Even though the Federal Reserve has been in existence for over a century, it remains a point of political contention. What is it about the Fed that makes it so controversial? And what does history tell us about the institution's founding as well as its performance over the first century of its operation?
Roger Lowenstein, author of America's Bank, which tells the story of the Fed's establishment, speaks to these issues on this week's episode of Industry Focus: Financials.
A full transcript follows the video.
This podcast was recorded on Jul. 11, 2016.
Gaby Lapera: This episode of Industry Focus is brought to you by Rocket Mortgage by Quicken Loans. Rocket Mortgage brings the mortgage process to the 21st century with a fast, easy, and completely online process. Check out Rocket Mortgage today at quickenloans.com/fool.
Hello everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You are listening to the financials edition, filmed today on Monday, July 11th, 2016. My name is Gaby Lapera, and joining me on the phone is John Maxfield. Hello, John!
John Maxfield: Good morning Gaby!
Lapera: We are also joined by phone by author Roger Lowenstein in Boston, Massachusetts. Thank you so much for joining us!
Roger Lowenstein: Gaby, it's a pleasure to be with you!
Lapera: Today, we're going to be chatting with Mr. Lowenstein about his book, America's Bank: The Epic Struggle to Create the Federal Reserve. It's this very handsome volume I have in my hands, if you happen to be watching us via video. Let's dive right in! We're super excited to have you here. We've talked about central banking before. Let's get the first question out of the way, and let's keep it super simple. What is the Federal Reserve? What is its purpose? What is a central bank, why do we need it?
Lowenstein: The simplest way to think of it is like that old home game Monopoly that everybody played as a kid, maybe still. Every time you pass go, you get $200. The game seems to work because when you get $200, it gives some players money to buy properties. But people do go bankrupt before dinnertime, so the game ends. So there's enough money to have a good game, but not too much that it goes on forever. That's the purpose of a central bank -- to keep the Monopoly game of our economy going so there's enough money that people can invest and create companies and jobs and so on, and other people can get those jobs, but not so much money that the money becomes meaningless or worthless, something like paper confetti. Obviously, if you had thousands and thousands of dollars, anybody could afford Park Place, and there'd be no tension in the game, and no value of that paper.
Another way of thinking about the central bank is, you want people making decisions based on the economic value of things such as buying products, or going to work, or taking a vacation, not based on whether money today is going to be worth more or less. You want a stable currency. That's the job of a central bank, the Federal Reserve.
And you want some stability, that's also the job of the central bank. In Monopoly, it's OK if a bunch of players go bankrupt. In fact, that's the only way the game ends. But we don't want too much of that in the real world, because obviously, that causes a great deal of misfortune and pain.
All of those are responsibilities of a central bank, in this country -- the Federal Reserve bank.
Lapera: Just to summarize that point, it helps set monetary policy, which is huge. And it's a lender of last resort, which we saw in the last financial crisis. That's why all the players aren't going bankrupt in the real world, right?
Lowenstein: That's right. It does set monetary policy. Another way of saying that is that it sets the basic short-term interest rate that largely helps determine the rates that banks charge for loans and mortgages and so on. And, it's a lender, as you put it, of last resort. When there's no other resort, when Bear Stearns was going broke, there was the Federal Reserve, and they made that loan.
Lapera: Yeah, and now it's a little bit more active as well in that it helps regulate banks.
Lowenstein: It's also the regulator of banks, that's been its job since it was created in 1913. Regulation means everything from what are the rules that banks have to follow when they give out mortgages -- rules that weren't followed very closely or very well before the recent crisis, obviously -- to how much capital does a bank have to have when it goes out in makes a loan. Rules are intended, hopefully, not to suffocate the banks, because we want them to make loans, but to keep them from being, in a perfect world, too liberal, so that they still have some money in the till to pay their own debts.
Lapera: Sorry. You guys have to understand, we have two people in the ether, and one person in the studio -- so we might accidentally talk over each other. Do you want to go ahead, Maxfield, with your question?
Maxfield: Absolutely. Roger, the United States has a pretty colorful history with central banks. In your book, in particular, which, by the way, this is the third book of yours that I've read and I've loved every one.
The first book of yours that I read was actually the first finance book that I read in my entire life, so maybe it's responsible for sending me on this track. It was When Genius Failed. I loved it. But, this book in particular is about the third iteration of the central bank, I guess we call it the Federal Reserve in the United States. It's all about the creation of the Federal Reserve, which really spanned that time period between 1907 to 1913. What was it about that time period in particular that led lawmakers and policy makers to come back to this idea of the Federal Reserve, and the idea of, what seems to be, since then, to put a permanent one in place?
Lowenstein: What led them to, John -- good question! -- is the same reason why we're talking so much about the Federal Reserve and the banks today -- because the system failed back in 1907. There was a terrible panic, there was a bank run, and when I say a bank run, back in 1907, I don't mean a red blip on your computer screen. I mean people ran down the block to get money out of the banks before there was no money. And banks did run out. They had to close. Many of them closed, many of them started passing out homemade script, Monopoly money, if you will, just something that businesses could use to meet their payroll, if the workers would accept it. The system really froze.
The system, at that time, was no system. It was really a few wealthy banker people, such as J.P. Morgan, a gentleman, if you will, who would extend loans to other banks when they were in trouble. That was a quaint way of doing things. It might have worked in the mid 19th century, but at the time of 1907, when we were a complicated and developed industrial power, we needed more than one earnest gentleman banker. So people in that period began thinking and plotting and disagreeing and so on about what kind of system we should have. Also, to bring it back to the present day, there was huge opposition then, as there is now, to any sort of government involvement in the central bank. Then, the financial system, would it be too biased toward Wall Street, would it just be a tool for the big banks, would it just bail out big banks? People said that 100 years ago. But not without some prescience.
You allude to the fact that we've had two iterations before that. Alexander Hamilton, the first Treasury Secretary, of course, started the First Bank of the United States. Thomas Jefferson didn't like it. Back then, the idea was, banks are going to be helping big financiers, therefore people in the cities, people in the farmlands don't need banks and so on. And they got rid of it, and it turned out not to be a good idea. So under President Madison, we started the Second Bank of the United States, went through the whole thing again. Andrew Jackson, another sort of popular leader, felt that banks were just favoring the rich and the central bank was an ally of the money centers. He abolished it. And once again, we went into a depression.
We have, in this country, a see-saw of our politics back and forth between wanting some force for stability based in the government to control and regulate the money flow, and give us a centralized banking reserve, so that when the country needs extra resources, it can be that lender of last resort that Gaby pointed out; and, on the other hand, the other tension, this real fear, particularly out in the hinterlands and farmlands away from the big city, that if you give a central bank all that power, they're not going to be acting with the common man or woman in mind. That was the tension in 1907 that I wrote about, and obviously, if you listen to Bernie Sanders today, or Donald Trump, it's very much a tension in our system today.
Lapera: That's really interesting. I was talking to my friend last night, and I asked him to guess when he thought the Federal Reserve in its current form had been created, and he said post-Civil War. And this really gets to an interesting point in your book, which is that central banking is something that has existed in other countries for centuries. The Riksbank -- which is the central bank of Sweden -- was founded in 1668. The Bank of England was founded in 1694. This pressure against centralization is something that's been very central to the United States, and has been pushing against Federal Reserve ever since.
Lowenstein: That's right, Gaby, you're right up on your history with the examples of Sweden and England. The same is true for other countries in Europe. We have had this political fear of centralization. I've said in the book, and think that it really goes back to our history as a people, after all, whose formative political experience was rebellion against the central monarch, King George III. That's our founding political story, that's our political Thanksgiving. Even though that was so many years ago, when you think about the way the country developed, always pushing West, I think the people of the frontier always tended to look back on Washington, New York, Philadelphia, and Boston, so on, similar to the way the early colonists looked on the British king, that this centralized power, these East Coast elites, weren't quite to be trusted. They didn't want to give up too much power themselves.
You see this in the very strong movement today, the Tea Party wing of the Republican Party. You saw it early in the country's history in things like the Shays' Rebellion, the Whiskey Rebellion, the settlers in Western Pennsylvania and Western Virginia, which was out West back then -- they didn't want to pay taxes to Washington. In other countries, national healthcare is just sort of something you do. People don't really think about it much. In this country, obviously, it's a very unsettled, difficult issue. Other countries have one system of corporation rules, we have 50, one in every state.
It's not a coincidence, by the way, that the idea for the central bank in the United States really began with the Europeans. One of the heroes of the book, Paul Warburg, who came to this country, a German who emigrated here, and was a banker, couldn't believe that we didn't have a central bank. In his analogy, it was like a town without a water reservoir, with everybody having a little well in their backyard. That obviously wouldn't do it if you had, say, a three-alarm fire. There are reasons why you need to unify the banking reserves and martial them into a more effective resource. But, what other countries take for granted, there's a political segment here that has always kept a very wary eye. That's why, for instance, other countries have one central bank, and we have a central banking apparatus in Washington, we really have 12. We have a bank in Philadelphia, we have one in Richmond, and one in St. Louis, and those 12 banks around the country. The idea there was to mimic the federal organization of the government itself.
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Thanks for your patience. Turning back to our topic, we've talked about the who, what, where, when, and why. So let's talk about the Fed's short-term success, in terms of history. In theory, the Fed was supposed to have stopped panics and crashes, but the Great Depression still happened. Can you give any insight on why?
Lowenstein: Yeah. The Great Depression is a huge black mark, obviously, on the Federal Reserve. And to some extent, it's a black mark on the founding organization of the Federal Reserve. I think it goes back to the point I just mentioned, that the founders were very aware that the country was pretty much allergic to the idea of a European-style police centralized bank. In fact, Carter Glass, the listeners may know him better as one of the authors of the Glass-Steagall Act that came later. In any case, Carter Glass, a congressman from Virginia, authored of the legislation, commonly known as the Father of the Federal Reserve, he himself was completely opposed to any sort of centralization. Originally, he proposed to President Wilson a draft of the bill with 20 different reserve centers around the country. This is nearly one for every two states, and nobody in Washington at all, no Federal Reserve System in Washington. So, he wanted a completely decentralized system. Others leaned on Wilson, and there was this compromise I alluded to where we have this hub and spoke system of 12 banks around the country and a governing body in Washington.
But the founders left it, to get to your question about the Depression, somewhat vague about where the power and responsibility would lie. Would it lie with the individual reserve banks? Would it lie in New York, which people knew would be the most powerful bank? Would it lie in Washington with the Federal Reserve system? Perhaps the Treasury? It was unclear. They fought about this. There were various times in the first 15 years of the Fed where one bank would say: "We want to raise interest rates," while the others in the system were lowering them, or vice versa. We wouldn't have this today, but there was quite a disagreement about the extent to which these banks were free to go their own way.
When the Depression hit, there was no consensus about who was running monetary policy. Who had the responsibility for marshalling and executing an effective response to the Depression? Was it the New York Federal Reserve bank? Was it Washington? Was it the President? As a result, we got a series of halfway policies. Some banks were more hawkish, some were more dovish. The Federal Reserve System, meaning the board in Washington, was fairly weak. Very much quite a contrast to recently, when we had this terrible economic crash in 2008. No matter what you think about Bernanke's response, whether you like it or not, there's no doubt about who was in charge. And there was no doubt among the various members of the Federal Reserve system that Bernanke was in charge. He came up with a plan, he executed a plan. Again, whether you like it or not, it was a very active plan. It was not a weak response. And you didn't have this in the Great Depression. I think that's one reason why it lingered so long.
These things are, also, as much art as science. One of Bernanke, and after him, Janet Yellen's, I think, key points that they've relied on is: we don't want to take the monetary medicine away too soon. There's been a lot of criticism that rates are staying too low for too long. But Bernanke and Yellen after him have been quite vehement in saying, we want to make sure the patient is really healthy. The reason they're saying that is, because in the 1930s, the Federal Reserve did not. After the economy had done a great deal of recovering in 1937, the Fed said: "OK, Mr. Economy, you're fine, we're taking your medicine away," and we went back into a very severe depression. We've learned from that. Why hadn't we then? People aren't perfect. Central bankers aren't perfect. They didn't have the experience then, and they made a mistake.
Lapera: Yeah. I think that's something that was really interesting in your book, too -- it appears that the original authors of the legislation, Nelson Aldrich, the Aldrich bill, which would later inform the Federal Reserve Act, they kind of left it vague on purpose because they wanted to build a pass, and there was such a sentiment against central banking that they wanted to make it kind of vague so people wouldn't react from their gut as opposed to actually thinking about it.
Lowenstein: That's right. It's hard to convey, hopefully it's contained in the book, how adamant people were against a central bank, how these words, just the words themselves, conveyed or set off fear, a lot of debate in Congress about whether or not the plan for the Federal Reserve Act was a "central bank" or not. It was almost like a four-letter word, or a four-letter phrase. Carter Glass, Representative Glass, would carry around in his pocket a copy of the Democratic platform of 1912. The bill was passed in 1913. And any time anybody said: "We ought to do such and such to the bill" -- if it entailed some centralization, he would pull out this copy of the platform and show them, the Democratic platform, the ruling party then, proscribed a central bank. And passage of the bill really involved this intricate dance, really quite a bit of subterfuge and play-acting, pretending that what they were constructing wasn't a central bank. It was.
We see this today, where certain things just become forbidden in the political culture. Back then, the idea of a central bank was one of those things. So even as they were doing it, they had to pretend that they weren't doing it.
Lapera: I think Maxfield has a question for you about the Fed and regulating banks, correct?
Maxfield: Yeah. Actually, let me take the question in a different direction, Roger. When you look back, you have the first central bank in the United States, you have the second central bank in the United States, now we have this third one. If you really look over the history of the Federal Reserve absent the Great Depression, when it was still trying to feel that way out and figure out the power allocation between its branches and its central monetary commission in Washington DC, really, it's augured in a period, in fact, in banking, they call it the Great Moderation. It's one of the least volatile periods in the history of banking in the United States, which is actually much more volatile than many other countries.
But then you have the financial crisis of 2008. That's kind of the one mark on its record since then. But it actually seems to have averted from a recession turning into a depression, which is what we had in the 1930s. So, for somebody like you, who has studied the history of the Federal Reserve and other central banks, and looking at this whole issue, when you look at the Federal Reserve's performance since its founding, how would you grade that? And then, the second part of that is, you alluded to this in your book, but you never teased it out further -- is there any fear, concern, or legitimacy to arguments that the Federal Reserve could go the same way as the first two central banks in the United States?
Lowenstein: First, I'll just point out other episode of failure. That's the great inflation of the 1970s. Really, the Fed had three, I'd say, significant failures: the Great Depression, a long period of stability, then we had this pretty terrible inflation. I quoted that, in the book, it's a different year in history, but President Nixon leaned on his former advisor and sent Chief Arthur Burns to open the spigot all the way. Nixon didn't want to risk losing the election. He did a lot of foolish things to be reelected, as people who know the Watergate history will know, but one of them was to lean on Federal Reserve chief. And Burns, unfortunately, went along with it, and we had this terrible inflation in the 70s.
Then, as you said, John, we had this long period referred to as a great moderation, followed by the crash. I think one of those begot the other. When you have a long period of stability, what happens? Each month, each year that conditions are stable, people feel a little bit more confident, they take a little bit more risk, and you just picture someone walking further and further out on a ledge. When are they going to stop walking out on a ledge? When they realize they're over thin air. And that's what happened. There was, I think the regulators, not just the Federal Reserve, but the Federal Reserve and others got too comfortable with the idea of deregulation. They committed all sorts of mortgages to be written that should not have been written. We can go into that another time.
Based on those three episodes, I'm going to give the Federal Reserve a B, not a B+, for the first 100 years. I gave it a stronger grade for its actions in helping the country to recover from the crisis, and as you say, preventing a depression. But that overall grade, for me, would be a B. Now, I'm forgetting, was there another aspect to your question? Or did we cover that already?
Maxfield: Is there a legitimate fear that the Federal Reserve could go in the same direction as one of the other two central banks?
Lowenstein: As I go around, giving talks with this book and so on, live audiences, there's a tremendous amount of hostility around the Federal Reserve. There's a temptation to think, these bankers, they're all in it together, they're just trying to help out other bankers. People seem to blame the Fed for all sorts of things. The central bank is a powerful institution. It's not responsible for forming new companies, hiring new workers. Most of what happens in the economy, it's important, but it's not omnipotent. People tend to blame it, I think, for just about everything when things go badly or we get slow periods. There's a great deal of frustration now, there's a willingness, I think, to experiment or indulge all sorts of extremes. Should we go back to the gold standard? Should we have some sort of electronic money, Bitcoin, even though the value of that is way more unstable than the value of the dollar? The Fed has done a pretty good job of maintaining a stable value of the dollar. People predicted that the value of the dollar would crash because the Fed's Emergency Relief Act has only strengthened since the crisis. We look pretty good compared to, certainly ECB in Europe and most of the other major currencies of the world. But I think the Fed has a public image problem, and probably a crisis of legitimacy to the greatest amount since its founding.
Lapera: Yeah, it's really ghosts of debates past. It's incredible, reading your book, that it's a lot of the same arguments that were back then that we're still having now. I do have one last wrap-up question, and this kind of has to do with your book. We have a few listeners who I know are aspiring writers. If you wouldn't mind, if there's one thing you could tell new writers, what would it be?
Lowenstein: This is my first history, so in a sense, I was a new writer on this book. I read a bunch of non-fiction books about recent financial drama. This is the first one that went back to a financial crash of 1907, and Presidents who are no longer alive, like Woodrow Wilson and Teddy Roosevelt and so on, they're fun characters, but you can't talk to them anymore. It turns out, if you have reporting instincts, and willingness to work hard and dig through and read the letters, sit down at a library and turn off that cellphone and everything, it's just as exciting, and you can learn just as much, and you can paint just as vivid a picture of a period gone by. In some cases, even more so, because you have to fill in some of the dots for yourself since those people aren't there talking to you. It's really, for me, as exciting than anything I've ever done to try to make history from 100 years ago come alive. I urge you listeners to go at it, whatever you're interested in, whether it's a current period or something of the past.
Lapera: Thank you so much, that was a really lovely answer and a really excellent interview. For our listeners, just in case you missed it the first time, the book is called America's Bank: The Epic Struggle to Create the Federal Reserve, and it is by Roger Lowenstein. Thank you again so much for joining us, Mr. Lowenstein.
Lowenstein: Gaby and John, it was great to be on the show.
Lapera: Thank you! Thank you very much to John, too, for joining us. As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Contact us at IndustryFocus@Fool.com, or by tweeting us @MFIndustryFocus if you have a suggestion for who we should interview next. Thank you very much to Anne Henry, today's totally awesome producer, and thank you to everyone for joining us! Hope everyone has a great week!
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