Federal Reserve System

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The Federal Reserve System is the central banking system for the United States, established by the Federal Reserve Act of 1913. Most countries have only one central bank, such as the Bank of England, or Germany’s Bundesbank. The Federal Reserve System makes up a system of 12 regional central banks. Central banks are bankers’ banks, holding deposits of commercial banks, making loans to commercial banks, and serving as lenders of last resort to commercial banks in an economic downturn. The Federal Reserve System also acts as a bank for the United States government, and has a monopoly on the issue of bank notes, called Federal Reserve Notes. The term reserve in the title refers to the role central banks play in determining the liquidity of commercial banks. The Federal Reserve System regulates the money supply, interest rates, and credit conditions in the United States.

The United States was slow to adopt the concept of central banks as systems of monetary control. The early years of the Republic saw the creation of the First Bank of the United States in 1791, but Congress failed to renew its charter in 1811. Congress chartered the Second Bank of the United States in 1816, but President Jackson vetoed the renewal of its charter in 1832. These two banks, similar in structure, were early experiments in central banking, but were unpopular. The United States government’s control over the management and policies of these banks was limited to the voting rights of a minority stockholder. Fear of East Coast domination of the banking industry helped undermine support for the Second Bank of the United States.

The decentralized and unregulated banking system of the latter 1880s constantly buffeted the country with money panics and financial crises, leading public officials to see the necessity for overcoming the political objections to a central bank. Political objections came from several angles, including government officials who felt that the banking industry could not be trusted to regulate itself, and leaders in banking who felt that elected politicians lacked the necessary knowledge to regulate banking and were often irresponsible in financial matters. In addition to the distrust between leading bankers and elected politicians, there was distrust between regions of the country. Many regions presumed that a central bank would be located in New York City, subjecting the country to Wall Street domination. These contending forces helped shape the Federal Reserve Act of 1913 that created the Federal Reserve System.

To diffuse the fear of Wall Street domination of banking the Federal Reserve Act created a system of 12 regional central banks. The Federal Reserve Bank of New York is the most important for policy purposes, but there are Federal Reserve Banks in Boston, Philadelphia, Atlanta, Cleveland, St. Louis, Kansas City (Mo.), Richmond, Dallas, San Francisco, Chicago, and Minneapolis.

Like the First and Second Bank of the United States, the Federal Reserve Banks are privately owned. Private ownership helped appease the banking community’s arguments that knowledgeable bankers can best regulate the banking industry. Commercial banks in each district that are members of the Federal Reserve System own the stock in the regional Federal Reserve Bank. The Federal Reserve Act requires all banks with national charters to be members of the Federal Reserve System.Page 112

The final authority for monetary policy lies with the Board of Governors of the Federal Reserve System. The president of the United States makes appointments to this seven-member board, subject to the approval of the Senate. The seven board members serve 14-year terms that are staggered so that one member’s term expires every other year. This constant rotation on the board dilutes the power of any one president to bias the board politically. One of the board members acts as chairman of the Board of Governors, and the president—with the approval of the Senate—appoints that person. The chairman serves a four-year term that is renewable. Congress organized the Board of Governors to be independent of either the banking industry or the elected politicians.

Despite the trend toward deregulation in banking, Congress has not limited the authority of the Federal Reserve System, except in certain areas such as fixing interest rates on savings accounts. The Depository Institution Deregulation and Monetary Control Act of 1980 gave the Federal Reserve System the authority to set reserve requirements for state-chartered banks in addition to its existing authority to set reserve requirements for national chartered banks. (The reserve requirement is the percent of money deposited in checking and savings accounts that a bank has to retain in the form of vault cash and deposits at Federal Reserve Banks.)

Because the Federal Reserve System’s governing board is composed of unelected officials who are somewhat immune to political pressure, the Federal Reserve System often bears the brunt of the responsibility for combating inflation in the United States. Anti-inflation policies are often accompanied by high unemployment, rendering these policies unpopular with elected officials, who like to earn credit for reducing unemployment rather than increasing it. Therefore the elected officials often defer to the unelected officials that compose the Board of Governors the responsibility for slowing down the economy and taming inflation.