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XVI. Central Banking in the United States IV: The Federal Reserve System


The new Federal Reserve System was deliberately designed as an engine of inflation, the inflation to be controlled and kept uniform by the central bank. In the first place, the banking system was transformed so that only the Federal Reserve Banks could print paper notes. The member banks, no longer able to print cash, could only buy it from the Fed by drawing down deposit accounts at the Fed. The different reserve requirements for central reserve city, reserve city, and country banks were preserved, but the Fed was now the single base of the entire banking pyramid. Gold was expected to be centralized at the Fed, and now the Fed could pyramid its deposits 2.86:1 on top of gold, and its notes 2.5:1 on top of gold. (That is, its reserve requirements were: 35 percent of total demand deposits/gold, and 40 percent of its notes/gold.)1 Thus, since gold reserves were centralized from the national banks to the Fed, it could pyramid further on top of them. All national banks were forced to become members of the Federal Reserve System, while state banks had a voluntary choice; but nonmembers could be controlled because, in order to get cash for their customers, they had to keep deposit accounts with member banks who had access to the Fed.


Figure 16.1 depicts the new inverted pyramid created by the Federal Reserve System in 1913. Nonmember banks pyramid on top of member banks, which in turn pyramid on top of the Fed, which pyramids its notes and deposits on top of its centralized gold hoard. The new central bank, being an arm of the federal government, carries the great prestige of that status, and also has a legal monopoly on the issue of notes.

How this reserve centralization was designed to be inflationary was pointed out by Phillips, McManus, and Nelson:

Suppose the total cash reserves of all commercial banks prior to the introduction of central banking amounted to one billion dollars; on the basis of these reserves, and with an assumed minimum reserve-deposit ratio of 10 per cent, the banking system could expand credit to the extent of 10 billion dollars. Now, suppose that the Federal Reserve System is established, and all reserves are transferred to the vaults of the new Reserve Banks, where they become deposits to the credit of (and at the same time are counted as the reserves for) the member banks. Against this billion dollars of deposits the Reserve Banks must maintain a minimum cash reserve of 35 per cent, or 350 million dollars. The remainder of the billion dollars of cash, 650 million dollars, becomes excess reserve for the Reserve Banks. On the basis of such excess reserves the Reserve Banks are able to increase their deposits, and hence the new reserves of the member banks, by the maximum amount of about $1.9 billion. ...

     In other words, the Federal Reserve Banks now have 2.9 billion dollars in deposits to the credit of the member institutions (against which they have the one billion dollars as a reserve, or a reserve ratio of 35 per cent), or conversely, the member banks now have 2.9 billion dollars in legal reserves, on the basis of which it is possible for them to expand credit to a total amount of 29 billion dollars. By virtue of the possession of this new, added, reserve of 1.9 billion dollars ... the member banks can now add 19 billion dollars new credit to the antecedently existing 10 billion dollars.2

But this was scarcely the only aspect of inflation built into the structure of the Federal Reserve System. At the beginning of the Fed in 1913, the most important single item of paper money in circulation was the gold certificate, held by the Fed and backed 100 percent by gold assets in the Treasury. But in a few years, the Fed adopted the policy of withdrawing gold certificates from circulation and substituting Federal Reserve Notes. But since the FRN only had to be backed 40 percent by gold certificates, this meant that 60 percent of the released gold was available as a base on which to pyramid a multiple of bank money.

In addition, as part of the creation of the Federal Reserve System, the previous reserve requirements were cut approximately in half, thereby allowing for a doubling of demand deposits. The average reserve requirement of all banks before the establishment of the Fed was 21.1 percent. Under the provisions of the original Federal Reserve Act in 1913, this requirement was cut to 11.6 percent, and it was cut further to 9.8 percent in June 1917.3 It is no accident that the Fed, as a result, was able to engineer a doubling of the money supply from its inception at the end of 1913 until the end of 1919. Total bank demand deposits rose from $9.7 billion in June 1914 to $19.1 billion in January 1920, while the total currency and demand deposits increased from $11.5 billion to $23.3 billion in the same period. Furthermore, the impetus from the Fed is shown by the fact that nonmember bank deposits expanded by only one-third over these six years, whereas member bank deposits increased by 250 percent.

Another inflationary step taken at the origin of the Federal Reserve System was, for the first time, to drastically reduce the reserve requirements on time or savings deposits as compared to demand deposits. During the era of the national banking system, the reserve requirement, averaging 21.1 percent, applied equally to time or demand deposits. The original Federal Reserve Act greatly reduced the reserve requirements on time deposits of commercial banks to 5 percent, and in 1917 it was further lowered to 3 percent.

It is true that if a deposit is a genuine time or savings deposit, then it is in no sense part of the money supply, and therefore needs no reserve requirement (assuming that monetary liabilities should have such requirements). But any creation of time deposits through the making of a loan is deeply suspect as not a time deposit at all, but rather a crypto-demand deposit. With the drastic reduction of reserve requirements on time deposits upon the inception of the Fed, the commercial banks had an enormous incentive to shift borrowers into time deposits, and thereby inflate further. And, indeed, that is precisely what happened after 1913 and during the 1920s. Deposits that were legally time deposits and only due in 30 days were really de facto demand deposits.

The Federal Reserve staff itself admitted that, during the 1920s,

there developed a tendency to induce depositors to transfer their funds from checking accounts to savings accounts. Banks frequently not only allowed such a transfer but encouraged it in order to take advantage of lower reserves and to obtain a large basis for credit expansion. ... In many cases, particularly in large centers, the aspect of savings was impaired by allowing depositors to draw a limited number of checks against time deposits.4

Time deposits expanded more rapidly than demand deposits from the outset of the Federal Reserve System. From June 1914 to January 1920, when demand deposits were growing from $9.7 billion to $19.1 billion, or 96.9 percent, time deposits at commercial banks rose from $4.6 billion to $10.4 billion, or 126.1 percent. Then, in the great boom of the 1920s, starting after the recession of 1920–21, total demand deposits rose from $16.7 billion in July 1921 to $22.8 billion eight years later, in July 1929, an increase of 36.5 percent. On the other hand, time deposits in commercial banks expanded from $11.2 billion to $19.7 billion in the same period, a far greater rise of 75.9 percent. The great boom of the 1920s was largely fueled by credit expansion going into time deposits.

Furthermore, Phillips, McManus, and Nelson point out that by far the greatest expansion of time deposits came in Central Reserve Cities (New York and Chicago), where the Fed’s open market operations were all conducted. Central Reserve City time deposits rose by 232 percent from December 1921 to December 1929; whereas Reserve City time deposits rose by 132 percent and Country Banks time deposits by 77 percent in the same period. Moreover, most of the rise in time deposits occurred in the three years 1922, 1925, and 1927—precisely the three big years of open market purchases by the Federal Reserve, and hence of creation of new bank reserves by the Fed. Significantly, these facts show that time deposits in the 1920s were not genuine savings, but merely a convenient means by which the commercial banks expanded on top of new reserves generated by open market operations of the Fed.

Phillips, McManus, and Nelson describe the process as follows:

Chronologically and causally, the order of developments was as follows: Federal Reserve open-market purchases resulted in expansion of member bank reserve balances; this served to instigate increased purchases of investments by the member banks; and the credit generated thereby took the form largely of time deposits. The Reserve Banks pumped credit into the money market, inducing increased reserve to purchase investments ... which created more deposits in the banking system, and the increased deposits, being unneeded by business men and corporations as demand deposits for current transactions, were shifted to time deposits which could draw interest.5

That time or savings deposits were, for all practical purposes, equivalent to demand deposits was noted by Governor George L. Harrison, head of the Federal Reserve Bank of New York, who testified in 1931 that any bank suffering a run must pay both its demand and savings deposits on demand. Any attempt to enforce the official 30-day notice for redemption would probably cause the state or the federal Comptroller of the Currency to close the bank immediately. In fact, the heavy bank runs of 1931–33 took place in time as well as demand deposits. The head of the National City Bank of New York at the time agreed that “no commercial bank could afford to invoke the right to delay payment on these time deposits.”6


A deeply inflationary structure understandably sets the stage for inflationary policies. Policies are enacted and carried forward by particular people, and so we must examine the controlling groups, and the motivations and procedures for carrying out monetary expansion after the launching of the Federal Reserve. We know in general that the bankers, especially the large ones, were using the federal government as a cartelizing and inflationary device. But what of the specifics? Which bankers?

With the passage of the Federal Reserve Act, President Wilson in 1914 appointed one Benjamin Strong to what was then the most powerful post in the Federal Reserve System. Strong was made Governor of the Federal Reserve Bank of New York, and he quickly made this position dominant in the System, autocratically deciding on Fed policy without consulting or even against the wishes of the Federal Reserve Board in Washington. Strong continued to be the dominant leader of the Fed from 1914 until his death in 1928.

Strong pursued an inflationary policy throughout his reign, first during World War I, and then in spurts of expansion of bank reserves in the early 1920s, 1924, and 1927. While it is true that wholesale prices did not rise, they were prevented from falling from increases of capital investment, productivity, and the supply of goods during the 1920s. The expansion of money and credit generated by the Fed during the 1920s kept prices artificially high, and created an unhealthy boom and investments in capital goods and construction, and in such capital title markets as stocks and real estate. It was only the end of the monetary expansion after Strong’s death that brought an end to the boom and ushered in a recession—a recession that was made into chronic depression by massive interference by Presidents Hoover and Roosevelt.

But who was Strong and why did he pursue these inflationary and eventually disastrous policies? In the first place, it must be understood that, like other bureaucrats and political leaders, he did not emerge full-blown out of the thin air in 1914. At the time of his appointment, Strong was head of the Morgan-created Bankers' Trust Company in New York—a bank set up by the Morgans to concentrate on the new field of the trusts. Tempted at first to refuse this high office, Strong was persuaded to take the job by his two closest friends: Henry P. Davison, partner at J.P. Morgan & Co., and Dwight Morrow, another Morgan partner. Yet a third Morgan partner, and another close friend, Thomas W. Lamont, also helped persuade Strong to take up this task. Strong was also an old friend of Elihu Root, statesman and Wall Street corporate lawyer, who had long been in the Morgan ambit, serving as personal attorney for J.P. Morgan himself.

It is not too much to say, therefore, that Strong was a Morgan man, and that his inflationary actions in office accorded with the Morgan outlook. Without the inflationary activity of the Federal Reserve, for example, the United States could not have entered and fought in World War I. The House of Morgan was hip-deep in the Allied cause from 1914 on. Morgan was the fiscal agent for the Bank of England, and enjoyed the monopoly underwriting of all British and French bonds in the United States during World War I. Not only that: J.P. Morgan & Co. was the financier for much of the munitions factories that exported weapons and war materiel to the Allied nations.

Morgan’s railroads were in increasingly grave financial trouble, and 1914 saw the collapse of Morgan’s $400 million New Haven Railroad. Concentrating on railroads and a bit laggard in moving into industrial finance, Morgan had seen its dominance in investment banking slip since the turn of the century. Now, World War I had come as a godsend to Morgan’s fortunes, and Morgan prosperity was intimately wrapped up in the Allied cause.

It is no wonder that Morgan partners took the lead in whipping up pro-British and French propaganda in the United States; and to clamor for the U.S. to enter the war on the Allied side. Henry E. Davison set up the Aerial Coast Patrol in 1915, and Willard Straight and Robert Bacon, both Morgan partners, took the lead in organizing the Businessman’s Training Camp at Plattsburgh, New York, to urge universal conscription. Elihu Root and Morgan himself were particularly active in pressing for entering the war on the Allied side. Furthermore, President Wilson was surrounded by Morgan people. His son-in-law, Secretary of the Treasury, William G. McAdoo, had been rescued from financial bankruptcy by Morgan. Colonel Edward M. House, Wilson’s mysterious and powerful foreign policy adviser, was connected with Morgan railroads in Texas. McAdoo wrote to Wilson that war exports to the Allies would bring “great prosperity” to the United States, so that loans to the Allies to finance such exports had become necessary.7

Strong pursued his inflationary policies during the 1920s, largely to help Great Britain escape the consequences of its own disastrous inflationary program. During World War I, all the European countries had inflated greatly to pay for the war, and so were forced to go off the gold standard. Even the United States, in the war for only half the duration of the other warring powers, in effect suspended the gold standard during the war.

After the war, Great Britain, the major world power and in control of the League of Nations’s financial and economic policies, made the fateful decision to go back to the gold standard at a highly overvalued par for the pound. Britain wished to regain the prestige it had earned under the gold standard but without paying the price of maintaining a noninflationary sound money policy. It stubbornly insisted on going back to gold at the old prewar par of approximately $4.86, a rate far too high for the postwar pound depreciated by inflation. At one point after the war, the pound had sunk to $3.40 on the foreign exchange market. But, determined to return to gold at $4.86, Great Britain persuaded the other European countries at the Genoa Conference of 1922 to go back, not to a genuine gold standard, but to a phony gold exchange standard. Instead of each nation issuing currency directly redeemable in gold, it was to keep its reserves in the form of sterling balances in London, which in turn would undertake to redeem sterling in gold. In that way, other countries would pyramid their currencies on top of pounds, and pounds themselves were being inflated throughout the 1920s. Britain could then print pounds without worrying about the accumulated sterling balances being redeemed in gold.

The overvalued pound meant that Britain was chronically depressed during the 1920s, since its crucial export markets suffered permanently from artificially high prices in terms of the pound. Britain might have overcome this problem by massive monetary deflation, thereby lowering its prices and making its exports more competitive. But Britain wanted to inflate not deflate, and so it tried to shore up its structure by concocting a gold exchange standard, and by going back to a gold bullion rather than gold coin standard, so that only large traders could actually redeem paper money or deposits in gold. In addition, Britain induced other European countries to go back to gold themselves at overvalued pars, thereby discouraging their own exports and stimulating imports from Britain.

After a few years, however, sterling balances piled up so high in the accounts of other countries that the entire jerry-built international monetary structure of the 1920s had to come tumbling down. Britain had some success with the European countries, which it could pressure or even coerce into going along with the Genoa system. But what of the United States? That country was too powerful to coerce, and the danger to Britain’s inflationary policy of the 1920s was that it would lose gold to the U.S. and thereby be forced to contract and explode the bubble it had created.

It seemed that the only hope was to persuade the United States to inflate as well so that Britain would no longer lose much gold to the U.S. That task of persuasion was performed brilliantly by the head of the Bank of England, Montagu Norman, the architect of the Genoa system. Norman developed a close friendship with Strong and would sail periodically to the United States incognito and engage in secret conferences with Strong, where unbeknown to anyone else, Strong would agree to another jolt of inflation in the United States in order to “help England.” None of these consultations was reported to the Federal Reserve Board in Washington. In addition, Strong and Norman kept in close touch by a weekly exchange of foreign cables. Strong admitted to his assistant in 1928 that “very few people indeed realized that we were now paying the penalty for the decision which was reached early in 1924 to help the rest of the world back to a sound financial and monetary basis”—that is, to help Britain maintain a phony and inflationary form of gold standard.8

Why did Strong do it? Why did he allow Montagu Norman to lead him around by the nose and to follow an unsound policy in order to shore up Britain’s unsound monetary structure? Some historians have speculated that Norman exerted a Svengali-like personal influence over the New Yorker. It is more plausible, however, to look at the common Morgan connection between the two central bankers. J.P. Morgan & Co., as we have seen, was the fiscal agent for the Bank of England and for the British government. Norman himself had longtime personal and family ties with New York international bankers. He had worked for several years as a young man in the New York office of Brown Brothers & Co., and he was a former partner in the associated London investment banking firm of Brown, Shipley & Co. Norman’s grandfather, in fact, had been a partner in Brown, Shipley, and in Brown Brothers. In this case, as in many others, it is likely that the ties that bound the two men were mainly financial.

  • 1. Since the establishment of the Federal Reserve System, the reserve requirement limits on the Fed itself have been progressively weakened, until now there is no statutory limit whatsoever on the Fed’s desire to inflate.
  • 2. C.A. Phillips, T.E. McManus, and R.W. Nelson, Banking and the Business Cycle (New York: Macmillan, 1937), pp. 26–27. In fact, the inflationary potential of the new centralization was not as great as this, since the previous national banking system was not fully decentralized, but had already been quasi-centralized to pyramid on top of a handful of Wall Street banks.
  • 3. Phillips, et al., Banking and the Business Cycle, p. 23n.
  • 4. Quoted in M. Friedman and A. Schwartz, A Monetary History of the United States 1867–1960 (Princeton N.J.: National Bureau of Economic Research, 1963), pp. 276–77. Also ibid., p. 277n. See also Phillips, et al., Banking and the Business Cycle, pp. 29, 95–101.
  • 5. Phillips, et al., Banking and the Business Cycle, p. 99. On time deposits in the 1920s, see also Murray N. Rothbard, America’s Great Depression, 3rd ed. (Sheed and Ward, 1974), pp. 92–94; Benjamin M. Anderson, Economics and the Public Welfare: A Financial and Economic History of the United States, 1914–46, 2nd ed. (Indianapolis: Liberty Press, 1979), pp. 140–42.
  • 6. Quoted in Rothbard, America’s Great Depression, p. 316n. See also Lin Lin, “Are Time Deposits Money?” American Economic Review (March 1937): 76–86. Lin points out that demand and time deposits were interchangeable at par and in cash, and were so regarded by the public.
  • 7. On the role of the Morgans in pushing the Wilson administration into war, see Charles Callan Tansill, America Goes to War (Boston: Little, Brown and Co., 1938), chaps. II–IV.
  • 8. O. Ernest Moore to Sir Arthur Salter, May 25, 1928. Quoted in Rothbard, America’s Great Depression, p. 143. In the fall of 1926, a leading banker admitted that bad consequences would follow the Strong cheap money policy, but asserted “that cannot be helped. It is the price we must pay for helping Europe.” H. Parker Willis, “The Failure of the Federal Reserve,” North American Review (1929): 553.
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