(Continued)
Since the second decade of the Twentieth Century, Congress and the Federal Reserve have shared the responsibility for managing the economic policy of the federal government. Congress had held sway over any official U.S. policy before 1913. However, private-sector banking had grown powerful already through its influence in what we may consider as informal economic policy. This policymaking followed in the wake left by the end of the War Between the States in 1865. When the United States embarked on the Great Expansion to the West, railroads and manufacturing grew rapidly during this period. Simultaneously, the financial institutions that funneled capital fueled this industrial growth, which in turn produced a consolidation of banks and trusts. This consolidation resulted in large financial institutions that stood on par with the industrial companies.
Challenges emerged among large financial houses during the last quarter of the Nineteenth Century. U.S. banks had come into their own, challenging the supremacy of European banks. Much earlier, financial institutions on “the other side of the pond” had realized that enormous size and power could produce tsunami effects for international banking and sovereign governments. Prepared for such effects, England, France, and Germany already had established central banks—banker’s banks—in their respective countries during the Seventeenth to Nineteenth Centuries. However, the United States had not erected any comparable financial edifice before the dawn of the Twentieth Century.
Among the firms themselves, the U.S. banking system controlled much of the supply and demand of capital in our country. During the decade preceding 1907, banking trusts had grown by 224%, national banks by 97%, and state banks by 82%. These institutions established the standards for prevailing interest rates and for the subsequent availability of credit through their private and minimally regulated financial houses, which interface with the open markets. However, if a significantly large bank or trust were to fail, such an event might destabilize the entire financial sector, thus producing negative externalities, i.e., spillover impacts on the rest of the American economy.
Morgan and the Knickerbocker
Generally, the financial sector looked after its own. John Pierpont Morgan, New York’s wealthiest and most well-connected U.S. banker internationally during the latter part of the Nineteenth Century and the beginning of the Twentieth, had rescued the U.S. Treasury and many banks during the Panic of 1893. As a result, his home at 219 Madison Avenue had become a financial clearinghouse during subsequent panics. One of the most important panics in American history is the high-watermark failure of 1907. We find this panic especially notable due to the preceding decade-long growth of the financial sector and the fact that this event triggered the development of the Federal Reserve Bank as the central bank of the United States.
A bank panic occurs when depositors lose confidence in a bank and believe that they will lose all of their money that is deposited in a bank. So, they go to their bank and demand to withdraw all of their money that they have on deposit. Even banks that have ample funds for daily operations will not have enough currency on hand to satisfy more than 20 to 25 percent of their customers. As banks also lend money to each other, a run on one bank may produce a domino effect throughout the banking industry. Legislation passed after the bank closures of 1933, help to protect the system from these types of runs.
Here is the breakdown: In late October 1907, there was a run on the Knickerbocker Trust, the third-largest trust bank in New York City. J.P. Morgan, the go-to lender for Knickerbocker, and his colleagues examined the books of the Knickerbocker Bank and found the company to be insolvent. As a result, Morgan then refused to rescue the Knickerbocker from bankruptcy. The president of Knickerbocker, Charles T. Barney, pleaded with Morgan to help him to stop the run, but to no avail. After Morgan refused to open the door to Barney, he went home, put a pistol to his head, and committed suicide. The next morning, the Knickerbocker Bank failed.
Not unlike the collapse of Lehman Brothers in September 2008, the run on the Knickerbocker quickly spilled over to other financial institutions. This event left Morgan with little choice but to intervene. He drew his line in the sand with the still-solvent Trust Company of America, which was founded by Ashbel P. Fitch, a former member of Congress, in 1899. Morgan backed the failing institution with an infusion of gold from the Bank of England and other European sources. He agreed to make deposits in order to purchase government securities from the endangered company in order to avert widespread financial disaster. Nevertheless, an economic contraction followed these events as industrial production decreased by 11% and unemployment more than doubled to 8%. Interestingly, the action performed by Morgan presented a harbinger of our forthcoming central bank: he took steps like those that the Federal Reserve Bank would use during later crises.
Birth of the Fed
In response to the ongoing structural problems of American banking, Senator Nelson Aldrich of Rhode Island organized a secret meeting of the leading bankers in the United States at the exclusive Jekyll Island Cottage on the coast of Georgia in November 1910. At this meeting, Aldrich and the accompanying bankers drafted the Aldrich Currency Report as the foundation of our new currency system. Supporters championed the proposal through the National Monetary Commission for almost three years of very heated resistance from many corners of American society; opponents viewed this concept of a central bank as a power-grab by Wall Street. Nevertheless, Congress passed the Federal Reserve Act and President Woodrow Wilson signed it into law on 23 December 1913. When he left office, Wilson stated publicly that he unwittingly ruined his country by allowing our government to fall under the control of a small group of dominant men. The passage of the Federal Reserve Act led to the establishment of the Federal Reserve Banking System. This system is composed of a Board of Governors that oversees twelve district banks, which regulate the banking industry and issue currency. Note: even though Congress gave birth to this “Creature of Jekyll Island,” the Federal Reserve Bank began as—and remains—a private-sector entity.
Today, the responsibilities for making and enacting economic policy remain split between Congress and the Federal Reserve. Congress holds the reins for policies administered through increases and decreases of both government spending and taxation. We refer to this method of economic guidance as Fiscal Policy. The Federal Reserve administers Fiscal Policy through the private banking sector by increasing or decreasing the amount of currency in circulation through the sale and re-purchase of government securities on the open financial market through its member banks. The Fed sets the percentage rate for Minimum-Reserve Requirements, the amounts of currency that banks must hold, and also establishes the Discount Interest Rate, which is charged to banks when they approach the Federal Reserve as the lender of last resort. In brief, purchasing securities from banks enables the Fed to increase the amount of currency in circulation immediately. Likewise, when the Fed decreases the minimum reserve-requirement or lowers its Discount Rate as a lender of last resort, the amount of money created by banks increases.
These actions enable banks to create more money within the economy by making loans to businesses and consumers. Collectively, these actions constitute the basis of our national Monetary Policy. Though created by Congress, the Federal Reserve Bank (aka the Fed) had a rough relationship with Congress as well as with the Council of Economic Advisors during the early decades of the Fed’s existence. This conflict occurred because of the political divisiveness that existed during the formative period of the Federal Reserve. However, Congress settled into its role as the politicized policymaker while the Fed has remained apolitical (as much as can be expected given the party affiliations of its officers).
Due to the emergence of computers, electronic data, and other advancements in information technologies, the degree of understanding and cooperation between policymaking entities has increased in recent decades. Congressional policy enacted through taxation and spending bills tends to be very bulky and slow-moving. This Fiscal Policymaking remains beset with sequential time-lags. First, a member of Congress must recognize a problem and then introduce a bill to remedy it. Between the Senate and the House, this bill passes through rewrites, committees, and deal-making before it finally passes into law, if at all. Once passed, appropriate government agencies must implement the specific spending or taxation program. Overall, the entire process may take years before the desired effect takes place. During that time, economic needs may change, though the tax and spending packages implemented remain static. Therefore, any resulting remedy may produce counterproductive outcomes.
Contrastingly, the Fed takes quick-working action. The Fed Open Market Committee meets every forty-five days in order to decide the number and values of government securities that it should sell or should consider as a buyback. Once the Fed makes the decision, implementation begins almost immediately. When a buyback occurs, new currency enters the reserve accounts of banks and creates money. They do this by using the increased cash deposits in order to grow the money supply through the loans that they make. For example, the Fed imposes a reserve requirement of 20%. A bank that is holding $10M in cash can expand its total deposits only up to $50M by making loans. This limit is established by the fact that $10M equals 20% of $50M.
In respect to making loans, decreasing the reserve ratio enables banks to increase their ability to lend more money immediately. As a result, banks are left holding more excess reserves when the Fed lowers the reserve ratio. The greater the dollar amount of excess reserves, the greater the dollar value of loans that banks can make. Finally, banks lend money to one another as the second-to-last-resort lender. In this sense, private-sector banks compete with the Fed. If the Fed lowers its Discount Rate, banks must lower their rates in order to remain competitive. As a result, the entire interest-rate structure of the financial market tends to shift downward.
An Analogy from the Great Canadian Sport (... and It’s not Hockey)
“It’s not just a rock. It is forty-two pounds of polished granite, with a beveled underbelly and a handle a human being can hold.”
–Popular quote within the Winter-Olympic sport of curling
Let us recap: Fiscal Policy, implemented through Congress, works slowly while Monetary Policy, executed by the Fed, works quickly. A combination of these two types of policy functions optimally when one hand knows what the other hand is doing. For example, let us consider the winter sport of Curling. Similar to shuffleboard, players slide a stone along a sheet of ice towards a target area at the far end. As the stone glides, two sweepers with brooms may influence the path and speed of the stone. These sweepers, who accompany the polished granite mass as it slides down the lane, use their brooms to alter the friction of the ice in front of the stone. This process involves strategy and teamwork in choosing the ideal path and directing the final placement of the stone. The skills of the curlers determine where the stone will come to rest in respect to its target.
Reflecting on this analogy, Congress launches the slow-moving Fiscal-Policy stone along its path. Once Congress releases the stone, this political body becomes powerless to control its path and distance directly. However, the Fed acts as players with brooms. Using Monetary Policy, the Fed can move quickly to guide the stone along its path to the desired destination at the bullseye of the target. In this way, Congress and the Federal Reserve work together in order to manage their mix of policies.
In conclusion, let us bring our discussion of Federal policies back to our local level. Financial markets, credit-flow, and interest rates operate globally. Policy actions taken by the Fed have a direct impact on borrowers and lenders in Southeast Michigan as well as far beyond. However, Congress can focus its Fiscal Policy with some degree of precision. Congress can bundle specific spending and taxation programs and direct them to Michigan and Metro Detroit. Such aid materializes from the matter of political savvy. In this respect, many local mayors have paid opportune visits to the White House in order to help to “bring home the bacon.”
Takeaway for Lawyers
We hope that our present discourse has enlightened and entertained our readership about the intricacies of banking as it affects our economy. In our next episode, we will explore the ups and down of business cycles in order to help us to remember not to fear recessions, which are part of the normal flow of the economy.
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Dr. John F. Sase teaches Economics at Wayne State University and has practiced Forensic and Investigative Economics for twenty years. He earned a combined M.A. in Economics and an MBA at the University of Detroit, followed by a Ph.D. in Economics from Wayne State University. He is a graduate of the University of Detroit Jesuit High School (www.saseassociates.com).
Gerard J. Senick is a freelance writer, editor, and musician. He earned his degree in English at the University of Detroit and was a supervisory editor at Gale Research Company (now Cengage) for over twenty years. Currently, he edits books for publication (www.senick-editing.com).
Julie G. Sase is a copyeditor, parent coach, and empath. She earned her degree in English at Marygrove College and her graduate certificate in Parent Coaching from Seattle Pacific University. Ms. Sase coaches clients, writes articles, and edits copy (royaloakparentcoaching.com).
