Federal Reserve

The Federal Reserve System, often referred to as “the Fed,” was founded on December 23, 1913, when President Woodrow Wilson signed the Federal Reserve Act. Its original purposes were to create an elastic money supply, to provide facilities for discounting commercial paper, and to supervise banks. These functions had long been performed by the central banks of major powers in Europe such as the Bank of England or the Bank of France.

The United States had had a central bank twice early in its history. The First Bank of the United States had been created in 1791. It was the successor of Robert Morris's private bank that had helped to finance the War for Independence. As secretary of the treasury, Alexander Hamilton championed a central bank, while Thomas Jefferson, secretary of state, opposed it. That first bank lasted until 1811 as an institution that provided financial stability for the new nation.

In 1811, the charter for the First United States Bank was not renewed and might well never have been reestablished if the War of 1812 had not revealed the financial weakness of the U.S. government. In 1816 the Second United States Bank was chartered. Its right to exist was challenged in McCulloch v. Maryland (1819). The case established the right of the federal government to exercise implied powers that were necessary and proper for the execution of the bank's expressly delegated powers. In this case a national bank, even though not expressly mentioned in the Constitution, was a fit institution for the U.S. government to create to aid in the performance of its financial activities.

The Second Bank survived the Panic of 1819; however, its president, Nicholas Biddle, was accused of exercising poor judgment for keeping credit tight. Biddle's tight credit policy put future President Andrew Jackson and his friends into a hard spot financially. Jackson's animus toward the bank was to be lifelong. Jackson and many in the new western states were in favor of easy credit, which was not liked by the more conservative and financially better off East. In 1832 Jackson vetoed the bill to recharter the Second Bank. Thus the bank remained chartered until 1836 as originally stipulated, Jackson having done an end run around the legally sanctioned institution by removing federal funds from the bank and putting them in state banks, often referred to as Jackson's “pet banks.” By 1837 the Second Bank's demise contributed, in part, to the Panic of 1837. It finally closed in 1841.

To curtail the use of state-chartered banknotes a federal tax was levied on state banks. As a result the number of federally chartered banks mushroomed. However, by the 1890s state banks had bounced back through the use of checking accounts. Still, two problems remained with the decentralized national banking system. First, the reserve requirements, much of which by law had to be held in U.S. Treasury securities, fluctuated in value, which meant that banks at times were forced to recall loans or to borrow from other banks. A second major problem included seasonal liquidity spikes. These spikes were associated with the enormous agricultural activity of the country.

The westward movement provided for an enormous growth in agriculture as well as the growth of small towns across the country, both of which presented a banking challenge. The cash reserves needed to supply planters, ranchers, stockmen, and others at planting and harvesting times were great. During the growing season, the need for cash or sound checks was significantly lower. The rapidly expanding West had greatly fluctuating currency needs while in the older East, where urban and industrial growth was strong, currency needs were more stable. As a consequence a small western bank could experience currency supply problems that could easily be met by a loan between banks (banker's loan) until harvests could be delivered and paid. The eastern banks, however, often presented the less stable western banks with expensive costs. Western farmers needed a lender of last resort. This became a problem even for the U.S. government during the Panic of 1907. It turned to J. P. Morgan for large sums of money to tide it over. Morgan organized the cooperation of other New York bankers to end the panic.

Some bankers and others, especially the populists across the South and West, were worried that Morgan and Wall Street had too much power. Others were more concerned with the financial instability that the decentralized system presented. An elastic money supply could prevent or soften financial panics.

By 1912, the Aldrich Plan was made public with Woodrow Wilson enlisted as a spokesman. It called for a system of financial stability, without political meddling, through a decentralized reserve financial system. The election of 1912 gave the Democrats control of the House and the Senate and put Woodrow Wilson into the White House, thus clearing the path for the Aldrich Plan.

President Wilson made the Aldrich Plan a vital issue. The bill could have failed because William Jennings Bryan, a Populist as well as Wilson's secretary of state, was a long-time enemy of Wall Street. Bryan had delivered his “Cross of Gold” speech to the Democratic Party National Convention on July 9, 1896. He opposed the gold standard that was used internationally and favored bimetallism, which would use both gold and silver coinage. Bimetallism was opposed by bankers, industrialists, and international traders because “free silver” allowed more inflation than the gold standard. Inflation was favored by farmers and ranchers because it gave them higher prices. The speech gained Bryan the nomination; however, he lost the presidential election of 1896 to William McKinley. In 1900 the United States adopted the gold standard.

Wilson gained Bryan's support by making the liabilities of the Federal Reserve liabilities of the U.S. government rather than of the private banks. In addition, farmers would be given federal loans. He also gained support because the 12 decentralized regional banks of the Federal Reserve would weaken Wall Street's influence. Moreover, regional Federal Reserve Banks, identified by number, would be controlled by a central Federal Reserve board appointed by the president with the advice and consent of the Senate. They were to engage in a coordinated effort to manage the nation's money supply. While ostensibly private, they are really entities of the federal government.

The Federal Reserve was slow to exercise its powers. Its first major role was issuing Liberty Bonds (under Treasury Department supervision) to finance the United States’ war effort in 1917. After the war it was given the authority to both create and destroy money. Its financial operations during the Roaring Twenties have been seen by later scholars as aiding the stock market bubble that ended with the Great Depression.

Between 1933 and 1951 the Federal Reserve was a subordinate part of the executive branch. Its functions since the 1970s have included managing the money supply to maximize employment in equilibrium with stable prices and moderate long-term interest rates.

The Great Recession of 2008 was global in scope; however, the Federal Reserve seems to have played the stabilizing role its founders intended. Its critics put forth complaints and charges that echo populist complaints of the financial conflicts of the eighteenth and nineteenth centuries.