After one of the biggest and most controversial battles ever to take place in both houses of Congress, the Federal Reserve Act of 1913 was passed. Stories about how the Act was passed in secret as the result of a hidden conspiracy are just that — stories. Not only were the issues debated for months in the public press, the testimony before both houses takes up several thousand pages in the Congressional Record.
The fixed belief popular among conspiracy theorists that a secret meeting of conservative Republican financiers led by Nelson Aldrich on Jekyll Island was the basis of the Federal Reserve can be totally discounted. Not only were a House and Senate controlled by the Democrats unlikely to pay any heed to a man they regarded as one of the prime movers behind the financial troubles of the country, Woodrow Wilson never would have signed such a bill. In any event, the Aldrich proposal that came out of the meeting on Jekyll Island was never adopted. As Harold G. Moulton explained,
"The Federal Reserve Act is a substantial improvement over the Aldrich plan. It should be chronicled here that the Federal Reserve Act is not a mere plagiarism of the Aldrich plan. In certain fundamental respects the new law is markedly different from and markedly superior to the Aldrich plan. . . . Subject to a great deal of hostile comment by the financial and business press during the period of its discussion before Congress, after passage the law very quickly became recognized at its true worth as the most constructive piece of legislation that had ever been placed upon the American statute-books. For once, at least, a vitally important, though technical, question had been resolved into its fundamental issues through public discussion, and in this instance a measure emerging into law did represent the best constructive thinking of the nation." (The Financial Organization of Society. Chicago, Illinois: The University of Chicago Press, Third Edition, 1930, 531-532.)
The Federal Reserve was to operate in a manner consistent with classic banking principles. The mechanism was to rediscount — "accept" (purchase) — eligible commercial, industrial and agricultural paper (bills of exchange) originally accepted by member commercial banks through the "discount window" whenever there was a need to increase liquidity. Rediscounting was to be supplemented by purchasing the eligible paper of non-member banks, businesses and individuals on the open, that is, secondary market. When there was too much liquidity in the system, the Federal Reserve would sell enough of its holdings of private sector paper to siphon off the excess.
Unfortunately there was a loophole in the Act. The National Bank Notes and the Treasury Notes of 1890 were backed by government debt. Any National Bank that wanted to issue banknotes to supplement its creation of demand deposits (checking accounts) and meet its daily transactions demand for cash had to purchase government bonds in an amount greater than the face value of the banknotes issued to ensure more than 100% coverage for the banknotes.
Incidentally, the requirement that National Bank Notes be backed by government debt gave rise to the myth that "the banks" were getting "double interest" on their note issues. This was presumably because the banks got interest on their holdings of government bonds that backed the National Bank Notes, and then interest again when they loaned out the notes to borrowers.
The facts fail to support this belief. The National Banknotes — along with the United States Notes ("Greenbacks"), Treasury Notes, Silver and Gold Certificates, and the gold, silver and base metal coinage — constituted by far the smaller portion of the money supply. The task of the currency was to meet the demands of everyday commerce.
The greater part of the money supply — approximately 80% in 1900 — consisted of various negotiable instruments: bills of exchange, mortgages of all types, promissory notes, demand deposits, and so on. When a commercial or mercantile bank (and the National Banks were commercial banks) made a loan on the strength of a collateralized contract (bill of exchange or mortgage), the bank discounted (accepted) the paper, thereby creating money. In return, the bank issued a promissory note that the borrower signed, which the bank used to back a new demand deposit.
The borrower was given a checkbook. If the borrower wanted currency — gold or silver coin or banknotes — he or she had to draw a check and cash it. The borrower paid the discount (the difference between the face value of the bill of exchange and the amount of money actually created by accepting the bill of exchange and put into the demand deposit), but usually nothing for the privilege of converting a portion of the demand deposit into National Bank Notes and using them in commerce. The bank was no more getting "double interest" on its banknotes than it was getting any interest at all on its holdings of United States Notes, Treasury Notes, Gold and Silver Certificates, or gold, silver, and base metal coins in its vaults.
Still, the National Banks were saddled with a large amount of government debt that the government did not have the capacity to retire all at once. Had the government called in all its debt at one time, it would have been redeemed at a considerable discount, causing enormous losses to the banks.
To get around this problem, the Federal Reserve was empowered to purchase the government debt from the National Banks over time. The Federal Reserve would hold the government paper, and the debt-backed National Bank Notes would be replaced with debt-backed Federal Reserve Bank Notes. As the government paid down its debt, the government debt-backed Federal Reserve Bank Notes would be replaced in turn with visually indistinguishable but private sector asset-backed Federal Reserve Notes.
To make certain that such "open market operations" would not tempt the government to monetize its deficits — the whole idea, after all, was to get rid of the national debt, at least that portion of it backing the currency — Congress adopted the Sixteenth Amendment to the Constitution: the income tax.