Contempt and Elitism Brought Us the Fed and QE

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In 1921, Robert Owen was mad. Not just angry, but beside himself with rage over what had become of the institution he helped create. Perhaps more than anyone else in Congress, Owen, as Chairman of the Senate Committee on Banking and Currency, had not only shepherded the Federal Reserve into existence, he had contributed perhaps more than anyone to what it actually became. So in the Depression of 1920-21 when the Federal Reserve was again appealing to "deflation", Owen could not tolerate such a course since the system he designed and crafted was created with the explicit idea that it would never do so.

There should have been no surprise, however, for Senator Owen. Benjamin Strong, Governor of the Federal Reserve Branch of New York, the most powerful and relevant of the newly established 12 branches, was explicit in his intent from the outset of his appointment in October 1914. Strong was an old gold man, from the tradition of sound banking as a banker himself. He wrote in 1919, "I expect deflation to be accompanied by a considerable degree of unemployment, but not for very long, and that after a year or two of discomfort, embarrassment, some losses, some disorders caused by unemployment, we will emerge with an almost invincible banking position."

But Strong was also in the newer school of those bankers that favored "currency elasticity", and thus a profound supporter of a third American central bank. Such placement earned him an invitation, as JP Morgan's representative, to the ultra-secret retreat on Jekyll Island in 1910, the meeting that would spawn the Aldrich Plan. Rhode Island Senator Nelson Aldrich (R) was also in attendance at Jekyll Island and would become the face of the idea and its sponsor in Congress.

The growing pains of an industrial and increasingly global economy were beginning to strain the limits of the US banking system. Owing in no small part to experience in the Panic of 1907, as well as the turbulent decade of the 1890's, New York bankers had come to accept the concept of currency elasticity. They knew, however, that a central bank born out of Eastern financial interests would go exactly nowhere; thus their secrecy.

The political expediency in which they could accomplish their goal was limited by a deep mistrust of centralization and of Wall Street. It mattered little what the actual Aldrich Plan said, it had no prayer of ever becoming law without some sort of appeal to "middle America." That was particularly true since the ruling Republicans had just been handed a stinging defeat in the midterm elections of 1910. It would be left to various elements in their midst to carry the ideas of reform to "the people."

One of those anointed Jekyll Island participants was Paul Warburg. It was Warburg's ideas that formed much of the basis for the Aldrich Plan, particularly the centralization of currency around a banker-owned and operated clearinghouse. In January 1911, Warburg proposed the creation of a "Business Men's Monetary Reform League" at the Monetary Conference of the National Board of Trade. The purpose would be to convince the business community in America of the necessity of the Aldrich Plan, creating apparent grassroots support.

Warburg himself was a recent immigrant from Germany. He had only moved to New York in 1902 as a result of an offer to join the powerful Wall Street firm of Kuhn, Loeb and Company - he had married the founder's daughter, making him Jacob Schiff's brother-in-law. The banking system in American was, in his words, blighted by "extreme individualism." Not long after making that observation known, he wrote,

"it is highly unfortunate that the general attitude of the country towards New York and Wall Street is such that any measure proposed from here would be doomed from the start. For this reason it looks to me as if the situation would have to come from the West."

So when it came time to pitch the idea for the new American Central Bank, the National Citizens' League for the Creation of a Sound Banking System placed its headquarters in Chicago. The actual work of the League was to recruit as many prominent non-New Yorkers to the Aldrich flag as possible. Further, they realized the danger to the central bank should it remain solely a Republican ideal. Thus the move to the Midwest and Great Plains would bring them into contact with many positively predisposed Democrats scattered about the interior. After William Jennings Bryan's defeats at the hands of William McKinley, the inflation/silver impulse had been searching for a constructive outlet.

Among those wandering souls of silver was Robert Latham Owen. He had rough experience with the decentralized American system, having watched his father lose everything in the Panic of 1873, and then nearly losing the bank he had founded, the First National Bank of Muskogee (Oklahoma), in the Panic of 1893. The problem as he saw it from the perspective of a bank owner, was that the system did not allow for orderly withdrawal of deposits during crisis. In such times, there was no central repository to which "sound" institutions could appeal and survive (though his bank did survive in 1893).

As a Cherokee and a lawyer, Owen's talents had brought him into the political realm as a lobbyist. But he was noticed and appreciated for his innovative and revolutionary insights into money and banking. At the 1896 Democratic National Convention in Chicago, he had been appointed to the Committee on Resolutions tasked with crafting the party's campaign platform. In his memoire, Owen wrote that,

"I strenuously urged a plank pledging the Democratic Party to protect the country from financial panics but failed to obtain support. I advocated, as a resolution before the Committee on Resolutions, that United States bonds might, in times of threatened panic, be made convertible into Treasury notes to serve as currency as a source of quick supply of money to offset the withdrawal of currency for hoarding by frightened depositors."

Further, Owen alleges that he convinced none other than Bryan himself of the idea, along with other prominent Democrats, but could not gain full recognition due to objections of Senator George (D-MS). According to Owen, it was George that ultimately convinced Bryan and the others that while there was something to the idea, it was too novel and untried in American experience to add to the already weighty campaign. The Democrats under Bryan were already risking their cause by adopting the rhetoric of the Populists, this was simply too much to incorporate since it was believed silver and inflationism would be enough.

The idea of currency elasticity in centralized form would not be set aside, however, as Owen began to actively seek its institution. In early 1900, he helped Senator James K. Jones of Colorado craft an amendment to the 1900 Aldrich Bill (there were more than a few attempts at monetary reform) that would authorize the US Treasury Secretary to establish a "circulation fund" where bonds and notes would be converted to "full legal tender." The measure was defeated, and after the Panic of 1907, Owen, now a Senator in Congress himself, became convinced that this idea would have worked in forestalling that crisis, and was therefore a priority.

His quote from that period is rather well-known to students of monetary history, with Chairman Bernanke referring to it in a speech to the NBER earlier this year. Owen wrote, "it is the duty of the United States to provide a means by which periodic panics which shake the American Republic and do it enormous injury shall be stopped." The confluence of events in the first decade of the 20th century brought that sentiment into full shape, first through Aldrich, and then in cooperation into the Federal Reserve.

But the rest of that quote is, to my mind, perhaps even more important in unlocking the course to which American economics would take over the next century, though it is largely discarded as an unexplored historical artifact. In setting out this important duty for the government, in the name of "public interest", the very foundation of this centralization is revealed as,

"It is the duty of the United States to protect the commercial life of its citizens against this senseless, unreasoning, destructive fear that seizes the depositor when he has been sufficiently hypnotized by the metropolitan press with its indiscreet suggestions."

In other words, the people are too dumb and unsophisticated to be trusted with monetary influence. It is very much akin to Paul Warburg's dismissal of "extreme individualism."

For the next few years, both Owen and Warburg would be working toward the same goals from different ends. Owen, the Senator, would introduce numerous bills, particularly in the direct aftermath of the 1907 panic, that would allow for Treasury-led currency elasticity, federal deposit insurance and even sought to restrict Wall Street activities toward stock "gambling."

Warburg would concurrently continue to spread the gospel through the League, maintaining its public appearance as a non-partisan association of businessmen. He published a weekly paper, Banking Reform, that was written from the perspective of a normal commercial view rather than an Eastern banker. All the while, the League was financed almost exclusively by those Eastern banks, and Warburg himself was closely tied with Aldrich and the Jekyll Island cabal.

It was the election of 1912 that brought these factions together. Woodrow Wilson and the Democrats had swept through the election and into the majority. It was Henry Morgenthau, future Treasury Secretary under FDR and close advisor to Woodrow Wilson, who approached Warburg with merging the Aldrich Plan into a bipartisan affair. To do so required a system that did not appear to be a puppet of Wall Street, but it also needed to be backed or controlled to some extent by the government in Washington.

In May 1913, Warburg and Owen finally met face to face to discuss competing ideas toward what would become the final Federal Reserve Act. One of the major points of contention at that time was exactly how any new currency would be structured, perhaps the central element of the entire framework. Owen would write,

"I recall spending seven consecutive hours discussing with Mr. Paul Warburg the question of whether the Reserve notes should be the notes of the United States Government or bank notes, he taking the position that they should be notes of the Federal Reserve banks and not United States Treasury notes, he contending that these notes would be the obligations of the United States and would weaken the credit of the United States when the United States came to borrow money from the banks or from the people. I took the position that the currency ought to have behind it the taxing power of the nation, that the United States should control the currency, and that private persons shall not control the currency..."

And that was the essence of the Federal Reserve Act, that there was to be no seat at the table for private citizens. On this point, Paul Warburg was no less clear than Senator Owen. Only he conceived of a council of "experts" with no government involvement, drawn in full part to what he saw as a vital degree of sophistication inherent in the entire project.

This contempt was on full display in one skirmish against a Republican faction seeking to revisit the Fowler Bill from 1908. Representative Charles Fowler (R) was, in Warburg's estimation, unfit to craft legislation for banks.

"Fowler has never been a banker, and never been successful, and I am astounded by his courage to advocate a new and untried scheme approved by no practical banker, against a plan which has been carefully developed on the well-established European principles by the combined banking and business brains of the country."

So the Federal Reserve was to be an elitist institution, in bipartisan partnership of both government and elite bankers. The common man, long distrusted, was to be absent from the structure of money. And thus, there was to be only benevolence as a check or limitation on the incursion of currency into the economic system.

Such an objection was raised in the course of debating the final Federal Reserve bill, primarily from Republican Senator Elihu Root who contended that the new currency, as a liability of government, was nothing more than a "greenback." Further, Senator Root charged that the Reserve Act did not countenance currency elasticity at all, but rather "uncontrolled expansion." The bill did not provide for any means by which any increase in currency, emergency or otherwise, would be withdrawn.

Only a few days before final passage, Senator Owen countered, "these notes could not expand or remain expanded beyond the requirements of our commerce, because, unless a bank needed currency, it would not call for these notes, and as soon as the need for currency was past the bank would return the currency to the Reserve Bank and the Reserve Bank would return such currency to the Federal Reserve agents." In other words, the munificence and magnanimity of the agents of the system, elitists all, would simply be trusted and expected to do what was "right."

Almost immediately after passage and creation of the Federal Reserve, this idea was put to the test. The urge of every government in history has been to devalue currency and money to pay for war, and here in 1914 was the emergence of a Great conflict to which the United States would be a party, if only indirect at first. All through World War I, this "independent" Federal Reserve, staffed and managed by both government and banker elites, as the Kansas City Fed puts it, "operated as a financing arm of the U.S. Treasury...Indeed, a primary role of Federal Reserve Bank Presidents (then called Governors) was to chair committees set up in each Fed District to sell Treasury bonds to the nonbank public."

The net result of such elastic currency and bank reserves was typical war inflation. Beginning in 1915, consumer prices began to rise, reaching 20% per year by the time the US actually entered the war. Prices would remain under such inflation until 1920 when Benjamin Strong finally put the Fed on course to reverse it. To Strong's thinking, there was nothing unusual about it, fully expecting, as I noted above, economic pain and sacrifice to accompany the readjustment. That was how every economic and monetary system operated after such periods of war-driven "necessity." Prewar parity was to be the central goal.

And in recent history to that point, only some sixty years prior, the US had done exactly that. After the Greenback inflation during the Civil War, the US government resolved, after much debate and fracture, to establish prewar parity of the dollar. Strong was only following the same path.

But like the Greenbackers before him, Robert Owen saw that adjustment as unduly striking the "common man", now a laborer in the industrial grist rather than an indebted farmer of the earlier age. In his mind, coming through his experience with bank panic and depression, the federal government working through its partial control of the Federal Reserve had a duty to obviate such economic dysfunction. Further, it was particularly galling, to Owen, that it would actively court "deflation." To the new strain of Greenback/Populist, as Owen represented, it was not just banking panics to be banished, but depression as well.

Owen charged onto the floor of the Senate in 1921 to decry what he saw as engineered depression, "under the pretext of lowering the cost of living, those in charge of some of the largest banks demanded the contraction of credit and currency." Ever the inflationist in spirit, there should be no move ever to contract currency, exactly as Elihu Root had charged nearly a decade prior.

The burden of adjustment had always fallen on the common man, first the farmer then the worker. Left unspoken was the reason for adjustment. Strong never disputed that there would be a nasty transition, only that such transition would see ultimate benefit. There should be no doubt as to Strong's inclinations here, either, as he spoke first in the interests of banks. However, those interests were closely aligned with stable prices, where the common man would most benefit by unwinding the real threat to economic stability, the artificial introduction of monetary imbalance. By restoring prices to pre-inflation conditions, labor would see a rise in purchasing power that would set the economic course on the best possible trajectory.

To Strong the error was not in creating deflation, but in allowing inflation in the first place. His intent was to correct that original mistake, allowable at the time due to wartime exigencies.

At this point the Fed was being besieged by dueling elite opinions very much reminiscent of Warburg's disagreement with Owen over proposed currency liabilities. Both sides saw themselves championing the "right" course, though both in doing so conformed to their natural constituencies. These benevolent statesmen, counted on to perform these vital operations in intended absence of the "common man", were nothing more than self-interested operators cloaked in the effrontery of "for our own good."

But that early Fed was also a partisan place, as the elections swung back and forth between parties. While Republicans obtained large majorities in 1920, the Democratic criticisms of Owen and his contemporaries had an important effect. The Fed itself became more insular and elitist, particularly in the face of its own failures (which became innumerable). Elite opinion offered no silver bullet or even a reprieve, but in the period of the threatening politics it simply appealed to that sense of superiority through complexity.

When the groundwork of governing philosophy has embedded the ideal of contempt for the "sufficiently hypnotized" or "extreme individualism", "for your own good" takes on whatever ideal is anointed at the time, including, it seems now, asset bubbles of historic proportions. It is, as James Madison once observed, no limitation whatsoever. Enlightened statesmen will not always be at the helm, and are in fact extremely rare specimens, so the only compatible ideal for lasting republican government is to limit authority and reach. People may be unsophisticated, but they do have a sense of their own good and a far more intuitive grasp of economic and monetary affairs than the convoluted nonsense that passes for policy. QE as a psychology experiment used to fool the American people in active repression fits right in with the founding principles of the agency.

As the centennial approaches for the Federal Reserve Act, commentary, and especially critique, will recognize its history and ultimate embrace of inflation and dollar erosion. There will be reference to panics past and present, and underperformance as the agency accumulated more and more powers, whether it earned them or not. And there may even be recognition that economic elitism has fused, as bankers and government overseers are now largely the same, or at least cut from the same ideological cloth.

These are all symptoms of the contempt for common Americans that has survived in nearly every iteration and configuration throughout the Federal Reserve's tortured history, due to elitism from both Republicans and Democrats. It is the Progressive stamp on monetary affairs aided by this governing appeal, that it is much easier to control the levers of power when actual freedom is messy and uneven. Tucked away, far from the common reach, utopia is very easy said, and never done, same as it has been since 1913.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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