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 by 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."

History

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 have failed, as evidenced by the Panic of 1907. In 1913, the American banking system received a central bank on 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, 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, nonmembers had to keep deposit accounts with member banks who had access to the Fed and so were under 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 in a few years, the Fed started withdrawing gold certificates from circulation and substituting Federal Reserve Notes. 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 has the Fed doubled the money supply from its inception at the end of 1913 until the end of 1919. Also, the reserve requirements on the time deposits in commercial banks (deposits, that could be withdrawn only after a certain time period) drastically lowered from the original 21.1 to 5 percent, and 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 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 eight years later, in July 1929, 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 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 Country Banks. As acknowledged by Federal Reserve officials, time or savings deposits were then, for all practical purposes, equivalent to demand deposits and should 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 made quickly this position dominant in the System and decided on Fed policy without consulting or even against the wishes of the Federal Reserve Board in Washington. Strong was the dominant leader of the Fed from 1914 until his death in 1928. He pursued an inflationary policy, to finance the war effort for WWI, connected to the interests of the House of Morgan. Another motivation was the attempt to prop up the Bank of England in the 1920s, when 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 gold standard.

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 Fed's founding. The goods and service bought for $1 in 1913, would be currently bought for $21.80 - falling to $0.05 of its 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 show 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 economical 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 other words, if someone wanted to advance in the field of monetary research, one would be disinclined to criticize the major employer in the field. This influence was criticized particularly after the Fed failed to foresee the current economical 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, Mises Daily, posted on 2009-09-16.