Federal Reserve System

The Federal Reserve System, (also known as the Federal Reserve, and informally as the Fed) is the central banking system of the United States. It was founded in 1913 by the Federal Reserve Act to "provide the nation with a safer, more flexible, and more stable monetary and financial system." Over the years, its role in banking and the economy has expanded.

Structure

Commercial Banks

• "State banks" are chartered by state governments, and have to obey state laws. They are also regulated by either the Federal Reserve (if member) or the FDIC. They can choose to become members of the Federal Reserve System, if they meet the standards set by the Board of Governors.
• "National banks", chartered by the federal government (through the Office of the Comptroller of the Currency in the Department of the Treasury) are by law members of the Federal Reserve System and are regulated by it. They are independent from state banking laws and can act across the whole USA.

Regional Federal Reserve Banks

As of March 2004, of the nation’s approximately 7,700 commercial banks approximately 2,900 were members of the Federal Reserve System (approx. 2,000 national banks and 900 state banks).

Member banks must subscribe to stock in their regional Federal Reserve Bank in an amount equal to 6 percent of their capital and surplus, half of which must be paid, the other half is subject to call by the Board of Governors. The stock does not confer control and financial interest like stock in for-profit organizations, and it may not be sold or pledged as collateral for loans. Member banks receive a 6 percent dividend annually on their stock, and vote for the Class A and Class B directors of the Reserve Bank. Stock in Federal Reserve Banks is not available for purchase by individuals or entities other than member banks.

Every Federal Reserve Bank has a board of directors, subject to the orders of the Board of Governors. The class A directors of a board are chosen by and represent the stockholders. Class B directors are also chosen by the stockholders, but represent the public, they can't be an officer, director, or employee of any bank. Class C directors are appointed by the Board of Governors, one of them is named the chairman of the board and another the vice-chairman. They cannot be officer, director, employee, or stockholder of any bank.

Board of Governors

The Board of Governors of the Federal Reserve System is a federal government agency. It is composed of seven members, including the Chairman and the Vice Chairman of the Board. All are appointed by the President of the United States and confirmed by the U.S. Senate. The full term of a Board member is fourteen years, and the appointments are staggered so that one term expires on January 31 of each even-numbered year. After serving a full term, a Board member may not be reappointed.

After it pays its expenses, the Federal Reserve turns the rest of its earnings over to the U.S. Treasury. About 95 percent of the Reserve Banks’ net earnings have been paid into the Treasury since the Federal Reserve System began operations in 1914. In 2003, the Federal Reserve paid approximately $22 billion to the Treasury.

The Federal Reserve System cannot be therefore considered an independent entity, and constitutes a Special Purpose Entity (legally a "Variable Interest Entity") of the US federal government.

Workings

State debt

When the US federal government runs a budget deficit, it can't simply have the Fed print up enough $100 bills to cover the shortfall. No, the Treasury always covers its budget deficits by issuing debt, referred to as Treasuries. These are bonds, IOUs sold by the Treasury to outside investors who lend the Treasury money today in the hopes of being paid back in the future.

One of the main buyers of this Treasury debt is the Federal Reserve itself. This phenomenon is especially pronounced during emergencies such as major wars and the times of financial crisis. In the second quarter of 2009, the Federal Reserve was the effective buyer of some 48 percent of the new Treasury debt issued that period, as part of its "quantitative easing." True, the Fed doesn't show up at the Treasury auctions and directly buy the new T-bills and so forth, but private dealers pay higher prices for the Treasuries knowing that the Fed will pick them up.

Let's say the Fed wants to buy $1 million worth of T-bills from Joe Smith. So it writes Joe a check for $1 million, drawn on the Fed itself. Joe hands the T-bills over to the Fed, where they end up on the asset side of its balance sheet. Joe then deposits the check in his personal checking account, which goes up by $1 million. So at this point the Fed has increased the money supply by $1 million. (In normal times, because of the fractional reserve banking system, Joe's bank would lend out $900,000 of the new deposit to another customer, so that the money supply would grow even further.)

By entering the bond market and buying Treasuries (with money created out of thin air), the Fed pushes up the price of the bonds. That of course means that their yield drops. So, for example, if the Treasury issues a T-bill promising to pay the holder $10,000 in 12 months, then the auction price determines how much money the Treasury actually gets to borrow now in exchange for this promise to pay back $10,000 in one year. If the demand is such that people pay $9,900 for each T-bill with a face value of $10,000, then the Treasury gets to borrow money for a year at an interest rate of 1 percent. If nothing else, the Fed's massive buying of Treasury debt pushes up the auction price of the Treasuries, meaning the federal government can borrow at cheaper interest rates.

The Treasury is paying interest on its debt, but the Fed gives the interest payments right back to the Treasury! After all, interest is how the Fed "makes money." It writes checks on itself (created out of thin air) and accumulates assets, and then earns the interest and (in some cases) capital gains on the assets. But after the Fed pays its employees and other bills, it remits the excess earnings back to the Treasury.

For example, according to its report , in fiscal year 2008 the Federal Reserve distributed to the US Treasury some $31.7 billion of its net earnings. So not only is the official rate of interest kept artificially low by the Fed's money-creation, but the interest payments themselves are largely refunded to the Treasury.

A debt should be repaid at some point. When the Treasury securities held by the Fed mature — so that the Treasury has to pay back the face value in principal — the Fed rolls over the debt. Over time, the nominal market value of the Fed's holdings of Treasury debt continually grows. Barring a sudden reversal in this policy, the Treasury knows that it will never have to pay off this debt.

By 1921, the Fed acquired about $400 million worth of government bonds, and $2.4 billion by 1934. By the end of 1981 it was no less than $140 billion of U.S. government securities; by the middle of 1992, the total had reached $280 billion. At the end of 2008, it held about $476 billion.

Issuing currency

Banks get cash from Federal Reserve Banks. The Federal Reserve orders new currency from the Bureau of Engraving and Printing, which produces the appropriate denominations and ships them directly to the Reserve Banks. For the banknotes, the Fed pays only the cost of printing. During the Fiscal Year 2008, the Bureau delivered 7.7 billion notes at an average cost of 6.4 cents per note.

Coins are a direct obligation of the Treasury, so the Reserve Banks pay the Treasury the face value of the coins. Large banks in some Federal Reserve Districts receive coins directly from the Mint.

History

See also: History of money and banking in the US

By the turn of the century the political economy of the United States was dominated by two generally clashing financial aggregations: the previously dominant Morgan group, which began in investment banking and then expanded into commercial banking, railroads, and mergers of manufacturing firms; and the Rockefeller forces, which began in oil refining and then moved into commercial banking, finally forming an alliance with the Kuhn, Loeb Company in investment banking and the Harriman interests in railroads. Although these two financial blocs usually clashed with each other, they were as one on the need for a central bank. Attempts to use the Treasury as a central bank had failed, as evidenced by the Panic of 1907. In 1913, the American banking system received a central bank of the European model, the Federal Reserve. The U.S. was the last great nation to introduce central banking.

The Federal Reserve System was deliberately designed to create and control inflation. Only the Federal Reserve Banks could print paper notes, and the member banks would buy them from the Fed by drawing down deposit accounts at the Fed. The different reserve requirements for central reserve city, reserve city, and country banks were preserved, but the Fed was now the single base of the entire banking pyramid. Gold was centralized at the Fed, and the Fed could pyramid its deposits 2.86:1 on top of gold, and its notes 2.5:1 on top of gold. (That is, its reserve requirements were: 35 percent of total demand deposits/gold, and 40 percent of its notes/gold.) All national banks were forced to become members of the Federal Reserve System, state banks had a choice. But in order to get cash for their customers, nonmember banks had to keep deposit accounts with member banks who had access to the Fed, and so were under its control as well.

At the founding of the Fed in 1913, the most important single item of paper money in circulation was the gold certificate, held by the Fed and backed 100 percent by gold assets in the Treasury. But within a few years, the Fed started withdrawing gold certificates from circulation and substituting Federal Reserve Notes (FRN). But since the FRN only had to be backed 40 percent by gold certificates, 60 percent of the released gold was available as a base on which to pyramid more bank money.

The average reserve requirement of all banks before the establishment of the Fed was 21.1 percent. Under the provisions of the original Federal Reserve Act in 1913, this requirement was cut to 11.6 percent, and to 9.8 percent in June 1917. As a result, the Fed doubled the money supply between its inception at the end of 1913 and the end of 1919. Also, the reserve requirements on time deposits in commercial banks (deposits that could only be withdrawn after a certain length of time) drastically lowered from the original 21.1 to 5 percent, and again in 1917 to 3 percent. As a result, banks encouraged their depositors to transfer their funds to savings accounts, to have a larger basis for credit expansion.

From June 1914 to January 1920, when demand deposits grew from $9.7 billion to $19.1 billion, or by 96.9 percent, time deposits at commercial banks rose from $4.6 billion to $10.4 billion, or 126.1 percent. In the great boom of the 1920s, that started after the recession of 1920–21 (a short recession, thanks to the budget cutting and lowering of taxes by Warren Harding), total demand deposits rose from $16.7 billion in July 1921 to $22.8 billion in July 1929, eight years later, an increase of 36.5 percent. Time deposits in commercial banks expanded from $11.2 billion to $19.7 billion in the same period, a far greater rise of 75.9 percent. The great boom of the roaring 1920s was largely fueled by credit expansion going into time deposits. The greatest expansion of time deposits came in Central Reserve Cities (New York and Chicago), where the Fed’s open market operations were all conducted, as opposed to Reserve Cities and areas served by Country Banks. As acknowledged by Federal Reserve officials, time or savings deposits were then, for all practical purposes, equivalent to demand deposits and would be paid on demand in case of a run on a bank.

With the passage of the Federal Reserve Act, President Wilson appointed Benjamin Strong to the most powerful post in the Federal Reserve System, Governor of the Federal Federal Reserve Bank of New York. He quickly used his position to dominate the System and made decisions on Fed policy without consulting the Federal Reserve Board in Washington, often against their wishes. Strong was the dominant leader of the Fed from 1914 until his death in 1928. He pursued an inflationary policy, partly to finance the war effort of WWI, connected to the interests of the House of Morgan. Another motivation was attempting to prop up the Bank of England after it returned to the gold standard with an overvalued pound. To prevent the loss of gold to the States, its governor Montagu Norman secretly convinced Strong to inflate in order to help England. The expansion ended only after his death and the Great Depression followed soon after. In 1928 Strong admitted that "very few people indeed realized that we were now paying the penalty for the decision which was reached early in 1924 to help the rest of the world back to a sound financial and monetary basis" - that is, to help Britain maintain a phony and inflationary form of the gold standard.

While for a brief time in the early 1920s the Fed was bent on providing credit only in emergencies, it soon reverted to its policy of extending credit during booms and depressions, thus promoting continuous and permanent inflation.

The Great Depression

The New Deal's Banking Acts of 1933 and 1935 transformed the face of the Fed, permanently shifting crucial power from the New York Fed to Washington, D.C. The result of these two Banking Acts was to strip the New York Fed of the power to conduct open-market operations, and to place it squarely in the hands of the Federal Open Market Committee, dominated by the Board in Washington, but with regional private bankers playing a subsidiary partnership role. The Federal Deposit Insurance Corporation (FDIC) was created to insure all bank depositors against losses. However, the FDIC only has in its assets a tiny fraction (1 or 2 percent) of the deposits it claims to "insure." The validity of this "insurance" may be gauged by noting the late 1980s catastrophe of the savings and loan industry, whose deposits were insured by another federal agency, the defunct Federal Savings and Loan Insurance Corporation.

After 1933, Federal Reserve Notes and deposits were no longer redeemable in gold coins to Americans; and after 1971, the dollar was no longer redeemable in gold bullion to foreign governments and central banks. The gold of Americans was confiscated and exchanged for Federal Reserve Notes, which became legal tender; and Americans were stuck in a regime of fiat paper issued by the government and the Federal Reserve. Over the years, all restraints on Fed activities or its issuing of credit have been lifted. Since 1980, the Federal Reserve has enjoyed the power to buy not only U.S. government securities but any asset, and to buy as many assets and to inflate credit as much as it pleases. There are no restraints left on the Federal Reserve.

The Fed greatly expanded bank reserves in the 1930s. Panicking at the inflationary potential in 1938, it doubled the minimum reserve requirements to 20 percent, sending the economy into a tailspin of credit liquidation. Ever since that period, the Fed has been very cautious about the degree of its changes. So although changes in bank reserve requirements happen fairly often, they're in very small steps, by fractions of one percent.

Goals

The Federal Reserve was supposed to protect the monetary and financial system against inflation and violent swings. According to a statement by the Comptroller of the Currency at its opening, it would supply "...a circulating medium absolutely safe, which will command its face value in all parts of the country, and which is sufficiently elastic to meet readily the periodical demands for additional currency, incident to the movement of the crops, also responding promptly to increased industrial or commercial activity, while retiring from use automatically when the legitimate demands for it have ceased. Under the operation of this law such financial and commercial crises, or "panics," as this country experienced in 1873, in 1893, and again in 1907, with their attendant misfortunes and prostrations, seem to be mathematically impossible." Also:

"Under the provisions of the new law the failure of efficiently and honestly managed banks is practically impossible and a closer watch can be kept on member banks. Opportunities for a more thorough and complete examination are furnished for each particular bank. These facts should reduce the dangers from dishonest and incompetent management to a minimum. It is hoped that national-bank failures can hereafter be virtually eliminated."

The value of the dollar has rapidly declined since the Federal Reserve's founding. The goods and services that could be bought for $1.00 in 1913, would be currently bought for $21.80 - a fall to $0.05 of its original value. In other words, over 95% of the dollar has been inflated away.

As for the business cycle and the abolition of panics, the data shows otherwise. Recessions of the 20th century as documented by the National Bureau of Economic Research include: 1918–1919, 1920–1921, 1923–1924, 1926–1927, 1929–1933, 1937–1938, 1945, 1948–1949, 1953–1954, 1957–1958, 1960–1961, 1969–1970, 1973–1975, 1980, 1981–1982, 1990–1991, 2001, and 2007 to the present.

Impact on the economics profession

It is argued that the Federal Reserve dominates the field of monetary economics through its extensive network of consultants, visiting scholars, alumni, and staff economists, so that real criticism of the central bank can be a career liability for members of the profession. The editorial boards of key journals have many members directly working or affiliated with the Federal Reserve. Milton Friedman noted that it has a sort of oligopoly on monetary opinion, in that someone wanting to advance in the field of monetary research would be disinclined to criticize the major employer in the field. This influence was criticized particularly after the Fed failed to foresee the current economic crises, along with many other mainstream economists.

External links

• Board of Governors of the of the Federal Reserve System - official website
• Wikipedia page on the Fed
• Historical Beginnings... the Federal Reserve (pdf) by Roger T. Johnson, Federal Reserve Bank of Boston, 1999.
• Is the Fed's Pumping Inflationary? by Frank Shostak, September 2009
• The Federal Reserve as a Cartelization Device by Murray Rothbard, 1984
• Bad Monetary Policy Is Redundant by George F. Smith, September 2010