What is The Fed: History

Introduction

The Federal Reserve System was established by Congress nearly a century ago to serve as the U.S. central bank. President Woodrow Wilson signed the Federal Reserve Act into law on December 23, 1913. Prior to the creation of the Fed, the U.S. economy was plagued by frequent episodes of panic, bank failures, and credit scarcity. The history of the Federal Reserve is bound up in the effort to build a more stable and secure financial system. This section describes key events leading to the establishment of the Federal Reserve and the evolution of the Federal Reserve System in response to the needs of the U.S. economy.

Money and Banking in Colonial America

Colonial banks were not like modern banks.

The American colonists were limited to using European coinage, barter, and commodity money as their primary means of exchange before independence from British rule. Troubled by foreign coin shortages and the inefficiencies of barter and commodity money, many colonies began minting coins and issuing paper currency by the end of the 17th century. This was ineffective. People lacked faith in colonial currency and the authority of the colonies to issue money was periodically interrupted by their British rulers.

Colonial banks were not like modern banks. They did not take deposits from the public or make loans. Instead, they issued paper currency backed by land or precious metals such as gold. Merchants and other individuals were the primary sources of credit.

Experiments with Central Banking

Alexander Hamilton proposed the idea of a federal banking system.

The origins of central banking in the United States began with the ratification of the Constitution in 1789. Secretary of the Treasury Alexander Hamilton developed a plan for a federal banking system to solve the nation’s credit problems after the War of Independence. This was controversial. Hamilton’s plan, backed by commercial and financial interests centered in the northeastern states, called for the creation of a federal bank to provide credit to government and businesses, and to establish a national currency. The federal bank would act as the government’s fiscal agent and provide a safe place to store government funds.

Secretary of State Thomas Jefferson led the opposition to Hamilton’s plan. Jefferson represented the country’s agrarian interests, which looked with suspicion at a central government bank and generally favored state over federal powers. He argued that the Constitution did not expressly authorize the federal government to charter a national bank or issue paper currency.

Hamilton, supported by the Federalist Party, won the debate. The First Bank of the United States was chartered in 1791. A bill to re-charter the bank failed in 1811. Without a centralized banking and credit structure, state banks filled the vacuum, issuing a multitude of paper currencies of questionable value. Congress attempted to solve the country’s financial problems by chartering the Second Bank of the United States in 1816. This second bank lasted until President Andrew Jackson declared it unconstitutional and vetoed its re-charter in 1836.

Free Banking Era

By 1860, nearly 8,000 state banks were issuing their own currency.

A period known as the Free Banking Era followed the demise of the Second Bank of the United States. Over the next quarter century, U.S. banking was a hodgepodge of state-chartered banks not subject to federal regulation. By 1860, nearly 8,000 state banks operated, each issuing its own paper notes. Some of the more marginal institutions were known as “wildcat banks” supposedly because they maintained offices in remote areas (“where the wildcats are”) in order to make it difficult for customers to redeem their notes for precious metals.

The need for reliable financing during the Civil War prompted the passage of the National Banking Act in 1863. The legislation created a uniform national currency and permitted only nationally chartered banks to issue bank notes, but did not create a strong central banking structure.

Financial Panics and Bank Runs

Fearful customers would run to the bank to withdraw money.

As the industrial economy expanded, the weaknesses of the nation’s decentralized banking system became more acute. Bank panics or “runs” occurred frequently. Many banks did not keep enough cash on hand to meet unusually heavy demand. Panics and runs often occurred when customers lost confidence in their banks after hearing news of failures of other banks. Fearful customers would rush to their banks to withdraw money, which often could not meet the sudden demand for cash. That sometimes created a contagion that triggered a succession of bank failures. A particularly severe panic took place in 1907 that abated only when a private individual, the financier J.P. Morgan, personally intervened to arrange emergency loans for financial institutions. This episode fueled a reform movement, which prompted Congress to establish the Federal Reserve System in 1913.

Evolution of the Federal Reserve System

Following a severe financial crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

Since the creation of the Federal Reserve, other pieces of legislation have shaped the structure and operation of the nation’s central bank. Following the Great Depression, Congress passed the Banking Act of 1935, which established the Federal Open Market Committee (FOMC) as the Fed’s monetary policymaking body. The Federal Reserve Reform Act of 1977 was enacted during a period of surging inflation. It explicitly set price stability as a national policy goal for the first time. The Full Employment and Balanced Growth Act, approved in 1978 and known informally as the Humphrey–Hawkins Act, established full employment as a second goal of monetary policy and required the Fed to report to Congress on its policy twice a year. Most recently, following the severe financial crisis of 2007-08, Congress passed the Wall Street Reform and Consumer Protection Act of 2010. The law, known as the Dodd-Frank Act, affects the Fed in many ways. It changes the Fed’s governance, increases its transparency, expands its regulatory responsibilities, and transfers most Fed consumer protection responsibilities to a new Consumer Financial Protection Bureau.

Sources:

American Currency Exhibit. Federal Reserve Bank of San Francisco. 2010

The Goals of U.S. Monetary Policy, by John Judd and Glenn Rudebusch, FRBSF Economic Letter 99-04, Jan. 1999

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