A Brief History of the Federal Reserves Birth and Its Impact on the US Economy

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Hadar Goldberg is a talented financial journalist with a strong passion for analyzing the stock market. She has a deep understanding of financial markets and is skilled at conducting research and analysis to uncover valuable insights for her readers. Hadar is known for her ability to explain complex financial concepts in a clear and concise manner.
 

•  Feb 23 2023
 

Despite wielding immense power and having a significant impact, there is a lack of understanding about the Federal Reserve, its operations, and the extent of its influence. Through a series of articles, we aim to demystify this organization, beginning with its name "Federal Reserve System". Unlike the Bank of England, which served as a prototype for subsequent central banks and includes the word "bank" in its name, the Federal Reserve System does not include this crucial term.

The name of the organization is closely tied to its origins, which trace back to a wintry evening in November of 1910. In a secluded train station in New Jersey, a handful of bankers from Wall Street and a distinguished senator from Rhode Island, Nelson Aldrich (1841-1915), held a clandestine meeting. Aldrich had a long political career in both the House of Representatives and the Senate, and was serving as chairman of the Senate Finance Committee at the time of the enigmatic gathering. The group boarded a private train car and traveled south to a small island on the border of Florida and Georgia. Accompanying the bankers on the train were the CEO of National City Bank, one of the earliest banks established in New York in 1812, which is known today as City Bank.

Following an extended journey, the gathering reached the petite Jekyll Island, which was home to an exclusive and secluded community of America's affluent. Over the course of the subsequent nine days, the group held discussions and drew up plans for the formation of the Federal Reserve within the luxurious confines of J.P. Morgan's private club. The secrecy surrounding the meeting was deliberate. Throughout history, Americans have harbored a deep distrust of bankers, and the idea of creating a central bank was met with significant opposition. Two prior efforts to establish a central bank in the United States were unsuccessful, and one of them was terminated after two decades of operation.

The covert gathering on Jekyll Island was a direct result of a significant and tumultuous event that occurred just three years earlier in New York: the Panic of 1907. The stock market was in rapid decline, and there was a sense of impending financial doom throughout Wall Street. The crisis began with the manipulative trading of shares in a small Montana mining company, which led to a series of bankruptcies and a wave of panic that nearly drove one of the largest trust companies in New York to insolvency. The public, frightened by the chaos, began to withdraw their money from banks en masse. But just as all seemed lost, J.P. Morgan, one of the wealthiest individuals in the city and a prominent banker, took action. He gathered over 100 bankers and industrialists who pooled their resources to assist the most vulnerable institutions. Despite their efforts, the funds were insufficient, and they were forced to enlist the help of the church and the press to calm the panicked masses. Gradually, the situation stabilized.

The Covert Establishment of a Central Bank

In the wake of the Panic of 1907, the Senate established an investigative committee led by the well-connected Senator Aldrich, who had close ties to the upper echelons of Wall Street. Despite the fact that the crisis was entirely the result of Wall Street's actions, the bankers sought a permanent solution in the form of a government entity that could provide support and rescue in the face of bank risks. However, in 1910 America, both the honorable senator and the bankers knew that this concept was entirely unacceptable. As a result, a protracted and covert process was required to pass legislation that would establish a central bank in the United States.

In utmost secrecy and seclusion, the bankers and the senator convened at the Jekyll Island club to draft the summary report of the examination committee for the 1907 crisis, which became known as the "Reform Plan". In later years, the president of National City Bank remarked in an interview, "Secrecy was necessary because it would have been disastrous for the senator's proposal if it were known that he was working with Wall Street to create the plan... If it were to be revealed that this group had come together to draft banking legislation, there would have been no chance of it passing through Congress."

In order to avoid the potential unpopularity of the central bank idea, the word "bank" was intentionally omitted from the name of the new institution. The term "Federal Reserve System" was deemed more innocuous, suggesting an internal and voluntary system for mutual aid. As the commission stated, "This is not a bank, but a collaboration of all the banks in the country for one very limited and very defined purpose." It wasn't until three years later that the commission's recommendations were translated into law. In December 1913, the "Federal Reserve Act" was passed, giving birth to a fourth branch of government and establishing the most powerful and influential economic institution in the American economy.

The Creation of Regional Branches

The Federal Reserve Act, which became law in December 1913, mandated the creation of 12 regional branches of the Federal Reserve. All major banks in each region were required to join and deposit a certain amount of money in these branches, which became known as the "reserve". The reserve was intended to be used only in emergencies, such as a bank run by one of the member banks. The law established a board of directors to oversee the Fed, whose members were to be appointed by the president and approved by the Senate. In addition, the new institution was granted extensive supervisory powers over the banking system, including control over the interest rate in interbank transactions, which indirectly affected interest rates throughout the economy.

Despite its establishment with the goal of preventing financial crises similar to the Panic of 1907, the Federal Reserve failed catastrophically in less than 20 years. During the Great Depression, over 2,350 banks - roughly 45% of those affiliated with the Federal Reserve system - either closed or went bankrupt. This disaster prompted significant changes within the Fed, including the transfer of power and authority from the 12 regional banks to the Board of Governors. The Board was also granted a majority of seats on the Open Market Committee (FOMC), which is responsible for setting interest rates.

From the Accord to the Dual Mandate and Beyond

In 1951, a significant change occurred when the Accord was reached between the Fed and the Ministry of Finance. This agreement separated the management of government debt from monetary policy, laying the groundwork for the modern-day Fed. In 1977, the law was amended once again, adding full employment and price stability to the Fed's tasks and responsibilities, which are now known as the "dual mandate". The Fed was also required to report regularly to Congress, and the chairman and deputy chairman were appointed for four-year terms, subject to Senate approval. In 1980, the Fed's authority was expanded, allowing it to lend money and provide services to both member and non-member banks and financial institutions, including foreign central banks. This amendment also subjected all banks, not just members of the Federal Reserve System, to the Fed's reserve guidelines, giving it significant control over the economy's money supply. In 1991 and 1993, further powers were granted to the Fed through legislative acts related to the financial system.

In under a century, the Federal Reserve, which was originally established to serve a specific limited purpose of banking collaboration, evolved into a global empire. As of 2021, the Fed had a workforce of roughly 23,700 employees and spent nearly $7 billion in expenses. The institution generated revenue, primarily from the interest on government and mortgage-backed bonds that it purchases using printed money. After covering its expenses, the Fed transfers the remaining balance to the treasury. In 2012, the transfer amounted to about $109 billion. Additionally, the Fed pays dividends to member banks that hold shares in its 12 regional branches. Although these shares are not tradable, the Fed is legally required to pay a 6% annual dividend to their owners. Roughly 2,900 banks are shareholders in the Federal Reserve System, and in 2021, they will collectively receive a dividend of $583 million.

Who owns the Federal Reserve, the institution that was established in secret by bankers and whose 12 regional branches, including the one in New York responsible for implementing monetary policy and representing the Fed in market activities, are still owned by private banks? What is the level of private sector involvement in the Fed's regional branches?

Fed Ownership and Private Involvement

The question of ownership of the Federal Reserve, particularly with regards to the involvement of private entities in its 12 regional branches, including the New York branch responsible for implementing the Fed's monetary policy, has been the subject of scrutiny. In an attempt to address this question, the Fed stated that it is not owned by anyone and that its Board of Directors is a government agency accountable to Congress. However, the Fed operates with characteristics of both private companies and public organizations. Despite this, it remains an independent central bank whose monetary policy is not subject to approval from the President or any government branch, and it is not funded by Congress. Additionally, board members are appointed over time during different presidential and congressional periods.

Due to its limited public scrutiny, self-determined budget, and few decision-makers with extensive power and control, the Fed is an extraordinary phenomenon within the democratic structure of the United States, which is based on "checks and balances." It is no surprise that the Fed is fiercely committed to preserving its position. In 2004, Alan Greenspan, who served as the chairman of the Fed from 1987 to 2006, recommended that "the Fed should not disclose too much to the public, for fear of losing control over a process that is not fully understood." In a speech in February 2004, his successor, Ben Bernanke, followed him with a self-satisfied and self-aggrandizing speech: "It is a fact that recessionary periods have become less frequent and less severe... Is this due to improved monetary policy, or just luck? This is an important question, but it makes me optimistic about the future." It is ironic that while the Fed flatters itself and asks for less involvement from those who do not understand its business, it is precisely the Fed and its leaders who did not comprehend or recognize the destructive real estate bubble that grew right under their noses and was in large part due to their actions, such as lowering the basic interest rate from 6% to around 1.25% in 2002. Regenerate response

The Fed's Challenging Moment: Deflating the Inflationary Balloon

The Fed is currently facing another challenging moment. Will it be able to deflate the balloon it has inflated without restriction during 2020-2021, or will the monetary genie break free and result in a painful economic crash? Will the inflationary period of 2022-2023 conclude without incident, or will the Fed once again lose command over a process that is understood by only a few individuals besides itself?

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Please note that the article should not be considered as investment advice or marketing, and it does not take into account the personal data and requirements of any individual. It is not a substitute for the reader's own judgment, and it should not be considered as advice or recommendation for buying or selling any securities or financial products.