From Bank Wars to the Panic of 1907

The National Banking System established during the Civil War reduced but did not eliminate American monetary disorder. National bank notes provided a more uniform currency than the kaleidoscopic array of state bank notes they replaced, but the system had structural defects that became apparent over time. Bank note issuance was tied to holdings of US government bonds -- which meant that as the national debt declined in the prosperous postwar decades, the money supply contracted, producing the persistent deflation that generated agrarian discontent.

The system also lacked a lender of last resort. When financial panics occurred -- in 1873, 1884, 1893, and 1907 -- there was no institution empowered to provide liquidity to solvent banks facing sudden deposit withdrawals. Banks responded to panics by calling in loans and hoarding reserves, which amplified the contraction rather than containing it. Seasonal variations in agricultural demand for credit caused regular monetary stringency in autumn, when farmers drew on bank reserves to pay for harvest labor, and excess liquidity in winter, when the crop had been sold and money flowed back to financial centers.

The Panic of 1907 brought this structural deficiency to a crisis point. A failed attempt by speculators to corner the copper market set off a cascade of bank failures in New York and around the country. The resolution required the personal intervention of J.P. Morgan, then 70 years old, who organized a private consortium of bankers to provide emergency liquidity -- essentially performing the lender-of-last-resort function that no public institution existed to perform. The episode illustrated that a national economy could not indefinitely depend on the willingness and capacity of a single private banker to prevent financial collapse.

We have no method of preventing the recurrence of panics. We have no institution capable of moderating the shock when they occur. The only question is whether we can create one.Nelson Aldrich, Senate Republican Leader, 1908

The political aftermath of 1907 was the Aldrich-Vreeland Act of 1908, which created a temporary emergency currency mechanism and, more importantly, established the National Monetary Commission to study the banking systems of other countries and recommend reforms. Senator Nelson Aldrich, who chaired the commission, spent two years studying European central banks -- particularly the Reichsbank and the Bank of England -- before convening the secret meeting at Jekyll Island that would draft the legislation eventually enacted as the Federal Reserve Act.

The design challenge that Aldrich and his colleagues faced was political as much as technical. Americans had spent a century debating central banking, and the debate had always been entangled with questions of class and regional power. Any institution that concentrated financial authority would be suspected of serving financial interests at the expense of producers. Any institution that appeared to centralize power in New York or Washington would face resistance from the South and West. The solution they devised -- a decentralized system of regional Reserve Banks with private ownership but public governance -- was a political compromise as much as a banking design.