Born of Panic: The Federal Reserve and the Panic of 1907, Part 2

This is the second of a two-part series. Read part 1 here.

During the Panic of 1907, a severe run on New York banks and trust companies left some financial institutions desperately short on cash. The squeeze on the banking system had major consequences for Wall Street, where brokers suddenly found themselves unable to get the loans they needed to fund their daily trades. Exacerbating the problem was the absence of any government entity responsible for cleaning up the mess.

"There was no lender of last resort, nobody trying to ensure the safety and soundness of the financial system, nobody trying to ensure the adequate liquidity of the money supply," said Robert F. Bruner, a professor of business administration at the University of Virginia and the co-author of "The Panic of 1907: Lessons Learned From the Market's Perfect Storm."

Legendary banker J. Pierpont Morgan stepped into the void. Morgan had helped bail out the American economy before: after the Panic of 1893, Morgan led a syndicate of bankers that bought U.S. government bonds and, in return, provided gold to shore up the country's dwindling reserves. In 1907, Morgan once again united a group of bankers, this time to rescue some of the trust companies—which were similar to traditional banks but were subject to less regulation—that had been paralyzed by the Panic.

Morgan "chartered a group of young men in their 20s to go down in the vault [of a financial institution], and look at their assets," Bruner said. "If it was solvent, J.P. Morgan and his circle would show up the next day with satchels full of gold coins and display them very prominently to the long line of depositors and basically lend the money to the bank."

One trust company that Morgan famously did not save was the Knickerbocker Trust because, according to the book, "Banking Panics of the Gilded Age," Morgan's team couldn't judge the trust's solvency quickly enough to provide aid and ward off its closure. The Knickerbocker Trust still managed to reopen the following year.

Morgan also met with U.S. Treasury Secretary George Cortelyou, who went on to place tens of millions of dollars of U.S. treasury reserves with national banks to help ward off damage there from any future bank runs. An existing private consortium of banks, The New York Clearinghouse, also provided support to troubled banks. Meanwhile, on Wall Street, Morgan convinced bankers to offer $25 million in loans to brokers to keep trading going.

Morgan didn't necessarily lead the rescue efforts out of "the goodness of his own heart," said Jon R. Moen, a University of Mississippi economics professor who, along with Ellis Tallman, the senior vice president and director of research at the Federal Reserve Bank of Cleveland, co-authored the paper "Lessons from the Panic of 1907." Morgan saw profits from the loans he made during the crisis, Moen said.

"I think it was a case where his own personal profit-making interests lined up with, for lack of a better term, the collective bank interests," he said.

Creating the Federal Reserve

Despite his prominent role in easing the Panic, the general public harbored ill feelings toward Morgan and toward bankers in general.

"Morgan was perceived as having exploited the circumstance for his own benefit," Tallman said.

In the year following the panic, Congress passed legislation creating a commission to study banking in the U.S. and in European countries (which had central banks) in hopes of learning how to avoid future panics.  "Something has got to be done," Rhode Island Senator Nelson Alrdrich said at the time, according to a report by The Federal Reserve Bank of Boston. "We may not always have Pierpont Morgan with us to meet a banking crisis."

But Aldrich, the sponsor of the act creating the commission, did secretly seek help from bankers, including one of Morgan's business partners. Aldrich, a Treasury official, and a handful of bankers met on an island off the coast of Georgia to design plans for a central bank. To outsiders, the gathering was portrayed as a duck-hunting trip.

"Anything that smacked of having any influence by J.P. Morgan would probably be viewed as completely suspicious and would have no chance of ever being passed as legislation," Moen said. "Given their reputation at the time […] bankers didn't want to be seen as the creators" of a central banking bill.

Aldrich, a Republican, introduced legislation to create a central bank in 1910, but the bill failed. In 1912, when Democrats took control of the Presidency and both houses of Congress, a new proposal by a Democratic congressman gained more traction.

The new proposal, introduced by Virginia representative Carter Glass, would also establish a central bank but with a key difference: the central bank wouldn't be one body, but rather a system of different districts, each governed by its own board. The board presidents would convene regularly in Washington D.C. to set monetary policy. That group today is known as the Federal Open Market Committee.

"The Democrats wanted a central bank that would be governed by the people, not ruled by the elites in the big money sector," Bruner said.

In 1913, President Woodrow Wilson signed the Federal Reserve Act into law.

"What makes the Panic of 1907 so significant is that the United States, for almost 100 years, had resisted having a central bank," Bruner said. But "the nineteenth century was a very turbulent time, financially...People finally got tired of that and decided to try a central bank."

Today, more than a century later, the Federal Reserve remains a staple of the U.S. economic system, with Wall Street watching—and reacting—to its every move.

Photo of an illustration called “J.P. Morgan striking photographer with cane” from 1910, courtesy of the Library of Congress.