The evolution of the Federal Reserve over 111 years

Examining the Federal Reserve's transformation from a gold-backed institution to a modern financial powerhouse.

The Marriner S. Eccles Federal Reserve Building in Washington, DC, on December 31, 2024. Photo by Samuel Corum/Bloomberg/Getty Images

By Adelina Indah and Hayu Andini

The Young Fed: The Banking Crises of the 1920s and the Making of a Lender of Last Resort, by Mark Carlson

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The Federal Reserve, often called the Fed, is a cornerstone of the American financial system. Known today for its significant influence over short-term interest rates and monetary policy, the institution’s journey began with youthful optimism and a gold-backed mandate. As it marks 111 years since its inception, the Fed’s transformation from a cautious, gold-standard-based lender to a central bank wielding unprecedented power reflects a story of adaptation and controversy.

Mark Carlson, a former principal economist at the Federal Reserve’s Board of Governors, delves into this transformation in his book The Young Fed. The narrative focuses on the institution’s formative years, particularly its response to banking crises during the 1920s. This was a time when the Fed, still finding its footing, faced challenges posed by an economy recovering from World War I and grappling with unstable financial systems.

When the Federal Reserve opened its doors in 1914, its mission was clear: to stabilize the financial system and provide liquidity to solvent banks. At the heart of its operation was a promise to exchange Federal Reserve notes for gold at $20.67 per ounce. The Fed’s role was limited to supporting commercial banks facing short-term liquidity challenges. However, its idealism quickly collided with the realities of a rapidly changing economy.

By 1917, the Fed was already deviating from its original mission. To support the Wilson administration's efforts during World War I, it introduced easy money policies that fueled inflation and speculation. The postwar period brought a severe but brief depression from 1920 to 1921. This downturn saw a dramatic 40.8% drop in wholesale prices and a 46.6% decline in stock values. The Fed, seeking to combat inflation, raised interest rates to a punitive 7%, exacerbating the deflationary pressures.

President Warren G. Harding, in his 1921 inaugural address, supported the Fed’s tight monetary policies. Harding’s words reflected a commitment to restoring sound money and resetting the economy, even at the cost of economic pain. His call for facing “grim reality” underscored the challenges of managing a young central bank tasked with stabilizing a volatile postwar economy.

Carlson’s book emphasizes the Fed’s early struggles to navigate the banking crises of the 1920s. These crises, while small in scale compared to later financial disasters, exposed weaknesses in an economy reliant on numerous undercapitalized and illiquid banks. Small agricultural banks, in particular, struggled as land and farm prices plummeted after the inflationary boom of World War I.

The Fed responded by stepping in as a lender of last resort, offering credit to struggling banks. Carlson details these interventions, providing case studies that illustrate the challenges of managing a decentralized banking system. One notable example occurred in 1925 when the Federal Reserve Bank of Dallas accepted hundreds of cattle as collateral from failing New Mexico banks. Another dramatic episode unfolded in 1926, when officials from the Federal Reserve Bank of Kansas City arrived at Park National Bank with sacks of cash and gold to prevent a bank run.

These colorful anecdotes highlight the Fed’s evolving role during its early years. The institution was not yet the monetary powerhouse it would become but rather a young organization learning to balance its responsibilities with the practicalities of crisis management.

The 1920s marked a period of financial orthodoxy in the United States. The dollar remained tied to gold at the prewar rate, offering stability in a world where many currencies were still reeling from the effects of World War I. Bank stockholders were personally liable for the solvency of their institutions, reinforcing a sense of responsibility in financial management.

During this time, the government prioritized reducing public debt. In 1919, the Treasury established a sinking fund to repurchase bonds and shrink the national debt. This approach reflected a commitment to fiscal discipline, a stark contrast to the financial practices of later decades.

However, as Carlson notes, the financial landscape began to shift. The personal liability of bank stockholders gradually gave way to collective responsibility, and the Fed’s role expanded beyond its original mandate. By the late 1920s, the seeds of modern financial practices—characterized by centralized decision-making and reduced individual accountability—were being sown.

Carlson’s book examines how the Fed evolved from a passive lender to an active policymaker. Initially, the Fed’s role was limited to providing liquidity to solvent banks. Over time, it became a central figure in shaping monetary policy and influencing economic outcomes.

This transformation was not without consequences. Critics argue that the Fed’s interventions have contributed to financial instability and eroded the purchasing power of the dollar. The transition from a gold-backed currency to fiat money, which allows for unlimited money creation, has facilitated massive public debt accumulation. Today, the U.S. gross public debt exceeds $36 trillion, a level that would have been unimaginable under the original gold standard.

Carlson’s analysis highlights the trade-offs of this evolution. While the Fed has played a crucial role in managing economic crises, its expanded powers have also raised questions about accountability and the long-term consequences of its policies.

As the Federal Reserve celebrates its 111th anniversary, its journey offers valuable lessons about the challenges of central banking. The institution has come a long way from its humble beginnings as a gold-backed lender. It now wields significant influence over global financial markets, shaping monetary policy and responding to crises.

Carlson’s work reminds readers of the complexities of this evolution. The Fed’s early years were marked by idealism, experimentation, and learning. Over time, it became a symbol of centralized financial power, a far cry from the decentralized system envisioned by its founders.

While Carlson’s conclusions may lack a strong critique of the Fed’s modern role, his detailed exploration of its history provides a foundation for understanding the institution’s transformation. The Federal Reserve’s story is one of adaptation, reflecting the broader changes in American finance and economics over the past century.

As the Fed continues to navigate new challenges, from inflation to financial stability, its past serves as a reminder of the importance of balancing innovation with accountability. Carlson’s The Young Fed offers a timely reflection on this journey, highlighting the enduring relevance of the institution’s history in shaping its future.

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