THE FEDERAL RESERVE
SYSTEM
- A BRIEF
HISTORY -
Actions of the Federal Reserve System impact many aspects of the average
American's every day life. The Federal Reserve and it's policies affect the
amount of interest banks pay on savings accounts and charge on loans. Business
activity and rates of employment are indirectly influenced. Even foreign
economies can be affected by it's decisions. The Federal Reserve has undergone
many changes since it's inception. This paper will discuss the environment in
which the Federal Reserve System was born, and the growing pains endured along
the way to become the powerful, autonomous institution it is today.
The United States has not always had the stabilizing force of a strong central bank. Early in the country's history, there were two attempts at a national bank, the First United States Bank (1791-1811) and the Second Bank of the United States (1816 - 1836). These banks' charters were allowed to expire. At the time, the idea of a federally controlled bank ran counter to the general belief in a free and independent banking system.
After 1836, the country relied on independent state banks. These banks issued their own currency. Quality of banking varied considerably among the states. Currency was unstable. By the time of the Civil War, there were thousands of state banks, all issuing notes which varied wildly in value. This created problems for both sides in financing the Civil War, and caused an overall loss of confidence in banking.
A national currency was established with the National Currency Act in 1863. In 1864, the National Banking Act was passed. It attempted to establish a reliable market for government bonds, as well as set rules for all banks, including the requirement to maintain reserves. These acts made improvements, but major problems persisted.
The bank system was not organized. All banks acted independently. Although
the requirement for reserves had been established, the mechanism was defective.
Loopholes allowed banks to misrepresent their reserves and carry less than the
required balance. Paper money was limited and banks couldn't adequately satisfy
demand during active periods of business activity. As a result, currency
commanded a premium. Interest rates skyrocketed. Loans were liquidated, and
borrowing became difficult. These crises occurred each year in the spring when
farmers would borrow for seed to plant, and each fall during harvest. An
especially severe crisis in 1907 convinced people that control outside and above
the banks was necessary.
Congress appointed the National Monetary commission to study the problems behind the recurring crises. It's recommendation was the U.S. needed a strong central bank that could issue currency. In 1913, Congress passed the Federal Reserve Act. It was signed by President Woodrow Wilson on 23 December of that same year. It's purpose, as stated in the act itself was "to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes" (McFarland 173). The Federal Reserve System was established. It is composed of 12 districts, each controlled by a regional bank: Federal Reserve Bank of Atlanta; Federal Reserve Bank of Boston; Federal Reserve Bank of Chicago; Federal Reserve Bank of Cleveland; Federal Reserve Bank of Dallas; Federal Reserve Bank of Kansas City; Federal Reserve Bank of Minneapolis; Federal Reserve Bank of New York; Federal Reserve Bank of Philadelphia; Federal Reserve Bank of Richmond; Federal Reserve Bank of San Francisco; Federal Reserve Bank of St Louis. A central governing agency, the Board of Governors, oversees and coordinates actions of, and between, regions.
In the very beginning, the Federal Reserve was relatively powerless to
influence monetary conditions. The new reserve banks had small, nearly
non-existent portfolios. The Treasury, the reserve banks, and the board competed
for power over the two major policy controls: changes in the rate of discount,
and open market operations. Action was often delayed and many questionable
decisions were made because of this competition. This continued for years and
legislative action towards a settlement was not even started until 1935.
The outbreak of WWI in 1914 affected the U.S. economy. Trade with Europe came to an immediate standstill. Goods ready for shipment suddenly had no buyer. Before the war, the U.S. was already a debtor nation the international scene. (This was due in large part to the cyclical harvest-time money crises.) Immediate payment of debt was demanded by European banks.
After the initial down turn, the economy picked up quickly as Allies rushed to purchase American goods. The U.S. was rapidly transformed from a debtor nation to a substantial creditor. Money flowed in at such a rate that commercial banks had no need to borrow from the reserve banks. As a result, the Federal Reserve was virtually powerless to affect the economy.
The Federal Reserve's first year was a period of organization. When the Act first passed, many believed the system's primary function was merely to provide aid during emergencies. The Reserve's first annual report illustrated that the board did not share in this belief. "The duty [of the reserve banks] plainly is not to await emergencies but by anticipation, to do what it can to prevent them" (West 182). Even though the system had few actual operations at that time, the Federal Reserve was poised to act; to be proactive.
April 6, 1917, the U.S. entered the war. In cooperation with the Treasury Department, low discount rates were offered on government securities, as a means of financing the war. "Most of the government expenditures financed by bond issues ... were not offset by savings in other sectors. Purchases of bonds were not equivalent to savings; instead they were based on extensions of credit by the banking system" (West 191). A substantial amount of government debt was incurred and the precedent was set that a substantial amount of the Federal Reserve's credit came to be based on government debt.
A large market sprung up for the debt that had been created. The existence of the debt, and the market for it, created an environment in which policy measures could be effected through open market operations. The use of government securities as collateral made the reserve system's portfolio more flexible. On the down side, the lack of savings and the heavy debt combined to drive inflation upward.
From 1919-1923 the dominant economic theory was that by simply providing credit to productive enterprises, and not granting credit to speculative ventures, the economy would take care of itself. The board shared this belief. Officials at the regional reserve banks were, at that time, much more knowledgeable than the board about the actual workings of the credit system. They understood, being at street level, that there was no way of guaranteeing that a loan would ultimately wind up for something productive. They wanted a well-defined loan policy. They also believed that rising prices could be curbed by limiting currency and credit. The banks wanted to ward off inflation by raising the discount rates. At the time, the board was still extremely susceptible to political pressure. The treasury department was against the rate hike, and used it's influence to keep rates from rising.
After WWI, the economy was growing. Industry was booming. With rates low, and credit easily obtained, investments in stocks and bonds rose to staggering heights. Almost no margin was required on these investments and speculation fever swept the nation. People assumed the prices would continue to increase indefinitely, and went deeply into debt. "From 1921 to 1928 loans at all commercial banks increased 35%. Total deposits increased by 60%. Investments in other than U.S. government securities increased by 96%. Borrowing by member bans at reserve banks increased by 96%. The discount rate was low: 3.5 to 6.5%. Broker's loans increased 441% (1,190 billion to 6,440millon) and then by 1 billion during the 4 months just prior to the crash. The Federal Reserve Bank holdings of U.S. government securities rose from 234 million to 617 million at the end of 1927, but sharply dropped to 228 million by end of 1928" (Moore 66).
The inevitable crash came on Monday, October 24, 1929. "More than 9,000 banks failed from 1930 to 1933" (Moore 75). Prices fell like meteors. Unemployment hit 25%. The Federal Reserve was unable to react. It had no way to control what loans were made for. Although legislation had always allowed for the use of the purchase and sale of government securities as a means of influencing availability of credit and cash, during this time it was just beginning to be as an effective tool of monetary policy.
The lessons learned during the Great Depression resulted in many changes to the Federal Reserve in the 1930's. "Except for the early years of our republic, and the decade of the 1860's, the decade of the 1930's saw more changes in government, in banking, in economic theories and in the attitudes of people than in any other period of our history" (Moore 75).
In 1933 the Banking Act was passed. This act gave the Federal Reserve the authority to regulate the volume of loans on securities, in order to limit speculation. It disallowed member banks from dealing in securities. Under the act, insurance of bank deposits was established, and member banks were required to participate.
The Banking Act of 1935 completely overhauled the system. It changed the basic organization of the power structure and the purpose of the system. Among the changes: the number of governors was set at seven, all to be appointed by the President with consent of Senate; the Comptroller of Currency and the Secretary of Treasury were dropped from board; the board was given authority to change member banks' reserve requirements; nonmember insured banks required to follow same restrictions and regulations as member banks; and the Federal Open Market Committee (FOMC) was established.
It took WWII to pull the economy completely out of the depression. Just as with WWI, the nation incurred debt as it fueled the war machine. After the war the country was once again faced with inflation and the danger of lurching headlong into another depression was a possibility. Again, the Treasury insisted on keeping rates low. The only tools at the Reserve's disposal were controls imposed during the war which directly controlled consumer spending. For example, caps on loans and shortened term lengths.
The Federal Reserve created a new division during the war. The initial purpose of this division was to monitor businesses and ensure compliance with the Trading with the Enemy Act. Presently known as the Division of Research and Statistics, this department currently is relied on quite heavily by both government and civilian sectors for reliable data on business trends and the state of the economy.
25 June 1950, President
Truman mobilized troops to assist South Korea after North Korea invaded. In
1952, General
Eisenhower was elected and promised to end the
conflict. As with the end of previous armed conflicts, the specter of
inflation reared its ugly head. The Federal Reserve once again stepped up
efforts to gain control of interest rates. Battle for freedom from dominance by
the treasury and independence in areas of monetary policy were crucial to the
effectiveness of the reserve system. By now the Reserve had earned some allies
on Capitol
Hill. After intense negotiations, the Federal Reserve System finally gained
control of interest rates (discount rate), with the signing Treasury-Federal
Reserve Accord on 3 March 1951. This accord, along with additional legislation,
has gradually expanded the power of the Federal Reserve.
There have been several key pieces of legislation passed since the Banking
Acts of 1933 and 1935 which have changed the way the Federal Reserve does
business. Some of these acts, as well as developments in the banking industry
brought on by the Reserve, follow. (Much of this information is available
through the Federal Reserve Board's homepage.)
page 4 consumer & community
(pdf)
page 11 appendix B
Today the Federal Reserve System has almost autonomous control over monetary policy. The mission of the Reserve includes using monetary policy to nurture economic conditions favorable to sustain high employment, stable currency values, stable prices, encourage saving, and increase consumption. Along with managing the nation's supply of money and credit, the Federal Reserve also supervises and regulates banks, and acts as a bank for other banks and for the U.S. government. The Federal Reserve implements monetary policy by influencing the money and credit supply. This is done in three ways: reserve requirements, open market operations, and changing the discount rate.
Reserve requirements refers to changing the amount of money banks are required to keep in reserve. This increases or decreases the volume of funds that member banks have available to lend, which is directly reflected in the amount of credit and of currency in circulation.
Open market operations directly affect the volume of reserves. Open Market operations get it's name from fact the federal reserve buys and sells treasury bills from securities dealers in the open market (private sector). Buying bills puts money into the market, and selling bills sucks money out of the market, decreasing the available supply. The FOMC is responsible for deciding when, and for how much, to buy or sell, and under what conditions the transactions are made.
The discount rate is the interest rate the Federal Reserve charges member banks when they borrow money. Through the discount rate, the federal reserve is able to influence availability of credit. This is the control mechanism/tool that the Reserve battled for all those years to gain power over.
Supervision and regulation of banking activities is another responsibility of the Federal Reserve. It takes on this oversight role to ensure the safety of the nation’s banking and financial system, and to protect the credit rights of consumers. It attempts to quell stock market speculation by controlling credit practices of banks through bank supervision and regulation. As an extension to the supervisory role is the power to take disciplinary action. This includes authorization to remove officers of member banks for violation of banking law or continued unsound banking practice, and to suspend member banks for using too much credit for speculative purposes.
Additional functions of the Federal Reserve system: facilitate the
clearance and collection of checks; transfer funds between banks; collect and
analyze business and economic information and statistics; and provide financial
services to the U.S. government, to include dealing in treasury bills and
savings bonds, and to direct U.S. interests internationally. The chairman of the
board participates in such international economic entities as the International Monetary Fund
and G7 (now
G8) meetings.
The Federal Reserve System was originally created to solve the relatively
simple problems of inelastic currency and inadequate bank reserves. Over time,
legislation was passed to clarify and add to that original charter. Through
several wars, and as the country moved from an economy based on agriculture to
one based on industry, the Federal Reserve adapted. Even now, in the age of the
technological revolution, the Federal Reserve System continues to meet the
challenges of our complex economy.
HARD COPY SOURCES - NOT AVAILABLE ON-LINE:
Moore, Carl H. The Federal Reserve System: A History of the First 75 Years. Jefferson, North Carolina, McFarland & Company, Inc., Publishers, 1990
Board of Governors of the Federal Reserve System, The Federal Reserve System. Its Purposes and Functions. Washington D.C.: The National Publishing Company, 1947
Paradis, Adrian A. How Money Works. The Federal Reserve System. New York: Hawthorn Books, Inc.,1972.
West, Robert Craig. Banking Reform and the Federal Reserve 1863 -
1923. Ithaca, NY: Cornell University Press, 1974
ON-LINE SOURCES AND LINKS REFERENCED:
Board of Governors of the Federal Reserve System / Washington, D.C.
homepage.
URL: http://www.bog.frb.fed.us/
Federal Reserve, Board of Governors, URL: http://www.federalreserve.gov/
Federal Reserve Bank of Atlanta, URL: http://www.frbatlanta.org/
Federal Reserve Bank of Boston, URL: http://www.bos.frb.org/
Federal Reserve Bank of Chicago, URL: http://www.frbchi.org/
Federal Reserve Bank of Cleveland, URL: http://www.clev.frb.org/
Federal Reserve Bank of Dallas, URL: http://www.dallasfed.org/
Federal Reserve Bank of Kansas City, URL: http://www.kc.frb.org/
Federal Reserve Bank of Minneapolis, URL: http://woodrow.mpls.frb.fed.us/
Federal Reserve Bank of New York, URL: http://www.ny.frb.org/
Federal Reserve Bank of Philadelphia. URL: http://www.phil.frb.org/
Federal Reserve Bank of Richmond, URL: http://www.rich.frb.org/
Federal Reserve Bank of San Francisco, URL: http://www.frbsf.org/
Federal Reserve Bank of St Louis, URL: http://www.stls.frb.org/
University of Groningen homepage - essays on AmericanStudies.
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HISTORY CHANNEL, URL: http://www.historychannel.com/perl/print_book.pl?ID=18151
Northeast Louisiana University, Center for Business & Economic
Research,
URL: http://cber.nlu.edu/DBR/Z2-4.htm
FDIC, URL: http://www.fdic.gov/publish/banklaws.htmll
Chartered Institute of Bankers, URL: http://www.cib.org.uk/eng/tlinks/t000297.htm
Internet Private Library, URL: http://www.ipl.org/ref/POTUS/wwilson.html
Max Forsythe Personal Hompage, URL: http://www.bright.net/~m4syth/iri/wwi.html
Lowrisk, URL: http://lowrisk.com/29crash.htm
US TREASURY DEPARTMENT, URL: http://www.ustreas.gov/menu.html
Personal Homepage of Steve Kangas, URL: http://www.scruz.net/~kangaroo/Timeline.htm
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Grolier Inc., URL: http://www.grolier.com/wwii/wwii_i.html
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Ed Hall's Homepage, URL: http://www.brillig.com/debt_clock/
University of Kansas, History Dept, URL: http://history.cc.ukans.edu/heritage/abilene/ikeeyes.html
University of North Carolina, Chapel Hill, URL:
http://metalab.unc.edu/pub/academic/history/marshall/military/korean.war/korea.txt
Library of Congress, URL: http://lcweb.loc.gov/global/legislative/congress.html
National Automated Clearing House Assoc., URL: http://www.nacha.org/nacha-info/ach.htm
National Information Center, URL: http://www.ffiec.gov/nic/general_information.htm
International Monetary Fund, URL: http://imfnt1x.imf.org/external/about.htm
Universiry of Toronto, URL: http://www.library.utoronto.ca/g7/scholar/rutint.htm