11.4 Banking and monetary policy reforms

The U.S. banking system faced major issues before the Progressive era. Decentralization, lack of a central bank, and inelastic currency led to frequent panics and instability. These weaknesses eroded public trust and hindered economic growth.

The Federal Reserve Act of 1913 aimed to fix these problems. It created a centralized system with 12 regional banks, standardized practices, and new monetary tools. This reform improved stability, crisis management, and economic flexibility, setting the stage for future growth.

Banking System Weaknesses and Reform

Weaknesses of pre-Progressive banking

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• Decentralized banking system lacked coordination between banks led to inconsistent practices across states
• Absence of central bank meant no lender of last resort limited ability to respond to financial crises
• Inelastic currency supply struggled to adjust money supply to economic needs caused seasonal fluctuations in demand
• Frequent bank runs and panics eroded public confidence in banks exacerbated by lack of deposit insurance
• Inadequate reserve requirements left banks undercapitalized increased vulnerability during economic downturns
• Wildcat banking allowed unregulated banks to issue own currency led to fraudulent practices and failures (Michigan, Illinois)

Provisions of Federal Reserve Act

• Established Federal Reserve System created 12 regional Federal Reserve Banks overseen by Federal Reserve Board
• Centralized control of monetary policy enabled setting interest rates and conducting open market operations
• Elastic currency supply introduced Federal Reserve Notes as new national currency expanded or contracted money supply as needed
• Standardized reserve requirements imposed uniform reserve ratios for member banks improved stability and liquidity
• Discount window lending positioned Federal Reserve as lender of last resort provided emergency liquidity to banks
• Check clearing system streamlined processing of interbank transactions reduced costs and improved payment efficiency

Role of Federal Reserve System

• Monetary policy tools:
  1. Open market operations: buying/selling government securities
  2. Discount rate adjustments: influencing bank borrowing costs
  3. Reserve requirement changes: affecting banks' lending capacity
• Money supply regulation controlled monetary base influenced broader money aggregates (M1, M2)
• Lender of last resort function provided emergency loans to solvent but illiquid banks prevented systemic crises
• Economic stabilization efforts implemented countercyclical monetary policy balanced inflation and employment objectives
• Financial system oversight conducted bank examinations and regulations promoted stability
• Payment system operation facilitated interbank settlements ensured smooth financial system functioning

Effectiveness of Progressive-era reforms

• Reduced frequency and severity of banking panics increased public confidence improved crisis management
• Enhanced monetary policy flexibility responded better to economic fluctuations controlled inflation/deflation
• Standardized banking practices lowered risk of failures due to mismanagement increased transparency
• Bolstered financial system resilience absorbed economic shocks improved institutional coordination
• Limitations of early reforms unable to prevent Great Depression necessitated additional measures (Glass-Steagall Act, FDIC)
• Long-term impact on growth created stable environment for business expansion attracted foreign investment due to credibility