federal Reserve
The crisis of 1907 eventually led to the Federal Reserve Act in 1913, which established regional banks across the country governed by a Board of Governors appointed by the President. The system was still very imperfect: it was constrained by the gold standard and a result of a political compromise that created a “committee of committees.” At the very least, it created a lender of last resort that provided a national currency and could help “smooth out” the money crunches that had led to many previous 19th century financial crises.
The Federal Reserve as we know it came about in the 1930’s as the country recovered from the Great Depression. In 1933, FDR took the country off the gold standard, which gave monetary authorities the flexibility to expand and contract the money supply per the needs of the economy, as opposed to based on a fixed supply of a precious metal. And in 1935, Congress passed and FDR signed the Banking Act of 1935, which centralized power in an independent FOMC (Federal Open Market Committee). The creation of an independent structure for the Fed and a floating currency laid the groundwork for the rapid American postwar economic expansion.
III. Future of the Federal Reserve
Despite significant improvements in American economic management over the last 150 years, there’s a lot more the Fed can do to create prosperity for everyone, and I’ll detail a few interesting ideas here:
Perhaps the most interesting idea here, and one with a clear fintech angle, is the idea of Fed-backed Public Banking and an associated Central Bank Digital Currency (CBDC). An article by Saule Omarova, a professor at Cornell Law, in the Journal of Financial Regulation, goes into this topic in great depth, and here I’ll just give a brief outline of what a system could look like. Every American individual and business could have a bank account set up by the Fed, and the Fed could deposit digital currency in the account as a monetary stabilizer whenever necessary. This would be a radical proposal, but it would also allow a very efficient, programmable, and targeted monetary policy. With this system, we could quickly and easily get money in the hands of ordinary Americans and small businesses during crises.
A lighter version of this proposal would be the Fed creating a digital, programmable currency that is more flexible and useful than cash for payment and contract purposes (perhaps with some crypto-like characteristics), but one that uses the current banking and payments system as intermediaries. Either route should be seriously examined, and I encourage all of you to read this outline of the potential benefits of a CBDC.
On a more technical note, America’s archaic payment system still creates barriers to seamless and easy money movement, and the Fed is developing the FedNow payment service that should vastly improve upon our current ACH system. Right now our payment system is the equivalent of a dilapidated and regressive toll road, where if you pay a reasonably costly toll, you can get through the system. The hope is that with FedNow, we’ll be able to have a modern, instantaneous payment system, and I’ll aim to cover this in more detail in a future newsletter.
Finally, and arguably most importantly, the Fed has historically targeted business and inflation stability as its main goal, but has recently adjusted its mandate to also target maximum employment and broad-based income growth. This is an extremely positive and welcome change in the Fed’s policy approach. Two organizations/movements, Employ America and Fed Up, have been important drivers of change in this area. We’ve also seen Fed Chair Jay Powell regularly meet with ordinary Americans to understand financial conditions on the ground and how monetary policy can better serve ordinary people. The benefits of the Fed’s more inclusive and growth-oriented strategy were seen in the pre-COVID labor market, which was the strongest and tightest American labor market in a very long time.
The takeaway from the history of the Fed’s development, and my recommendations for future paths for the Fed, is that monetary policy and management is a constantly evolving issue, and that there’s always room for improvement. Just as the United States moved from a fragmented and disjointed banking system to the Federal Reserve in the early 20th century, and then moved off the Gold Standard in the 1930’s, we can continue making changes to our economic policy framework in the 21st century that improve the lives of all Americans.