What is the Fed: History

Introduction

The Federal Reserve System was established by Congress over 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 scarce credit. 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 System and how the Fed has evolved to meet the needs of the U.S. economy.

Money and Banking in Colonial America

Banks in the colonies did not take deposits or make loans.

Prior to gaining independence from British rule, American colonists were limited to using European coins, commodity money, and barter as their primary means of exchange. Troubled by shortages in foreign coins and the inefficiencies of barter and commodity money, many colonies decided to mint coins and issue paper currency for transactions.

Unlike the banking system today, banks in the colonies did not take deposits or make loans. Instead, they issued paper currency (commodity money) backed by land or precious metals such as gold. The primary sources of credit or loans came through wealthy merchants and other individuals. This was ineffective. People lacked faith in colonial currency and the right of a colony to issue money was often challenged by their British rulers.

Experiments with Central Banking

Alexander Hamilton developed a plan for a federal banking system.

Central banking in the United States began with the ratification of our 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 business and financial leaders from the northeastern states, called for the creation of a federal bank to provide credit to government and businesses. The new federal bank would also establish a national currency, replacing the notes issued by the colonies. In addition, the federal bank would carry out all financial matters for the U.S. government 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 farming interests, which looked with suspicion at a central government bank and generally favored states’ rights over federal powers. He argued that the Constitution did not 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. Twenty years later, a bill to re-charter the bank failed. Without a centralized banking and credit structure, state banks took on the same role as the original colonies and began issuing their own paper currencies, often of questionable value. In 1816, Congress attempted to solve the country’s financial problems by chartering the Second Bank of the United States. This second bank lasted until 1836, when President Andrew Jackson declared it unconstitutional and vetoed its re-charter.

Free Banking Era

By 1860, there were nearly 8,000 state banks, each issuing its own paper notes.

A period known as the Free Banking Era followed the demise of the Second Bank of the United States. Over the next 25 years, U.S. banking was a hodgepodge of state-chartered banks operating without any federal regulation. By 1860, there were nearly 8,000 state banks, each issuing its own paper notes. Some of the more questionable banks were known as “wildcat banks,” supposedly because they maintained offices in remote areas (“where the wildcats are”). This made it difficult for customers to exchange their notes for gold or silver.

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. The legislation cleared up the problem of thousands of different bank notes circulating in the U.S. at the time, but did not create a strong central banking structure.

Financial Panics, Bank Runs, and the Creation of the Fed

Worried customers rushed to withdraw money before their bank failed.

As the industrial economy expanded following the Civil War, the weaknesses of the nation’s decentralized banking system became more serious. Bank panics or “runs” occurred regularly. Many banks did not keep enough cash on hand to meet customer needs during these periods of heavy demand, and were forced to shut down. News of one bank running out of cash would often cause a panic at other banks, as worried customers rushed to withdraw money before their bank failed. If a large number of banks were unable to meet the sudden demand for cash, it would sometimes trigger a massive series of bank failures. In 1907, a particularly severe panic ended only when a private individual, the financier J.P. Morgan, used his personal wealth to arrange emergency loans for banks.

The 1907 financial panic fueled a reform movement. Many Americans had become convinced that the nation needed a central bank to oversee the nation’s money supply and provide an “elastic” currency that could expand and contract in response to fluctuations in the economy’s demand for money and credit. After several years of negotiation and discussion, Congress established the Federal Reserve System in 1913.

Evolution of the Federal Reserve System

Key changes to the Fed have resulted from periods of instability in the economy.

Since the creation of the Federal Reserve, other pieces of legislation have shaped the structure and operation of our nation’s central bank. Each of the key changes highlighted below resulted from periods of instability in the economy. Following the Great Depression, Congress passed the Banking Act of 1935. That act established the Federal Open Market Committee (FOMC) as the Fed’s monetary policy-making body. During a period of very high inflation, Congress enacted The Federal Reserve Reform Act of 1977. It explicitly set price stability as a national policy goal for the first time. Stable prices help people and businesses make financial decisions without worrying about where prices are headed. Economies with stable prices tend to be healthier in the long run.

The very next year, Congress passed The Full Employment and Balanced Growth Act of 1978, which established the second policy goal as full employment. It also required the Fed to report to Congress on policy goals twice a year. Finally, following the severe financial crisis of 2007-2008, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. More commonly known as the Dodd-Frank Act, this law affected the Fed in many ways. It changed the Fed’s governance, made its operations more open to scrutiny, and expanded its supervisory responsibilities.

Sources:

American Currency Exhibit, Federal Reserve Bank of San Francisco.

Crisis & Response: Regulatory Reform, Federal Reserve Bank of San Francisco.

Federal Reserve History, Federal Reserve System.

The Federal Reserve System Purposes & Functions, Federal Reserve Board of Governors, Tenth Edition, October 2016.

The Goals of U.S. Monetary Policy, by John Judd and Glenn D. Rudebusch, FRBSF Economic Letter 1999-04, January 29, 1999.

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