The banking panics of the Gilded Age were caused by the vast power of New York City banks to control the economy through control of the money and credit supply. These were symptoms of the National Banking System that had existed since the Civil War. Due to federal legislation, interior banks could only earn interest on their reserves by depositing them with larger national banks in New York City. When planting season arrived and the farmers needed credit, the interior banks would rely on the New York City banks to return their deposits and provide them with liquidity. This gave the New York City banks power over a large percent of the nation's capital, which gave them the opportunity to exert tremendous influence over the stock market and play speculative games for profit. During panics, these irresponsible investments would come to light, and the New York City banks would be unable to provide money to the interior banks. This would cause a contraction of the money supply throughout the whole country, which would decrease employment, prices, and investment. The rigid gold standard made these panics even worse because it did not allow for sufficient expansion of the money supply during times when the demand for credit was high. Nevertheless, there were many methods of providing liquidity during crises which effectively reduced the severity of these panics. The US Treasury, for example, would buy bonds back early and make deposits to shore up the reserves of shaky financial institutions. In addition, the actions of the New York Clearing House (NYCH) strongly affected the severity of the banking panics of the Gilded Age. The movements for banking reform in the early 1900s were strongly motivated by the need for a more elastic currency, but the reform movement did not attack the gold standard for constricting the money supply, and it did not attack the National Banking System for centralizing banking power in New York. Mainly spearheaded by big bankers, the reform movement instead fought for centralized coordination of banking power to create this much needed elasticity, and the Federal Reserve System replaced the National Banking System in 1913. Pooling gold and reserves in a central bank would reduce transactions costs, make it easier to expand and contract the money supply in reaction to the market, and create a system which was not biased against interior banks, but it would also lead to uniformity in the economy rather than diversity and centralized control of the economic fate of the nation.
The National Banking System had already increased the severity of the panics of the Gilded Age by concentrating banking power in New York City, yet the banking reform movement further centralized banking power by enacting the Federal Reserve System. In the National Banking system, rural banks had to keep their reserves in city banks if they wanted to earn interest, and city banks had to keep their reserves in New York City banks in order to earn interest. The New York bankers would use the interior banks' deposits to invest in the stock market, attempting to use their massive power over other people's money to affect market trends for speculative profit. If the New York banks had over-invested and could not meet the volatile credit demands of the interior banks, there was the danger of a panic. Louis Brandeis demonized JP Morgan and the New York Money Trust, claiming that “a main cause of these large fortunes is the huge toll taken by those who control the avenues to capital and to investors.” Brandeis recognized that the bankers in New York were using their control of credit for personal gain, and he endorsed legislation to make their activities and profits transparent to the public. Brandeis encouraged states to act as their own banks in order to cut out the middlemen, but government intervention would actually increase the power of the Money Trust. Some have argued that the Money Trust was quite incapable of controlling competition through their management of credit before the Federal Reserve System, and that the banking reform movement was the big bankers' reaction to the decentralization of power which was the trend after the mergers of 1901.1
The increased power of the federal government over banking which came with the passage of the Federal Reserve Act simply increased the power of the big banks, since they could control legislation most easily at the federal level. The big bankers had most strongly supported the Aldrich Bill, which proposed the creation of a National Reserve Association run by bankers to issue the country's currency, set interest rates, and centrally regulate the whole country's money supply. Since the Aldrich Bill had given bankers the responsibility of choosing the managers of the central bank, it evoked much public criticism, and the Glass-Owen Bill would ultimately pass as the Federal Reserve Act under Wilson. While the Glass-Owen Bill gave more control of the Federal Reserve System to political appointees, it was similar to the Aldrich Bill in that it still created a central bank to coordinate the nation's access to credit, and "in certain spots even the language of the two bills was identical." The power of New York bankers had begun to decrease after the 1890s, and the banking reform effort which created the Federal Reserve System was meant to offset the decentralization of banking power. In fact, the Glass-Own Bill centralized banking power even further than the Aldrich Bill had proposed to, enacting national rather than regional control. Aldrich though that the Glass-Owen Bill would “be the first and most important step toward changing our form of government from a democracy to an autocracy,” making it clear that the Federal Reserve Board would determine the entire nation's livelihood. Ben Bernanke agreed with Milton Friedman's assessment that the Federal Reserve Board's irresponsible decisions in setting the interest rate exacerbated the Great Depression, and he promised it would never happen again, but why didn't he criticize the structural issues which give so much monopolistic power to one governing board, how can he vouch for the future chairmen? While the Federal Reserve Act would dismantle the National Banking System's pyramidal structure and level interest rates to the benefit of the South and West, its greatest advantage would be its ability to expand and contract the money supply based on the needs of the market. It would be impossible for the central planners to detect the needs of the market, however, because nobody, not even elected experts, can predict the future, and the flexibility and adaptability of money markets under free banking is preferable to the minor reduction in transactions costs achieved under central banking.2
While it would be easier to control the money supply under the Federal Reserve System, there were already a variety of methods which had provided for monetary expansion during crises. Clearing houses emerged as a simple way for banks to clear checks but they soon began to take on the functions of a lender of last resort. The panic of 1873 was solved quickly because the New York banks had pooled their reserves in the NYCH and had sufficient access to money and credit. The panics of 1884 and 1890 (I know what you're saying: what panics?) were ameliorated by the use of clearing house loan certificates, which acted as an internal currency for bankers and freed up money for public circulation. Benjamin Tucker's Liberty, a contemporary magazine, had recognized that these clearing house certificates were so effective because they had increased the money supply with currency that was not redeemable in gold. These certificates were not allowed to circulate among the public because the federal government would levy a ten percent tax on these notes and indirectly prohibit them. While Brandeis recognized that the federal government was taxing private and state bank notes out of existence, he did not consider the malicious effect this had on restricting credit when it was in high demand. In addition to the reserve pooling and the loan certificates of the clearing house, elasticity was also provided by the US Treasury, which “would often shift gold and currency to different regions” in order to provide credit where it was needed the most. During the Panic of 1907, Roosevelt's Treasury would provide credit to banks without any guidelines about how to spend it, using public money to insulate the bankers from their monetary mismanagement. The actions of the clearing houses and the US Treasury in expanding the money supply determined the severity of the panics of the Gilded Age, and the failure of the NYCH in ameliorating the Panic of 1907 can be seen as the catalyst which drove the banking establishment to clamor for a public lender of last resort.3
The devastating Panic of 1907 was so destructive because the NYCH, the traditional lender of last resort, refused to save the Knickerbocker Trust. There had not been a clearing house for the trusts, even though they carried out many of the same functions as banks, and the NYCH did not want to take responsibility for this one. The closure of Mercantile Bank, which had occurred due to a failed attempt to corner the market on United Copper Company stock, caused the subsequent failure of other banks which endangered the liquidity of Knickerbocker Trust. Even though there were adequate reserves, the NYCH had suspended cash payments to depositors for three weeks, and this only drove to worsen the panic. In addition, the NYCH refused to use loan certificates to increase the supply of credit during this severe crisis. The Knickerbocker Trust was finally saved when JP Morgan personally provided a loan, using its securities and assets as collateral. With the support of US Treasury deposits, Morgan was able to pool enough money to shore up the Knickerbocker Trust and prevent further bank runs and failures. The refusal of the NYCH to cooperate with the banks and expand the money supply increased the severity of the panic to such an extent that people began to look to the government to provide clearing house services for the banking industry.4
Bankers understood that severe panics could be avoided if the money supply could expand and contract based on the needs of the market. The National Banking System had caused such a concentration of money in the hands of New York bankers that the entire economy of the nation was reliant on the cash reserves in New York, which fluctuated radically based on the stock market trends. This inextricably tied the fate of the interior banks to the fate of the New York banks. Essentially, such a large amount of resources were under the control of so few banks that failure became an impossible option for the larger banks and trusts. In light of the centralized coordination of so much money, certain institutions became so large and essential that only the government could provide the guarantee that the bankers were looking for. A Federal Reserve System could be beneficial because it would be easier to expand and contract the money supply when necessary, but the fate of America's economy would be completely reliant on the wisdom of the Federal Reserve Board's decisions. These central planners would need to be able to predict future market trends in order to know exactly when to expand and contract the money supply for the benefit of the public interest. If the interest rates were set too low during periods of over-investment, a recession would be caused by the liquidation of these bad investments, and if the interest rates were set too high during recessions, there would not be enough credit to maintain price levels and employment. The Federal Reserve System, which mandates that the whole country's interest rate is to be set by one monopolistic governing board, does not allow for individual choice or secession, and this is a problem because the fear of losing customers to competition is the most effective check on irresponsible management. Without competition, public oversight is the only method of ensuring that the central planners are at least trying to act in the public interest, but the Fed's activities are not even transparent to the public! Even if we gain the right to audit the Fed, this will be insufficient because the uniformity of policy and the lack of diverse experimentation will still remain, and this deprives us from essential information which allows us to understand what is in our interest. In conjunction with the US Treasury, clearing houses were already providing the liquidity that was needed to protect the nation from panics and recessions. This kept the panics of the Gilded Age contained and small in comparison to later recessions. To solve the remaining elasticity problems, the reform should have focused on eliminating the ten percent tax on private and state-chartered bank notes to increase the flexibility of the money supply. In addition, the gold standard should have been lifted to allow money to be created with any sort of asset as collateral. Instead, big bankers guided reform to increase rather than decrease the centralization of banking power, and reliance on fewer and fewer banking institutions would lead to even more severe recessions and depressions.5
1Robert F. Bruner and Sean D. Carr, The Panic of 1907: Lessons Learned from the Market's Perfect Storm (Hoboken: John Wiley and Sons, Inc., 2007), p. 58; Elmus Wicker, Banking Panics of the Gilded Age (Cambridge: Cambridge University Press, 2000), p. 120; Louis Brandeis, Other People's Money; Gabriel Kolko, The Triumph of Conservatism: A Reinterpretation of American History, 1900-1916 (London: The Free Press of Glencoe, 1963), p. 146.
2Bruner and Carr, The Panic of 1907, p. 58; Brandeis, Other People's Money; E.W. Kemmerer, “Some Public Aspects of the Aldrich Plan of Banking Reform,” Journal of Political Economy (December 1911); Kolko, The Triumph of Conservatism, p. 251-3, 247, 244, 248; Kemmerer, “Aldrich Plan,” Journal of Political Economy.
3Wicker, Banking Panics of the Gilded Age, p. 16, 34, Bruner and Carr, The Panic of 1907, p. 107; “A Panic and its Lessons,” Liberty (December 1907), p. 9-10; Brandeis, Other People's Money; Wicker, Banking Panics of the Gilded Age, p. 115, Bruner and Carr, The Panic of 1907, p. 58-9, Kolko, The Triumph of Conservatism, p. 154; “A Panic and its Lessons,” Liberty, p. 9-10.
4Bruner and Carr, The Panic of 1907, p. 71-3, Wicker, Banking Panics of the Gilded Age, p. 84, Bruner and Carr, The Panic of 1907, p. 90-1, Wicker, Banking Panics of the Gilded Age, p. 111-3.
5William B. Greene, Mutual Banking.
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