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Why Was the Federal Reserve Founded in the First Place?

By Motley Fool Staff – Jul 14, 2016 at 5:16PM

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A best-selling author explains what led to the Fed’s founding in 1913.

The idea for the Federal Reserve was born in the Panic of 1907. After decades of frequent bank failures throughout the Gilded Age, lawmakers had had enough of the panics and depressions that followed. It was believed at the time that the Federal Reserve would bring this to a stop.

Roger Lowenstein expands on this in the latest episode of Industry Focus: Financials. The author of America's Bank, a history of the Fed's founding, sat down with The Motley Fool's Gaby Lapera and Fool contributor John Maxfield to tease out the most salient points from the central bank's history.

A full transcript follows the video.

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This podcast was recorded on July 11, 2016.

John Maxfield: 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 policymakers 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?

Roger 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.

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