America has a long and storied love-hate relationship with its banking system. The most vilified institution is the nation’s central bank, the Federal Reserve, or just the Fed. The Fed is not America’s first central bank or even its second. Regardless of your feelings toward it or the history behind it, the Fed is at the center of the American economy and deserves your careful consideration.
At the end of the American Revolution, the United States was saddled with significant war debt. In order to handle the debt and to create a unified currency, Alexander Hamilton proposed the creation of a central bank for the young nation. The First Bank of the United States, headquartered in Philadelphia, was modeled after the Bank of England. It served as the nation’s central bank from its charter in 1791 until 1811 when the charter was allowed to expire.
In the nineteenth century, America went through a series of economic panics that led to the creation of another central bank. This bank eventually became a political target and failed to bring economic stability to the country.
The Second Bank of the United States was given a twenty-year charter in 1816 to help the U.S. economy recover from the economic effects of the War of 1812. The Second Bank established a uniform currency and acted as a depository for the Treasury’s accounts. The Second Bank of the United States was believed by many to be corrupt, and political pressure from President Andrew Jackson sealed its fate. In 1833, three years before its charter expired, Jackson had his Treasury secretary withdraw the U.S. government’s deposits from the bank and place them in state-chartered banks. This effectively killed the bank, and by 1841 the Second Bank of the United States was bankrupt.
During and after the Civil War, the United States created more national banks and reintroduced a single uniform currency. These national banks were instrumental in allowing the government to borrow by issuing bonds. Unlike the First and Second Banks of the United States, however, these national banks were decentralized.
The Bank Panic of 1907 was the impetus for creating the Federal Reserve System. A failed attempt by a Montana investor to corner the copper market led to a loss of confidence in the financial institutions associated with him and his brother. The contagion spread to unassociated institutions and within a few days, an all-out run on the New York financial system was under way. Fortunately, J.P. Morgan and Theodore Roosevelt’s Treasury secretary brought calm to the situation by injecting cash into the banking system and eventually bringing an end to the bank runs. The Panic of 1907 showed that America needed a central bank to act as a lender of last resort to ensure liquidity in the banking system.
The 1913 passage of the Federal Reserve Act, signed into law by Woodrow Wilson, created the Federal Reserve System. Unlike previous attempts at central banking, the Fed drew from the strengths of its predecessors. Instead of creating a single central bank, the Federal Reserve Act established a decentralized, public-private banking system. The Fed is not headquartered in a single location, but has separate locations across the United States. The Federal Reserve is neither a purely governmental institution, nor is it a purely private institution. The Fed has features of both.
The Fed is the bank for the U.S. government. The Treasury keeps its accounts with the U.S. government and the government in turn writes checks from its accounts with the Fed. The taxes collected and the money borrowed through issuing government bonds are all deposited in the U.S. Treasury’s account with the Fed. Every time a taxpayer receives a refund, or a Social Security recipient receives their check, the checks are being drawn from the Treasury’s account with the Fed.
Most of the money on deposit with the Federal Reserve exists in electronic form, but each of the district banks has a significant vault with millions of dollars under heavy security. In the early days of the Fed, the teller window was protected from bank robbers by pillbox-encased machine guns.
The Federal Reserve System’s government arm, the Board of Governors, is headquartered in Washington DC. The governors are appointed by the President of the United States and confirmed by the Senate for single, staggered fourteen-year terms. The Board is supervised by the Fed chairman and vice chairman, who are also members of the Board. The chairman and vice chairman are appointed by the president and confirmed by the Senate for unlimited four-year terms. The Fed chairman is the face of the Federal Reserve System and is considered by many to be second in power only to the President of the United States when it comes to economic influence. The Board of Governors creates policy and regulations for the nation’s banking system, sets reserve requirements, and approves changes in the discount rate.
In keeping with the United States’ federal nature, the Fed is divided into twelve distinct geographic districts with headquarters for each district located in cities across the United States. Each district is an equal part of the Federal Reserve System. The district banks act as the bankers’ banks and accept deposits from member banks. The district banks also perform a regulatory role in their district by monitoring the member banks and enforcing regulations within their respective districts. The district banks serve a vital role in processing paper checks and electronic payments for the banking system. Finally, the district banks issue the currency to the banking system that they acquire from the U.S. Department of Treasury.
The Federal Open Market Committee (FOMC) is the chief architect of the nation’s monetary policy. The twelve voting members of the committee are made up of the Fed chairman, the Board of Governors, the Federal Reserve Bank of New York’s president, and four other district bank presidents who serve on a rotating basis, although all the district bank presidents are present at the committee meetings. The FOMC meets eight times a year, or about once every six weeks, to review economic performance and decide the course of monetary policy by targeting the fed funds rate. FOMC meetings are closely monitored by the press and financial markets. Members of the media and investors carefully analyze the FOMC’s press releases, looking for clues as to what might be the future direction of policy.
Investors attempting to profit by speculating on the Fed’s interest rate policies would study the size of Alan Greenspan’s briefcase during his tenure as Fed chairman. They theorized that if the briefcase was big and heavy, he was carrying documentation to support his argument for changing interest rates. If the briefcase was light, then interest rates would probably remain unchanged.