FEDERAL RESERVE SYSTEM

FEDERAL RESERVE SYSTEM. On 23 December 1913, the Owen-Glass Act founded the Federal Reserve System—the central bank of the United States. "The Fed," as most call it, is unique in that it is not one bank but, rather, twelve regional banks coordinated by a central board in Washington, D.C. A central bank is a bank for banks. It does for banks what banks do for individuals and business firms. It holds their deposits—or legal reserves—for safekeeping; it makes loans; and it creates its own credit in the form of created deposits, or additional legal reserves, or bank notes, called Federal Reserve notes. It lends to banks only if they appear strong enough to repay the loan. It also has the responsibility of promoting economic stability, insofar as that is possible, by controlling credit.

Founded in 1781, the nation's first bank, the Bank of North America, was possibly the first central bank. Certainly, the first Bank of the United States (1791–1811), serving as fiscal agent and regulator of the currency as well as doing a commercial banking business, was a central bank in its day. So too was the second Bank of the United States (1816–1836). It performed that function badly between 1817 and 1820, but improved between 1825 and 1826. The Independent Treasury System, which existed between 1840 and 1841 and between 1846 and 1921, was in no sense a central bank. A great fault of the National Banking System (1863–1913) was its lack of a central bank. The idea, and even the name, was politically taboo, which helps explain the form and name taken by the Federal Reserve System.

The faults of the National Banking System, especially perversely elastic bank notes—the paradox of dispersed legal reserves that were unhappily drawn as if by a magnet to finance stock speculation in New York—and the lack of a central bank to deal with the panics of 1873, 1884, 1893, and 1907, pointed out the need for reform. After the 1907 panic, a foreign central banker called the United States "a great financial nuisance." J. P. Morgan was the hero of the panic, saving the nation as if he were a one-man central bank. However, in doing this, he showed that he had more financial power than it seemed safe for one man to possess in a democracy. The 1912 Pujo Money Trust investigation further underlined his control over all kinds of banks. (Congressman Arsene Pujo, who became chairman of the House Banking and Currency Committee in 1911, obtained authorization from Congress to investigate the money trust, an investigation highlighted by the sensational interrogation of Morgan.) Meanwhile, the Aldrich-Vreeland Currency Act of 30 May 1908 provided machinery to handle any near-term crisis and created the National Monetary Commission to investigate foreign banking systems and suggest reforms. In 1911, Republican Sen. Nelson Aldrich proposed a National Reserve Association that consisted of a central bank, fifteen branches, and a top board controlled by the nation's leading bankers, which critics said J. P. Morgan, in turn, dominated. The proposal never passed, and the Democrats won the 1912 election. They accepted the groundwork done by Aldrich and others, but President Woodrow Wilson insisted that the nation's president choose the top board of this quasi-public institution. Democratic Rep. Carter Glass pushed the bill through Congress.

All national banks had to immediately suscribe 3 percent of their capital and surplus for stock in the Federal Reserve System so that it had the capital to begin operations. State banks could also become "members," that is, share in the ownership and privileges of the system. The new plan superimposed the Federal Reserve System on the National Banking System, with the new law correcting the major and minor shortcomings of the old one. In addition to providing a central bank, it supplied an elastic note issue of Federal Reserve notes based on commercial paper whose supply rose and fell with the needs of business; it required member banks to keep half their legal reserves (after mid-1917 all of them) in their district Federal Reserve banks; and it improved the check-clearing system. On 10 August 1914, the seven-man board took office, and on 16 November the banks opened for business. World War I having just begun, the new system was already much needed, but some of the controversial parts of the law were so vague that only practice could provide an interpretation of them. For that to be achieved, the system needed wise and able leadership. This did not come from the board in Washington, chaired by the secretary of the treasury and often in disagreement about how much to cooperate with the Treasury, but instead from Benjamin Strong, head of the system's biggest bank—that of New York. He was largely responsible for persuading bankers to accept the Federal Reserve System and for enlarging its influence.

At first, the Federal Reserve's chief responsibilities were to create enough credit to carry on the nation's part of World War I and to process Liberty Bond sales. The system's lower reserve requirements for deposits in member banks contributed also to a sharp credit expansion by 1920, accompanied by a doubling of the price level. In 1919, out of deference to the Treasury's needs, the Federal Reserve delayed too long in raising discount rates, a step needed to discourage commodity speculation. That was a major mistake. In 1922, the system's leaders became aware of the value of open-market buying operations to promote recovery, and open-market selling operations to choke off speculative booms. Strong worked in the 1920s with Montagu Norman, head of the Bank of England, to help bring other nations back to the gold standard. To assist them, he employed open-market buying operations and lowered discount rates so that Americans would not draw off their precious funds at the crucial moment of resumption. Nonetheless, plentiful U.S. funds and other reasons promoted stock market speculation in the United States. Strong's admirers felt he might have controlled the situation had he lived, but in February 1928 he fell sick and, on 16 October, died. As in 1919, the Federal Reserve did too little too late to stop the speculative boom that culminated in the October 1929 crash. In the years 1930–1932, more than 5,000 banks failed; in 1933, 4,000 more failed. Whether the Federal Reserve should have made credit easier than it did is still debatable. Businessmen were not in a borrowing mood, and banks gave loans close scrutiny. The bank disaster, with a $1 billion loss to depositors between 1931 and 1933, brought on congressional investigations and revelations, as well as demands for reforms and measures to promote recovery. Congress subsequently overhauled the Federal Reserve System.

By the act of 27 February 1932, Congress temporarily permitted the Federal Reserve to use federal government obligations as well as gold and commercial paper to back Federal Reserve notes and deposits. A dearth of commercial paper during the depression, along with bank failures that stimulated hoarding, created a currency shortage. A new backing for the bank notes was essential. However justified at the moment, the law soon became permanent and made inflation in the future easier.

Four other measures around this time were very important. These were the Banking Act of 16 June 1933; parts of the Securities Act of 27 May 1933 and of the Securities Exchange Act of 19 June 1934; and the Banking Act of 23 August 1935. Taken together, the acts had four basic goals: (1) to restore confidence in the banks, (2) to strengthen the banks, (3) to remove temptations to speculate, and (4) to increase the powers of the Federal Reserve System, notably of the board. To restore confidence, the 1933 and 1935 banking acts set up the Federal Deposit Insurance Corporation, which first sharply reduced, and, after 1945, virtually eliminated, bank failures. To strengthen banks, the acts softened restrictions on branch banking and real estate loans, and admitted mutual savings banks and some others. It was felt that the Federal Reserve could do more to control banks if they were brought into the system. To remove temptations to speculate, the banks were forbidden to pay interest on demand deposits, forbidden to use Federal Reserve credit for speculative purposes, and obliged to dispose of their investment affiliates. To increase the system's powers, the board was reorganized, without the secretary of treasury, and given more control over member banks; the Federal Reserve bank boards were assigned a more subordinate role; and the board gained more control over open-market operations and got important new credit-regulating powers. These last included the authority to raise or lower margin requirements and also to raise member bank legal reserve requirements to as much as double the previous figures.

The board, in 1936–1937, doubled reserve requirements because reduced borrowing during the depression, huge gold inflows caused by the dollar devaluation in January 1934, and the growing threat of war in Europe, were causing member banks to have large excess reserves. Banks with excess reserves are not dependent on the Federal Reserve and so cannot be controlled by it. This action probably helped to bring on the 1937 recession.

During the Great Depression, World War II, and even afterward, the Federal Reserve, with Marriner Eccles as board chairman (1936–1948), kept interest rates low and encouraged member banks to buy government obligations. The new Keynesian economic philosophy (the theory by John Maynard Keynes, perhaps the most important figure in the history of economics, that active government intervention is the best way to assure economic growth and stability) stressed the importance of low interest rates to promote investment, employment, and recovery, with the result that—for about a decade—it became almost the duty of the Federal Reserve to keep the nation on what was sometimes called a "low interest rate standard." In World War II, as in World War I, the Federal Reserve assisted with bond drives and saw to it that the federal government and member banks had ample funds for the war effort. Demand deposits tripled between 1940 and 1945, and the price level doubled during the 1940s; there was somewhat less inflation with somewhat more provocation than during World War I. The Federal Reserve's regulation limiting consumer credit, price controls, and the depression before the war, were mainly responsible. Regulation W (selective controls on consumer credit) was in effect from 1 September 1941 to 1 November 1947, and twice briefly again before 1952. The board also kept margin requirements high, but it was unable to use its open market or discount tools to limit credit expansion. On the contrary, it had to maintain a "pattern of rates" on federal government obligations, ranging from three-eighths of 1 percent for Treasury bills to 2.5 percent for long-term bonds. That often amounted to open-market buying operations, which promoted inflation. Admittedly, it also encouraged war-bond buying by keeping bond prices at par or better.

Securities support purchases (1941–1945), executed for the system by the New York Federal Reserve Bank, raised the system's holdings of Treasury obligations from about $2 billion to about $24 billion. The rationale for the Federal Reserve continuing these purchases after the war was the Treasury's wish to hold down interest charges on the $250 billion public debt and the fear of a postwar depression, based on Keynesian economics and memory of the 1921 depression. The Federal Reserve was not fully relieved of the duty to support federal government security prices until it concluded its "accord" with the Treasury, reported on 4 March 1951. Thereafter, interest rates moved more freely, and the Federal Reserve could again use open-market selling operations and have more freedom to raise discount rates. At times, bond prices fell sharply and there were complaints of "tight money." Board chairman William McChesney Martin, who succeeded Thomas McCabe (1948–1951) on 2 April 1951, pursued a middle-of-the-road policy during the 1950s, letting interest rates find their natural level whenever possible but using credit controls to curb speculative booms in 1953, 1956–1957, and 1959–1960 and to reduce recession and unemployment in 1954, 1958, and late 1960. After the Full Employment Act of 1946, the Federal Reserve, along with many other federal agencies, was expected to play its part in promoting full employment.

For many years, the thirty member banks in New York and Chicago complained of the unfairness of legal reserve requirements that were higher for them than for other banks, and bankers generally felt they should be permitted to consider cash held in the banks as part of their legal reserves. A law of 28 July 1959 reduced member banks to two classifications: 295 reserve city banks in fifty-one cities, and about 6,000 "country" banks, starting not later than 28 July 1962. According to this law, member banks might consider their vault cash as legal reserves. Thereafter, the requirement for legal reserves against demand deposits ranged between 10 and 22 percent for member city banks and between 7 and 14 percent for member country banks.

During the period 1961–1972, stimulating economic growth, enacting social welfare reforms, and waging war in Vietnam were among the major activities of the federal government that: (1) raised annual expenditures from $97 billion in fiscal 1960 to $268 billion in fiscal 1974; (2) saw a budget deficit in all but three years of that period; (3) raised the public debt by almost 70 percent; and (4) increased the money supply (currency and demand deposits) from $144 billion on 31 December 1960 to $281 billion on 30 October 1974. As early as 1958, the nation's international balance of payments situation was draining off its gold reserves (reflected in the Federal Reserve's gold certificate holdings). These fell from $23 billion on 31 December 1957 to $15.5 billion on 31 December 1964. With only $1.4 billion free (without penalties to the Federal Reserve) for payments to foreign creditors, Congress, on 18 February 1965, repealed the 25 percent gold certificate requirement against deposits in Federal Reserve banks on the theory that this action would increase confidence in the dollar by making $3.5 billion in additional gold available to foreign central banks or for credit expansion at home. Unfortunately, the situation worsened. On 18 March 1968, Congress removed a similar 25 percent reserve requirement against Federal Reserve notes, thereby freeing up all of the nation's gold. Nevertheless, the gold drain became so alarming that, on 15 August 1971, President Richard M. Nixon announced that the United States would no longer redeem its dollars in gold.

All these developments affected, and were affected by, Federal Reserve policies. During much of the 1960s, government economists thought they had the fiscal and monetary tools to "fine tune" the economy (that is, to dampen booms and to soften depressions), but the recession of 1966 damaged that belief. During the late 1960s, the monetarist school of economists, led by Milton Friedman of the University of Chicago, which sought to increase the money supply at a modest but steady rate, had considerable influence. In general, Reserve board chairman Martin advocated a moderate rate of credit expansion, and, in late May 1965, commented on the "disquieting similarities between our present prosperity and the fabulous'20s." Regardless, Congress and President Lyndon B. Johnson continued their heavy spending policies, but the president reappointed Martin as chairman in March 1967 because his departure might have alarmed European central bankers and precipitated a monetary crisis. With Martin's retirement early in 1970 and Arthur F. Burns's appointment as board chairman, credit became somewhat easier again.

Throughout this era, restraining inflation—a vital concern of the Federal Reserve—was increasingly difficult. What did the money supply consist of? If demand deposits are money, why not readily convertible time deposits? Furthermore, if time deposits are money, as monetarists contended, then why not savings and loan association "deposits," or U.S. government E and H bonds? What of the quite unregulated Eurodollar supply? As a result of such uncontrolled increases in the money supply, consumer prices rose 66 percent in the period 1960–1974, most of it occurring after 1965.

As of 27 November 1974, members of the Federal Reserve System included 5,767 of the 14,384 banks in the United States, and they held 77 percent of all bank deposits in the nation. Nevertheless, the Federal Reserve has changed markedly in structure, scope, and procedures since the 1970s. In the middle of that decade, it confronted what came to be known as "the attrition problem," a drop off in the number of banks participating in the Federal Reserve System. The decrease resulted from the prevalence of unusually high interest rates that, because of the central bank's so-called reserve requirement, made membership in the system unattractive to banks. In the United States, the federal government issues bank charters to national banks while the states issue them to state banks. A federal statute required all national banks to join the Federal Reserve; membership was optional for state banks. The Fed provided many privileges to its members but required them to hold reserves in non-interest-earning accounts at one of the twelve district Federal Reserve banks or as vault cash. While many states assessed reserve requirements for nonmember banks, the amounts were usually lower than the federal reserves, and the funds could be held in an interest-earning form. As interest rates rose to historical highs in the mid-1970s, the cost of membership in the Fed began to outweigh the benefits for many banks, because their profits were reduced by the reserve requirement. State banks began to withdraw from the Federal Reserve, and some national banks took up state charters in order to be able to drop their memberships. Federal Reserve officials feared they were losing control of the national banking system as a result of the attrition in membership.

The Depository Institutions Deregulation and Monetary Control Act of 1980 addressed the attrition problem by requiring reserves for all banks and thrift institutions offering accounts on which checks could be drawn. The act phased out most ceilings on deposit interest and allowed institutions subject to Federal Reserve requirements, whether members or not, to have access to the so-called discount window, that is, to borrow from the Federal Reserve, and to use other services such as check processing and electronic funds transfer on a fee-for-service basis.

In the same decade, a period of dramatic growth began in international banking, with foreign banks setting up branches and subsidiaries within the United States. Some U.S. banks claimed to be at a competitive disadvantage because foreign banks escaped the regulations and restrictions placed on domestic banks, such as those affecting branching of banks and nonbanking activities. In addition, foreign banks were free of the reserve requirement. The International Banking Act of 1978 gave regulatory and supervisory authority over foreign banks to the Federal Reserve. Together with the Depository Institutions Act of 1980, it helped level the playing field for domestic banks.

Unlike most other countries where the central bank is closely controlled by the government, the Federal Reserve System enjoys a fair amount of independence in pursuing its principal function, the control of the nation's money supply. Since passage of the Full Employment and Balanced Growth (Humphrey-Hawkins) Act of 1978, Congress has required the Federal Reserve to report to it twice each year, in February and July, on "objectives and plans…with respect to the ranges of growth or diminution of the monetary and credit aggregates." The Federal Reserve System must "include an explanation of the reason for any revisions to or deviations from such objectives and plans." These reports enable Congress to monitor monetary policy and performance and to improve coordination of monetary and government fiscal policies. The independence of the Federal Reserve System and its accountability continued to be controversial issues into the 1990s.

BIBLIOGRAPHY

Broz, J. Lawrence. The International Origins of the Federal Reserve System. Ithaca, N.Y.: Cornell University Press, 1997.

Kettl, Donald F. Leadership at the Fed. New Haven, Conn.: Yale University Press, 1986.

Livingston, James. Origins of the Federal Reserve System: Money, Class, and Corporate Capitalism, 1890–1913. Ithaca, N.Y.: Cornell University Press, 1986.

Morris, Irwin L. Congress, the President, and the Federal Reserve: The Politics of American Monetary Policy-Making. Ann Arbor: University of Michigan Press, 2000.

Toma, Mark. Competition and Monopoly in the Federal Reserve System, 1914–1951: A Microeconomics Approach to Monetary History. Cambridge, U.K.; New York: Cambridge University Press, 1997.

Wells, Wyatt C. Economist in an Uncertain World: Arthur F. Burns and the Federal Reserve, 1970–1978. New York: Columbia University Press, 1994.

Wheelock, David C. The Strategy and Consistency of Federal Reserve Monetary Policy, 1924–1933. Cambridge, U.K.; New York: Cambridge University Press, 1991.

Earl W.Adams

Donald L.Kemmerer/a. e.

See alsoAldrich-Vreeland Act ; Banking ; Clearinghouses ; Federal Agencies ; Great Depression ; Keynesianism ; Open-Market Operations ; Pujo Committee ; andvol. 9:Fireside Chat on the Bank Crisis .

Federal Reserve System. Congress created the Federal Reserve System, the central bank of the United States, in 1913. It consisted of twelve regional banks and the Federal Reserve Board in Washington, which had ill‐defined powers of oversight. Lawmakers expected the system to regulate the supply of money and credit (monetary policy), mitigating the effects of the business cycle; to oversee, in concert with other federal and state agencies, the operations of commercial banks; and to carry out the government's international financial transactions. Ideally, the system's decentralized structure would reduce the influence of New York City banks over the nation's credit system.

During World War I, the Federal Reserve financed government deficits by expanding the money supply, and it broke the postwar inflation by raising interest rates and sharply restricting credit. In the 1930s, however, the shortcomings of the Federal Reserve's decentralized structure became apparent. During the Great Depression, infighting between the regional banks and the central board prevented a coordinated response to the crisis. Incoherent monetary policy permitted the money supply to contract by a third, contributing mightily to the catastrophe.

Accordingly, President Franklin Delano Roosevelt and Marriner Eccles, his appointee as chair of the Federal Reserve Board, initiated reforms. Eccles persuaded Congress to enact new legislation confirming the board's authority over the regional banks, solidifying the position of its chair, and vesting in the Open Market Committee (a group consisting of members of the Federal Reserve Board and the presidents of the regional banks) control over monetary policy.

Despite its new organization, the Federal Reserve soon fell under the influence of the Treasury Department. Throughout World War II and for many years after, the central bank at the behest of the Treasury “pegged” long‐term interest rates at a low level, permitting Washington to finance its debt cheaply. This policy became controversial after 1945 because, by accommodating every demand for credit, it threatened to fuel inflation. Surging prices during the Korean War forced the Treasury to relent and grant the Federal Reserve the authority to set interest rates as it saw fit. The subsequent increase in the cost of money, engineered by the central bank, helped stabilize prices.

Over the next twenty years, the Federal Reserve exercised its newfound autonomy carefully, following policies described as “leaning against the wind”. Put simply, during recessions it cut interest rates to stimulate production, and when inflation threatened it increased rates to cool demand. But the stagflation of the 1970s—simultaneous inflation and recession—stymied the central bank. After years of vacillating between expansion and contraction, the Federal Reserve in 1979 under Chairperson Paul Volcker embraced a policy of fierce monetary stringency, driving interest rates to near 20 percent and triggering the worst recession since the 1930s. Hard times inspired calls for reforms to make the Federal Reserve more responsive to elected officials. Economic recovery after 1983, however, coupled with stable, low inflation, bore out the wisdom of Volcker's policy and garnered the Federal Reserve immense prestige. Subsequently, the central bank followed policies designed primarily to keep prices stable. Under the leadership of Alan Greenspan, the Federal Reserve continued this policy through the long boom of the 1990s.
See also Banking and Finance; Depressions, Economic; Economic Regulation; Federal Government, Executive Branch: Department of the Treasury; Federal Reserve Act; New Deal Era, The; Progressive Era.

Bibliography

John T. Wooley , Monetary Politics: The Federal Reserve and the Politics of Monetary Policy, 1984.
Donald F. Kettl , Leadership at the Fed, 1986.

Wyatt C. Wells

FEDERAL RESERVE SYSTEM

The Federal Reserve System, also known simply as "the Fed," is a U.S. central bank. Its primary role is to influence the amount of money and credit circulating in the economy in order to promote full employment, stable prices, and economic growth. It also regulates and supervises the U.S. banking industry, distributes currency and coins, clears checks, and handles some electronic funds transfers. Unlike traditional banks, the Fed's purpose is not to make a profit but to serve the national interest. Moreover, its customers are not individual citizens but the roughly 4,300 banks that make up its members. The Fed is governed by a sevenmember Board of Governors appointed by the President of the United States and it is led by the Board's chairperson, who since 1987 has been Alan Greenspan (1926—). Although the Board determines the Fed's policies, the twelve district Federal Reserve banks, located in major cities across the United States, perform its day-to-day operations.

The Federal Reserve System came into being after four financial panics destabilized the U.S. economy between 1873 and 1907. Congress established the National Monetary Commission to determine what made the U.S. banking system so susceptible to these periodic crashes. The commission's report led directly to the Federal Reserve Act of 1913, which created the Federal Reserve System. Initially, the Fed performed only the narrow functions of lending money to banks when they could not get loans elsewhere, supervising the banking industry, and increasing or decreasing the money and credit supply in response to changing economic conditions. However, many believed that the Great Depression of the 1930s occurred in part because the Fed did not provide banks with enough reserves to make loans that would have increased the money supply and kept the economy from contracting. In response, Congress passed the Banking Act of 1935 to give the Fed greater controls over the minimum amount of reserves each member bank needed to make loans. The Full Employment Act of 1946 empowered the Fed to make full employment and stable prices explicit goals of its policy, and the Full Employment and Balanced Growth Act of 1978 required that the Fed publicly state what the objectives of its monetary and credit policies are. In the 1980s, under President Ronald Reagan (1981–1989), the Fed adopted a monetary policy of maintaining specific rates of growth in the money supply.

See also: Central Bank, Federal Reserve Act of 1913, Financial Panic, Alan Greenspan

Federal Reserve System (USA) A regulatory body of the US banking sector, set up by the 1913 Federal Reserve Act in an effort to stabilize the hitherto relatively unregulated US banking system. It comprised twelve federal reserve banks, which were all owned by private banks, but with power to issue federal reserve notes as currency. They were supervised by a Federal Reserve Board consisting of the Secretary of the Treasury, a Controller of the Currency, and five members of a Board of Governors appointed by the President. The regional banks had the power to alter regional interest rates, expand or contract the money supply, and expand or contract credit. The system still contained many weaknesses. The relationship between the regional banks and the center remained ill-defined, and thousands of small banks continued to operate relatively freely. By 1929, only about one third of all banks were members of the Federal Reserve System (FRS). The FRS was thus unable to respond effectively to the Great Depression after the 1929 Wall Street Crash. Its reorganization was thus a central issue in the New Deal. The Banking Act of 1933 reorganized and strengthened the central Board of Governors, who were given control over interest rates, reserve requirements, and all activities of the twelve federal reserve banks. The successes of the US postwar boom owe much to the Federal Reserve System, which had supported the war through a policy of cheap money. From the 1950s, the Federal Reserve System received autonomy in setting interest rates, and in the late 1970s it responded to the oil price shocks by pursuing a policy of monetary stability and low inflation. This inaugurated a period of monetary stability which characterized the 1980s and 1990s, interrupted only by an economic downturn in the late 1980s. The Federal Reserve System has enjoyed much greater freedom than other central banks such as the European Central Bank, since it is not bound by any predetermined economic targets.

Federal Reserve System US central bank, established in 1913 to maintain sound monetary and credit conditions. Twelve regional banks are supervised by a Federal Reserve Board of Governors. All national banks are members, as are many state and commercial banks. The Federal Reserve System regulates money flow and credit by varying its discount rate on loans to member banks and by varying the percentage of total deposits member banks must keep in reserve.

http://www.federalreserve.gov

Federal Reserve System The central bank of the USA, established in 1913, that holds the US gold reserves and implements government financial policy. There are 12 Federal Reserve Districts in the USA and each has its own Federal Bank. The Federal Reserve System is controlled by the Federal Reserve Board, based in Washington, DC.