Throughout the late nineteenth and early twentieth centuries, the American economy was repeatedly paralyzed by severe financial contractions. The so-called panics of 1873, 1884, 1893, and 1907 were triggered by currency drains that occurred when banks, lacking sufficient cash reserves, were besieged by depositors demanding their money. The devastating Panic of 1907, which required an emergency bailout by J.P. Morgan, convinced Wall Street and Washington that the country desperately needed an “elastic currency” and a permanent “lender of last resort” to instill confidence and offset sudden credit contractions.
To engineer this solution, a group of powerful Wall Street financiers—including Paul Warburg, Harry Davison, and Senator Nelson Aldrich—met in profound secrecy at the Jekyll Island Club in Georgia in 1910. They drafted a blueprint for a central bank that would pool the nation’s bank reserves and possess the power to create unlimited amounts of fiat money to protect banks from customer runs. In December 1913, President Woodrow Wilson signed the Federal Reserve Act into law. To satisfy populist fears of concentrated Wall Street power, the Federal Reserve was designed as a hybrid institution: a system of twelve private regional reserve banks overseen by a public Federal Reserve Board in Washington.
While the Federal Reserve was ostensibly created to stabilize the economy and end banking panics, its power to manipulate fiat money quickly achieved the exact opposite. Following World War I, the Federal Reserve Bank of New York, led by Benjamin Strong, emerged as the dominant force within the System. Strong entered into a close alliance with Montagu Norman, the Governor of the Bank of England, who was desperate to restore London’s financial preeminence and return the British pound to the gold standard. To assist the ailing British economy, the Federal Reserve deliberately kept U.S. interest rates artificially low and inflated the American money supply, discouraging investors from keeping their gold in America and prompting it to flow to London.
The Federal Reserve utilized its “open market operations”—the purchase of government bonds and bankers’ acceptances with newly created fiat money—to flood the U.S. banking system with fresh reserves. In 1924, the Fed suddenly created $500 million in new money, which commercial banks quickly parlayed into more than $4 billion in expanded credit. In 1927, following a secret meeting with European central bankers, the Fed again pumped new money into the system and lowered its rediscount rate. Between 1921 and 1929, the quantity of dollars in the American economy expanded by nearly 62 percent, fueled entirely by money substitutes like loans and bonds rather than actual currency.
This massive infusion of excess credit spilled directly into the stock market, triggering a fantastic speculative boom. Banks functioned more like speculators, generating abundant, cheap loans that allowed everyday investors to plunge into the market on a 10-percent margin—putting down just $1,000 to buy $10,000 worth of stock. The Federal Reserve’s easy-money policies artificially suppressed the natural forces of supply and demand, fueling a euphoric “Roaring Twenties” bubble that divorced corporate securities from the reality of underlying assets.
When the Federal Reserve finally decided to put the brakes on this runaway speculation, the resulting crash was catastrophic. After briefly attempting to tighten credit in 1928, the Fed reversed itself again to aid Europe, pumping nearly $2 billion more into the money supply. Finally, in August 1929, the Fed decisively applied the pin to the bubble: it raised the discount rate to 6 percent and began aggressively selling securities in the open market. This sudden contraction of the money supply choked off the liquidity that the market had become utterly dependent upon; rates on brokers’ loans jumped to 20 percent, and the stock market suffered a devastating collapse in late October 1929.
Rather than stabilizing the banking system, the Federal Reserve had scientifically amplified the boom-bust cycle. By expanding the supply of fiat money to support foreign economies and then suddenly contracting it, the central bank engineered a massive structural imbalance that guaranteed the Great Crash, setting the stage for a decade of agonizing economic depression.