Federal Reserve Act (1913)

views updated May 23 2018

Federal Reserve Act (1913)

Andreas Lehnert

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.

HISTORICAL DEVELOPMENT

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 short–term 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 newly–established 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: Bank the of United States, Bland-Allison Act; Coinage act of 1792; Coinage Acts; Glass-Steagall Act; Gold Reservee act of 1934; Gold Standard Act of 1900.

BIBLIOGRAPHY

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 Treasury–Federal Reserve Accord. 2001. <http://www.rich.frb.org/research/specialtopics/treasury/>.

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): 26–56.

Rockoff, H. "'The Wizard of Oz' as a Monetary Allegory." 4 Journal of Political Economy 98 (1990): 739–760.

Major Acts of Congress Lehnert, Andreas

Federal Reserve Act of 1913

views updated May 18 2018

FEDERAL RESERVE ACT OF 1913

On December 23, 1913, President Woodrow Wilson (1913–1921) signed the Federal Reserve Act, and thereby created the Federal Reserve System. The Federal Reserve Act was intended to prevent a national financial crises and promote economic stability. The legislation established a national system for governmental regulation of currency supply and federal distribution of currency to banks. The Act also relocated supervision of the banking system from the private sector to the federal government. After years of popular national opposition to the federal government's involvement in the banking system, the passage of the Federal Reserve Act was a turning point. The Act represented a recognition that banking and currency would remain unstable without a unifying regulatory system at the national level.

Opposition to a federal banking system dated back to the United States' beginnings. The newly formed United States was largely agrarian, with little banking experience and a deep distrust of any central government activity. Nevertheless, many congressional members believed that a banking system was crucial to the fledgling nation's economic development. Under leadership of the first Secretary of the Treasury, Alexander Hamilton (1755–1804), Congress established the First Bank of the United States in 1791. However the First Bank (and its successor the Second Bank, established in 1816) fell prey to fears that the federal government's power was excessive at the states' expense. As the nation expanded a stampede ensued to establish state banks under numerous state laws. These banks wildly vacillated between freely issuing bank notes and lending money, to tightening down on the money supply. Bank failures and loss of depositors' savings were widespread.

Not until the nation was faced with the financial demands of the American Civil War (1861–1865) did the government attempt to intervene in the financial sector again. Congress passed National Bank Acts in 1863 and 1864. The acts created a system of privately owned banks called "national" banks because they were chartered and regulated by the federal government. The national banks issued a uniform currency nationwide, but the national bank system was not equipped to meet the money supply needs of a rapidly expanding economy.

A series of devastating cash panics between 1873 and 1907 focused public attention on the need for more extensive banking and monetary reform. The Aldrich Vreeland Act of 1908 provided temporary issues of emergency currency. In 1910 the National Monetary Commission began extensive investigations of the banking system, laying the groundwork for the system's reform. After much Congressional debate and compromise, the Glass-Owen bill—the Federal Reserve Act—was passed and signed into law in 1913.

Careful to avoid the label "central bank," the Federal Reserve Act diffused bank supervision by creating 12 Federal Reserve Districts. Each district had a Federal Reserve Bank and a Federal Reserve Board to oversee and coordinate operation for the entire system. To ensure that commercial bankers throughout the country would have a voice, the Federal Advisory Council was established and composed of twelve members, one from each Federal Reserve district and elected by member banks of that District.

All national banks had to belong to the entire system. Member banks also included a small number of state-chartered banks that were willing and qualified to join. The required investment of each member bank was six percent of its capital. Each member bank received an annual dividend of six percent of the amount it invested in the Reserve Bank.

Passage of the Federal Reserve Act began a long organizing process. Section 10 of the act charged the Federal Reserve Board with establishing a centralized banking system to meet the challenging and changing needs of the U.S. economy. The board, based in Washington, D.C., consisted of seven members serving 10-year terms. The board members were: the Secretary of the Treasury, the Comptroller of the Currency, and five members appointed by the President of the United States with consent of the Senate. In order to avoid potential domination by any region, the act specified that no more than one of the five appointed members could be from any one Federal Reserve District. To eliminate partisan pressures the framers of the act intended that the appointees be public figures who could not financially benefit from board decisions. The act also required that at least two board members be knowledgeable in banking and finance so that the commercial and financial needs of the nation were addressed according to scientific principles. To insulate the board from the legislative branch, all expenses were paid from Reserve Bank earnings rather than congressional appropriations. Once they were appointed, board members were neither directly responsible to the president nor to any other branch of the federal government.

The Federal Reserve Board was charged with establishing and overseeing the twelve Reserve Banks. In addition, the board would examine the accounts, books, and affairs of reserve and member banks, and review discount rates (the rate charged to member banks for loans from Reserve Banks) set by each Reserve Bank. The Federal Reserve Board was also charged with oversight of currency circulation. This included regulating the amount of gold reserves held against Federal Reserve notes (paper money), supervising the issue and retirement of notes, serving as a central clearinghouse for checks, and executing various supervisory and regulatory functions pertaining to Reserve Banks.

Conflicts arose between the Federal Reserve System and U.S. Treasury. The Banking Act of 1935 diffused the discord by removing the Treasury Secretary and Comptroller of the Currency from the Federal Reserve Board. All seven board positions became presidential appointees. The 1935 act also established the Federal Open Market Committee (FOMC), a group consisting of the seven board members and five of the twelve Reserve bank presidents. For over fifty years the powerful FOMC held complete control over the country's money supply.

By the end of the twentieth century the Federal Reserve System remained largely an independent agency of the government. At that time the system controlled the flow of money and credit in three ways. First the Federal Reserve System conducted open-market sales or purchases of government securities; second, the system raised or lowered the discount rate. Finally the Federal Reserve System changed reserve requirements— the percentages of deposits that a member bank must hold as currency in their vaults or as deposits in their district Federal Reserve Bank. The Federal Reserve System continued to grow and undergo adjustments, assuring economic stability in the United States.

See also: Bank of the United States (first), Bank of the United States (second), Woodrow Wilson