How the Federal Reserve was Born – Part II

Even prior to the passage of the Federal Reserve Act in 1913, banks were allowed to issue more promises to pay than they had in their vaults. In fact, they didn’t issue just a little bit more promises to pay than the money they had in the vault. They issued a lot more promises to pay than money in the vault by a factor of 300 to 1. If every depositor were to request his or her money back at the same time, the bank would most certainly go under. This was called a “run on the bank.”

A “currency drain” was another event that caused the same result as a run on the bank by depositors. People used checks to pay for things, rather than going to the bank to pull out cash for every transaction they made. If the check which the buyer gave to the seller was deposited at the same bank that held the funds of the buyer, nothing needed to be done except to adjust the account balanced of the buyer and the seller. However, if the check was deposited at a different bank, the banks needed to handle the necessary fund transfer between them. There was a good chance, however, that the deposits made at Bank A requiring funds from Bank B were similar in amount to the deposits made at Bank B requiring funds from Bank A. The net result was that very little money needed to actually be moved between banks at the end of the day.

Now imagine this going on between many banks. If they all used the same reserve ratio (amount kept in the vault relative to the amount of their “promises to pay”), then it would all pretty much even out and only small transfers between banks would be necessary. However, when one bank used a smaller reserve ratio than the other banks, they tended to have more outflows to other banks, simply because they had issued more promises to pay relative to what they had in their vault. Before the Federal Reserve Act, banks operated independently and didn’t all have to use the same reserve ratio. The reckless banks with the lower reserve ratio sometimes had to transfer all of their funds to other banks, thereby experiencing a “currency drain.” The end result for them was bankruptcy.

The Same Reserve Ratio for All Banks

The scheme concocted on Jekyll Island would force all banks to use the same reserve ratio. The result would be that all checks between these banks would balance, over a long-enough period of time. No individual bank would experience a currency drain and fail.

You might be thinking, “that sounds like a good thing.” Well, the downside is that the whole banking system can fail if the reserve ratio is set too low. This sounds like a bad thing. These schemers had a way to address this scenario, too. If the whole banking system were to fail, the economy, trade deficits, or any number of other scapegoats could be blamed for the failure. This, in turn, would justify saddling the public with saving the system. It truly was a scheme worthy of a Pinky and the Brain episode. Doesn’t this scenario sound familiar?

In truth, currency drains happened mainly during times of relative prosperity. Some banks would reduce their reserve ratio’s because there was so much opportunity to make loans, making them vulnerable to currency drains. Again, making loans was the only way to bring in interest payments. Currency drains caused panics in 1873, 1884, 1893, and 1907.

The Fed is a Success Story?

If the purpose of the Federal Reserve was to stabilize the economy, then they failed miserably. Since the creation of the Fed, we have experienced crashes in 1921 and 1929, we have had the Great Depression of 1929 to 1939, we have had recessions in 1953, 1957, 1969, 1975, and 1981. We have also experienced “Black Monday” in the stock market and inflation has reduced the purchasing power of the US dollar by 90%. In other words, in 1990, it would require $10,000 to buy what cost $1000 in 1914, the year after the Federal Reserve became a legal organization. Does this sound like a law that has benefited the public?

Yours in prosperity,
Sophia Hilton (A Savvy Woman)


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