Money, Banks, and Power: Birth of the Federal Reserve System

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The American Founding Fathers envisioned a very different monetary system than the one we have today. This article explores the origin of our current money system, who is behind it, and why Congress bought into it without constitutional authority. We will begin with a tour of the history of banking in Europe.

The Story of the Bank of England

In 1694, King William III of England needed a significant amount of money to fund the war against France. To obtain the necessary funds, he borrowed from a wealthy Englishman named William Paterson and his associates. In exchange for the loan, Paterson and his group requested two key privileges: the establishment of a privately owned bank, which they called the Bank of England, and the authority from the king to issue their own banknotes as the official legal tender for England.

The Bank of England promised that these notes would be redeemable, "on demand", in gold. However, the bank soon issued more notes than it could back with gold. To work around this problem, Paterson entered into an agreement with the King, promising him a percentage of the interest on the notes if the bank could loan out more notes than it could legitimately back with gold. This system allowed the bankers to effectively create money out of thin air, a practice known as fractionalized banking.

"Fractional Banking" — Making Money Out of Nothing

Fractional banking, also known as "reserve banking," began with goldsmiths in Europe who built secure vaults for storing precious metals. When other people requested to store gold with the goldsmiths, they received certificates that represented their deposits that could be traded as though they were gold or used to reclaim their gold.

Since only a small percentage of depositors came to retrieve their gold at any given time, the goldsmiths realized they only needed to keep a fraction of this precious medal on hand as a "reserve", to meet the needs of those who did. Recognizing this, the goldsmiths started issuing more gold certificates than the actual amount of gold they held. This practice allowed them to create certificates on gold they didn't possess, effectively "making money out of nothing." These certificates could be used to purchase tangible assets, or be loaned out with interest, offering a path to significant wealth for the bankers.

The Challenge of a "Bank Run"

Occasional suspicions arose that a bank might not possess as much gold as claimed. This led to a rush of people attempting to exchange their certificates for available gold before it depleted, commonly known as a "run on the bank." In such situations, the banks would initially attempt to reassure the first depositors by promptly providing the precious metal in exchange for the certificates.

Nevertheless, if the "run" persisted, they could not sustain this pretense for long as the bank's gold reserves would eventually be exhausted. In such cases, the only recourse was to "close their doors" in disgrace and cease their banking operations.

Can You Sell the Same Horse to Four Different Buyers?

Fractional banking could be likened to a farmer who sells the same horse to multiple buyers, each with different riding schedules. The farmer sells the horse again and again, thinking he can do so safely. The problem arises when all the buyers decide to ride their horse at the same time. This situation is comparable to a "run" on the bank, where multiple people demand their deposits at the same time, leading to potential trouble.

Avoiding “Bank Runs”

The major banks in Europe learned to avoid "bank runs" by establishing cooperative agreements with other banking families. If a bank faced a run from depositors wanting their gold, other banks would pool their gold resources and send help to the troubled bank until the situation calmed down. They realized that if a bank could demonstrate it had sufficient gold to honor its certificates, people would regain confidence and redeposit their gold. Eventually, the gold could be returned to the central banks from which it was temporarily gathered. This practice helped maintain stability in the fractional banking system.

Fractional Bankers Do Something Ordinary People Cannot Do

Since fractional banking is literally "making money out of nothing," banks who engage in this practice literally sell something they don't truly possess. This practice would be considered fraudulent for an ordinary individual, much like selling a horse they don’t own. However, European bankers found a way around this by involving the government in their operations. The bankers recognized that if the government benefited significantly from the arrangement, it was unlikely to prosecute them. To do this, they established privately owned banks that essentially covered the entire nation's banking needs. By sharing the benefits with the government, they made these banks appear as official government branches. This is what William Paterson did when he founded the Bank of England.

When the King recognized the potential for profit through the scheme of fractional banking, he created a plan that largely eliminated competition for the Bank of England. He did this by granting Paterson and his associates an official charter and required the goldsmiths of London to stop issuing receipts as depositories for precious metals. This led most merchants to store their gold with the Bank of England, solidifying the bank's position as the official depository of the Crown and the issuer of legal tender banknotes. This historical episode marked the establishment of a privately owned bank that had the power to create money out of nothing, a practice that continues to influence monetary systems today.

These central banks gained immense economic and political power, becoming the primary managers of a nation's money and credit. They handled significant investments in various sectors, including agriculture, industry, and housing. Importantly, they also lent money to the government, particularly during emergencies such as wartime. As a result, the governors of these central banks found themselves overseeing both government affairs and the nation's economy.

Central Banks Suffer from Two Temptations

Central banks often face two destructive temptations when seeking ways to accumulate more wealth. The first temptation is to encourage war involvement, as it forces the nation to borrow heavily, and government bonds become valuable collateral assets for the central bank. The second temptation is to manipulate the economy through "boom and bust" cycles. This involves starting a boom with low-interest loans, then abruptly raising interest rates, calling in loans, and causing financial hardship for homeowners, industries, farmers, and millions of people who trusted the bank's policies.

While some economists, including Karl Marx, argue that these cycles are inherent to a free-market economy, they are in reality a result of manipulated economics orchestrated by those in powerful positions to control money and credit. These cycles often involve warmongering and economic manipulation. Understanding these issues is essential when examining the history of banking, as they are recurrent problems driven by wealthy money managers who exploit their power for personal gain.

How the American Colonists Originally Developed a System of "Sound" Money

In the late 17th century, the leaders of Massachusetts decided to establish a system of "sound money” to stabilize their economy. They sought to issue money exclusively through the government to represent the interests of the entire population. Sound money encourages investment, as people know their money's value will remain consistent, and it also encourages saving, as the money retains its value and accumulates interest over time. There are historically two ways to achieve stable money: tying currency to precious metals that have a stable value or regulating the money supply to match the growth in productivity.

Massachusetts introduced its own paper money on July 2, 1692, making it full legal tender for all types of debts, public and private. This currency was used to cover public expenses, fund public projects, and provide loans to private citizens for extended periods at low interest rates. These currency bills were physically treated as if they were precious metals, and the interest earned on loans was paid into the colony's treasury, reducing the need for taxes. The colony didn't pay interest to anyone. Other colonies adopted similar sound monetary practices, leading to a period of remarkable prosperity for colonial America.

The Bank of England Invades America

In the early 18th century, the privately owned Bank of England sought to compel the American colonies to borrow "bank notes" from them. The Bank of England encouraged the British Parliament to outlaw colonial money, but the colonies resisted. This defiance continued for several years but abruptly ended in 1749 when the British Parliament passed the Resumption Act, which mandated that all taxes and contracts had to be settled with gold or silver. Since precious metals were scarce within the colonies, this decision had disastrous consequences, leading to a severe depression characterized by falling prices and stagnant trade. These economic hardships played a significant role in triggering the Revolutionary War.

Early Americans Learn a Bitter Lesson in How Not to Issue Money

After the colonies declared their independence, Congress and the states began issuing paper money without any significant limitations. This "Continental" currency was not backed by precious metals, and there were no constraints on the quantity issued. As a result, the Continental dollars experienced massive inflation, becoming worth less than a penny. Even after winning the Revolutionary War, this monetary system led to skyrocketing inflation, a severe economic downturn, and social unrest. The situation was so critical that some New England states threatened to secede.

To address these issues in the new constitution, it was decided that Congress, alone, would have the duty of coining money and regulating its value. This change attempted to bring back a system where the government issued the money and tied it to precious metals. The treasury would create branches to provide loans as it did before 1720, and the interest earned would help fund the nation, reducing the potential for high taxes.

Alexander Hamilton Makes a New Proposal

Even though the gold and silver standard was explicitly written into the Constitution, Alexander Hamilton, who served as the Secretary of the Treasury under George Washington, proposed a plan to address the nation's substantial war debt. Hamilton's plan involved issuing bonds and selling them to private banks. He also advocated that these private banks, for a period of twenty years, establish a bank in the name of the United States, which would be responsible for issuing money, controlling its quantity, determining its value, and financing the U.S. government. President Washington was particularly attracted to the idea of having the bank finance the government.

However, there was no constitutional authority for the federal government to create such a bank. Hamilton argued for the concept of "implied powers," which has since undermined the very definition of a "limited" government. Despite Washington's initial discomfort with the idea, Hamilton convinced him by making rosy promises of stability and prosperity under this "temporary" arrangement. Eventually, Washington set aside his concerns and signed the bill into law.

As it turned out, Washington's initial concerns about the plan were justified. Even Hamilton himself acknowledged that the plan had been a significant mistake. In 1798, He wrote a letter to his successor, Oliver Wolcott, urging him to encourage the abandonment of this plan he had devised, and return to the original concept discussed at the Constitutional Convention. Hamilton proposed that the government should create its own money circulation, which would require ending the practice of allowing private banks to issue money.

The First Bank of the United States

The First Bank of the United States, despite being privately owned, was named the Bank of the United States, giving the impression that it was a government institution. The advantage of the new bank was its ability to provide immediate credit resources to a financially struggling nation. This practical benefit appealed to President Washington, notwithstanding the associated risks.

However, Secretary of State Thomas Jefferson strongly protested the establishment of the bank, leading to a heated dispute with Alexander Hamilton. Jefferson argued that the bank was unconstitutional, as there was no Constitutional authority for granting it a charter. Furthermore, the bank was permitted to issue paper money, an unauthorized delegation of Constitutional authority. The charter also allowed the bank to loan out its notes for interest, exempted it from paying taxes, and made it responsible for collecting taxes and holding government funds instead of the U.S. Treasury. Only one-fifth of the bank's stock was owned by the government, ensuring that private banks had control over national policies and decision-making. Jefferson saw this scheme as an unconstitutional threat to American civilization, expressing concerns about banks controlling the issuance of currency through inflation and deflation, which would ultimately deprive the people of their property. He believed the power of issuing money should be taken from the banks and returned to Congress and the people.

The Struggle for Power

This tactic of using a government-like name was employed again in 1913 when the Federal Reserve System was created. The Federal Reserve System was a result of a complex and manipulative process characterized by intrigue and political maneuvering, along with the deliberate creation of an economic crisis. The main driving force behind these actions was the significant financial prize at stake and the desperation of the major money managers to gain control of it. What stands out in this period of financial history is the ruthless and relentless competition among top money managers, demonstrating a "dog eat dog" mentality.

Moreover, the record shows that this same cutthroat code of behavior extended to exploiting and deceiving the common people, who were often left helpless because they didn't fully comprehend the events unfolding around them. In the high finance circles, all the participants were well aware of the dynamics at play. They strategically navigated the complexities of the money markets, aiming to gain a legal advantage over their rivals, potentially leading to the annihilation of opponents. This power struggle was in full swing when the financial crash of 1907 was triggered.

Wall Street Goes for a Bust in 1907 and 1908

The economic turmoil that gripped the United States in 1907 and 1908 resulted from a fierce financial battle on Wall Street, where a major money trust sought to eliminate its competitors. The conflict began when John D. Rockefeller's interests in Amalgamated Copper aimed to destroy Frederick A. Heinze's Union Copper Company. The Rockefeller faction manipulated the stock market, causing Heinze's Union Copper stock to plummet from 60 to 10. Rumors were spread that not only Heinze Copper but also the Heinze banks were succumbing to Rockefeller's pressure. J.P. Morgan joined forces with the Rockefellers, suggesting that the Knickerbocker Trust Company would be the first of Heinze's banks to fail.

This triggered a run on the Knickerbocker Bank, as depositors rushed to withdraw their funds, eventually forcing the bank to close. Fear and panic spread to other Heinze banks and then across the entire banking sector, leading to the financial crash of 1907. Millions of people lost their savings and homes, and a shortage of circulating money made the situation worse. To address the crisis, J.P. Morgan intervened, offering to rescue the last Heinze bank, the Trust Company of America, in exchange for the Tennessee Coal and Iron Company in Birmingham, which he wanted to add to the U.S. Steel Company. Despite violating anti-trust laws, the transaction was approved in the crisis atmosphere.

J.P. Morgan also recognized the utility of "tokens" issued by various businesses as a temporary medium of exchange, which was widely circulated. He convinced Washington, D.C., to allow one of his establishments to issue $200 million in "tokens," which were essentially certificates backed by corporate credit. This move helped restore public confidence and prompted the circulation of hoarded money. J.P. Morgan's experience with creating "certificates" out of thin air and receiving formal approval from the government planted the seeds for the creation of the Federal Reserve System in his mind.

How J.P. Morgan Became Attracted to Woodrow Wilson

J.P. Morgan's reputation as a savior of the financial system greatly impressed Woodrow Wilson, who had established himself as a respected writer and educator in the early 1900s. Wilson's influence extended to Princeton University, where he essentially shaped the Department of Political Science. He was critical of the American system of government, advocating for stronger administrative control over the nation's affairs, which diverged from the Constitutional concepts of the Founding Fathers. Wilson even suggested that a committee of public-spirited individuals like J.P. Morgan could avert economic troubles, highlighting his inclination for centralized power in Washington, D.C.

When Wilson became president of Princeton University, Morgan began encouraging him to enter politics. By 1910, Wilson won the New Jersey gubernatorial election, and in 1912, he was pushed into the presidency of the United States, as these same forces played a key role in his political rise.

The Popular Demand for Monetary Reform

In 1908, J.P. Morgan, with the help of Senator Nelson W. Aldrich, aimed to establish a private central banking system in the United States, akin to those in operation in Europe. Morgan's motivation stemmed from the satisfaction of issuing "certificates" based on his corporate credit, reminiscent of the goldsmith-bankers' schemes.

Simultaneously, public pressure was mounting, demanding reforms to eliminate Wall Street's control and exploitation of the economy. Senator Aldrich was appointed chairman of the National Monetary Commission, tasked with studying the U.S. monetary system and suggesting improvements. The commission traveled to Europe, and after spending $300,000, returned with a report that praised Europe's central banking system.

At a similar time, Paul Warburg, with support from the Rothschild family, came to the United States. He joined forces with Wall Street financial leaders and Senator Nelson Aldrich and traveled across the nation, giving speeches at universities and business groups. Warburg promoted a new national banking system to stop the damaging economic cycles on Wall Street, assuring that it would limit the influence of major bankers. The public embraced his message, unaware that Wall Street had its own plan for monetary reform in the works.

The Meeting at Jekyll Island

On November 22, 1910, a group of influential individuals, including Senator Nelson W. Aldrich, A. Piatt Andrew, Frank A. Vanderlip, Henry P. Davison, Charles D. Norton, Paul Warburg, and Benjamin Strong, met in secret on Jekyll Island, Georgia, at the J.P. Morgan estate. Over nine days, they crafted a bill for Congress that would become known as "The Aldrich Plan." To garner support for the plan, major banks contributed five million dollars to influence Congress and the American public.

However, the plan encountered resistance in the House of Representatives, where an investigation had exposed the role of powerful financial interests on Wall Street, especially Rockefeller and Morgan, in the 1907-1908 financial crisis. As opposition grew, it became clear that the Republicans would not be able to pass the Aldrich Plan.

To overcome this hurdle, the strategy shifted to the Democratic party, which presented an alternate plan called the Federal Reserve System. This plan was nearly identical to the Aldrich Plan but bore a different name.

The Election of President Wilson

In the lead-up to the 1912 election, the primary goal was to prevent the Republican President, William Howard Taft, from opposing the Aldrich Plan. To achieve this, the political strategy was modified to encourage Teddy Roosevelt, another popular Republican, to run as an independent candidate against Taft. This division within the Republican party aimed to benefit the Democrats. Key figures from the Morgan and Rockefeller camps, including Fran Munsey, George Perkins, George Harvey, and others, threw their support behind Roosevelt and Wilson. Notably, some Morgan officials who managed Roosevelt's campaign also provided substantial funding for Wilson. The strategy succeeded, and Woodrow Wilson was elected President.

The Wilson Administration Begins Reshaping America

When Woodrow Wilson assumed the presidency in 1913, he enlisted Wall Street advisers, including Colonel Edward Mandell House, who played a pivotal role in shaping the Wilson administration's policies. A bill was promoted to establish the Federal Reserve System as a privately owned central bank, which closely resembled the previously rejected Aldrich bill.

Wall Street financiers executed a coordinated act to publicly protest the bill, employing strong language like "populistic," "socialistic," and "destructive." However, it was largely a smokescreen. Privately, many of them were more supportive. William G. McAdoo, Wilson's Secretary of the Treasury, noted the disingenuous nature of their opposition and discovered their true feelings in private discussions.

In this environment of supposed Wall Street opposition, Congress ultimately passed the bill, swayed by promises of preventing depressions, stabilizing the money system, and reducing Wall Street's influence on American life. Congressman Charles A. Lindbergh voiced strong opposition, but the bill passed in the House on December 22, 1913, the Senate on December 23, and was signed into law by President Wilson the same day. This act created a powerful private central banking system that would later play a significant role in shaping the country's economic and political landscape. Its long-term consequences have unfolded over the subsequent century, including the confiscation of gold, inflation, and the nation's entanglements in foreign affairs.