Alfred M. Mthimkhulu
“We must have a currency . . . elastically responsive to sound credit . . . the normal ebb and flow of personal and corporate dealings,” explained President Woodrow Wilson as he made the case for US banking reforms on June 23, 1913. He was set to step on big guys’ toes and they were not going to sit and watch him whisk away their cheese.
He was not a career politician. He was as close to his-own-man as they can be in such high offices, or so history suggests. When the Democratic Party leadership wooed him from academia to run for Governor of New Jersey two years earlier, he had not minced his words which I paraphrase: If I am elected I will be grateful to you gentlemen, but I will owe you nothing; I will owe citizens all of me. They either dismissed his stance as naive or knew voters would be swept to tears by such words.
On that day in June, he was addressing a joint session of Congress. Many worried the Executive was interfering with the Legislature. “If Mr Wilson comes to Capitol to influence legislation, he will be more foolish than the donkey that swam the river to get a drink of water,” protested Republican Bradley of Kentucky.
Another Republican complained that the President was addressing them like “a schoolmaster telling fourth-grade school children to be good.” Dr Wilson, the only doctorate-holding President that country has ever had was being mocked but he was well within his constitutional box. He was never one to be easily distracted from his goals. A few months earlier, as biographer A. Scott Berg shares, he had planned to holiday with his family at a cottage in New Hampshire. In June, he realised that forces against his banking reforms were too numerous and too determined to be taken likely. So, he stayed behind to do all he could to push the legislation through both houses.
Why banking reforms? Answers to “why” are usually more enlightening than details of the reforms. The reform outcome in this case was the formation of the Federal Reserve Board (Fed) or the US central bank. We know what a central bank does. Restating its responsibilities in this article could make me sound like a schoolmaster.
I don’t want to sound like a schoolmaster, not now. Given that his reform created an institution at the very centre of the country’s financial market, we might as well, as we dig for reasons for the reform, consider if our financial system is structured well-enough to ease access to economic opportunities for citizens because that is the overarching purpose of public institutions.
Now to the “why” of his reform. I will start from the very beginning and move fast. They rebelled against England in 1776 and declared independence.
They had no manufacturing sector but farms and slaves. They introduced a paper currency to fund their liberation war. By 1780 that currency was 2 percent of its original value. They re-indexed it like Reserve Bank of Zimbabwe did with “bearer cheques”.
In April 1781, as the currency hovered on worthlessness while the army grew more restless with many deserting, 26-year old Colonel Alexander Hamilton wrote a letter to the man in charge of national finances. It read: “The present plan is the product of some reading on the subjects of commerce and finance.”
He proceeded to outline in 6000 words a plan he would eventually implement as the Secretary of the Treasury a decade later. In those day, the idea of a limited liability company was resented. Value and wealth were gold, silver, slaves, land and fruits of land, not abstract ideas. There was thus strong opposition to Hamilton when he set up the Bank of the United States in 1791, raising its capital by selling its shares to the public who were allowed to pay for the shares in instalments. The Bank of the United States, like others, issued banknotes but was also the designated bank for government activities. Its charter would lapse in 20 years and it did.
Ironically, when Thomas Jefferson became President, he relied on the good credit standing of the US in the London bond market to raise $15 million to buy Louisiana from France in 1803, that’s 2,1 million square kilometres, 5.5times the size of Zimbabwe. President Jefferson had been the foremost critic of Hamilton’s abstract ideas of bond and markets and an industrial economy, the very ideas on which the good credit standing had been built in the 1790s.
In 1811 President Madison, another Hamilton critic did not renew the charter. Why? A disinterest in abstract things. He relented in 1816. It lapsed in 1836. President Jackson did not renew for the now-familiar reason.
The country continued without a designated national bank. Its credit standing suffered in the 1840s even into the 1890s. Local banks, mostly partnerships, still issued notes backed by gold and at times silver while other currencies circulated widely. Civil War broke in 1861 pitting the north against the south on the slavery question.
The north passed the Legal Tender Act introducing a currency backed by Treasury. The south did the same but the currency quickly became worthless. Northerners’ currency also lost as much as two-thirds of its original value in the course of the war.
The country would hop from one financial panic to another: 1867, 1873, 1884, 1893, 1896 and 1907. With hindsight, the underlying cause in all is clear: no one was in charge of managing money supply such that when demand for goods increased, money ran out because banks could only issue notes up to their gold reserves. Since no one was in charge, no one knew if all banks had adequate reserves!
Supposing all but two banks were prudent and held adequate reserves, if depositors tendered banknotes to the two banks and asked for the gold equivalent and the two failed to honour, a panic would ensue. Even if some banks had excess reserves, they wouldn’t dare bail the other without knowing the scale of the problem. And therein was the need to instil prudence in banking, another to monitor reserves and yet another to ensure that money supply was responsive to changes in consumption patterns of households and industry. To that end, President Wilson’s reform set up a “big” bank in each state (e.g. Federal Reserve Bank of Cleveland) to closely monitor and forecast fluctuations in the demand for money in Cleveland. A union of all the “big” state banks (i.e., the Federal Reserve Board) was to manage money supply for the country.
Unsaid thus far is that as the US hopped from one financial panic to another, the manufacturing sector was expanding at a massive scale. As Alan Greenspan and Adrian Woodridge write, there arose in the mid-to-late nineteenth century “men who grasped that something big but formless was in the air and gave that something form and direction, men who squeezed oil out of rocks and created industrial machines out of chaos” just as Alexander Hamilton had envisaged in his 1791 paper to Congress titled “Report on Manufactures” which was, in fact, the country first industrial policy.
Increases in firm productivity; swings in demand for goods locally and abroad; a surge in salaried workers as people quit subsistence ventures, as slave left the plantations and immigrants crossed the Atlantic — all this and more conspired to periodically shock money circulation. Some bankers and industrialists quibbled on details of the reform. He sat them down, literally. He prevailed.
We know of none of note in the 138 years we have covered in this discussion who from rooftops implored: “let us also make a central bank in the likeness of England so that we too can be prosperous”.
Anti-England sentiments ran deep back then, even reciprocated. Since many like Alexander Hamilton drew lessons from the Bank of England or the Reichsbank, the Fed was shaped by domestic experiences and tailored to fix experienced and envisaged flaws in the domestic financial system. What is the meaning of all this? Prudence suggests we leave the question to the schoolmasters.
Alfred M. Mthimkhulu is an economist and can be contacted on email: [email protected]; Twitter: @mthimz