Hallmark missed this, but yesterday was the 100th anniversary of the founding of the Federal Reserve, sometimes abbreviated as the Fed. The Federal Reserve is a confederation of 12 banks located around the country, and they are “the banks of last resort.” In other words, during times when the economy is in recession or doing poorly, banks can borrow money from the Federal Reserve to stay solvent.

This didn’t come out of nowhere. There’s an excellent article at NPR’s Planet Money blog. The article begins with the San Francisco Earthquake of 1906. Insurance companies in England were paying huge claims and so much money was leaving English banks that they clamped down the money flow to American banks. This led to some American banks failing, or not being able to pay their bills. Since there was no FDIC or bank insurance, any money deposited in those banks was lost.

If this wasn’t bad enough, people who had their money in safe banks began to panic and tried to withdraw all their money. This led to bank runs, and eventually to the Panic of 1907. The federal government had no power to do anything, and the panic was ended only when J.P. Morgan gathered other wealthy bankers and put up the money to keep the American economy going.

Senator Nelson Aldrich (R-RI) saw this and realized that panics were become too frequent and we could not depend on the wealthiest people to bail out the entire country. He introduced legislation that year to create the Federal Reserve. It took a while to pass both houses of Congress, but it did and on December 23, 1913 President Wilson signed it into law.

In addition to being the bank of last resort for troubled banks, the Fed also set the interest rate at which they will lend, and this sets the standard for the interest rate banks lend to other banks. During times of inflation the Fed will increase the interest rate to “tighten up” the money supply. During times of recession (as happened in 2008) they will lower interest rates to encourage borrowing.

There are those who oppose the Fed and they do this for two reason. First, they say that the board of governors (who govern the Fed) have too much power. Since they essentially set interest rates for much of the money flow in the country they control too much of what happens in the economy. They also believe that since banks know they will be bailed out, they can be irresponsible. If the banks keep all their profits and don’t have to worry about their losses, they have no reason to be careful.

I understand both of these arguments but in the final analysis I think we’re better off giving the government the flexibility to guide the economy.