FEDERAL RESERVE SYSTEM

The Federal Reserve System (Fed) came into existence in 1913. To overcome fears that a unified U.S. central bank would become too closely allied to the federal government and to big money interests, the Fed was made up of twelve regional reserve banks each with a high degree of local autonomy. A Federal Reserve Board, located in Washington D.C., operated as a supervisory body with a duty to ensure that the Federal Reserve banks complied with the law. All national banks, that is institutions that had received their charter from the federal government, were required to join the Fed. State banks were permitted to join if they could meet the relatively high reserve requirements laid down by the new system.

THE EARLY EXPERIENCE: 1913–1921

Few bankers wanted a strong central bank, and there was widespread support for regional division. In fact the dual system of national and state banks that the majority of bankers wished to retain had been preserved. After 1913 the commercial banking sector was made up of national banks, which were members of the Fed, and state banks, some of which joined the Fed while others remained nonmembers. In 1921, only 9,779 of the 29,018 commercial banks were members of the reserve system. Even in 1929 the structure was essentially the same. The Fed had 8,522 members while non-members numbered 15,173.

Among the objectives of the new system were the provision of ample credit for legitimate business, the stabilization of interest rates, and the maintenance of the gold standard. A key aspiration stressed by the supporters of central banking was the avoidance of financial panics and the attendant bank failures to which the American financial system was prone. Multiple bank failures during the depression of 1907 had proved to be a decisive turning point in the argument for the creation of a central bank.

Almost as soon as the Fed was established, the economy was affected by the demands of World War I. The Fed successfully lubricated the wheels of credit and after April 1917, when the United States entered the conflict, it directed credit to essential users and also supported the Treasury in its aim of keeping interest rates low so that the costs of war borrowing would be minimized. Unfortunately this action helped to fan the flames of inflation. When, in 1920, the Fed raised interest rates in order to bring rising prices under control, the severe postwar Depression of 1920 and 1921 quickly followed. Only after 1921 did the Fed begin to operate under normal peacetime conditions.

MONETARY POLICY: 1922–1928

During this period the New York Reserve Bank, under its influential governor, Benjamin Strong, emerged as the leading institution. It had become apparent that if the reserve banks insisted on behaving independently, each raising or lowering discount rates or purchasing or selling securities, monetary policy would lack cohesion. Strong advocated the coordination of open market operations, and in 1922 a committee was formed to supervise the sale and purchase of government securities. With this tool, Monetary policy could be used to counter the impact of both booms and slumps and seasonal fluctuations in credit, so that the monetary authorities could influence events rather than simply react to them.

Some scholars believe that the Fed intervened directly to ensure that the minor recessions of 1924 and 1927 did not develop into full-blown Depressions. During each, the Fed adopted liberal credit policies by purchasing government securities and lowering discount rates. As the economy recovered rapidly in both cases, it would seem that the policies were very effective. However, compelling evidence suggests that the motives for the Fed's actions were linked to international rather than domestic issues. The Reserve wanted to keep U.S. interest rates low in order to assist European countries in either returning to the gold standard or staying on it. Credit was extended to European central banks, and low U.S. interest rates encouraged capital to flow to the old world. In other words, the domestic benefits of expansionary monetary policy were entirely secondary.

While the Fed encouraged the adoption of the gold standard overseas, it efficiently managed the massive influx of gold into the United States during the war and post-war years. The gold was effectively sterilized and not allowed to exert inflationary pressure. Indeed, this period is one of remarkable price stability given the economy's vigorous growth. However, the actions of the Fed in accumulating a large gold reserve, a strategy also pursued by the French, put pressure on other gold standard countries that were attempting to operate the system with inadequate reserves.

By 1928 the domestic advantages of reserve bank monetary co-operation had become apparent. For example, collective action had reduced seasonal fluctuations in interest rates, and bankers were becoming more confident in their ability to use monetary policy effectively. Bank failures, however, continued to be a problem. Between 1921 and 1929, some 776 national banks, 229 state banks, and 4,416 non-member banks closed their doors. The vast majority of the failed institutions were small banks adversely affected by farm misfortune. The figures reflect the fact that big banks joined the Fed, and the small, usually under-capitalized unit banks, remained outside and were unable to call on central bank help when in need.

THE FED AND THE ONSET OF THE DEPRESSION

In 1928 danger signals from the New York Stock Exchange (NYSE) were becoming a concern. The Fed reacted to growing stock market speculation by introducing a tight money policy. Intended to make borrowing for speculation less attractive, the higher interest rates were expected to reduce frenetic speculative activity. Unfortunately, this policy was totally ineffective as speculative activity actually increased. However, the policy did have an adverse effect on economic performance, and in the middle of 1929 it was clear that the economic boom had come to an end. Wall Street quickly absorbed these signs, the stock market collapsed in October 1929, and then the Fed, seeing speculation quashed, reduced interest rates.

The economic recovery that followed the crash did not last long. From the middle of 1930 the economy began a long slide, which took it to a trough in the winter of 1932 and 1933. A sustained recovery did not begin until the spring of 1933. A central feature of the Great Depression was extensive bank failure. Indeed, in mid-March 1933 there were approximately 12,600 fewer commercial banks than had been open for business in June 1929. Yet one of the duties of the reserve system was to act as a bulwark against bank failure. Why did the Fed fail in this task?

Scholars usually identify three banking crises in which the failures were concentrated: the first took place in 1930, the second in the fall of 1931, and finally the banking system reached an almost total state of collapse in the winter of 1932 and 1933. There is now widespread agreement that the 1930 wave of bank failures was part of a regional problem and had little national impact. However, the 1931 crisis was far more serious and occurred after Great Britain left the gold standard and devalued sterling. Speculators who had previously worried about the ability of the Bank of England to support the pound now turned their attention to the dollar. To give speculators a clear message that protecting the currency was a priority, the Federal Reserve raised interest rates and pursued a tight money policy. This was a logical move to protect the dollar, but it was disastrous for a banking system under great pressure. The beleaguered banks needed low interest rates and an easy money policy that would give them ready access to central bank support, quite the reverse of what was provided. As some institutions failed, panic spread and even soundly run banks could not keep their doors open when faced with so many customers who wished to withdraw deposits. Exactly the same thing happened during the "lame duck" period between Roosevelt's election in November 1932 and his inauguration in March 1933. Uncertainty led to further speculation against the dollar and the Fed responded by raising interest rates. By this time the financial sector had been exposed to such shocks that most state governors were forced to close their banks in order to save them from failing. The creation of the Reconstruction Finance Corporation in January 1932, with powers to assist troubled banks, is a clear indication that the Fed was failing to do its job. In February, the Glass-Steagall Act liberalized the Fed's discount provisions but, unfortunately, this move came too late to have a major impact.

Milton Friedman and Anna Schwartz are highly critical of the Federal Reserve and believe that its perverse decisions, which led to the failure of so many banks and a severe contraction in the money supply, transformed a recession into a major depression. However, the actions of the Fed in defending the dollar were consistent with the policies that seemed so effective in 1924 and in 1927, when external factors determined action. Elmus Wicker, the most authoritative of banking historians for this period, is cautious in his assessment of Federal Reserve policy. Unlike most commentators he does not believe that the Fed initiated the 1931 banking crisis, but he is critical of the failure to implement vigorous open market operations in 1930 and in 1931 that could have prevented the dramatic fall in depositor confidence. Even though most of the failed banks were not reserve members, the Fed wins few friends for its policy choices in the worst years of the Depression. Most scholars debate whether the failures were just bad or disastrous.

THE FEDERAL RESERVE AND THE NEW DEAL

There was unanimous agreement that the banking sector needed assistance to achieve stability, and the first response of the Roosevelt administration was to create a breathing space by declaring a national bank holiday. On March 9, 1933, the Emergency Banking Act gave the executive branch of the government power to reopen banks once they had been examined and declared sound. The Banking Act (June 16, 1933), gave the Fed increased control over bank credit, called for greater coordination of open market operations and the legal recognition of an Open Market Committee. The act forbade the payment of interest on demand deposits by member banks and also regulated the interest payments on time deposits. The decision to separate commercial and investment banks so that the former could no longer underwrite securities gained widespread support. In spite of a lack of enthusiasm on the part of both the president and bankers, the Federal Deposit Insurance Corporation (FDIC) was established to ensure that depositors would be so confident in the security of their deposits that bank runs would become a thing of the past. All members of the Federal Reserve System were obliged to join FDIC.

A further refinement of the banking system came with the Banking Act (1935), which brought about fundamental changes in the Federal Reserve System. Marriner Eccles had assumed the chairmanship of the Board of Governors. An experienced banker with a forceful personality and known by Congress to be no friend of Wall Street, Eccles insisted on greater centralization and more power for the board. The 1935 Act was one of the most significant pieces of legislation in U.S. financial history establishing with its predecessor a structure for banking that was to last half a century. It created a Federal Reserve Board consisting of seven members to be appointed by the president and confirmed by Senate. The Federal Open Market Committee, which had consisted of the twelve governors of the Federal Reserve banks, was replaced by one consisting of the board and just five representatives from the Reserve Banks. The new Committee, which had far more authority than the one it replaced, came to play a leading role in shaping policy. It exercised a firm control over interest rates, the provision of credit, and the money supply. The board also gained the power to approve the appointments of the presidents, as they came to be called, of reserve banks and the authority to alter the reserve requirements of member banks.

The 1935 act transferred power from the reserve banks to the Reserve Board. This shift was possible because of Eccles's determination and authority combined with a congressional distrust of the reserve bankers that was shared by many members of the public. The U.S. president also acquired new powers of appointment to the board.

It is ironic that the Fed, having relentlessly pursued policies that most scholars believe made the impact of the Depression more acute, was given so much additional power by New Dealers. Moreover, an early action of the newly constituted board was to tighten the reserve requirements of member banks, which were viewed as excessive and a potential inflationary threat. This action, together with the imposition of a restrictive fiscal policy as Roosevelt strove to balance the federal budget, contributed to the onset of the deep recession of 1937 and 1938.

See Also: BANKING PANICS (1930–1933); FEDERAL DEPOSIT INSURANCE CORPORATION (FDIC); GOLD STANDARD; GLASS-STEAGALL ACT OF 1933; MONETARY POLICY; RECESSION OF 1937; STOCK MARKET CRASH (1929).

BIBLIOGRAPHY

Calomiris, Charles W. and Eugene N. White, "The Origins of Federal Deposit Insurance." In The Regulated Economy. A Historical Approach to Political Economy, edited by Claudia Goldin and Gary D. Libecap. 1994.

Chandler, Lester V. American Monetary Policy 1928–1941. 1971.

Eccles, Marriner, S. Beckoning Frontiers. Public and Personal Recollections. 1951.

Friedman, Milton, and Anna J. Schwartz, A Monetary History of the United States 1867–1960. 1963.

Kennedy, Susan Estabrook. The Banking Crisis of 1933. 1973.

Smiley, Gene. The American Economy in the Twentieth Century. 1994.

Wheelock David C. The Strategy and Consisitency of Federal Reserve Monetary Policy, 1924–1933. 1991.

White, Eugene N. "Banking and Finance in the Twentieth Century." In The Cambridge Economic History of the United States, Vol. 111: The Twentieth Century, edited by Stanley L. Engerman and Robert E. Gallman. 2000.

Wicker, Elmus. Federal Reserve Monetary Policy 1917–1933. 1966.

Wicker, Elmus. The Banking Panics of the Great Depression. 1996.

PETER FEARON