Long ago, in a universe of sane fiscal policy far away, there existed an institution, then new to the world of international banking and finance, called the Federal Reserve Bank, whose primary concern of the day—the day being its founding on December 13, 1913—was to have very large reserves of cash backed by even larger reserves of gold that were enough “to earn the public trust.” It was an unusual kind of organization, where crude, simplistic policy directives such as “safety and sound judgement”, “lawful money” and “normal monetary order” possessed none of the sophisticated reasoning of “zero-interest rate policy”, “helicopter Ben” and “quantitative easing’ characterizing that Bank’s latter day ne’er-do-well progeny. Few American bankers at the time really even wanted a “Fed”, fearing that the public--and the bankers themselves--would not understand what its mission was not: that is, to not be an endless source of easy credit and bail-outs. Indeed, it was altogether another world.
“There are always many citizens and some bankers who believe that a central bank exists for the purpose of making credit easy at all times and obtainable without difficulty by any bank, no matter what its condition may be or the circumstances under which it wishes to borrow”, wrote Thomas Conway, Jr. in a seminal article, “The Financial Policy of the Federal Reserve Banks” in The Journal of Political Economy in April 1914. A central bank, as “the bankers’ bank”, was in a general way expected to do what banks of the community were supposed to do for the individual business man and depositor, “and this does not mean that it is free to tend lavishly to a bank without inquiry into the purpose of the loan”, continued Conway. “Nor does it mean it is obliged to come to the rescue of every bank that is in serious difficulty.”
The early Fed founders took their cues from the central banks of the British and the French—in particular, those banks’ stringent codes of monetary conduct. Without wanting to romanticize the era, one may say that fiscal conservatism was indeed the international order of the day and the models of the mighty Bank of England and the Bank of France made high reserve ratios the imperative of the early Federal Reserve. Before the days of those Fed banks, no agency existed to lead banks in attempting to avoid undue credit expansion such as preceded the crisis of 1907. The general economic situation at the time was comparatively sound and the crisis was largely a result of the excessive inflation caused by the banks. “The importance of a large reserve cannot be too strongly emphasized”, wrote Conway, “and the directors of these institutions must be forced by public opinion, if necessary, to realize that they are trustees of the nation’s prosperity and that they must carry large reserves.” Conway added: “It would be very unsafe for the Federal Reserve Banks customarily to allow their reserves to run down below 50% and safety demands, at least in the early years when the system is getting into operation that reserves shall run as high as 75%.”
The Federal Reserve Act had provided that every Federal Reserve bank would retain “reserves in gold or lawful money of not less than 35% against deposits and reserves in gold of not less than 40 % against its Federal Reserve notes in actual circulation.” Inflation was not seen as a threat because of this large storehouse of gold. Still, prudence and caution ruled the day. As Charles Sumner Hamlin, the first Fed chairman, was to point out: “So long as the reserves of the Federal Reserve Banks are above the point demanded by safety and good judgement, there is no reason why demands for funds by a member bank should not be met out of the stock of lawful money and gold in the vaults of the reserve banks.” He then warned: “But when the reserves of the reserve banks fall to the point where any further depletion would weaken them, or cause anxiety among bankers and businessmen, the Federal Reserve Banks should disregard all thought of their saving which they can effect by paying out lawful money and should resort to the practice of issuing Federal Reserve notes.”
It is interesting to note that after World War I, the governors of the British and the French central banks remained as conservative as ever, insisting upon about putting their fiscal house in order to pre-war standards. Keynesian “monetary policy” and genteel welfare-state-ism had not yet become the intellectual opiate of choice amongst these philosopher-economists. This mindset is described in a colorful article, “An Analysis of the Condition of the Central Banks of England, France and the United States 1911-1919”, published in an MIT economics journal of September 1919, which details a meeting that January of the “Special Committee on Currency and Foreign Exchanges after the War” headed by Lord Cunliffe, then Governor of the Bank of England. Cunliffe expressed caution at the ravages of war- financing by the state and its threat to the gold standard. Acknowledging the inevitable fiscal stress of war expenditures, Cunliffe nonetheless maintained that the practice had led “to an effective departure from the gold standard, to a real though not measured depreciation of the currency in terms of gold, and to the stopping of the Bank of England's recognized machinery for controlling discount rates, the foreign exchanges, and the gold supply.” He urged the Committee to restore “without delay” the conditions necessary to the maintenance of an effective gold standard” and also demanded, “as essential steps in this restoration, the end to government borrowings and the early repayment of government securities held by the banks, the gradual reduction in the currency note issue, and its eventual replacement by Bank of England notes.”
The same sense of fiscal urgency held true for The Bank of France at the end of World War II, whose authorities also shunned debt and money printing and “looked with grave misgiving upon the increase in the note issue” for the “extraordinary arrears in the form of advances to the state”, as detailed in the above-cited article. At the end of 1918 these debts had reached a total of over twenty billion francs (6o% of notes in circulation), in spite of the Bank's endeavors to reduce the loans made to the state. The Governor of the Bank of France, Georges Pallain, apologized for this situation by stating at a stockholders’ meeting in January 1919: " The excessive issue of bank notes, the leading item in the list of our liabilities, weighs heavily on exchange conditions and aggravates the crisis in prices…The repayment of the debt of the state to the Bank is the necessary condition for this, and the only means of re-establishing normal monetary order.”
Having watched closely the situation in Europe, the U.S. was confident of its prudent attitude. Aldoph Miller, head of the Federal Reserve of New York, wrote in 1921 of Federal Reserve policy: "The three chief elements of the policy of a central bank or system of reserve holding institutions are best disclosed in connection with the attitude towards 1) gold 2) currency 3) credit." He noted proudly: "The federal reserve system has met [these] tests on the whole with remarkable success."
Nonetheless, years prior to the outbreak of World War II, the seeds of the corruption of the “bankers’ bank” largely black-and-white view of the world—its obsessive fiscal conservatism, its focus on fundamentals, its suspicion of anything that “eased” or loosened standards of credit—was giving away to philosophical and intellectual blurred lines and vagaries of language. “It is increasingly more difficult to distinguish monetary and economic policy”, wrote scholar Harold D. Gideonese, in an essay “Money and Finance” of May 1934. “We are far from a time when economic advisers could set up a ‘gold standard’ without concern for related problems such as debt payments and their relation to a creditor country’s tariff policy.”
And even as early as 1920 bankers echoed the experience of the governors of the Bank of England and the Bank of France in warning against money-printing magic of central bank tendencies and that the panacea of any fiscal crisis was discipline. A Barton Hepburn of Chase National Bank, then president of that institution, in a lively address otherwise dryly entitled, “A Discussion of Financial Policies in Relation to Government Inflation” of June 1920 to the Academy of Political Science in New York City. Hepburn stated: “We struggled here in this country for forty years to amend our archaic banking laws, and finally succeeded […] But the administration of the Federal Reserve banking system has made it a central bank; the system is absolutely dominated by the Federal Reserve Board at Washington and the Secretary of the Treasury, more particularly the latter so far, because of the extreme needs of the Government in its financial operations during the war. In its administration, I think that the system is worthy of all credit, .and we are very much to be congratulated upon having it in force in our country. Dr. Willis alluded to the fact that it was regarded as a superman and more was expected of it than could be realized; that is true. […]We cannot now have a money stringency panic, but we can have panics in this country, and unless I am very much mistaken, we are heading toward one now; there are all the elements of danger not only underneath the surface but right on the surface, and no panacea will correct them except economy and conservatism.”
"It was, at least in theory, simple enough in the old days," wrote a wistful W. Randolph Burgess, head of the New York Federal Reserve, in 1938. "In the present strange new world, where the old gold portents have lost their former meaning, where is the radio beam which the central banker may follow? As noted in this article , “the men of his era and of the late nineteenth century understood the meaning of such a question and, more importantly, why it is one that must be asked.” But theirs was a different world, when some antiquated notion such as “the public trust” guided policy and to be a conservative was the most future-oriented outlook one could adopt.