What Jerome Powell might learn from Nelson Aldrich

As if Federal Reserve Chairman Jerome Powell hasn’t got enough on his mind as he struggles to tame a surge in inflation without causing a U.S. recession and a global financial crisis, he is facing a drumbeat of calls to further expand the Fed’s mandate. 

Activists, supported by influential voices in government and the investment community, believe the Fed, via its supervision of the banking system, should join the fight against climate change.

According to the National Oceanic and Atmospheric Administration, the U.S. suffered 20 major weather and climate disasters in 2021, with damages totaling about $145 billion. With hurricanes Fiona and Ian the most recent occurrences, 2022 will provide a costly accounting as well.

These disasters have the potential to offer real political leverage in Congress. In 2021 Sens. Jeff Merkley (D-Ore.) and Ed Markey (D-Mass.) introduced legislation that would require the Fed to mandate that banks stop financing fossil fuel projects. Proposals of this kind will continue to keep pressure on the central bank.

The original Federal Reserve Act of 1913 assigned a decentralized Federal Reserve System modest responsibilities by today’s standards. The Fed was conceived as a lender of last resort, charged with supplying the currency and bank reserves necessary to limit financial panics that had been far too frequent in the turn-of-the-century economy. 

In a telling 1907 critique, Paul Warburg, a partner at the firm of Kuhn Loeb, had lamented that the United States’s financial system was “at about the same point that had been reached by Europe at the time of the Medicis.” How then did the necessary changes to American finance finally come about?

In light of today’s climate debate, it’s ironic to point out that the path to the creation of the Federal Reserve System began as a response to a natural disaster, one that reverberated around the world.

In April 1906, San Francisco was struck by an earthquake measuring 7.9 on the Richter scale. In a city built largely of wood, the subsequent fires over four square miles destroyed 28,000 buildings. The death toll probably topped 3,000 and 250,000 were left homeless. Insured property losses were $235 million — nearly $7 billion in today’s dollars.

But in a fascinating 2004 analysis, Professors Kerry Odell and Mark Weidenmier documented the impact of the quake on global financial markets. Here the aftershocks were also catastrophic. 

In a world governed by the gold standard, where investors were insulated from currency exchange risk, 50 percent of the fire insurance policies in San Francisco were underwritten by British companies. The business was highly profitable, but, in retrospect, the premiums charged did not account for earthquake risk.

San Francisco policyholders presented claims in London totaling $108 million ($3.2 billion in today’s dollars) and asserted their right to be paid in gold. A total of $48 million was eventually paid, resulting in a massive outflow of British gold reserves to the U.S. That shift demanded the Bank of England tighten U.K. monetary conditions. 

The Bank then took the extraordinary step of abandoning its laissez faire principles by jawboning British banks to refrain from rolling over American commercial paper in the London money markets. Gold reserves flowed back from New York to London, causing a serious liquidity squeeze in the U.S as interest rates spiked to double digit levels.

The nation suffered a 30 percent drop in industrial production in the second half of 1907. More importantly, the New York money market entered the autumn seriously low on reserves.

In October, an investor’s attempt to corner the copper market (reminiscent of the Hunt brothers’ attempt with silver in 1980) combined with the failure of the Knickerbocker Trust Company, contributed to bank runs in New York that led to a national financial panic. After serious losses, the damage was finally curtailed when leading figures in private finance, led by J.P. Morgan, put up the funding to bail out institutions they deemed solvent.

In the aftermath, the financial community turned to its allies in government for a solution to Paul Warburg’s lament. In 1908 Rhode Island Senator Nelson Aldrich, the Republican chair of the Senate Finance Committee (and grandfather of Nelson Rockefeller) sponsored a bill that created a National Monetary Commission to propose reforms to the financial system.

Aldrich and the bankers came up with the notion of a decentralized Reserve Association that would perform the key functions of a central bank on a region-by-region basis. It eventually became the basis for the legislation signed by Woodrow Wilson in December of 1913.

Spurred by depressions in the 1920s and 1930s, and the need to support the financing of two world wars, the Fed over its first half century assumed a more active role than its creators envisioned in managing flows of money and credit in the economy.

Then, under the impact of a decade-long stagflation, the Fed’s so-called dual mandate – to promote effectively the goals of maximum employment (and) stable prices – was enshrined in a 1977 amendment to the original Federal Reserve Act. It is under those twin pillars that Jerome Powell and his colleagues deliberate today.

It is unlikely that Hurricane Ian, floods in Pakistan or a renewed outbreak of California wildfires will spark a financial panic anytime soon. And the current global energy crisis has given fossil fuels a reprieve from widespread demand for their eradication.

But it’s worth remembering that while the 1906 quake is considered a once-in-200-year occurrence, there is no way of knowing what other “black swan” events might be lurking over today’s horizon. Once the current inflation crisis is past, should the markets be severely impacted by a catastrophe that is deemed climate induced, the Fed may well find itself operating under a third mandate.

Paul C. Atkinson, a former executive at The Wall Street Journal, is a contributing editor of the New York Sun.