Today we bring you Part V of “A Brief Monetary History of the United States” from the Ron Paul Monetary Policy Anthology. The full series can be found at the following links:
The Panic of 1907
The year 1907 saw a particularly severe financial panic and recession. The underlying cause of the recession, as in previous instances, can be found in the government’s intervention into banking and monetary affairs. The Treasury Department sought to conduct itself as a central bank, even to the extent of making purchases on the open market to supply liquidity to the financial system. Once the Treasury-created inflation bubble burst, banks began to fail and the stock market plunged. Specie redemption was once again suspended, leading to runs on banks.
In the aftermath of the panic, calls for reform of the monetary and banking systems intensified. The nascent central bank movement acted with renewed vigor in its attempt to create a central bank. The Aldrich-Vreeland Act, passed in 1908, established a National Monetary Commission, which ostensibly sought to examine possible reforms to the American banking system. Like many commissions established by Congress, its conclusions were pre-ordained. It was intended to solicit expert opinions in favor of central banking in order to convince the public of the necessity of creating a central bank. The commission surveyed the banking systems of the United States, Canada, Mexico, and many European countries, eventually recommending the creation and formation of a national reserve association, similar in structure to what eventually became the Federal Reserve System.
Creation of the Federal Reserve System
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Senator Nelson Aldrich (R-RI)
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Cartoon displaying opposition to the National Reserve Association, Aldrich’s original central bank proposal. Image: U.S. Money vs. Corporation Currency
Bankers hoped that with the establishment of a central bank, panics could be averted. They hoped that the central bank would create a more “elastic” money supply, allowing the supply of money to expand and contract with seasonal and other demand fluctuations. In addition, they hoped for the central bank to be a lender of last resort in the event that banks found themselves unable to make good on their obligations. While private clearinghouse associations existed to perform lender of last resort functions, they often lent at penalty rates in order to discourage banks from making regular recourse to loans from the clearinghouse. The creation of a central bank, it was hoped, would allow banks to take out loans at lower rates and with friendlier terms when they got into trouble.
The Federal Reserve’s Inflationary Character
Commencing operation not long after the outbreak of World War I, the Federal Reserve almost immediately started expanding the money supply. Just as the creation of the Banks of the United States and the passage of the National Banking Acts were intended to spur the purchases of government bonds, the Federal Reserve was involved from the outset in accommodating purchases of Treasury bonds for the war effort. Through special discount rates, easing of reserve requirements on the banks within the Reserve System, and other policies, the Federal Reserve grew the money supply to unprecedented levels. The cost of the war to the United States was immense, and the Fed’s inflationary monetary policy to help pay for the war resulted in a near-doubling of the domestic price index by 1920.
Depression of 1920-21
The Depression of 1920-21 is sometimes referred to as the “Forgotten Depression.” As a result of the policies both of the Federal Reserve and the federal government, the federal government’s debt level was enormous, and prices were rising at a rate of nearly 20 percent per year. The federal government responded to the end of the war by slashing its budget 65 percent from FY1919 to FY1920, while the Federal Reserve raised its discount rate. The drop in the monetary base and the overall contraction of credit were more severe than during the Great Depression, yet the Depression of 1920-21 only lasted about a year before the country pulled out of it. The federal government continued to slash its budget even further, and engaged in no intervention into the markets to combat the ensuing depression or its effects. The result was that the economy rebounded and recovered very quickly.
In the aftermath of the Depression of 1920-21, the Federal Reserve decided on a program of price stability. While price stability sounds innocuous at first, it really means a policy of subtle inflation. The general prices of goods have a natural tendency to decrease over time if the monetary unit remains stable. (A prime example from modern times is the decline in the price of computers.) When new goods or technologies are first introduced they are often expensive, but as technology improves and production increases, the price decreases. This natural tendency for prices to fall should lead to a gently decreasing price level. As time progresses and the price level falls, the purchasing power of each unit of currency increases. Increased production thus leads to an increased standard of living.
While industrial production increased throughout the 1920s, the Federal Reserve counteracted what would have been a naturally falling price level by adherence to its policy of price stability. Prices remained relatively stable throughout the decade, since the Fed would not allow prices to fall as low as they would have in an unhampered market. In fact, the money supply increased 61 percent from 1921 to 1929* and yet the price level remained relatively constant throughout that same period. The freeing up of resources due to reduced government expenditures and the increased use of newer methods of manufacturing allowed industry and markets to expand throughout the 1920s. But the benefits of lower prices through increased production and efficiency were masked by the Fed’s inflation of the money supply, which artificially propped up prices.
* Murray Rothbard, America’s Great Depression, p. 92
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