Edward Lotterman
Our nation is in a dangerous economic situation this year. A financial crisis worse than that of 2007-09 is now possible, because of the ways markets have developed, and because the Federal Reserve let this happen.
Some economists, including me, believe that, over the last 40 years, Fed policies have amplified, rather than diminished, the size of inevitable problems.
We have crawled out on a rotten limb from which it is difficult to get down. To understand how this peril came to be, we’ll continue the abbreviated history of banking and its regulation that we began last week.
In 1913, the year my mother was born, the U.S. economy was the largest, most diverse and most complex economy in the world. The population had tripled in the 50 years since the Civil War. Huge land areas were wrested from Native Americans and devoted to farming, mining and lumbering.
We had passed the United Kingdom and then Germany in steel production. We had the world’s largest rail network and were the largest producer and exporter of agricultural, forest and mining output. Germany led in industrial chemicals and the U.K. had a larger merchant fleet, but there was no question our nation was now the dominant global economic power.
But we still punched below our weight in finance. London remained the center of that world. We had thousands of commercial banks accepting deposits and making loans, plus investment banks that issued and traded corporate stocks, corporate and government bonds as well as organizing mergers. Writing life and property insurance was a healthy and dispersed sector.
However, at the micro level, our large, fragmented banking sector had many bank failures. These pauperized depositors and devastated local economies. Damage to the economy was not just among those who lost funds. The very possibility that such failures could occur forced the population as a whole to be defensive in how they saved. This made use of capital for the whole economy less efficient.
Also at the macro level, periodic financial crises involving large financial institutions hit the general public as “panics.” Frauds or defaults at the top of the economic pyramid rapidly spread downward. Contracting output and employment caused widespread suffering in the general public.
Historians identify at least seven such panics between 1865 and 1910. Those in 1873, 1893 and 1907 were particularly severe. Recovery from ensuing recessions took years, including four, three and five years respectively for the three harsh ones cited. Again, exposure to frequent and unexpected crises forced all businesses to take preventive measures, again reducing overall efficiency in our nation’s use of capital.
The problem was that we lacked a central bank like the Bank of England. We had experimented with two separate Banks of the United States, but these were very imperfect and each vanished after an initial 20-year charter expired. President Andrew Jackson’s refusal to renew the charter of the second in 1833 touched off a recession lasting eight years.
Periods of sharp inflation and harsh deflation were a third problem of the 1800s. Naïve people today still think that tying their money to gold and silver guarantees price stability. That ignores history. If output grew faster than supplies of these metals, output prices and wages had to fall, while mortgages and other debts still had to be paid. If the supply of metals grew faster than output, more money chased a limited quantity of goods. Inflation set in.
The U.S. dollar was once tied to the value of gold and/or silver. Consumer prices went up 34% in six years after the discovery of gold in California in 1848 and by 30% during the Alaska gold rush. More harshly, prices inexorably fell by 52% between 1864 and 1884. Farmers who got mortgages to buy land saw prices of wheat, cattle and other products fall year after year. For a half century, “the Depression” referred to that period from the mid-1860s to the mid-1890s. That is why hard times in the 1930s are now called the “Great Depression” to distinguish them from the “Long Depression” of the late 1800s.
Many during this time saw the need for a central bank to regulate the money supply, to provide liquidity to meet seasonal variations in the credit needs, or stem panics in financial markets. However, a thorny issue prompted divisions that went back to the 1820s. Small businesses and households feared a Wall Street financial leviathan. And Wall Street did not want anything to do with Washington or government.
The Panic of 1907, though short, scared everyone. The ensuing recession remained fresh at the 1912 elections. Financiers and lawmakers arrived at a compromise and the Fed was created.
There would be 12 central banks rather than one. Each would be an entirely private corporation chartered in the state where located. Commercial banks could choose to join this system by buying shares of stock in their regional Fed bank in proportion to their capital and deposits. Such “member banks” would vote to choose a board of directors for the regional Fed that would hire day-to-day managers.
The new banks would be Federal Reserve Banks because they would hold the reserves — deposits minus loans — of commercial banks. Banking regulations specified these meet at least a minimum percentage of deposits, but amounts could be larger.
Such central depositories for each region’s banks streamlined check clearing. Most importantly, these reserve accounts created a means to achieve the “elastic currency” seen as necessary to prevent bank failures, generalized financial crises or crippling deflations and inflations.
At that time, virtually all business loans from main street banks were “callable.” The promissory notes borrowers signed included clauses that if the bank gave notice, the borrower would have to repay the loan in, say, 10 business days regardless of original date due. This was so a bank facing many withdrawals could get cash to meet withdrawals. Ceasing payment would cause a bank to fail. But farmers who had borrowed for a crop or merchants who had ordered inventory for peak seasonal sales did not have cash. That was the dilemma that had plagued the economy for decades.
With a regional reserve bank, any commercial bank, especially small ones, could go to that regional Fed and borrow funds to tide them over. As collateral, they could present promissory notes for loans they had made to local borrowers. If the small town bank failed to repay the Fed, that new institution could collect directly from farmers, mines, lumber companies or merchants when their operating loans came due.
To protect the new Feds, these would not loan funds equal to the total value of the promissory notes presented as collateral. These would be “discounted.” And the borrowing bank would have to pay interest. If a bank came with $100,000 in promissory notes for loans made to customers, the Fed might loan only $95,000. The Fed office making such loans was called the “discount window.” The rate of interest charged on them was the “discount rate.”
If a regional Federal Reserve bank wanted to increase liquidity so commercial banks could lend more freely, it could lower the discount rate. Raising it was a signal that it wanted to tighten credit.
Now comes the crucial factor that makes a central bank a central bank and gives it power over the economy as a whole. When a regional Fed bank made discount window loans to its member commercial banks, it created the loaned money out of the air. It just made a pen and ink entry in its ledgers. It simply increased the amount of money in that bank’s reserve account on paper. It could draw down as needed as long as above the required minimum.
Nothing had to come from the Treasury or any Wall Street entity. It was pure money creation from nothing. The money supply for the nation increased.
The counterpoint was that when a borrowing bank repaid its discount loan, the money simply disappeared. Nothing went to the U.S. government or Wall Street. But the nation’s money supply shrank.
This is hard for econ students to get their heads around. Yet it was what the Bank of England or Sweden had been doing for centuries. It is essentially what every central bank around the world does today.
Moreover, while some terms have changed, it happens every day. The “discount window” still exists and there still is a “discount rate.” But it is dwarfed by another source of newly created Fed money.
On the last business day of 2025, Wall Street banks borrowed $74.6 billion from the New York Fed’s “Standing Repo Facility.” Instead of promissory notes from farmers, loggers and hardware store owners, this huge sum was collateralized with $31.5 billion in Treasury bonds and $43.1 billion in mortgage-backed securities — yes, those same instruments of debt that caused the 2007 crisis. That last category is part of the rotten limb on which we are now perched. But one more column is needed to tie this all together.
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St. Paul economist and writer Edward Lotterman can be reached at stpaul@edlotterman.com.
