This discussion of the birth of the Federal Reserve System and the regulatory responses to the problems Paul Krugman describes begins with an illustration of how to stop a bank run:
Born of a panic: Forming the Federal Reserve System, The Region, FRB Minneapolis: The banker was frantic. A large crowd was gathering outside his bank and the people were clamoring for their money. The banker called the Federal Reserve Bank in Minneapolis and warned that unless the "mad run" were stopped, he would soon be out of currency. With the bank nearly 200 miles from Minneapolis, a small plane was chartered and two Fed officials, along with a half-million dollars in small denomination bills, were quickly flown to the town.
Upon approaching the town the pilot guided the plane low over the main street to dramatize its arrival and then landed in a nearby field. From there the Fed officials were ceremoniously escorted into town by the police and the money was stacked along the bank's teller windows. The sight of all that money piled up inside the bank quelled the customers' fears and saved the bank from failing.
Although that story—from the Minneapolis Fed's 1953 annual report—is a latter-day account of a Depression-era bank rescue, it dramatically illustrates the two key responsibilities given to the Federal Reserve System 75 years ago: to serve as a lender-of-last-resort in times of crisis and to provide a national currency that would expand and contract as needed. Such was the primary vision of the framers of the Federal Reserve Act in the summer of 1913 as they planned the most radical banking reform in the country's history. Later that year, on Dec. 23, 1913, President Woodrow Wilson laid to rest years of political and practical debate when he signed the Federal Reserve Act into law. But far from being the end of a journey, Wilson's signature catapulted the Federal Reserve System into an economic adventure that would see it evolve from a passive institution designed to prevent banking panics, into what came to be known as a central bank—an active promoter of overall monetary stability and a multi-faceted player in the financial services industry.
But in order to understand the evolution of the Fed and the role it plays in today's economy, it is important to know why, and how, the Federal Reserve System was established. Essentially, the evolution of the Fed didn't begin on Dec. 23, 1913; rather, the Banking Panic of 1907, the most severe of four national banking panics that had occurred in the previous 34 years, was the primary inspiration for major banking reform. Abram P. Andrew, secretary of the National Monetary Commission—the committee assigned in 1908 to study the country's banking problems—collected nearly two hundred samples of various bank currencies created to stem the 1907 panic, and he provided a vivid description of the banks' quandary at that time:
[The banks] were so singularly unrelated and independent of each other that the majority of them had simultaneously engaged in a life and death contest with each other, forgetting for the time being the solidarity of their mutual interest and their common responsibility to the community at large. Two-thirds of the banks of the country entered upon an internecine struggle to obtain cash, had ceased to extend credit to their customers, had suspended cash payments and were hoarding such money as they had. What was the result? ... Thousands of men were thrown out of work, thousands of firms went into bankruptcy, the trade of the country came to a standstill, and all this happened simply because the credit system of the country had ceased to operate.
The National Monetary Commission's list of banking problems was dominated by two flaws: a banking system prone to panics and a currency that was not responsive to changes in demand. To combat those problems the Commission made an urgent plea for effective lending to banks (referred to as “rediscounting” in the Federal Reserve Act). Banks in the earlier part of the century needed the flexibility provided by rediscounting if they were to meet the demands of the economy and avoid banking panics. Other problems highlighted by the Commission were inadequate supervision of banks and an inefficient check collection system.
The Federal Reserve System, in part, developed as a response to those problems; and, even though legislators and bankers from 1908 to 1913 could agree on the problems, they had a hard time agreeing on the ultimate solution.
The Federal Reserve Act was not the first proposal made for banking reform prior to 1913. An earlier plan that was the offshoot of the National Monetary Commission—the National Reserve Association—was politically doomed, in large part, because of its chief sponsor, Sen. Nelson W. Aldrich of Rhode Island. Aldrich was seen as the embodiment of the “eastern establishment”—the perception by southern and western states that the wealthy families and large corporations of the northeast ran the country. Hence, the National Reserve Association was derided as giving undue power to the banking industry of the northeast. Indeed, many country bankers, who would seemingly benefit from a Reserve Association controlled by the banking industry, also opposed Aldrich's plan because they believed his plan would mainly benefit northeast banks. Furthermore, with neither party controlling both Houses of Congress prior to 1912 and with the Republican Aldrich unable to muster complete bipartisan (or even partisan) support, his banker-oriented plan was politically unfeasible.
In 1912, with the election of a Democratic President, Woodrow Wilson, and a Democratic Senate, which gave the Democrats a majority in both Houses of Congress, the stage was set for passage of a comprehensive banking reform bill. The key players then turned to the other side of the political aisle, with Woodrow Wilson and Carter Glass, Democratic Representative of Virginia and chairman of the House Banking Committee, largely acknowledged as the driving forces behind the passage of the Federal Reserve Act. Glass had a plan in the works by the fall of 1912 and was conferring with Wilson before the president-elect was inaugurated. Wilson, who wasn't well-versed in the technicalities of banking reform, was strongly influenced by William Jennings Bryan's populist ideas, and he employed a little Bryan rhetoric of his own during his presidential campaign. (Bryan, a populist politician and frequent Democratic contender for president, became Wilson's secretary of state.) About a year before he was elected Wilson said, “The greatest monopoly in this country is the money supply,” adding a couple months later that he would not accept “any plan which concentrates control in the hands of the banks.”
The eventual Federal Reserve Act, which took shape by the fall of 1913, was similar to the earlier plan launched by Senator Aldrich, except, of course, that private banks were not given as much control. Also, another primary difference in the Federal Reserve Act was the provision that all nationally chartered banks must be members of the Federal Reserve System. Many private banks, obviously, were opposed to certain provisions of the Federal Reserve Act because they reduced the banks' influence.
Following the passage of the Federal Reserve Act, The New York Times' editors sulked: “[The Federal Reserve Act] reflects the rooted dislike and distrust of banks and bankers that has been for many years a great moving force in the Democratic Party ... The measure goes to the very extreme in establishing absolute political control over the business of banking.” Likewise, for the most part, populist factions approved of the banking plan, and Carter Glass echoed their feelings when he rejoiced at its passage: “The thing which had been vainly discussed and intermittently attempted for 20 years had finally been accomplished!”
In the end, following years of political and philosophical disagreements (disagreements that existed through the years and continued to shape the structure of the Federal Reserve System), the preamble to the Federal Reserve Act addressed the practical problems facing the country's banking system:
An Act to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.
The Federal Reserve Act provided for the establishment of up to 12 Federal Reserve Banks (district banks) to coordinate policy with a seven-member Federal Reserve Board in Washington. Over the years the titles and the length of term of the board members have changed, as have other details involving the Fed's structure. For example, the name of the Federal Reserve Board was changed to the Federal Reserve Board of Governors in the 1930s, and thereafter the members were referred to as governors. The current structure of the Federal Reserve System, then, includes members of the Board of Governors who are are selected by the president and confirmed by the Senate for 14-year terms, staggered to expire every two years. The 14-year term was designed to encourage the board of governors to take a long-run view of the economy, as well as reduce the chance that all seven members of the board could be appointed under one administration. One member of the board is appointed to serve as chairman and another as vice chairman, to serve four-year terms.
The district banks are headed by a president (prior to the 1930s district banks were headed by two officials: an agent and a governor), who is selected by a board of directors. The board of directors consists of nine members—selected to represent various banking, business and public interests in the district—who share a responsibility to report to the district banks on economic conditions in the region. Six of the district board members are elected by member banks, with three representing stockholding banks; the other three, who are appointed by the Board of Governors, represent the general public. As noted earlier, all nationally chartered banks are required to be members of the Federal Reserve System, with state banks retaining an option to join.
The framers of the Federal Reserve Act in 1913 were not so smug as to assume they had concocted a perfect plan. As the last sentence of the Act states: “The right to amend, alter, or repeal this Act is hereby expressly reserved”—a reservation, it seems, that understates the challenge and uncertainty that faced the country in the early days of the Federal Reserve System. While the country had experience with national banking systems in the past, it had no experience to prepare itself for the Federal Reserve System. Indeed, an overlying theme of the Federal Reserve Act was the notion of uncertainty; many of the provisions of the Act were left to be specified at a later time (such language as “under the rules and regulations to be specified by the Federal Reserve Board,” and “subject to review and determination of the Federal Reserve Board” exists in the Act). In a sense, the rules had to be developed as the game was learned—decisions were made as unprecedented situations arose. For example, while the Federal Reserve System was established to prevent such economic disasters as the Great Depression, Fed officials were seemingly unprepared to deal with such a severe economic slump, and the Fed was criticized as having failed in its mission. Nearly 60 years later, however, the Fed was largely credited with helping to stem the negative impacts of the October 1987 stock plunge...
And, a bit more history from the Fed's site:
...1929-1933: The Market Crash and the Great Depression During the 1920s, Virginia Rep. Carter Glass warned that stock market speculation would lead to dire consequences. In October 1929 his predictions seemed to be realized when the stock market crashed, and the nation fell into the worst depression in its history. From 1930 to 1933 nearly 10,000 banks failed, and by March 1933 newly inaugurated President Franklin Delano Roosevelt declared a bank holiday, while government officials grappled with ways to remedy the nation's economic woes. Many people blamed the Fed for failing to stem speculative lending that led to the crash, and some also argued that inadequate understanding of monetary economics kept the Fed from pursuing policies that could have lessened the depth of the Depression.
1933: The Depression's Aftermath In reaction to the Great Depression, Congress passed the Banking Act of 1933, better known as the Glass-Steagall Act, calling for the separation of commercial and investment banking and requiring use of government securities as collateral for Federal Reserve notes. The Act also established the Federal Deposit Insurance Corp. (FDIC), placed open market operations under the Fed and required bank holding companies to be examined by the Fed, a practice that was to have profound future implications, as holding companies became a prevalent structure for banks over time. Also, as part of the massive reforms taking place, Roosevelt recalled all gold and silver certificates, effectively ending the gold and any other metallic standard.
1935: More Changes to Come The Banking Act of 1935 called for further changes in the Fed's structure, including the creation of the Federal Open Market Committee (FOMC) as a separate legal entity, removal of the Treasury Secretary and the Comptroller of the Currency from the Fed's governing board and establishment of members' terms at 14 years. Following World War II, the Employment Act added the goal of promoting maximum employment to the list of the Fed's responsibilities. In 1956 the Bank Holding Company Act named the Fed as the regulator for bank holding companies owning more than one bank, and in 1978 the Humphrey-Hawkins Act required the Fed chairman to report to Congress twice annually on monetary policy goals and objectives. ...