Financial History 144 Winter 2023 | Page 19

Act into law on December 23 , 1913 . In November 1914 , the system was up and running , and for the first time in history , the United States had a fully functional central bank . Currency stability was maintained by the issuance of Federal Reserve notes . Bank regulation was strengthened by the Fed ’ s new powers to examine and demand adjustments to banking practices . The Federal Reserve became the first US central bank to have the power to serve as a lender of last resort . Finally , the Fed gained the power to manage monetary policy by engaging in open market operations to adjust prevailing interest rates .
Wisdom from Failure
“ Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve . I would like to say to Milton [ Friedman ] and Anna [ Schwartz ]: Regarding the Great Depression . You ’ re right , we did it . We ’ re very sorry . But thanks to you , we won ’ t do it again .”
— Ben Bernanke , Former Chairman of the Federal Reserve , November 8 , 2002
“… the Federal Reserve System had the power to abort the inflation at its incipient stage 15 years ago or at any later point , and it has the power to end it today … It did not do so because the Federal Reserve was itself caught up in the philosophic and political currents that were transforming American life and culture .”
— Arthur Burns , Former Chairman of the Federal Reserve , September 30 , 1979
Since its establishment in 1913 , the Federal Reserve has prevented many financial shocks from spiraling into devastating financial crises . But the Federal Reserve has also made many mistakes . Most had consequences that were containable , but two failures stand out . The first was the Great Depression in the 1930s , and the second was the Great Inflation in the 1970s . With respect to the first error , the Fed ’ s actions in the early 1930s did not cause the Great Depression , but they did cause it to deepen unnecessarily . The biggest mistake was standing by idly while the banking system collapsed after several waves of bank runs .
Confidence in the banking system was restored after President Franklin D . Roosevelt declared a national bank holiday ( see article , page 18 ) and then slowly reopened banks in March 1933 . The most important lesson from the Great Depression was that preserving the integrity of the banking system — even when bank executives are unworthy of support — is critical to preventing catastrophic depressions . This lesson was applied during the Global Financial Crisis in 2008 and 2009 , and it explains why the US unemployment rate topped out at 10 % in 2009 rather than 25 % like it did during the Great Depression .
The Fed ’ s second greatest failure occurred in the late 1960s and 1970s . Under pressure from politicians , and impaired by an inaccurate understanding of the Phillips curve and natural rate of unemployment , the Fed allowed inflation to remain at elevated levels for too long . Once higher inflation expectations became entrenched in the American psyche , stagflation set in and Americans suffered from both high inflation and high unemployment . Chairman Paul Volcker ended the scourge of stagflation by enacting draconian monetary policies which caused a brutal recession from 1981 to 1982 . The key lesson from this experience was that taming inflation early and aggressively is essential to economic prosperity .
The lessons from the Great Depression and Great Inflation proved critical over the past three years . First , in March 2020 , the Fed acted quickly to provide liquidity to the financial system after a large portion of the economy suddenly shut down during the first year of the COVID-19 pandemic . This enabled the United States to avoid a repetition of the Great Depression . Then , in early 2022 , the Fed began tightening monetary policy aggressively to end post-COVID-19 inflation . This effort remains in progress , but lessons from the painful experience of the 1970s will likely prevent the Federal Reserve from ending the tightening cycle prematurely and inviting a repetition of the Great Inflation .
What Lies Ahead ?
In his recent book , 21st Century Monetary Policy , Former Federal Reserve Chairman Ben Bernanke presents multiple challenges that central bankers must overcome in the decades to come . Some are technical , such as managing monetary policy amid secular stagnation and a low natural rate of interest . But one challenge that is easily understandable is the growing threat to the Fed ’ s independence . Such threats come from both extremes of the political spectrum . Examples have included presidential attempts to influence FOMC decisions , proposed legislation to “ audit ” Fed monetary policy decisions and even legislation to restrict the Fed ’ s lender of last resort powers .
The United States has an exceptional economic track record , but one weakness is the tendency of politicians to yield to pressure to knock down walls without checking first to see if they are load bearing . History demonstrates that the presence of an independent central bank is essential to US economic prosperity . That does not mean the Fed is infallible . Over the past 108 years , the Fed has made many errors , with the most notable ones contributing to the Great Depression and Great Inflation . Fortunately , the Federal Reserve has learned from these errors and adjusted its tactics accordingly . Despite the imperfections of the Federal Reserve System , it continues to play a critical role in the economic success and financial stability of the United States .
Mark Higgins , CFA , CFP ® is a seasoned investment advisor with more than a dozen years of experience serving large institutional investors , such as endowments , foundations , public pension plans , and corporate operating reserves . He is also an avid financial historian and is publishing a book on the full history of the US financial system with Greenleaf Book Group in 2023 .
Bernanke , Ben . 21st Century Monetary Policy . New York : W . W . Norton & Company . 2022 .
Chernow , Ron . The House of Morgan . New York : Grove Press . 1990 .
Hamilton , Alexander . Final Version : First Report on the Provision Necessary for Establishing Public Credit . December 13 , 1790 . https :// founders . archives . gov / documents / Hamilton / 01-07-02-0227-0003
Stedman , Edmund . The New York Stock Exchange : Volume I . Stock Exchange Historical Company : New York . 1905 .
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