It has been at least a week since I mentioned central banks on this blog – probably a first. There are many areas of economics and public policy that interest me more, and which matter more. But I have just finished reading Roger Lowenstein’s new book, America’s Bank: The Epic Struggle to Create the Federal Reserve. The Federal Reserve opened for business on 16 November 1914, amidst the global liquidity crisis, affecting the United States as much as the combatants, created by the outbreak of World War One. There was, of course, little hint of what was to come when Woodrow Wilson had signed into law the new Federal Reserve Act into law on 23 December the previous year, one of the landmark pieces of legislation in Wilson’s first year in office.
(For anyone wanting to know more about the 1914 crisis, there are two worthwhile modern books; Saving the City is a British-focused global story and When Washington Shut Down Wall Street is the American story.)
Lowenstein is a financial journalist (rather than an economic historian), with a number of books to his credit. He is perhaps best-known for When Genius Failed: The Rise and Fall of LTCM. His tale of the political and banking background to the passage of the Federal Reserve Act is a very readable account for anyone interested in the topic. In places, it felt like an account of 1912 presidential election campaign – a particularly torrid affair as the Republican incumbent, Taft, was challenged at the general election both by the Democrat Wilson, and by Theodore Roosevelt, Taft’s predecessor and former friend and mentor. I hadn’t realised how important William Jennings Bryan – 1896 Democratic nominee, and author of the famous Cross of Gold speech – still was in the Democratic party’s own debates on a central bank.
By the early 20th century, the United States was relatively unusual , but hardly unique, in not having a central bank. Britain, France, Japan, Germany and Italy all did, but then Canada, Australia, South Africa and New Zealand did not. The US had had central banks previously – the most recent had lost its position when Andrew Jackson vetoed the renewal of its charter in the 1830s. But what marked out the United States in the 1900s was not the absence of a central bank but the presence of repeated severe financial crises – the most recent in 1907, the effects of which – while relatively short-lived- were felt around the world. As I’ve noted here previously, it is not as if the repeated financial crises seemed in any way to be derailing the longer-term progress of the United States or the sustained lift in living standards. At the time, the United States competed with places like New Zealand and Australia for having the highest material living standards in the world.
But in the short-run, the crises were enormously disruptive, and even the seasonal pressures – in an economy where farming still played a large role – were large. There were plenty of signs that something was broken, and some fix was needed.
The fix chosen turned out to be a central bank – or rather, a system of regional central banks, loosely overseen and bound together by the Federal Reserve Board in Washington.
It needn’t have been. Lowenstein tells the story as if the only sensible outcome was the founding of a central bank – an outcome towards which all history was tending. He tells his story vividly, and draws on a wide range of primary and secondary sources – and the cover includes plaudits from former central bankers Ben Bernanke, Alan Blinder, and Paul Volcker. But the book is weakened because the author shows no sign of having engaged with the alternative hypotheses about what had left the American system so prone to crises. Many – most recently Calomiris and Haber – have noted the contrast between the US system and that of Canada, which has been largely free of serious financial stresses before and after the founding of the central bank in 1935. On a much smaller scale, but also in a heavily agricultural economy, one could include among the relative stable systems that of New Zealand.
If what rendered the US prone to crisis was the absence of a lender of last resort – or even of external seasonal finance – then the case for a central bank was much stronger. But a plausible case can be made that what left the US system prone to crises was the regulatory structure put in place over the previous few decades. The United States system pre 1914 is often loosely characterised as “free banking”. In fact, it was a highly regulated system. The two most important regulations were the restrictions on branch banking and interstate banking, which made it very difficult for banks to effectively diversify risks, including liquidity risks, and the restrictions on the issuance of notes. Physical currency was still a hugely important medium, and demand was highly seasonal. State banks could not issues notes, and national banks were able to issue their own notes only to the extent that they held US government bonds to back them. Bonds were relatively scarce, and expensive and, as noted, the demand for notes was highly seasonal. The conversion of a deposit into a note did not change the nature of the credit risk the holder of the claim faced, but the ability of banks to do that readily, when customers wanted it, was constrained by law. Perhaps the political economy would have made dealing with the restrictions on the geographic scope of banks impossible at the time (it took many decades), but Lowenstein does not even deal with the question of whether, for example, amending the restrictions on the note issue might have largely dealt with the pressures – for an ‘elastic currency’ – that, at the time, gave rise to the creation of the Fed.
Not doing so perhaps make the construction of his narrative easier, and more powerful. But by not treating seriously those opposed to the creation of a central bank it does limit the insights he can offer. Some perspectives from, say, the archives of the Bank of England of the Banque de France on what they made of the whole long process might also have been interesting. Of course, the beauty of being a big country is that there are many other books and papers that deal with some of these issues.
I notice that George Selgin, from whom I’ve learned a great deal over the years, expresses similar views in his own comments on Lowenstein’s book and offers some richer comments on the weaknesses of the pre-1914 regulatory structures. To repeat, Lowenstein’s book is a good read, especially for anyone interested in the politics of it all, but just bear in mind the limitations
Our own central bank was not founded for another 20 years, opening for business on 1 August 1934. There is a line commonly heard these days that central banks were largely created to deal with financial system stresses. That was true in the United States – although the most severe crises in US history have come since 1914 – but it certainly wasn’t true here (or in Australia or Canada). The Reserve Bank of New Zealand was created to allow independent macroeconomic management for New Zealand, especially to be distinct from Australia. No one envisaged anything quite like modern discretionary central banking, with data reviews and potential policy adjustments ever six or eight weeks. But it was about ensuring that New Zealand conditions – export earnings and access to credit in London – drove the behaviour of domestic credit in New Zealand, not those of the larger Australasian area. New Zealand’s sovereign debt was extremely high around the time of the Great Depression, but nothing like as concerning to lenders as that of Australia.
Gary Hawke’s 1973 history of the Reserve Bank, Between Governments and Banks, remains the best account of the background to the founding of our central bank. A more easily accessible perspective, by Matthew Wright – a New Zealand historian on the Reserve Bank’s staff – is here.