The Creation of the Fed

Paul_Warburg

Federal Reserve chief architect Paul Warburg
at the 1st Pan-American Financial Conference, May, 1915
From the United States Library of Congress's Prints and Photographs division

 

How, and why, was the Federal Reserve System created?

The Founding Father of American financial journalism was one B.C. Forbes, founder of the eponymous magazine, father of Malcolm S. Forbes, grandfather of the gold standard proponent and former presidential candidate Steve Forbes.  It was the young Scottish immigrant B.C. who first ferreted out the colorful story of the formulation of the Federal Reserve System.  Published in Leslie’s Weekly, the story then was included in Forbes’s 1917 book, Men Who Are Making America.  It sets forth, strikingly, the how.

Picture a party of the nation's greatest bankers stealing out of New York on a private railroad car, hieing hundreds of miles south to an island deserted by all but a few servants, and living there a full week under such rigid secrecy that the name of not one of them was once mentioned lest the servitors learn their identity and disclose to the world this historic episode in American finance. …

Senator Aldrich … issued a confidential invitation to Henry P. Davison of J P Morgan & Co.; Frank A Vanderlip, president of the National City Bank and an ex-Assistant Secretary of the Treasury; Paul M. Warburg, then of Kuhn, Loeb & Company, and A. Piatt Andrew, Assistant Secretary of the Treasury, to accompany him on an extremely important and secret trip.  Mr. Davison had gone with the Commission to Europe as an adviser, Mr Vanderlip was a recognized authority on banking and currency fundamentals, Mr. Warburg had written most learnedly on the subject, and Mr. Andrew had done a great deal of work for the Commission.

After a journey hedged with the utmost secrecy, the party were landed in a small boat at the deserted Jekyl Island, off Georgia.

"The servants must under no circumstances learn who we are," cautioned Senator Aldrich.

"What can we do to fool them?" asked another member of the group. The problem was discussed.

"I have it,” cried one. "Let's all call each other by our first names. Don't ever let us mention our last names."

It was so agreed.

The dignified, veteran Senator Aldrich, king of Rhode Island and a power second to none in the United States Senate, became just "Nelson"; Henry P. Davison, everywhere recognized as among the ablest international bankers America has ever produced, forthwith became "Harry"; the president of the nation's largest bank became "Frank," and the quiet, scholarly member of the powerful international banking firm of Kuhn, Loeb & Co. became "Paul."

After a general discussion it was decided to draw up certain broad principles on which all could agree.  Every member of the group voted for a central bank as being the ideal cornerstone for any national banking system. One by one other features were brought forward and carefully pondered. Day after day for more than a week these giant intellects wrestled with their colossal problem. They worked not five or eight hours a day, but all day and far into the night.

As quietly as they had left, the authors of the epochal Aldrich report disappeared from Jekyl Island and slipped into New York undetected.

Paul M. Warburg more than any other man had made banking reform possible in this country. Trained scientifically in European national and international banking, our anachronistic currency system shocked him.

“The United States is at about the same point that had been reached by Europe at the time of the Medicis.   We have been shown bricks of the time of Hammurabi, the Babylonian monarch, evidencing the sale of a crop and similar transactions, and I am inclined to believe that it was as easy to transfer the ownership of these bricks from one person to another as it is to-day for an American bank to realize upon its discounted paper, if indeed it was not easier.”

Thus witheringly he wrote in 1907.  But he did more than criticize, he applied his whole talents to bringing about a cure.

And why was the Federal Reserve created? Panic. The Aldrich Commission and its ensuing Plan — which, indeed, formulated the structure for what was to become the Federal Reserve System was precipitated by the Panic of 1907. As so memorably described by Liaquat Ahamed in his Pulitzer Prize winning Lords of Finance (Penguin Books, 2009, pp. 53-54):

Morgan swiftly assembled the very best financiers to assist him with the rescue effort….  The task force had two assignments.  The first … was to decide which banks caught in the upheavals were to be bailed out and which left to go under.  The second… was to raise the money for the rescue effort.  By early November, despite having injected $3 million of his own cash, raised over $8 million from the other banks collectively, secured a commitment from the secretary of the treasury to provide $25 million in deposits, and even managed to extract $10 million from John D. Rockefeller, Sr., Morgan had been unable to check the panic.  Depositors continued to withdraw their money and one of the largest trust companies in the country, with over $100 million in deposits, tottered on the edge of collapse.

Finally, on the night of Sunday, November 2, Morgan summoned the presidents of the major New York banks to his new library, at the corner of Madison Avenue and Thirty-sixth Street, an Italian Renaissance-style palace he had built next door to his house to showcase his collection of rare books, manuscripts, and other artwork.  Its marble floors, frescoed ceilings, walls lined with tapestries and triple-tiered bookcases of Circasian walnut, crammed full of rare Bibles and illuminated medieval manuscripts, made it an incongruous setting for a meeting of the banking establishment.  Once the moneymen had gathered, Morgan had the great ornamental bronze doors to the library locked and refused to let anyone leave until all had collectively agreed to commit a further $25 million to the rescue fund.

The 1907 panic exposed how fragile and vulnerable was the country’s banking system.  Though the  panic had finally been contained by decisive action on Morgan’s part, it became clear that the United States could not afford to keep relying on one many to guarantee its stability, especially since that man was now seventy years old, semiretired, and focused primarily on amassing an unsurpassed art collection and yachting to more congenial climes with his bevy of middle-aged mistresses.

Shaken by the crisis, the U.S. Congress decided to act.

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