The creation of the Federal Reserve System was supposed to have meant the end of banking panics and financial crashes. It was, after all, established in the wake of the Panic of 1907 to manage the money supply and credit, with the specific intent that it should be a buffer against such events. Yet the Great Depression happened only a generation later. Why was the Fed unable to stop that economic disaster from happening?

Roger Lowenstein explains why 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 John Maxfield to explain the problems with the central bank's structure that allowed the Great Depression to happen on its watch.

A full transcript follows the video.

This podcast was recorded on Jul. 11, 2016.

Gaby Lapera: 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 crashed, but the Great Depression still happened. Can you give any insight on why?

Roger 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 fully 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 marshaling 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's (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 didn't. 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? Well, 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 -- [and] Nelson Aldrich, [sponsor of] the Aldrich bill, which would later inform the Federal Reserve Act -- they kind of left it vague on purpose because they wanted to the bill to 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. U.S. Rep. Carter 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 [that] the Democratic platform, the ruling party then, proscribed a central bank. 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.

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