The Development of the Federal Reserve

To guard against this possibility, bankers prior to the establishment of the Federal Reserve would establish lines of credit with larger banks. In the event of a run, the smaller bank would draw on the line of credit. The larger banks, or central banks, to keep shady small-time operators out of business, evaluated the line of credit. Nobody would invest serious money to a small bank not protected against a run by a larger partner. However, the system was not perfect. In times of panic, large numbers of depositors would demand to withdraw their money. Only the largest Wall Street banks, with millions of dollars in reserve, could guard against this. Stories of bank runs- tales of people running to withdraw all their cash from their accounts- may seem dramatic, almost theatrical to people today. But to people living in an economically unstable society, like the early twentieth century, they were an expected occurrence. The banks were independent rivals, the amount of currency in circulation was fixed, and there was no element of trust between the depositor and the bank.
The banks, in an attempt to avoid bank runs, were hoarding their money. However in order to hoard the money, they did not lend any out, bringing the economy to a standstill. The credit system of the country had ceased to operate, and thousands of firms went into bankruptcy. Something had to be done that would provide for a flexible amount of currency as well as provide cohesion between banks across the United States. A large regulated bank, like the Federal Reserve could make this happen. The Federal Reserve Act of 1913 helped to establish banks as a united force working for the people instead of independent agencies working against each other. By providing a flexible amount of currency, banks did not have to hoard their money in fear of a bank run. Because of this, there was no competitive edge to see who could keep the most currency on hand and a more expansionary economy was possible.... [continues]

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