Let’s recap for a minute:
As you’ll know from the last two posts (link to 1st, link to 2nd), American banking was a disaster at the turn of the century. The would-be (but not really) central banks failed. The free banks failed. And the national banks failed.
What happened during the panic, exactly? Well…as you might expect, panic or fud (Fear Uncertainty Doubt). A lot of it.
Within three weeks, the NY Stock Exchange fell by 50% from its peak the previous year! There was widespread panic, leading to bank runs, and as a result, many businesses went bankrupt.
Dow Jones Industrial Average 1904–1910
The panic really (and understandably) made many people question the resiliency of the US economy.
Financier J. P. Morgan (yes, you’ve definitely heard of him… his banks are still around today!) pledged a large amount of his own money to help prevent the economy from sliding into a deeper recession, and he convinced other New York bankers to do the same.
Each of these financial panics caused serious damage to the US economy. Bankers felt it was crucial to have a central bank that provided stability and emergency credit as needed. European states, for example, could expand the supply of money when banks were starting to have low cash reserves, and vice versa. The US did not have such a system.
The invention of the Federal Reserve
Five years later, under President Woodrow Wilson, Congress passed the Federal Reserve Act, which was signed into law in December 1913. With the Federal Reserve now official, the US finally had a central bank.
Originally, the Federal Reserve was created to address bank runs by being the money-creator of last resort whenever there was a downward spiral in the economy. While calming panics was the main goal, the founders of the Fed also had another goal: to expand the use of the US dollar globally and make it a more prominent currency in international trade.
The US was incredibly successful in meeting the second objective, in part due to a fluke of timing. Just as the Federal Reserve was established, World War I disrupted European financial markets and reduced the power of European banks to supply credit to international markets, which in turn provided a perfect opportunity for US banks.
By the mid 1920s, over half of US imports and exports were dollar-denominated. The relative strength of the US economy at the time paved the way for the dollar to eventually become the world’s leading reserve currency.
We started with a recap, so let’s end with another one:
So far, we’ve learned what money is, the functions it serves, the properties it has, and how money evolved from commodities to collectibles to metals to the greenish-gray paper you now fill your wallet with.
We’ve also learned how the concept of a central bank was first created in Europe, followed by the series of events that led to a central bank being created in the USA.
In the next post, we’ll take a closer look at what exactly the central bank’s role is and how it tries to keep us from having even more panics.