By: Zachary Notkin  | 

The Federal Reserve System

Faith in the political system is at a historic low. Inflation ravages the American economy in a way it hasn’t since the 1970s. Recent stock market and crypto gains have gone up in smoke. One thread connects all of these events, and it is the Federal Reserve system. You may be familiar with the Federal Reserve from conspiracy theories and cursory glances at the business section on your way to the sports section, but you probably don’t know what it actually is. 

    Understanding the Federal Reserve requires understanding the history of banking in America. A bank borrows money from depositors in the short term, and lends that money to borrowers in the long term, profiting from the difference in interest rates. During the so-called free banking era of the early 1800s, banks were basically unregulated, and relied on consumers trusting that their gold deposits were secure. However, only a fraction of the deposits were actually held in reserve. If the bank went bankrupt, depositors could lose everything. If rumors, even untrue, spread that a bank was facing trouble, it could lead to run on the bank. With every depositor demanding their gold at the same time, the bank would be unable to function. In order to facilitate transactions, banks would issue paper notes in exchange for gold deposits. Since these notes would be worthless if the bank went under, they would trade for less than their face value. So called “Wildcat Banks” would issue more notes than they could ever redeem, effectively stealing from their depositors. (It should be noted that a form of modern cryptocurrency called “stablecoins,” are effectively wildcat banks.)

    In order to help pay for the Civil War, Congress eventually authorized the creation of one paper currency, nicknamed “greenbacks,” that would be accepted throughout the country. They also replaced the unregulated local banks with more reputable “National Banks,” nearly eliminating all other currencies in circulation. However, without a strong central authority backing them, even these banks were subject to runs and panics. After financier J.P. Morgan personally bailed out several banks in 1907, demand grew for stronger government action. However, that demand did not defeat the longstanding resistance to the creation of a single government-run central bank. At a highly secret meeting on Jekyll Island, America’s financial elite agreed on a proposal for the creation of the Federal Reserve System that was passed by Congress in 1913.

    The system, which remains in place to this day, requires all major banks to hold stakes in their regional Federal Reserve Bank, of which there are twelve. While the regional banks are theoretically equal, the New York Fed is practically the most important. A politically appointed Board of Governors officially oversee the system, but the Federal Open Market Committee, which includes the seven members of the Board of Governors and the presidents of the regional banks, make the most important decisions. Generally, all twelve regional presidents sit in on meetings, but they only receive five total votes, which they assign on a rotating basis, except for the president of the Federal Reserve Bank of New York, who has a permanent seat. By tradition, the chairman of the Board of Governors, currently Jerome Powell, is elected chair, and the president of the Federal Reserve Bank of New York is vice chair. 

    The question of what exactly the Federal Reserve does is complicated, since the financial system has changed so much since its inception. The overall goal of the system is to maintain the nation's economic stability by minimizing inflation and maximizing employment. The system failed its first test, now known as the Great Depression. During World War II, the Fed helped the war effort by allowing the government to borrow money at low rates. However, the desire to avoid the many international money crises during the Great Depression prompted all of the free nations of the world to send representatives to Bretton Woods, New Hampshire, where the modern global economic system was founded. At that time, the United States made up the majority of the global developed economy, and held most of the world’s gold reserves. Therefore, the U.S. Dollar, still at this point redeemable for a fixed amount of gold, was set as the global reserve currency, with every other currency exchangeable to it at a fixed rate. This meant that the Fed had to maintain the value of the U.S. Dollar at precise levels. However, in the 1970s, a combination of high unemployment and inflation, called stagflation, punished the American economy, and the Fed could do nothing about it. So, after a secret meeting at Camp David, President Nixon formally abolished the gold standard, sending global currencies to the whims of the free market. This meant that the dollar is fiat currency, backed by nothing, valued at whatever the market thinks it is valued at. However, since people need dollars to pay their taxes, buy stocks and bonds from regulated exchanges and basically everything else, the value of the dollar isn't dissapearing anytime soon. 

    The Fed has continued to expand its role in the U.S. economy. Since money is now fiat, it can print as much money as it wants to pump into the economy. After the market crash of 2008, the Federal Reserve increased its role in the U.S. economy, and the COVID crisis has only exacerbated this. Due to the uncertainty among even the greatest economists regarding how the Fed can best fulfill its dual mandate, it has a lot of leeway in choosing how to act. Historically, this has allowed it to make choices that increase its own significance and power, regardless of how well it does.

This has served as merely a cursory glance into the working of the Federal Reserve. Hopefully, in a follow up article, we can discuss what exactly the Fed does in the modern economy, and how that might change in the future.

Photo Caption: Chicago Federal Reserve Bank Building

Photo Credit: Unsplash/Joshua Woroniecki