The Federal Reserve is the central bank of the United States. It, like all central banks, is charged with maintaining internal economic stability through control of exchange rates, interest rates, and money supply. It is the arbiter and implementer of American monetary policy. Hated by conspiracy theorists, gold standard true believers, and anti-globalization forces alike the Fed is one of the most powerful organizations in the world. It is a pity, then, that so few understand what it does or why.

In 1907 the United States experienced its fourth banking panic in 35 years. Liquidity dried up as depositors withdrew funds and interest rates shot sharply upward as banks scrambled for cash to cover the withdrawals. Institutions that still had cash on hand stopped lending, preferring to hoard their cash in case of another run on deposits. The sudden withdrawal of credit forced more businesses to make large cash withdrawals to meet operational costs and debt repayments. Lacking any mechanism to influence liquidity the federal government was forced to sit idly by as thousands of businesses failed, drowning in a horrific financial whirlpool created by the vicious cycle of simultaneous cash and credit crunches.

The need for reform was clear, but the political will was severely lacking and efforts stalled. Bills sponsored by senators from New England failed to win widespread support, those that did pass didn't go far enough. People in the south and fast-growing west were unwilling to accept legislation pushed by people viewed as being in the pocket of large eastern banks and corporations (think JP Morgan, Standard Oil, and the like). Opposition arising from Americans' instinctive distrust of any centralized power was more widespread.

The first attempt was the Aldrich-Vreeland Act, enacted in the spring of 1908. This provided emergency currency to help the still fragile financial system recover from the panic of 1907. It also formed the National Monetary Commission and charged it with creating a plan for the reform of the banking system. The bill also generated intense opposition for perceived pandering and cronyism. The lead sponsor, Nelson Aldrich of Rhode Island, had numerous apparent conflicts of interest, he was a close friend to J.P. Morgan and his daughter was married to a junior Rockefeller.

Opposition didn't come only from those worried about the scope of government or threatened by pork-barrel politics--bankers and businessmen were against the idea of any reform at all if it would increase their cost of business. Still, over the next 4 years and after much compromise and the spending of much political capital the commission came back with a recommendation. Named the Alrdrich Plan, it called for the creation of a privately held central bank backed by commercial assets, The Federal Reserve.

The election of 1912 changed that. Woodrow Wilson swept in and with him came a Democrat majority Senate to go along with the Democrat majority House. The Aldrich plan was a good plan, though, not designed to benefit the rich Northerners at everyone elses expense. His main concern when drafting it had been to adequately check the powers of elected officials over the economy while still retaining government oversight and accountability. In this he succeeded, and the final Federal Reserve Act, passed in 1913, ended up, in the words of President Wilson, "70% faithful" to the original Aldrich Plan.

The structure of the Federal Reserve

70% Aldrich it may have been, but the man most associated with the creation of the Fed was Georgian Carter Glass. An antebellum Southern gentleman, Glass believed absolutely in the supremacy of the white male property owner. A politician of the Jeffersonian flavor, he was staunchly opposed to the centralization of power and it is in this respect that the most important 30% of the Aldrich Plan was gutted.

The original plan called for the creation of a single central bank with power of the currency of the United States. Glass changed this to a system consisting of several independent central banks, each with responsibility for a certain geographic area. These banks would be operated by professional bankers and would not be wholly owned (in the sense that they were not wholly originally capitalized) by the Federal Government. Initial capital for each branch would come from the banks in its region, for which each Reserve branch would conduct the routine business of a central bank--settlement and clearing, interbank loans, and the like--for member banks in its region.

Overseeing these banks would be the Federal Reserve Board of Governors, a seven member committee appointed by the President and confirmed by the Senate. This Board, plus five of the governors of the regional branches, would constitute the Federal Open Market Committee which would be vested with control over monetary policy. Both Aldrich and Glass had recognized the importance of checking the private bankers natural inclination to push policy beneficial to them or their industry with publicly accountable officers while at the same time ensuring that partisan politicians couldn't hijack the economy.

This plan passed as the Federal Reserve Act of 1913. Today, the Fed is organized along these broad lines. The members of the Board of Governors are appointed to 14 year terms with a term expiring every two years. To avoid regional bias, no Fed district can have more than person on the Board at a time.

The mission of the Fed

The Fed sees its mission as fourfold:

  1. Conduct the monetary policy of the United States
  2. Supervise and regulate the American banking system
  3. Maintain the stability of the financial system
  4. Provide banking services to member banks and the federal government

As the designer of monetary policy the Fed engages all of the traditional powers of the central bank--the ability to set interest rates, control over the money supply, and control over the nation's foreign reserves. It uses these powers to implement and maintain a set of policies collectively known as the Golden Straitjacket.

As supervisor of the banking system the Fed is responsible for setting capitalization requirements for banks, overseeing the credit processes, and enforcing other banking regulations.

As a lender of last resort the Fed has the power to preserve the stability of the financial system by providing emergency cash infusions to institutions facing severe cash problems. Banks on the verge of bankruptcy can be rescued while an orderly dispersal of assets or management restructuring is performed.

Finally, the Fed provides clearing and settlement services to its member banks and to the federal government. Its settlement service processes more than one-third of all checks written in the United States, $12 trillion annually. It handles more than $200 trillion annually if purely electronic transactions are factored in.

Federal Reserve Banks