The Great Depression brought the failure of thousands of banks in the United States, and none in Canada. Comparing Canada and the United States suggests that there was something deeply wrong with the American banking system. But what was it?
Before the creation of the Federal Reserve System, the American central bank, in 1913, America had been plagued by recurrent banking crises and suspensions of payments. But this cannot be the ultimate justification for the Fed, because Canada, which did not have a central bank until 1935, had very few such crises. Renée Haltom, an economist with the Federal Reserve Bank of Richmond, writes:
If you define "financial crisis" as a systemic banking panic--featuring widespread suspensions of deposit withdrawals, bank failures, or government bailouts--the United States has experienced 12 since 1840. ... That's an average of one every 14 and a half years. Canada has had zero in that period.
The Great Depression brought the failure of thousands of banks in the United States, and none in Canada. Comparing Canada and the United States suggests that there was something deeply wrong with the American banking system. But what was it? The short answer is that American banks were heavily regulated, contrary to Canadian banks.
In 19th-century America, so-called "free banks" (which were in fact not free at all) as well as the "national banks" were forbidden to issue notes except by guaranteeing them with government bonds. In Canada, on the contrary, each bank could freely issue its own currency up to the value of its capital until the early 20th century.
There are two keys to understanding real free banking, which includes the freedom to issue private banknotes. First, issuing banknotes is just like accepting deposits: both create a bank liability against a corresponding asset. Loans are usually the corresponding assets, whether the bank lends deposited money or newly issued banknotes. The second key is that private banks cannot overissue banknotes when the latter are rapidly returned for redemption in underlying money (such as gold or any legal-tender money like national currency), which any bank has an incentive to do. If a bank does issue more notes than it can redeem, it will be rapidly revealed bankrupt before it can do much damage. This system worked well in Scotland and in Canada.
Another problem in America lay in the branching limitations or prohibitions (depending on the state) during most of the 19th century (some were not completely eliminated until 1994). A large number of banks were "unit" banks, that is, they could not legally open any branch besides their headquarters. Canadian banks, by contrast, faced few limitations on branching, and none after 1867. Around 1890, Canada had only a few dozen banks, but with branches all over the country that soon reached into the thousands, compared with 30,000 separate banks, often unit banks, in the United States. In his 1894 report, economist L. Carroll Root explained (page 320):
Under our United States system, which leaves each bank so largely dependent upon the fortunes of its locality, and the business of each locality so entirely dependent upon its local banks, nothing is more common than to see mutual ruin of banks and business in numerous widely scattered localities, while the business of the country has been as a whole sound. Such results are inconceivable in Canada. The widely extended system of each of the great banks, with its branches in every part of the country, constitutes a practical financial Lloyd's insurance, by which each helps to guarantee the soundness of all.
The central banking system, set up primarily to render impossible the restriction of payments by commercial banks, itself joined the commercial banks in a more widespread, complete, and economically disturbing restriction of payments than had ever been experienced in the history of the country.
Besides the problems caused by the overregulated and inefficient banking system, a second factor played in favor of the creation of the Fed: the climate of opinion in the Progressive Era was becoming less favorable to free enterprise, and more open to the role of government experts and European ideas. The main founders of the American Economic Association had studied in Germany with professors who rejected the free-market model. Richard T. Ely was one of them and, as the president of the Academy of Political Science, he helped popularize the work of the National Monetary Commission, chaired by Republican Senator Nelson Aldrich. Most European countries already had central banks, and Aldrich was apparently converted to central banking by a visit to Europe on behalf of his Commission. He became the main mover of the central bank project.
The relative role of ideas and interests in the creation of the Fed is debatable, but Wall Street bankers certainly played a major role, with the active help of their political crony, the same Nelson Aldrich. Wall Street banks liked the unit-banking system, which limited effective competition against them and insured that other banks in the country, unable to branch in New York, would continue to deposit much of their reserves with them. They also thought that a central bank would rescue them if necessary. Economic historian Elmus Wicker, wrote:
[Aldrich] and his associates argued that every precaution had been taken in the bill to keep the influence of Wall Street to a minimum and suggested that the fear of Wall Street control was groundless! No one knew that Wall Street drafted the bill! ...
One of the great anomalies of U.S. financial history is how Wall Street bankers managed to play the role they did while politicians and the public were decrying Wall Street domination and influence!
Notwithstanding the appearance of decentralization and government control, control of the Fed had, in fact, been "captured" by Wall Street.
A crucial meeting between Aldrich and his banking cronies was held on Jekyll Island, Georgia, in November 1910. The five participants--three prominent Wall Street bankers and one Harvard economist besides Aldrich himself--"[a]ll agreed the central bank should be controlled by the bankers and not by the government," Wicker writes. The project was in many respects the same as later adopted under the new Democratic administration of Woodrow Wilson. (I learned much about the whole topic of this post at a Liberty Fund/Cato Institute conference directed by George Selgin and held in the same room as the historic 1910 meeting.)
One of the bankers at the Jekyll Island meeting, German-born Paul Warburg, was a good representative of the European influence and the Progressive Era's faith in government. Economic historian James Levingston writes that Warburg, in his arguments for a central bank,
... went out of his way to suggest that the notion of a "self-regulating" market, even as enclosed and underwritten by specific government policy or legislation, was inappropriate and inapplicable to modern conditions, particularly with respect to the money market. "No automaton--no tax or fixed regulation"--would do. Instead, "the best judgement of the best experts must indicate the policy to be pursued from time to time." The evolution of the economy could no longer be understood as external events that by their nature remained impervious to knowledge and purposeful action; if left untouched the market would destroy, not regulate, itself.
On the contrary, a more free-market, free-banking, Canadian-style reform would have created a much more efficient and reliable banking system in America. The Fed was a bad solution.
To summarize, three reasons seem to explain why this bad solution was adopted. First, an over-regulated banking system was fueling regular crises. Second, domestic and international opinion favored government intervention (supporting an old populist suspicion of private banks in America). Third, Wall Street bankers welcomed a central bank as a protection for their dominant position.