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Story of The Fed

In this week's FinMail we will go through the story of the creation of one of the most influential financial institutions of this world - The Fed.

The Context

On the eve of Wednesday, 15 December 2021, all of the world's eyes were on the Federal Reserve, the central bank of USA. The FOMC (Federal Open Markets Committee) meet was about to happen which was going to decide the fate of the economy of United States and ultimately impact the other major economies as well.

For the uninitiated, the FOMC is pretty much similar to the RBI's MPC (Monetary Policy Committee) in India. The FOMC and the Federal Reserve decide the interest rates in US' economy, and as what happens in the US affects almost every other major economy, all the world's major economies, including India had their eyes locked in to know what was going to happen in the FOMC Meet.

Explaining the outcome of this meeting, in brief, FOMC and the Fed (short of Federal Reserve) decided to fasten the rate of tapering in US and thus giving more room for increasing the interest rates in the next financial year. If you don't know what is tapering and what effect does it have, do check out our issue on the same.

Anyways, so while the Fed is in constant buzz regarding the Taperings, and the inflation in US at record highs, we thought why don't we cover the story of how one of the world's powerful institutions came into existence. And also coming December 23 is the 108th anniversary of the Federal Reserve Bank; so we thought let's cover the story of the Fed.

You might think that many institutions come into existence and go as well. But what is so unique about the Federal Reserve that we had to cover its story?

Well for starters, as mentioned, the Fed is one of the most powerful financial institutions in the world. And the story of how the Fed came into existence is no less than a story you come across in movies. It has all the drama that you might need this Sunday morning. So what are we even waiting for? Let's start right away.

The Beginning

It was the year 1907. Try going near to a bank and you'd see long lines, even camps set up, a crazy amount of people panicking, and all of this to take their money out from the banks. Even if the bank was one of the reputed banks, it didn't matter. People just wanted to cash out their deposits. Stock Markets fell by more than 50% in just about a month. And a financial crisis hit USA. It all began from a massive earthquake that hit San Fransisco on April 18, 1906. The earthquake was so massive that it destroyed about 80% of the city of SF.

The financial jolts of this earthquake were not limited to the US economy alone. Insurance Companies based out of the US too were under pressure as there were Insurance claims worth millions of dollars that were made at that time. One thing led to another and a cycle was created that led to the financial crisis of 1907. The recession hit, lay-offs were made, banks started to fail. One after the other, banks had to shut down as there were no deposits left with the bank. Failure of banks led to lesser lendings and slow industrial development which further pushed the US economy into recession.

At that time, there was no Central Bank in US that could step in and save the economy from its doom. It is not that the country never had a central bank in place. It did, btw twice, but both of the times the banks had a short stint as they had to shut down due to one or the other reasons. So without the central bank in place, the bankers of the US turn to one man; a 70-years-old private banker to save them from the economic crash.

The Savior

The man was none other than John Pierpont Morgan; J.P. Morgan - the name which we recognise today as one of the largest banks. J.P. Morgan was so powerful at that time that it was believed that he managed the world's economy from his library in New York. The bankers basically went to JP Morgan seeking help to save the economy from crashing further, to which he agreed and decided to come up with a plan.

On a typical Saturday night, JP Morgan calls some of the biggest bankers in the country to his library and asks them to pay $25 millioneach to help create a pool that will save the banks & the economy and sign their declaration. He'd even put his own funds into the pool. Now $25 Million at that time was a significant amount of money to pool in. Of course, bankers being bankers; they denied putting in their own money. Now you can't force someone to pay a huge amount but guess what?

JP Morgan then goes on to lock the door and says, "Gentlemen, we are not leaving until you sign the paper". The bankers then sit and discussed while JP Morgan played solitaire in the next room waiting for the bankers' decision. And in the early morning, the bankers finally agreed to pay the sum, and the 1907 panic was finally put to an end; at least until the next panic. JP Morgan saved the day.

The Realisation

US soon realised that they can't rely on JP Morgan or some other powerful person for saving them from such dooms every time; they had to think of a way to stop such panics from happening. And one of the strongest believers of this ideology was Senator Nelson Aldrich. He believed that the panics kept happening no matter what and hence it was about time for America to have a Central Bank.

A Central Bank that could step in at such times of panic and can help save the economy by providing the banks some more money to stop them from shutting down. And where would the money come from? By giving the central bank the authority to create money from thin air; by printing more money.

Senator Aldrich made a plan for a Central Bank but as we know the US had failed twice in the past for a Central Bank. So the senator had to make sure to create a plan that the public at large approved and the one that the government was ready to accept and pass the law. But the senator felt that he was not competent enough to create such rules and laws about a Central Bank that would not fail.

He needed a group of bankers that would help him do that. But just imagine how a group of bankers would create laws for Central Bank that would be neutral; in favor of the banking and the financial system and not in the favor of their own. So in 1910, he literally came up with a plan to create a proper plan for a Central Bank.

The Secret Meet

In 1910, Senator Aldrich calls some of the biggest bankers and asks them to gather at a Train Station based in New Jersey. But here's more drama. Senator calls each one of them and asks them to come individually, wearing clothes like they are a bunch of Duck Hunters and were going for Duck Hunting. This was done to ensure that nobody gets a hint of such secret meet around a Central Bank. Wait for it, there's more

Senator further asked to look for his private coach of his own, present at the station attached to a train heading towards Georgia. The bankers were asked to address themselves only by their first names like Nelson, Harry, Frank, Paul, Piatt, and Arthur in order to safeguard their identities from the train staff and people around them.

Now the bankers would not discuss this on a train but rather on an island in Georgia; Jekyll Island. At Jekyll Island, there was a private club, an exclusive club accessible only to the likes of people like JP Morgan where they would meet. So most probably it was JP Morgan who arranged for the meet there. The group of bankers including Aldrich Nelson would then stay there for about a week discussing about the creation of what would be one of the biggest & powerful institutions in the coming 100 years or so...

BTW, the story about their stay for a whole week that they were laying low on an Island did not come to public notice until 1916 or so after the Federal Reserve was formed so you can imagine how secretive it would have been.

So the group prepares a plan on the secluded Island; prepares a draft to present it to the government. The plan which was known as 'The Aldrich Plan" suggested creating a central bank; rather a central bank having 15 bank branches across the nation in order to cater to the different financial interests of various states. The bank branches would be located across important regions of the country and would be responsible for issuing currency, issuing securities, holding reserves, etc. The group then leaves thinking that they have done their part and the country is ready for a Central Bank. The Aldrich Plan was officially ready.

The Approval

The plan was then presented to the National Monetary Commission in 1911 and was objected at first; obviously. And the plan was not accepted for a few years due to the opposition of the government. But after several years of rejections and debates, a plan modified and adjusted a little bit, having the base idea of The Aldrich Plan, was signed by President Woodrow Wilson on 23rd December 1913.

The USA finally got its central bank and that too with 12 branches; some allocated as per necessity and some as per political reasons and all of the drama ultimately led to a Happy End.

Happy End: Is it really?

The very purpose of creating a central bank was to mainly avoid and absorb the effects of an economic recession, if not prevent it, to help reduce bank failures. But it didn't really happen on the ground. US has witnessed at least 14 recessions after the creation of the Fed. Since its authorisation, there have been some serious allegations and criticism on the Fed and its policy framework, not just from people largely but from some of the economists as well.

Nobel laureate economist Milton Friedman and his fellow monetarist Anna Schwartz criticised the Fed's response to the Wall Street Crash of 1929 arguing that it made the bad situation worse which led to the Great Depression. Had it taken appropriate steps, the Great Depression would have just been a normal recession or a panic.

Many have since agreed with this, including Ben Bernanke, Chairman of the Federal Reserve from 2006 until 2014.

Cut to the recent, Fed is also believed to be responsible for the 2007-08 crises. Although it is agreed that the steps were taken by Fed after the crisis was key to helping the economy to recover but it was the Fed's reforms and activities that led that the situation on first hand. After the 2001 tech bubble burst, Fed brought interest rates down, for a very long time which led to another bubble (housing/real estate bubble).

The Fed's role as a supervisor and regulator has been criticized as being ineffective. It is also alleged that it has done more bad than good and more than half of the US's people want Fed to be more regulated and transparent or else it should be abolished. Didn't see that coming...

So that is it for this week's FinMail. Keep learning and we will see you next week.


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