The Federal Reserve

FNCE 4070 – Financial Markets and Institutions

Bank Notes

• Paper Money got is start in London in the early 17th century.

• Goldsmiths in London– Merchant deposits his gold with a goldsmith– Goldsmith issues a promissory note which was a

safe and convenient form of money backed by the goldsmith’s promise to pay.

Bank Notes

• In the early United States bank notes were issued by state chartered banks

• These were backed by gold and silver on demand.– The holder of a note could go to the bank and

demand gold or silver in exchange• There were exchange rates between state bank

dollars.• The gold standard was finally dropped in 1971.

First Bank of the United States

• 1791-1811• First proposed by Alexander Hamilton• Highly controversial – Believed by some to be unconstitutional– Southern landowners didn’t trust banks

• $10m in seed capital and was owned 20% by the federal government.– The federal government did not have $2m to pay so the

bank raised $8m externally and leant the US government $2 to buy its stake.

First Bank of the United States

• It was a combination of a commercial bank and a central bank.

• Issued currency that became a safe medium of exchange– Note this existed alongside state banked issued

currency.• Largest business in the early US– 8 branches from New Orleans to Boston– US government was its largest customer as a borrower

and a depositor.

Early Central Banking Functions

• Attempted to regulate state banks by curtailing those that had over-issued their bank notes

• In coordination with the treasury discussed economic conditions and attempted to promote the safety of the credit system

• Tried to coordinate aggregate policy changes across its branches.

First Bank of the United States

• The vote to re-charter the bank was lost in 1811 and the bank closed.

• In 1812 the US went to war with the British.• President Madison began to print

unsupported money.• Sent the nation into a financial crisis and state

banks stopped redeeming federally issued money.

Second Bank of the United States

• 1817-1837• Larger than its predecessor $35m in capital• The government owned 20% of the bank.• Again highly controversial.

Early Central Banking Operations

• Open Market Operation– State Bank issued money would come into the

possession of the Bank– The bank would determine whether it believed the

State’s credit policies were appropriate or too loose.– If appropriate then the bank would return the notes

into circulation– If inappropriate the bank could demand gold/silver

from the state bank and thus reduce money in circulation.

Problems with the Central Bank

• The bank effectively limited growth through these operations.

• Many individuals feared the federal government’s power to force bank closures – thus leaving ordinary citizens with worthless paper money.

• Northern bankers wanted federal money deposited in their own banks.

• Expansion-minded western bankers did not want federal supervision.

• Democrats did not believe that the bank was constitutional.

Independence Principle

• There is no one principle better understood by every officer in the Bank that he must abstain from politics. The course of the Bank is very clear and straight on that point. We believe that the prosperity of the Bank and its usefulness to the country depend on its being entirely free from the control of the officers of the Government, a control fatal to every bank which it ever influenced. In order to preserve that independence it must never connect itself with any administration – and never become a partisan of any set of politicians

Financial Crises

• Panic of 1837– In the last few years of the Second Central Bank

the money supply grew at an average rate of 30% rather than under 3% previously

– The result was a speculative bubble in land and commodities that burst in 1837

– A depression followed that lasted until 1843

National Banks

• In 1863 a bank was allowed to choose between a state and a national charter.

• With a national charter the bank had to issue government printed bills for their notes and had to back these notes with federal bonds

• In 1865 state bank notes were taxed out of existence

• This was the first time that the United States had a uniform national currency.

More Financial Crises

• Panic of 1873 and 1893– Generally to do with the overexpansion of

railroads and the collapse of railroad bonds.• Panic of 1907– Caused when Augustus Heinze attempted to

corner the copper market– As there was no central bank J. P. Morgan and

other bankers arranged investments and extended lines of credit to stabilize the economy

Federal Reserve Act 1913

• It was not a commercial bank– Did not extend loans other than to banks– Excess profits would be returned to the treasury

• It was decentralized– 12 regional banks – Avoided centralization of power in Washington or NY– The regional banks were owned by the commercial

banks in the region– Each district issued its own currency backed by the

promise to redeem it in gold.

Federal Reserve Act 1913

• The Federal Reserve Board made up of presidential appointees

• The Federal Advisory Board elected by the regional banks

• Took over the nations payments systems• As before a 20 year charter – it was made

permanent in 1927

Glass-Steagall Act 1933

• Created the Federal Deposit Insurance Corporation• Separated Commercial Banking from Investment

Banking• Prohibited Investment Banking from taking

deposits.• Gave the Federal Reserve Board the power to set

maximum interest rates on time deposits.• Created the Federal Open Markets Committee

(FOMC)