By James Grant

The Federal Reserve we know is the mature, dollar-spinning behemoth that holds short-term interest rates in the hollow of its hand. "The Young Fed" is the central bank's coming-of-age story.

Mark Carlson, a former principal economist at the Fed's Board of Governors, has set for himself the task of describing the untested institution's responses to the banking crises of the 1920s. The '20s did roar, all right, but they sometimes squealed in pain -- there were too many small, undercapitalized and illiquid banks, and they perished by the score as farm prices and land prices retreated from the government-induced inflation of World War I. The crises, small as they were in dollar terms, challenged the judgment and technical proficiency of an institution that was intended to put an end to bank runs and money panics for all time.

The Fed opened for business in 1914 full of youthful idealism. It would exchange its Federal Reserve notes on demand for gold at the rate of $20.67 an ounce. It would not presume to direct the American economy but rather to provide short-term liquidity to illiquid, though solvent, commercial banks. They would have to ask for it.

Yet, by 1917, the youngster was facilitating the Wilson administration's war-financing program with lots of easy money. Naturally, the result was a mighty inflation, as well as high and rising interest rates, lots of speculation and millions of unhappy consumers. A severe but instructively short-lived depression followed in 1920-21. The Fed responded to this deflationary downturn -- one that produced declines of 40.8% in wholesale prices and 46.6% in stock prices -- not by lowering interest rates but by raising them, all the way up to a punitive 7%. The green central bank was determined to expunge the inflation that, little did it know, was fast ending.

The depression was still in progress in 1921 when President Warren G. Harding delivered an inauguration address that touched on nearly every conceivable topic before it reached the economy. In so many words the president endorsed the Fed's deflationary vise as a means to the end of restoring sound money. "Perhaps we never shall know the old level of wages again, because war invariably readjusts compensations," said Harding. "We must face a condition of grim reality, charge off our losses and start afresh. It is the oldest lesson of civilization."

Mr. Carlson's business is not the forest of the macroeconomy but the trees of the banking microeconomy -- he zips past the 1920-21 affair to explain the machinery of the new central bank, its chain of command and public purposes. He describes how the Fed went about the work of extending credit to banks in need and illustrates theory with practice in a chapter devoted to case studies of Federal Reserve interventions.

Storytelling is not the author's chief excellence, but he furnishes enough colorful detail to keep the monetary layman turning pages. Thus, in 1925, the Federal Reserve Bank of Dallas found itself owning several hundred head of cattle that it had accepted as collateral for the loans it had extended to a number of once merely troubled, now insolvent, New Mexico banks; it took 13 employees to ride herd on the unwanted animals. In 1926, officials at the Federal Reserve Bank of Kansas City stopped a run on the local Park National Bank with their showy, 11th-hour arrival on the scene with "sacks of bills, big sacks in which a large man could have been tied up. There were little sacks of clinking gold, middle-sized sacks of silver dollars, halves and quarters." In all times and places, cold cash soothes the anxious spirit.

The presence of that clinking gold reminds us that the 1920s were the high noon of American financial orthodoxy. The dollar was still convertible into gold at the prewar rate (a rarity among the world's war-torn currencies). The stockholders of a bank were still responsible for the solvency of the institution in which they owned a fractional interest -- in case of impairment or insolvency, it was they who stumped up the funds with which to make the depositors whole. The government still set its sights on reducing the public debt, not merely slowing its rate of rise. In that noble cause, in 1919, the Treasury had established a sinking fund, a device to shrink the debt by repurchasing the bonds from the same investors who had bought them.

More and more in the following decades, collective responsibility nudged aside personal responsibility in American finance. True, individual American investors are still at risk -- they are not too big to fail. It's otherwise with the big banks, the kind that agitated Woodrow Wilson in his campaign against his imagined "Money Trust." In signing the Federal Reserve Act into law in the waning days of 1913, Wilson had meant to bring the moneybags to heel, but the big money has retained its power, while the biggest money of all, the Federal Reserve, mistakes itself today for a kind of central-planning bureau.

Perhaps the least satisfying portion of Mr. Carlson's formidable history is its bland conclusions. He expresses no regrets at the retirement of the convertible gold dollar, though only its successor -- the pure-paper model (money so easily conjured) -- could have facilitated today's $36.2 trillion in gross public debt. Neither does he mourn the shift from the personal liability of bank stockholders to the doctrine that some banks are too big to fail. Still less does he grapple with how the Fed's evolution from passive lender to omnipresent meddler has contributed to the ever-shrinking purchasing power of the once almighty dollar.

Before the Fed came into being, recalled Adolph C. Miller, a member of the central bank's board of governors in testimony before Congress in the year before the 1929 crash, bankers made their own decisions about risk. Some were conservative, others not. Some held a big reserve, others took their chances with a small one. "Now," Miller observed, "there is no reason why any bank should carry a surplus reserve. I think one of the things that is overlooked in banking changes under the Federal Reserve system, with its safeguards, is that the banker has been released from that constant sense of responsibility for his own good condition that was characteristic -- at least, more characteristic -- of banking under our old money system."

The Fed marked the 111th anniversary of its enactment last month. Old it may be. But wise?

--Mr. Grant, founder and editor of Grant's Interest Rate Observer, is the author of "The Forgotten Depression -- 1921, the Crash That Cured Itself," winner of the 2015 Hayek Prize.

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January 17, 2025 11:47 ET (16:47 GMT)

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