Mark Toma, University of Kentucky
The historical origins of the Federal Reserve System can be traced to chronic currency problems in the nineteenth century. Under the National Banking System, national banks were required to hold eligible government securities in order to obtain national bank notes from the Treasury. Contemporary observers complained that such restrictions made the currency inelastic, so that the supply of money did not expand when the demand for money rose, which resulted in periodic shortages of currency and bank panics. In response to the Panic of 1907, Congress created the National Monetary Commission charged with the mission of reforming the currency system. It soon became clear that some type of central banking institution would emerge from the Commissions deliberations, albeit one operating within the context of a gold standard. The key question was what type of central bank? Would it be a centralized one, or a populist, decentralized one?
Early victories went to the advocates of centralization. The head of the National Monetary Commission, Republican Nelson Aldrich, presented a bill to Congress in early 1912 that followed the European model of a monopoly central bank. But Aldrich’s bill stalled, and the election of a Democratic President, Woodrow Wilson, in November 1912 gave added momentum to the populist movement. A central bank embodying a decentralized, competitive supply mechanism was now on the fast track.
Over the course of 1913, Wilson and the Democratic Congress crafted the populist blueprint that would become the Federal Reserve Act and would shape the operation of the currency system during the early years (1914-1930) of the Federal Reserve. The nominal structure of the Fed was a curious mixture of private and public elements. On the private side, the Fed was to be polycentric system of 12 reserve banks, each having the power to produce a distinct gold-backed currency marked by a seal indicating the district of origin, each owned by its member banks, and each required to finance itself from earnings. On the public side, the most important government element was the Federal Reserve Board, a political body that was to oversee the operation of the system.
The details of the Federal Reserve Act would determine how the private-public balance would play out. Consider first the financing arrangement. The Act forcefully rejected the typical budgetary arrangement instead giving reserve bank management first call on earnings from discount loans, open market operations, and fees charged for providing clearinghouse services to member banks. These earnings were to be used to finance reserve bank expenses, dividend payments to member banks, and, residually, payments to the Treasury. One thing the Act did not do was to authorize payments from the general government to the individual reserve banks in case of a shortfall in earnings. In this sense, the reserve banks faced a bottom line.
With respect to ownership rights, the Federal Reserve Act nominally designated member banks as shareholders. They were required to subscribe to the capital stock of their reserve bank. Stock ownership, however, did not convey voting powers. Nor were there secondary markets where shares could be traded.
With respect to selection of the Fed management team, every member of the Federal Reserve Board was to have a government connection. In addition to five political appointees, the Board included the Secretary of Treasury and the Comptroller of Currency. Discount rates set by the individual reserve banks were “subject to review and determination of the Federal Reserve Board.” Thus the government, through the Board could influence, if not control, money created through the discount window.
The Federal Reserve Act contained one important loophole, however, which tended to undermine the Board’s influence. According to the Act, the one margin of adjustment over which individual reserve banks unambiguously could exercise discretion was the amount of government securities to buy and sell. These open market operations were to be at the initiative of the individual reserve banks and each bank was to have first claim to the earnings generated by the government securities in its portfolio.
Whether the populist founders of the Federal Reserve were fully aware of the role the open market operation loophole might play is subject to debate. Nevertheless, the loophole emerged as a key feature of the money supply process in the first decade, the 1920s, of the system’s peacetime operation. While gold convertibility held in check currency oversupply, the power possessed by each reserve bank to purchase government securities for its own account held in check any tendency the Board might have to pursue a tight monetary policy by raising discount rates significantly above market rates.
The Great Depression marked the end to the novel experiment in monetary populism. The Federal Reserve Board sharply raised discount rates and reserve banks failed to fill the void with open market operations. Numerous explanations have been offered for the restrictive depression policy. The traditional explanations have emphasized a failure in leadership, a flawed policy procedure, and a rigid adherence to the gold standard. Another contributing factor may have been a shift in decision-making power away from the individual reserve banks and toward the Board that effectively shutdown the decentralized open market operations that had been the hallmark of the twenties.
In the aftermath of the Great Depression, a series of presidential and legislative initiatives created the Fed we now know. Franklin Roosevelt ended the domestic gold standard in 1934 and the Banking Act of 1935 centralized open market operations under the authority of a new agency, the Federal Open Market Committee, a majority of whose members were political appointees. Interestingly, the new powers lay dormant for the next decade and a half, as the Treasury took the monetary lead. The Treasury-Fed Accord of 1951 ended the period of Treasury dominance and the Fed assumed the role of a full-fledged central bank exercising significant discretionary powers in the last half of the twentieth century.
Recent global events have rekindled mainstream interest in the historical origins of the Fed. For one thing, debate on the institutional structure of the European Monetary Union has invited comparisons with the founding of the Fed. More generally, financial innovations have made it easier for agents worldwide to substitute among various currencies, thereby reducing the power of any single currency supplier. The upshot is that currency supply in the twenty-first century may have more in common with the “populist” early Fed than the “monopolist” Fed of the late twentieth century.
Further Reading
Broz, J. Lawrence. The International Origins of the Federal Reserve System. Ithaca: Cornell University Press, 1997.
Meltzer, Allan H. A History of the Federal Reserve, Volume 1, 1913-1951. Chicago: University of Chicago Press, 2003.
Friedman, Milton, and Anna Schwartz. A Monetary History of the United States, 1867-1960. Princeton, Princeton University Press, 1963.
Toma, Mark. Competition and Monopoly in the Federal Reserve System, 1914-1951. Cambridge: Cambridge University Press, 1997.
Wheelock, David. The Strategy and Consistency of Federal Reserve Policy, 1924- 1933. Cambridge: Cambridge University Press, 1991.