INTRODUCTION

The expanding flow of funds that financed twentieth-century American economic growth was channeled by alternating waves of financial innovation and government regulation. At the beginning of the century, markets became more integrated as barriers to competition broke down. Yet the financial system was far from stable, and safety and soundness were the quest of public policy. The Federal Reserve System and the New Deal attempted to protect depositors and investors. They appeared to be successful because of subsequent periods of stability. Their limitations were revealed by the stock market crashes and banking crises of the Great Depression and the 1980s. Shaped by special interests, banking and financial reform built up a complex and burdensome regulatory regime. Over time, market pressures brought about the decline of traditional intermediaries and the rise of new institutions and markets. Only in the last twenty years, after inflation and recession battered the financial system did a thorough deregulation begin. Returning to pre—New Deal trends, distinctions between types of intermediaries have faded and financial markets have become more integrated and efficient.

THE FEDERAL RESERVE IN WAR AND PEACE, 1913–1929

In 1913 the Federal Reserve System was established to prevent banking crises. The Fed was a creature of late-nineteenth-century American banking, designed to correct its perceived weaknesses without changing its structure. Supervised by the Federal Reserve Board, the twelve Federal Reserve banks formed a new American “central” bank. To ensure long-term price stability, the Federal Reserve Act enshrined a gold standard rule of convertibility and enforced it by imposing gold reserve requirements for Federal Reserve notes and deposits.