13.2: Creation of the Federal Reserve System

The Federal Reserve System (commonly referred to as “the Fed”) is the central bank of the United States. It plays a critical role in maintaining the stability of the financial system, managing inflation, promoting employment, and supporting the overall health of the economy through monetary policy. 

But the Federal Reserve was not always part of the U.S. economic landscape. It was created in response to a series of financial panics that exposed serious weaknesses in the U.S. banking system. Understanding the Fed’s historical roots helps us see why it was established, how it has evolved, and what it is designed to do. 

The Financial Crisis of 1907 

During the Panic of 1907, financier J. P. Morgan played a pivotal role in averting a total collapse of the U.S. banking system (at a time when the country had no central bank). 

The panic began in October 1907 when a failed attempt to corner the market in United Copper Company stock (an effort to gain control of enough shares to manipulate the price upward) triggered fears about the solvency of certain trust companies. These institutions, which were less regulated than traditional banks, became the focus of public anxiety. As rumors spread, depositors rushed to withdraw their money, setting off a cascade of bank runs and widespread market turmoil. The New York Stock Exchange plunged, and many financial institutions teetered on the brink of collapse. 

J.P. Morgan Steps In 

At 70 years old, J.P. Morgan was already the most powerful private banker in America. With no central bank to coordinate a response, Morgan took it upon himself to stabilize the financial system. 

Here are the key actions he took: 

• Gathering Bank Leaders 

Morgan convened presidents and key figures from the major New York banks, trust companies, and railroads at his library on Madison Avenue. His goal was to coordinate a collective response to restore confidence and liquidity in the banking system. 

• Locking the Bankers in a Room 

One of the most dramatic and often retold moments of the crisis occurred when Morgan locked the presidents of the major New York banks in his study overnight. He told them bluntly: they would not be allowed to leave until they reached an agreement to recapitalize the Trust Company of America, one of the institutions most under threat. If it collapsed, it could trigger a chain reaction of failures across the financial system. 

Morgan reportedly said, “This is the place. Gentlemen, you must act. If you don’t, we’ll have a complete collapse by morning.” 

The doors were literally locked, and Morgan left them inside to deliberate under extreme pressure. 

Eventually, after hours of intense negotiation, the bankers agreed to pool their resources to rescue the trust company. The infusion of liquidity helped calm the panic, at least temporarily. 

• Personally Coordinating Loans and Liquidity 

Over the next several days, Morgan personally oversaw the commitment of over $25 million (an enormous sum at the time) from various banks to shore up failing institutions and stabilize the stock market. He also worked with U.S. Treasury Secretary George Cortelyou, who deposited government funds into select banks to bolster reserves. 

• Saving the New York Stock Exchange 

When panic spread to the stock market, Morgan arranged for a $25 million loan pool to be made available to the New York Stock Exchange. This move helped prevent a total crash and reassured investors. 

Legacy and Consequences 

Morgan’s interventions were successful in halting the financial collapse, but they raised profound concerns about the concentration of economic power in private hands. Many Americans were uneasy with the idea that the fate of the nation’s economy depended on the actions of a single, unelected financier. 

This crisis (and Morgan’s prominent role in resolving it) became a catalyst for financial reform. It led directly to the National Monetary Commission and eventually the creation of the Federal Reserve System in 1913, which was designed to prevent future panics and take over the stabilizing role Morgan had played. 

The Federal Reserve Act 

The Federal Reserve Act, signed into law by President Woodrow Wilson on December 23, 1913, created the Federal Reserve System as the central bank of the United States. It was passed by Congress under the powers already granted in the Constitution, specifically under Article I, Section 8, which gives Congress the authority to “coin money” and “regulate the value thereof.” No constitutional amendment was necessary because Congress already had the power to create a national banking framework.