Federal Reserve Act (Great Events from History: North American Series)
Article abstract: Money and the banking system are placed under control of a central bank, giving the federal government significant economic powers.
Summary of Event
By the beginning of the twentieth century, the U.S. economy was the most powerful in the world, yet its banking system was less than efficient. The United States had two major types of commercial banks: those chartered by the states, and those chartered by the federal government. National banks received their charters through the authority of the National Bank Acts of 1863 and 1864, which required a bank seeking a national charter to purchase government securities and submit to federal regulation. The bank then could issue national bank notes, which became the national currency after greenbacks were withdrawn, beginning in 1865.
Most important, the National Bank Acts either prohibited (in the case of national banks) or did not expressly permit branch banking, particularly interstate branch banking. That had the dual effect of subjecting the individual state systems to the vicissitudes of local or regional economic dislocations, and of producing state-line barriers to rapid transfers of money and capital in the event of such dislocations.
As a result, the nation’s banking system operated under two regulatory systems, one for state banks and one for national banks. States had far lower capital requirements for banks, and some states...
(The entire section is 1906 words.)
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Federal Reserve Act (1913) (Major Acts of Congress)
The question of how to regulate financial affairs was one of the earliest and most enduring problems facing the American republic. Congress formally resolved the issue only in 1913 with the passage of the Federal Reserve Act (38 Stat. 251), which created, for the first time, a permanent national central bank. The product of this act, the Federal Reserve System, was in some ways an awkward compromise among all sides of the national debate, but by the end of the twentieth century, it had become one of the most respected American public institutions. The European Union would use the Federal Reserve System as a model for its own European Central Bank.
From the founding of the republic to the Civil War, no national consensus existed on banking or monetary policy. Agrarian and populist interests were deeply suspicious of the concentration of wealth in Eastern financial institutions and sought regulations to constrain their power. At the same time, business and manufacturing interests sought regulations to ease commerce and expand trade.
After the Civil War, the political debate centered on the gold standard, which the United States had left in 1861. Agrarian, populist, and labor interests opposed the deflation required to resume the standard. Because of the massive expansion in incomes following the war, the gold standard was resumed with relatively little pain in 1879. Nonetheless, opposition to the gold standard continued under the free silver movement, championed by William Jennings Bryan. Indeed, the novel The Wizard of Oz by L. Frank Baum is an extended allegory favoring free silver. In the novel, as opposed to the film, the magic slippers Dorothy uses to save herself are silver, not ruby.
The period after the Civil War was also marked by successive financial panics and crises. Banks at that time were required to hold only a fraction of their deposits in reserve, that is, in the form of specie, vault cash or government securities, and could lend the remaining portion of the deposits to businesses and individuals. These loans were often illiquid, in the sense that although they were fundamentally sound investments in the long run, in the short run they could only be converted into cash for a fraction of their value. Such a system is prone to bank runs, in which a bank's depositors literally race each other to the bank to withdraw their deposits. Following the Panic of 1907, all political parties agreed that a mechanism had to be found to supply banks with shorterm liquidity (known as an "elastic currency" at the time).
CONGRESSIONAL PASSAGE AND EARLY IMPLEMENTATION
Congress passed the Aldrich-Vreeland Act in 1908 in reaction to the Panic of1907. The act provided for a system of temporary liquidity for banks (slated to expire in 1914), and it also created a National Monetary Commission chaired by Senator Nelson Aldrich to find a permanent solution to the problem of bank runs. The Aldrich Commission's report was submitted to Congress in 1912. Although Woodrow Wilson, a Democrat, won the 1912 election, the Republican Aldrich's plan shaped the extensive debate that followed. A Democrat, Carter Glass of Virginia, shepherded the Federal Reserve Act through the Congress, and on Dec. 23, 1913, Congress adopted the Federal Reserve Act, also known as the Owens-Carter Act. Although Glass went to some lengths to distinguish the Federal Reserve Act from the Aldrich Commission's plan, the two acts had quite a bit in common.
The Federal Reserve Act provided for the creation of between eight and twelve Reserve Banks in cities throughout the United States. These institutions were to be capitalized by the member banks within each Reserve District; the member banks would control the board of directors of each Reserve Bank and appoint its president and chairman. The entire system was to be overseen by an appointed Federal Reserve Board, based in Washington, D.C. By 1914 a full complement of twelve Federal Reserve Banks had been established in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.
In keeping with the act's central requirement that the Federal Reserve System provide an "elastic" currency (that is, one whose quantity could grow or shrink as required by economic policy), the system required its member banks to keep a certain fraction of their assets on deposit with the Reserve Banks as Federal Funds. In addition, the system issued Federal Reserve notes, the immediate ancestors of the familiar paper banknotes used today. The founders of the system hoped to prevent further banking panics by providing their member banks with ready and immediate access to liquidity via the discount window at which member banks could borrow at a published discount rate. Finally, as the United States was still on the gold standard in 1914, all Federal Reserve notes and deposits were backed by gold.
The Federal Reserve System's initial design, however, assured a continuing struggle between the twelve Reserve Banks and the Washington-based Federal Reserve Board. The Federal Reserve Bank of New York, in particular, had a relatively sophisticated understanding of financial markets and often advocated policies different from those pursued by the Federal Reserve Board. The tension between the Reserve Banks and the Federal Reserve Board was heightened by the fact that the Secretary of the Treasury and the Comptroller of the Currency were ex officio members of the Board.
The Federal Reserve System officially opened for business in November of 1914, shortly after the start of World War I. Conceived in peacetime to prevent banking panics, the system's first duty would be to manage the monetary dislocations of the period of American neutrality, and then to assist the Treasury in financing the war expenditures.
After the war, the United States was one of the first nations to resume the gold standard. Other nations attributed the relatively easy resumption of the gold standard in America to, in part, the newlystablished Federal Reserve System. In the 1920s the system was held in high regard domestically and abroad. Indeed, the period is sometimes known as "the high tide of the Federal Reserve"
In October of 1929 the U.S. stock market crashed, losing a considerable fraction of its value. This probably would not have been enough to cause the Great Depression; however, beginning in October of 1930 a series of small Midwestern banks failed and a full-scale nationwide banking panic began. This panic was the first of three banking crises that would culminate with the long "banking holiday" of March of 1933, when the entire U.S. banking system was closed by presidential directive. The system, along with all mainstream academic and government economists, firmly believed in the "real bills doctrine," which held that providing liquidity against purely financial claims (including U.S. government bonds) was bad policy. In short, when banks came to the discount window, they were required to present as collateral claims against viable business interests, which they did not have. The Great Depression began, in essence, as a classic banking panic of the late 1800s. Because the U.S. economy had become more complex and dependent on the smooth functioning of capital markets, the damage wrought by the bank runs of the early 1930s was much greater than in previous episodes.
REFORMS OF THE NEW DEAL AND BEYOND
The Roosevelt legislative program contained several measures designed to address the problem of bank runs and general financial instability. Many of the key New Deal laws affected the functioning of the Federal Reserve System.
Among the first laws passed under the Roosevelt administration was the Banking Act of 1933, also known as the Glass-Steagall Act. This act provided the first nationally-guaranteed system of insuring bank deposits by creating the Federal Deposit Insurance Company (FDIC). Deposit insurance ended forever the problem of bank runs and banking panics (although it would open the door to the thrift crisis of the late 1980s). The Glass-Steagall Act contained several other provisions that have since been modified or superannuated, but which in their time were extremely important. These included prohibiting banks from paying interest on short-term deposits (known as "Regulation Q"); prohibiting banks from underwriting securities ("investment banking"); and prohibiting banks from engaging in many other forms of non-bank activities such as underwriting insurance.
The Banking Act of 1935 renewed and extended many of the 1933 provisions to banks outside the Federal Reserve System. However, this act is of particular note because it finally clarified several of the institutional tensions designed into the Federal Reserve System. Under the act, the Federal Reserve Board became the supreme institution; it was renamed the Board of Governors of the Federal Reserve System, and members of the Board were given the title of "Governor," the traditional title for central bankers. In addition, the act ended the ex officio membership of the Secretary of the Treasury and Comptroller of the Currency on the Board. Finally, the act formally recognized the Federal Open Market Committee (FOMC) as a separate legal entity.
The Employment Act of 1946 directed the Federal Reserve System to implement policies designed to balance the two goals of full employment and low inflation. Achieving these goals has been the guiding principle of the system, and indeed almost all modern central banks, since.
The final step in the modernization of the Federal Reserve System was the Treasury Accord of 1951. Before the accord, the system acted as a buyer of last resort for Treasury debt. If investors demanded interest rates on government bonds above a ceiling (set to 2.5 percent at the time of the accord) the system would step in to buy the residual debt. With government spending hitting new records during the Korean War, this support rule demanded an inflationary monetary policy. Under the terms of the accord, the Federal Reserve System was relieved of the responsibility of keeping interest rates low.
THE MODERN FEDERAL RESERVE SYSTEM
The formal laws governing the conduct of monetary policy have remained largely unchanged since the 1950s. Monetary policy decisions are largely made by the Federal Open Market Committee (FOMC). The FOMC is a separately-recognized legal entity made up of the seven Governors in Washington, D.C., the president of the Federal Reserve Bank of New York, and the presidents of four of the remaining eleven Reserve Banks (chosen on a rotating basis). It typically meets eight times a year. The FOMC dictates the conduct of open market operations, the technical means by which the Federal Reserve System affects short term interest rates.
The Full Employment and Balanced Growth Act of 1978, also known as the Humphrey-Hawkins Act, amended the Federal Reserve Act to require that the Board of Governors submit reports on the state of the U.S. economy and the conduct of monetary policy twice a year (typically in February and July). In addition, the chairman typically testifies before the relevant House and Senate Committees as part of the report. This appearance, referred to as the Humphrey-Hawkins testimony, has become a closely-watched event.
Several of the financial regulatory reforms of the 1980s and 1990s involved the Federal Reserve System to some extent, either in its role as a bank regulator or by amending the Federal Reserve Act directly. The most important of these include the Depository Institutions Deregulation and Monetary Control Act of 1980, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, and the Gramm-Leach-Bliley Act.
Finally, several consumer protection and anti-discrimination laws also involve the Federal Reserve System. Among of the most important of these are the Home Mortgage Disclosure Act of 1975 and the Community Reinvestment Act of 1977.
See also: ; COINAGE ACT OF 1792; COINAGE ACTS; GLASS-STEAGALL ACT; GOLD RESERVEE ACT OF 1934; GOLD STANDARD ACT OF 1900.
Board of Governors of the Federal Reserve System. Federal Reserve Act and Other Statutory Provisions Affecting the Federal Reserve System (As Amended Through October 1998). Washington, DC, 1998.
Federal Reserve Bank of Kansas City. Fed 101. <http://www.kc.frb.org/fed101/>.
Federal Reserve Bank of Richmond. The Fiftieth Anniversary of the Treasuryederal Reserve Accord. 2001. .
Friedman, M. and A. J. Schwartz. A Monetary History of the United States, 1867-1960. Princeton, NJ: Princeton University Press, 1963.
Friedman, M. and A. J. Schwartz. Monetary Trends in the United States and the United Kingdom. Chicago: University of Chicago Press, 1982.
Hamilton, J. D. "The daily market for Federal Funds." 1 Journal of Political Economy 104 (1996): 266.
Rockoff, H. "'The Wizard of Oz' as a Monetary Allegory." 4 Journal of Political Economy 98 (1990): 73960.