REPORT DEAD LINKS --- we can't keep this site up-to-date without your help
/ There are ten CHAPTERS and the original press release. Link to them here -- I • II • III • IV • V • VI • VII • VIII • IX • X • press release
CHAPTER IV of "A Primer On Money" / continue to Chapter V
WHY WAS THE FEDERAL RESERVE ACT PASSED?
Passage of the Federal Reserve Act in 1913 was only one of the many steps taken by the Federal Government over the years toward creation of a stable and reliable money system-though undoubtedly the most notable.
In the last chapter, the Federal Reserve appeared in many guises. One was as a banker’s bank; i.e., a bank which gave credit to the commercial banks and also held their deposits-their official reserves. In other dress, the Federal Reserve acted as the regulator of the money supply through the System’s dual power to create reserves and circumscribe the commercial banking system’s ability to manufacture money. A bank which performs these and other related functions is called a central bank, for obvious reasons.
Most of the important nations of the world-and many of the others as well-have a central bank whose main purposes are: Exercising the government’s powers to create and manage the nation’s money supply; determining the general level of interest rates which business and consumers pay; and handling settlement of the nation’s debts with other nations. The central banks of various nations either create all of the nation’s money or supervise and regulate its creation by private banks. Since they are organs of the central governments, they are, with few exceptions, owned and operated by the governments.
By definition, the Federal Reserve is a central bank. But, as might be expected, it has distinctive features arising out of American traditions and history that are not found in other major central banks. First, it was established as a decentralized system of 12 separate regional Federal Reserve banks, under a Board of Governors in Washington. Furthermore, the framers of the System intended the 12 regional banks to be largely independent of each other in determining the money supply of the various regions of the country. The regional economies were considered insulated enough from each other to require distinct money supplies. This belief was fortified by the traditionally sharp commercial rivalries among the regions and by a general resentment everywhere directed against financial control emanating from “Wall Street.”
Another homespun feature of the American Central Bank is that membership in the Federal Reserve System is not compulsory for private commercial banks except for national banks. As a matter of fact, however, commercial banks which do belong to the System not surprisingly called member banks-hold roughly 85 percent of the assets of all commercial banks, member and nonmember.
The United States established a full-fledged central bank only after more than a century of trial and error with banking systems that proved inadequate to the needs of a surging economy. The Federal Reserve Act was a response to these historical experiments and their aftermath. Its architects had specific aims consistent with the form and spirit of American democracy “when they drafted the system. An all-too-brief excursion through the country’s money and banking experience before the Federal Reserve Act helps illustrate the goals of the President and Congress in enacting the Federal Reserve legislation. It is against these goals that the growth and performance of the system can best be measured.
The idea of a central bank was not a novelty by the early 20th century. The advantages of a central bank had been demonstrated for almost two centuries in several European countries. The outstanding example was the Bank of England, established as early as 1694, which enjoyed a high reputation throughout the world.
The Federal Reserve was not the first central bank of the United States; the United States had experimented briefly and half-heartedly with a central bank early in the 19th century. Both the First and Second Banks of the United States had been chartered by the Federal Government, with authorization to combine the functions of central and private banking. Although the Government had a minority interest in both banks, they were predominantly under private ownership and control. The charters were granted for limited periods, however, and, as events proved, public opinion in the United States was ill disposed to both banks because private ownership and control were widely believed to constitute unjustifiable special privilege.
Andrew Jackson’s famous attack on the Second Bank culminated in his militant refusal to extend its charter in 1836. This ushered in a long period in which the Federal Government did almost nothing to provide the Nation with a money system. And, until the beginning of the Civil “War banking anarchy prevailed. The number of State banks tripled between 1834 and the beginning of the Civil “War and so, too, did their deposits and note issues. In some States, notably New England, laws and voluntary associations did give the local State banks safety and stability. But elsewhere, banks began operations and issued currency on little more than the promoter’s high hopes.
By the 1860’s, the Federal Government found it necessary to reenter the money system. Specifically, in 1863 and 1864 the Federal Government enacted the National Bank Act, creating a system of private national banks which were to receive their charters from the Federal Government, operate under Federal supervision, and issue currency of a uniform value under certain limitations and safeguards imposed by Federal law.
Interest in a uniform currency, where a bank note issued in one part of the United States would be acceptable in another, was spurred by the changes taking place in the scope of industry and trade: when the nationwide system of railways was completed and very large manufacturing plants began to appear, the Nation had moved into an em of nationwide trade. This is why there were high hopes that the national banks would provide both a national currency and a stabilizing force against the periodic money panics and breakdowns in the banking system which more and more were disrupting the whole economic fabric.
A national currency, of sorts, was realized. But, the country was to learn by repeated and bitter experience, instead of being free of bank panics and depressions, it was to be afflicted with increasingly serious bank panics and bank-intensified depressions. As the 19th century economy developed into a complex money economy-and checkbook money replaced circulating currency -- the chronically deficient banking system turned into a costly and tragic extravagance.
At the most general level, the trouble with a banking system, haphazardly thrown together in a loose bundle of individual State and National banks, derived from the fractional reserve principle, wild and untamed.
Money panics and disorders have blemished the history of fractional reserve banking, often leading to serious breakdowns, depressions and crashes in the general economy.
It is undeniable that, where the fractional reserve technique is practiced, no individual bank standing on its own, without other sources of funds available in an emergency, can pay cash to a large proportion of its depositors if it is suddenly called upon to do so. For example, today the average bank has deposits equal to about 7 times its reserves and, therefore, cannot promptly payoff more than about 15 percent of its deposits in cash. The average bank would be severely embarrassed if called upon to do so. Indeed, the average bank would be greatly embarrassed even if asked to pay much less than 15 percent of its deposits. Obviously, if a bank had paid off 15 percent of its deposits, it would have to use all its reserves for this purpose. This would leave it with no remaining cash, and no source of ready cash, to carryon its normal banking functions for the depositors accounting for the other 85 percent of its deposits.
This does not mean that the average commercial bank today is an unsafe place for depositors’ money, or that bank operations are as risky as the above figures would suggest. On the contrary, we are simply saying that a fractional reserve system stands in need of a fireman ready to come to the rescue of any individual bank which suddenly loses a large portion of its reserves, through demands for cash or through depositors’ transferring their deposits to other banks.
Furthermore, most banks today own large amounts of Government securities and other highly liquid assets as a “secondary” reserve ‘which can be promptly sold for cash if it is necessary.
Before the Federal Reserve Act, money panics, bank crises, and depressions had been set off by the very dangers just described. Banks were called upon to meet depositors’ demands for more cash than existed in the banks’ cash reserves. An individual bank in pre-Federal Reserve days, after exhausting its cash reserves, could only close its doors and begin to slow process of liquidating its loans and investments in an effort to raise enough cash to meet the rest of its deposit liabilities. But one bank’s closing is, as the record shows, likely to set oft’ a chain reaction in which more and more banks are caught up in the same difficulty. A run on the second, third, or fourth bank proves these banks can no more raise immediate cash, after the reserves go, than the first bank could.
Even those banks on which no run has been made begin calling their loans-preparing for the worst-and this too contracts the money supply and adds to the difficulties of all concerned. In the general rush to convert investments to cash, market values fall and the first bank which set out to liquidate its investments can, by now, do so only at considerably less than at 100 cents on the dollar invested. Moreover, some bank customers have by now been forced into bankruptcy and cannot repay their loans, so the banks cannot fully repay their depositors. Depression and unemployment ensue, with a prolonged interruption in the production of real wealth, until confidence is restored, all because of a breakdown in the money system which is designed, presumably, to facilitate the production and distribution of real wealth.
Aside from a “Neanderthal” fractional reserve system, our pre Federal Reserve monetary system suffered endlessly from its inability to provide the necessary money for the country’s growing volume of industry and trade on a methodical basis. The ability of the State banks to create deposit money depended on the dollar value of their “reserves,” usually gold. The amount of deposit-money dollars a State bank could manufacture for each dollar of reserve depended entirely on the laws of the particular State in which the bank operated.
National banks, permitted to create both deposit money and national bank notes, were also limited in any expansion by the amount of their gold reserves. The amount of notes and other liabilities the national banks could issue or assume was tied to gold -- at times to both gold and silver -- and the amount of Government bonds which happened to be outstanding. (National banks could only issue their notes against Government bonds which they deposited with the Comptroller of the Currency.)
This meant that the total money supply of the country-supplied by State and National bank deposits as well as national bank notes grew unsystematically, unresponsive to the amount of goods and services being produced and traded and to the cash needs of the time. Accidents in the discovery of gold, import-export flows of the precious metals and fluctuations in outstanding Federal debt combined to run the money mills at an uncertain and varying tempo.
With a nonsystem such as this, seasonal or periodic demands for cash-aside from any longer run monetary needs of the economy created recurrent nightmares. Harvest time was always a period of money stringency. At harvest time the banks in agricultural areas of the South and West withdrew funds which they usually left on deposit, directly or indirectly, with New York banks, in order to finance the movement of farm crops and to supply local merchants with the extraordinary amounts of hard cash needed for settling accounts at the harvest season. This perfectly ordinary transaction would send a shudder through the whole banking system.
The problem was rooted in the peculiarity of the reserve requirements under the national banking system, which resulted, paradoxically, in the simultaneous scattering and “pyramiding” of reserves. Country banks had to maintain reserves equal to 15 percent of their deposits (both demand and time); Reserve city banks-banks in cities of moderate size -- and central Reserve city banks in the large cities, had to maintain reserves equal to 25 percent of their deposits. Although theoretically these reserves were cash, country banks were permitted to count their deposits held at big-city banks as reserves, up to three-fifths of the required amount; and Reserve city banks could do likewise, up to half of their required reserves. The central Reserve city banks had to keep their full reserves in cash. The consequence was that little pools of unused cash reserves were scattered throughout the banking system.
At the same time, there was a persistent heavy cash flow to the New York banks, which acted as correspondents, and paid attractive rates of interest on the banks’ funds deposited with them. These New York banks then used these funds extensively for “call loans,” in the money market.
The “call loans” tied the banking system to the stock market. “Call loans” were loans usually made to brokers and speculators in the stock exchange on the understanding that the bank could call for their repayment on 24 hours’ notice.
When the New York banks had reason to call a large volume of their outstanding loans to brokers, a scramble for funds ensued and, naturally, stocks fell. Sometimes speculators and others dumped their stocks in a rush for cash to cover their loans and a panic followed which left both brokerage firms and banking houses bankrupt.
When demands for cash arose in the country at large (as was the case at harvest time), the country banks put a squeeze on the city banks; and the city banks were compelled to call their loans. This inevitably resulted in a sudden contraction of money supply, with accompanying hardships and inconvenience. The problem was made even worse because many perfectly sound banks preferred to close their doors rather than use their cash reserves to meet the demands of their depositors, apparently because of the heavy legal penalties applied to a bank which let its reserves fall below the legal minimum.
With this reserve arrangement, the money industry acted in humpty-dumpty fashion. The money supply-meaning the total of cash and deposits -- contracted at the moment people wanted to hold more of their money in cash, making all forms of money difficult to obtain. And banks went into bankruptcy with cash reserves intact rather than be penalized for using their reserves to satisfy their depositor creditors.
Sometimes monetary expansions financed large speculative activities which, as a rule) led to “busts,” bank failures, money contractions, and general depressions. Speculations in land, in mines, railroads, guana, sugar, cotton, and the abuse of credit to finance fraudulent stock issues, all played their part in triggering money panics and depressions. Between the end of the Civil War and passage of the Federal Reserve Act, the country suffered four major panics, famous not only for the widespread suffering then entailed, but also for the speculative activities which seemed to have set them off. These were the panics of 1873, 1884, 1893, and, finally, the panic of 1907 which led to a widespread sense of public outrage, to Investigations, and ultimately to passage of the Federal Reserve Act.
There was considerable public suspicion that the periodic money panics were brought on by deliberate manipulation or corrupt practices on the part of large money interests. Subsequent investigations proved, that these suspicions were not always groundless. Indeed, corrupt practices were not confined to years of panic. The panic of 1873 followed several grandiose speculative schemes and the corruption of both Members of Congress and individuals having exceptional influence in President Grant’s administration. For example, two famous money barons of the day, Messrs. Gould and Fisk, had set about to corner the gold market. It appears that these gentlemen elicited the help of President Grant’s brother-in-law in this project, persuading him that it would be a good thing for the whole country if the price of gold could be made to go up. As an incidental item, these gentlemen invested $1.5 million in gold mining shares, on the brother-in-law’s account, so that he might participate in the country’s expected gains.
It was not, however, until the panic of 1907 that the public generally began demanding banking reforms and investigations to see what was wrong. That panic had its origins in a sort of financial warfare between two of the country’s large, private money groups. Specifically, the so-called Standard Oil group set about to break a bank, the Mercantile National Bank in New York City, in which a rival financial power, one Mr. Heinze, was heavily involved. The Standard Oil people had developed a personal animosity toward Heinze over a contest for control of copper mining in Montana. Heinze won this battle and forced the Standard Oil people to buy his copper interests at what was considered an exorbitant figure -- some $10.5 million.
Heinze used the proceeds of this sale to acquire control of the Mercantile National Bank, and then proceeded to make heavy investments of the bank’s funds in the stocks of a new and more or less fictitious copper company. The Standard Oil people, aware of the risky enterprise in which Heinze was engaged, quietly invested large sums in these same stocks, then dumped the stocks on the market at a crucial moment, breaking both the price of the stocks and Heinze’s bank.
Perhaps the breaking of this one bank was all that was intended; but as .we can well understand from the nature of banking in that day, the crash of one bank was likely to, and often did, precipitate runs on other banks. Such was the result of the crash of the Mercantile National Bank; the whole country was thrown into a depression.
When reports of trouble at Heinze’s bank reached the newspapers, runs on other N ew York banks were triggered. Great and respected financial barons of the day immediately issued reassurances that all was well. The Secretary of the Treasury rushed from Washington to New York to deposit some $35 million of Government funds with the other banks of that city, in an effort to prevent further collapse and the spread of panic. But the publicity given these events appear to have stirred more panic. It spread to the stock market in New York City and to commercial banks all across the country. Hundreds of millions of dollars went into lockboxes and other private hoards. In some cities legal tender money was sold at a premium.
In New York, ,J. P. Morgan took command, called the banks of the New York Clearing House Association together, and secured from them pledges of mutual assistance. The panic was finally broken when President Theodore Roosevelt approved a proposal that the New York Clearing House Association issue $100 million in “certificates” which were to function as money. The obvious remedy to panic lay, in a rough way, with a principle which was to support the Federal Reserve System. Meanwhile, however, industry and trade in the Nation had been seriously disrupted, causing unemployment and widespread hardship. -
It might be added that in the course of the panic of 1907, Mr. Morgan won President Roosevelt’s consent, the antitrust laws not· withstanding, for the Morgan steel interest, centered in the United States Steel Corp., to acquire and merge the southern steel industry, centered at Birmingham.
On the tide of public indignation aroused by the panic of 1907, Congress authorized investigations, in 1908, by a national monetary commission headed by Senator Nelson Aldrich. The results of the study were published in more than 20 volumes; in 1912, Senator Aldrich introduced a bill to establish his proposed reforms. The main reform proposed was a central bank, with powers to regulate banking; the central bank was to be privately owned and privately controlled.
Meanwhile, however, the House of Representatives had begun a separate investigation, that made by the famous Pujo committee. Intimate facts unearthed for the Pujo committee gave the public a picture of a “money trust,” a network of holding companies and other interlocking relationships which gave a small’ group of ‘Wall Street tycoons control not only of all the big banks of New York City, but of most of the financial power in the whole country. There was wide public demand for a new central system of maintaining bank reserves and for regulation of the banking system. And the demand was for a public body, not one under Wall Street control. Indeed, public sentiment was then opposed to any single central bank, because of the possibility that a single bank might come to be controlled, or unduly influenced, by special interest groups or by the financial interests of some particular section of the country.
There were then three glaring weaknesses of the monetary system as this brief account of banking before 1913 illustrates. First, it was less a system, than a nonsystem. Each individual bank stood alone, no stronger than itself but quite capable of weakening all the others. The only reserves a bank could call on were those it owned. A rush on one bank’s reserves might bring the bank down, with dire consequences for the entire banking structure, even though all the banks together held enough reserves to satisfy the first bank’s creditors and more. Panic could be stopped at the source if all the banks together did what no one bank could demobilize” the pools of existing reserves.
The idea of mobilizing reserves was simply this; ‘Whereas previously reserves, which were then mostly gold, gold certificates, and coin, were scattered about the country in the vaults of the individual banks, any new system should draw all of these reserves into one place where they would be readily available for lending to any particular bank, or banks in any particular part of the country, that might be called upon for exceptional amounts of cash. Furthermore, it was expected, and rightly so, that such a system would increase public confidence in banks, and that many people who had previously preferred to hold gold and silver coins would deposit these coins with the banks, thus increasing the amount of gold reserves which the banking system would have.
A second flaw of the monetary industry was that the money supply was too inflexible. In the accepted phrase, the country needed an “elastic currency.” Cash drains occurred with monotonous regularity and the nonsystem was incapable of meeting the challenge. Banks could not get cash as they needed it without withdrawing reserves, and, of course, somewhere along the line monetary contraction would set in as the reserve base flowed out through the cashier’s window. There had to be a source of reserves, which provided the short-run wherewithal just to keep the machinery of a monetary economy functioning. (That long-run needs should also be provided for was a utopian consideration, given the need to erect a workable system, any workable system.)
As a final fault bank practices followed a crazy quilt of State and National standards. Since the banking system was not much stronger than its weakest banks -- crashes and runs due to imprudent management flashed through the system shocking everyone-some minimum enforced standards were necessary. This entailed some central supervisory body to enforce reasonably sound practices, safeguarding against insolvency and loss of the depositors’ money. President Wilson summarized the situation drawing on the findings of the Aldrich committee as follows:
-----------------------------------------------------
We must have a currency, not rigid as now, but readily elastically responsive to sound credit, the expanding and contracting credits of everyday transactions, the normal ebb and flow of personal and corporate dealings. Our banking laws must mobilize reserves; must not permit the concentration anywhere in a few hands of the monetary resources of the country or their use for speculative purposes in such volume as to hinder or impede or stand in the way of other more legitimate, more fruitful uses. And the control of the system of banking and of issue which our new laws are to set up must be public, not private, must be vested in the Government itself, so that the banks may be the instruments, not the masters, of the business and of individual enterprise and initiative.
--------------------------------------------------
Other-subsidiary-purposes were to be served by the proposed reforms. These were: to provide a more uniform nationwide regulation of banks, particularly their power to create “checkbook money,” and also to provide a system by which the banks could clear checks promptly and uniformly throughout the Nation. This corrected one flaw III the National Bank Act: although the act had provided that currency have uniform value the country over, an individual bank would often clear a depositor’s check drawn on another bank only at less than par-that is, the bank would return the depositor less than 100 cents on each of the dollars he had deposited.
The reforms eventually settled on regional-central bank legislation. And the bank that emerged, the Federal Reserve System, was unmistakably an American animal. By reason of strong public opinion in the Western and Southern parts of the country -- stirred by the Pujo committee finding -- the Federal Reserve Act of 1913 established 12 separate regional Federal Reserve banks -- a decentralized system each having more or less independent powers. At the same time all 12 banks were joined in a monetary pipeline through which bank reserves could be shunted to one part of the country or another as the need arose.
While the Federal Reserve proposals were being considered and legislation drafted, the struggle over private versus public control of the system continued. President ‘Woodrow ‘Wilson and Senator Robert L. Owen, chairman of the Senate Banking Committee, supported public demands for an agency under public control Private bankers, on the other hand, found their views expressed in the Aldrich proposal for a centralized private bank and fought a last-ditch fight for private control. In the end, some compromises were made. The private commercial banks were given control of the 12 regional Federal Reserve banks; that is, they were given the privilege of electing two-thirds of the directors of the banks, and these directors, in turn, selected the presidents and other chief officers of the banks.
At the same time, however, the functions and duties assigned the 12 Federal Reserve banks were largely defined by law. It was not contemplated that they would have much discretionary power over the money supply. Both increases and decreases in the money supply were to be “automatic”-that is, in proportion to the “needs” of trade and commerce. (Because the word “needs” is subjective, the money supply was never regulated automatically but rather controlled and sometimes perversely as will be shown.) Private banks would continue to create money-and to extinguish money-as before, but under safeguards prescribed by law and Federal Reserve Board regulations. A member bank requiring funds to meet the needs of industry and commerce in its locality was to be able to obtain the funds from the nearest Federal Reserve bank by discounting “eligible paper” with the bank. (Discounting means reselling to the Federal Reserve a commercial bank’s loan agreement with a customer at a price less than the bank actually loaned the customer. How much less is governed by the discount rate.) “Eligible paper” was defined by law. It represented bank loans made to farmers, merchants, and other businessmen. The next chapter will explore the money supply provisions further.
The discount rate, on the other hand, was subject to the review and determination of the Federal Reserve Board in Washington, a public body consisting of members appointed by the President of the United States and continued by the Senate. The minimum amount of reserves which member banks of the System were required to keep on deposit with the Federal Reserve banks was prescribed by law, being left to the discretion of neither the Board nor the regional banks. Other regulations to safeguard the banks against dangerous and imprudent practices were to be promulgated by the Board, in accordance with the general guidelines specified in law.
Commercial banks were not compelled to become members of the System. All national banks must, as a matter of law, be members. But banks chartered by the States may join the System, or withdraw from the System, as they choose-though to be a member of the System a bank must meet certain minimum standards prescribed by the Board of Governors and otherwise comply with the Board’s regulations. This feature of the law was a concession, not to the popular view which distrusts control by big financial groups, but to a large body of popular opinion which distrusts Federal control. Framers of the Federal Reserve Act hoped, however, that all, or substantially all, State banks would join the System, because of the quite substantial advantages which membership in the System was expected to offer.
One of the main advantages of membership was prompt collection and payment of checks -- between banks -- and at the face value of the check. Difficulties and delay in check collection and payment -- particularly between banks located in different cities -- was not the least of the defects of the pre-1913 money system; check clearance between banks was subject to the same difficulties which attended note issues of the various banks before the National Bank Act when notes of the various banks were of varying values and questionable acceptance. In short, weeks might pass before a check drawn in one city on a bank in another would be ultimately settled. Individual banks frequently refused to accept checks drawn on a distant bank, and, as noted even more frequently checks were accepted only at a discount. In brief, commercial demands for improvements in the system of checkbook money were, in large part, responsible for passage of the Federal Reserve Act.
Were any emergency measures taken before the establishment of the Federal Reserve?
Some emergency measures adopted during panics are worth mentioning because they further illustrate the nature of the problems that had to be solved.
The New York Clearing House and other private clearinghouses which cleared checks for their members-adopted the expedient of issuing clearinghouse loan certificates. ‘When a bank had to meet an unfavorable clearinghouse balance, it could turn over securities instead of funds to the clearinghouse. The clearinghouse then issued loan certificates secured by these obligations and used the certificates to pay the local banks having credit balances. Later on, if the banks that had received certificates had unfavorable clearing balances, they could use the certificates to meet their deficiencies. This device increased the amount of funds available for meeting out-of-town withdrawals. Its significance lay in the fact that banks could thus obtain additional funds (if the certificates could be termed funds) on the basis of their earning assets without having to sell those assets.
The clearinghouses also printed scrip, like certificates but in a form that could be paid out over the banks’ counters and used as currency by the public during the monetary shortage. The clearinghouses, in effect, were creating reserve money, however primitively.
The Aldrich-Vreeland Act of 1908, passed after the panic of 1901, contained a provision based on the same principle as the clearinghouse loan certificates. This act provided that 10 or more national banks could form a national currency association to issue notes, secured by the deposit of bonds (other than U.S. Government bonds) or of commercial paper (or of both) with the association. These notes could be issued in amounts equal to 10 percent of the market value of the securities (90 percent of the market value with municipal bonds). To make certain that the notes would be retired as soon as possible, they were subject to a graduated tax, 5 percent a year for the first month that the notes were outstanding, then, by gradual increases to 10 percent at the end of the first year. Nearly $400 million of this kind of currency was issued between the outbreak of war in Europe in July 1914 and August 1915, preventing any possible panic from ensuing. However, the law was allowed to expire in 1915 because of the establishment of the Federal Reserve System.
How was the Federal Reserve System an improvement over its predecessor?
The Federal Reserve System was specifically designed to solve many of the weaknesses inherent in the precedent system.
(1) By requiring the banks to keep their “reserves” with the district Federal Reserve banks rather than with other private banks, the Federal Reserve banks acted as the Nation’s central bank. This made it possible to convert these reserves into currency in times of difficulty, something not possible under the system of pyramiding reserves.
(2) The Federal Reserve System was also a decentralized central bank, located in 12 regions throughout the Nation. This was designed to reduce the concentration of the money mechanism in New York City and the dangers of such concentration.
(3) It was hoped that virtually all the banks in the Nation would join the Federal Reserve System, thus providing uniform regulations for all banks. But this did not transpire. Even today over half of the banks in the Nation are not members of the System.1 The first effort to bring most banks under uniform regulation and control had occurred in 1863 with the passage of the National Bank Act, but it was unsuccessful. A second unsuccessful attempt was the Federal Reserve Act. A third such venture meeting greater success was the Federal Deposit Insurance Act of 1933.
(4) The Federal Reserve’s check-clearing operations proved a major benefit to commercial banks. It significantly reduced the time required to clear checks drawn on banks outside the city of the payee.
(5) Further, the Federal Reserve System was designed to provide an elastic currency. This was to be accomplished through the rediscounting process. By making funds available through the discount window, both cash and the total money supply could expand in accordance with the business needs of the community. But recall this is not a clear-cut criterion and may even lead to perverse money supply changes.
How is the Federal Reserve System organized?
The three basic parts of the Federal Reserve System are the Board of Governors, the 12 Federal Reserve banks, and the approximately 6,100 private commercial member banks. In terms of policy determination, however, the most important group is the Federal Open Market Committee.
(1) Board of Governors. -- There are seven members of the Board of Governors. They are appointed by the President for terms of 14 years, with one term expiring each 2 years. Each member receives a salary of $20,000 a year, except the Chairman of the Board, who receives $20,500.
(2) Federal Reserve Banks. -- There are 12 Federal Reserve banks, located in the following cities: Boston, New York, Philadelphia, Richmond’ Atlanta, Cleveland, Chicago, St. Louis, Dallas, Kansas City, Minneapolis, and San Francisco.
(3) Private member banks.-As of June 29,1963, there were 6,058 commercial banks which were members of the System. About 4,500 of these are national banks chartered by the Federal Government under the act of 1863. Such banks are required to be members of the System. The remaining 1,500 member banks are chartered by the various State governments. State-chartered banks may join the System if they desire and if they meet the requirements of the act and the supplemental rules laid down by the Board of Governors.
(4) Federal Open Market Committee. -- The Federal Open Market Committee consists of 12 members: the 7 members of the Board of Governors plus five of the 12 presidents of the Federal Reserve banks.
-------------------------------------
Remember though, that member bank accounts for about 83 percent of total deposits.
-----------------------------------------
Because it is the most important and powerful group in the System as far as monetary policy is concerned, the next chapter is devoted to this Federal Open Market Committee and the market through which it operates.
What are the operations of the Federal Reserve System?
There are three basic types of operations of the Federal Reserve System: routine operations, regulatory operations, and policy operations.
(1) Routine operations. -- Perhaps the most significant of the routine operations of the System is that of clearing checks. Federal Reserve officials have estimated this accounts for upwards of 40 percent of the total cost of the System.
As the situation now stands, the check-clearing service is open to nonmember as well as member banks, though banks which are not members of the System clear their checks through a member bank. Another important routine function of the System is that of furnishing currency. The Federal Reserve banks are charged with getting all the currency issued in the United States into the hands of the Private banks and, thus, the public. The Federal Reserve banks also act as fiscal agent for the U.S. Government by issuing all notes and bonds of the Federal Government. Also in the routine category is the contact with foreign central banks. This is handled through the Federal Reserve Bank of New York. Finally, the Federal Reserve bank hold the reserves of the member banks.
(2) Regulatory operations. -- The Federal Reserve has two basic types of regulatory operations. First, it regulates the number of banks which are in the System by fixing the requirements for membership. Second, the Federal Reserve periodically examines the books of State member banks to see that these banks meet the requirements for operation of member banks laid down by the Board of Governors. National banks are periodically examined by the Comptroller of the Currency.
(3) Policy operations. -- The most important aspect of Federal Reserve operations in terms of well-being of the national economy lies in the determination of monetary policy. The Federal Reserve has the power to determine the money supply and thus strongly influence the level of economic activity and the general level of interest rates. It controls the money supply through Its control over the reserve requirement of member banks and by controlling the amount of reserves available to these banks. Although the Board of Governors has a variety of methods for controlling credit, the most important method-determination of the amount of member banks reserves-is in the hands of the Federal Open Market Committee. Operating in the open market is the essential tool of our monetary policy. Other controls available to the Board of Governors include: changing the rediscount rate, changing the reserve requirement, and changing the margin of cash payment required on stock market investments.
What are the sources of revenue of the Federal Reserve?
By far the largest single source of income of the Federal Reserve banks is interest on holdings of U.S. Government securities. In 1963, interest on Government securities accounted for 98.9 percent of the total income of the Federal Reserve. Income to the System from discounts and advances is very small. Sources of income and the main items of expense of the System in 1963 were as follows:
TABLE 1. -- Earnings and outlays of the Federal Reserve banks, 1963 xxxxxxxxxxxxxxx to be filled in
look up the numbers in the .pdf of this book
Earnings:
U.S. Government securities ............................................
Discount and advances ....................................................
Foreign currencies ...........................................................
Acceptances ....................................................................
All other ..........................................................................
Total, current earnings ...................................................
Expenses:
Saleries ............................................................................
Other operating expenses ................................................
Federal Reserve currency ................................................
Board of Governors .........................................................
Total, current expenses ....................................................
Dividends paid to private commercial member banks ....
Paid to U.S. Treasury ......................................................
Source: Federal Reserve Bulletin, February 1964.
How much of the Federal Reserve’s earnings must be returned to the Treasury?
No law or regulation specifies how much of the Federal Reserve earnings must be returned to the Treasury nor when payments must be made.
In practice, the Federal Reserve spends all of its income that it cares to spend, pays dividends to its member banks on their “stock” and sets aside a large amount as “surplus.” The remainder is returned to the Treasury at the end of each year.
Despite the fact that there is no limitation on how much the Federal Reserve may spend to meet “expenses,” it usually returns to the Treasury an amount many times the amount of its expenses. In 1963, it returned to the Treasury $879,685,219.