The last crisis before the Fed came into being..

An interesting piece of monetary history by Tim Sablik of Richmond Fed. We usually talk about the 1907 panic and great depression to question the Fed’s role, not really read on the crisis which happened just as WW-I broke out. The interesting thing is Fed was just set-up in 1913 and was not ready to fight the crisis. This led to some innovations by Treasury to intervene and stabilise the markets. The author says if this experience was learnt before, may be there would have been no need for Fed. After all Fed was formed to address financial stability amidst huge opposition for setting a centralised institution to manage money. The background:

You gentlemen are to form the bulwark against financial disaster in this nation,” Treasury Secretary William Gibbs McAdoo told the members of the first Federal Reserve Board as they took their oath of office on Aug. 10, 1914. The seven men — including McAdoo, who served as the first chairman of the board — would not have to wait long for their first test. Less than two months earlier, Austria’s Archduke Franz Ferdinand and his wife were assassinated by a Bosnian-Serb nationalist, plunging Europe into war.

The United States would also be swept up in the conflict, but its first battles were waged in financial markets. European powers needed money to finance fighting, and that meant gold. At the time, the United States was a debtor nation and a minor financial power, but the warring European nations could no longer trade with each other. They quickly began selling their holdings on the New York Stock Exchange, converting dollars to gold.

In June and July, the United States had nearly $70 million in net gold exports. The effect of several European nations calling in their debts simultaneously created a significant external drain on U.S. gold reserves, threatening to place constraints on banks’ ability to lend domestically.

It would have been a golden opportunity for the nascent Federal Reserve to save the day. According to 19th century British economic writers Henry Thornton and Walter Bagehot, a lender of last resort could counter such a threat by raising interest rates to stem the outflow of gold to foreign nations while lending freely to sound financial institutions to satisfy domestic demand for money. The Federal Reserve System had the capacity to do just that, but there was one problem: It wasn’t actually up and running yet.

Basically McAdoo changed the rules of the game which allowed banks to get liquidity and step out of crisis:

Without the Fed to provide liquidity to sound institutions, McAdoo had to turn to the Aldrich-Vreeland Act. Loans under the Act would not be bailouts, as any bank seeking emergency currency would have to put up full collateral and pay increasing interest to ensure the funds would be retired quickly after the crisis passed.

McAdoo had actually invoked the Act to offer emergency loans the previous summer, when legislation to reduce tariffs  prompted a decline in stock prices as businesses worriedabout greater foreign competition. Although no banks applied for the emergency currency, the stock market reacted favorably to the announcement. Almost exactly one year later, McAdoo made a similar announcement: “There is in the Treasury, printed and ready for issue, $500,000,000 of  currency, which the banks can get upon application under that law.”

This time, banks were keenly interested in obtaining the currency, but there were some problems. The Act allowed national banks to apply for the emergency loans only if they had already issued national bank notes equal to at least 40 percent of their capital. The restriction was intended to prevent overuse of the currency, but it meant that many major  banks could not participate at all. For example, National City Bank in New York had $4 million bank notes in circulation in 1913 — only 16 percent of its capital. Additionally, state-chartered banks and trusts could not borrow under Aldrich-Vreeland, mirroring the lack of access that hadescalated the Panic of 1907.

Recognizing the potential problem, McAdoo visitedCongress the same day he invoked the Act, asking legislators to remove the restrictions.“If depositors thought that certain institutions didn’t have the currency, there might have been a run on those institutions. So the fact that the major New York bankscould not have qualified for Aldrich-Vreeland money could have been an impediment,” says Silber. 

Once Congress amended the Act, the emergency notes flowed to banks quickly (see chart). Just one week after McAdoo’s announcement, banks had requested $100 million in Aldrich-Vreeland currency, and large trucks delivered bags full of the preprinted notes to Treasury offices around  the country. ..

It basically boils down to providing liquidity which freezes suddenly.. In the end:

Other countries mitigated panics with systems very different from the one the United States ultimately adopted (see “Why Was Canada Exempt from the Financial Crisis,” p. 23). Acentral bank fulfills many other functions in addition to panic prevention, but if panics were the only problem, the success of Aldrich-Vreeland suggests that there may have been alternatives to the Fed.

Nice bit from history..

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