The Mystery of Banking

Central Banking in the United States III
233
15
See Kolko, 
Triumph of Conservatism
, pp. 146–53.
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headed the pro-central banking studies of the Congressionally
created National Monetary Commission; Frank A. Vanderlip of
Rockefeller’s National City Bank; Paul M. Warburg, of the invest-
ment banking firm of Kuhn, Loeb & Co., who had emigrated
from Germany to bring to the U.S. the blessings of central bank-
ing; Henry P. Davison, a partner of J.P. Morgan & Co.; and
Charles Norton, of the Morgan-controlled First National Bank of
New York. With such powerful interests as the Morgans, the
Rockefellers, and Kuhn, Loeb in basic agreement on a new cen-
tral bank, who could prevail against it? 
One particularly ironic note is that two economists who
played an especially important role in establishing the Federal
Reserve System were highly conservative men who spent the rest
of their lives attacking the Fed’s inflationary policies (though not,
unfortunately, to the extent of repudiating their own roles in cre-
ating the Fed). These were University of Chicago professor J. Lau-
rence Laughlin and his former student, then a professor at Wash-
ington & Lee University, H. Parker Willis. Laughlin and Willis
played a large part, not only in the technical drafting of the bill
and the Fed structure, but also as political propagandists for the
new central bank. 
234
The Mystery of Banking
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XVI. 
C
ENTRAL
B
ANKING IN
THE
U
NITED
S
TATES
IV:
T
HE
F
EDERAL
R
ESERVE
S
YSTEM
1. T
HE
I
NFLATIONARY
S
TRUCTURE OF THE
F
ED
T
he new Federal Reserve System was deliberately designed
as an engine of inflation, the inflation to be controlled and
kept uniform by the central bank. In the first place, the
banking system was transformed so that only the Federal Reserve
Banks could print paper notes. The member banks, no longer able
to print cash, could only 
buy
it from the Fed by drawing down
deposit accounts at the Fed. The different reserve requirements
for central reserve city, reserve city, and country banks were pre-
served, but the Fed was now the single base of the entire banking
pyramid. Gold was expected to be centralized at the Fed, and
now the Fed could pyramid its deposits 2.86:1 on top of gold,
and its notes 2.5:1 on top of gold. (That is, its reserve require-
ments were: 35 percent of total demand deposits/gold, and 40
235
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percent of its notes/gold.)
1
Thus, since gold reserves were central-
ized from the national banks to the Fed, it could pyramid further
on top of them. All national banks were forced to become mem-
bers of the Federal Reserve System, while state banks had a vol-
untary choice; but nonmembers could be controlled because, in
order to get cash for their customers, they had to keep deposit
accounts with member banks who had access to the Fed. 
236
The Mystery of Banking
1
Since the establishment of the Federal Reserve System, the reserve
requirement limits on the Fed itself have been progressively weakened, until
now there is no statutory limit whatsoever on the Fed’s desire to inflate.
F
IG
. 16.1 — T
HE
F
EDERAL
R
ESERVE
P
YRAMID
Figure 16.1 depicts the new inverted pyramid created by the
Federal Reserve System in 1913. Nonmember banks pyramid on
top of member banks, which in turn pyramid on top of the Fed,
which pyramids its notes and deposits on top of its centralized
gold hoard. The new central bank, being an arm of the federal
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government, carries the great prestige of that status, and also
has a legal monopoly on the issue of notes. 
How this reserve centralization was designed to be inflation-
ary was pointed out by Phillips, McManus, and Nelson: 
Suppose the total cash reserves of all commercial banks
prior to the introduction of central banking amounted to
one billion dollars; on the basis of these reserves, and with
an assumed minimum reserve-deposit ratio of 10 per cent,
the banking system could expand credit to the extent of 10
billion dollars. Now, suppose that the Federal Reserve Sys-
tem is established, and all reserves are transferred to the
vaults of the new Reserve Banks, where they become
deposits to the credit of (and at the same time are counted
as the reserves for) the member banks. Against this billion
dollars of deposits the Reserve Banks must maintain a min-
imum cash reserve of 35 per cent, or 350 million dollars.
The remainder of the billion dollars of cash, 650 million
dollars, becomes excess reserve for the Reserve Banks. On
the basis of such excess reserves the Reserve Banks are able
to increase their deposits, and hence the new reserves of the
member banks, by the maximum amount of about $1.9 bil-
lion . . . . 
In other words, the Federal Reserve Banks now have 2.9
billion dollars in deposits to the credit of the member insti-
tutions (against which they have the one billion dollars as a
reserve, or a reserve ratio of 35 per cent), or conversely, the
member banks now have 2.9 billion dollars in legal reserves,
on the basis of which it is possible for them to expand credit
to a total amount of 29 billion dollars. By virtue of the pos-
session of this new, added, reserve of 1.9 billion dollars . . .
the member banks can now add 19 billion dollars new
credit to the antecedently existing 10 billion dollars.
2