Chapter 13

1. Chapter 13 Central Banks and the Federal Reserve System

2. The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design. – F.A. Hayek

3. Historical Development of the Banking System Figure 1

4. The first Bank of the United States was chartered in 1791 (The Feds Before the Fed by Trask) The Federalists argued that a national bank was necessary to bolster the credit and assist the fiscal operations of the federal government. 3/4 of its capital was composed of government bonds. paper-money was still in its infancy… little was said of the need to regulate the currency. In 1811, Congress ended the first Bank of the U.S. the Jeffersonian Republicans that controlled the House did not renew the charter. A Senate tie was broken by vice president George Clinton (NY) Pre-Fed

5. The second Bank of the United States (The Feds Before the Fed by Trask) Congress declared war on Great Britain in June of 1812 to uphold "free trade and sailor’s rights" (or seize Canada?) The Madison administration financed it by borrowing paper money from the banks and individuals printing interest-bearing treasury notes. a classic Austrian-style boom ensued (inflation and specie was driven from the country). New Englanders refused to lend money and state militia to the federal government Continued to trade with the British in Canada NE banks vs. non-NE banks As NE banks accumulated gold, non-NE banks were nearing bankruptcy NE’s currency remained backed by specie, the rest of the nation’s was depreciated bank paper non-NE banks suspended their gold standards when the British invaded the Chesapeake in 1814 Inflation exploded as non-NE banks expanded their issues writers began praising the flexibility, expansibility, and wealth-creating power of the paper currency The federal government’s revenue was collected in depreciated bank paper or treasury notes, and bonds could only be sold by offering enormous premiums. Pre-Fed

6. The second Bank of the United States (The Feds Before the Fed by Trask) In 1815, Madison lobbied for a second national bank to remedy the of the consequences of its monetary policies boost the credit of the government provide a “uniform national currency” pressure the state banks to resume specie payments curtail state bank’s excessive note issues. Madison’s critics argued Congressman Ward (MA): If the gov’t wants banks to resume paying hard money, it could refuse to accept the notes of nonspecie paying banks for the payment of import duties the purchase of public lands the buying of government bonds John Randolph of Virginia: the national bank will aggravate rather than remedy the situation Senator William Wells (DE): This bill came out of the hands of the administration ostensibly for the purpose of curtailing the over-issue of Bank paper: and yet it came prepared to inflict on us the same evil, being itself nothing more than a simple paper making machine; and constituting, in this respect, a scheme of policy about as wise, in point of precaution, as the contrivance of one of Rabelais’s heroes, who hid himself in the water for fear of the rain. The disease, it is said, is the Banking fever of the States; and this is to be cured by giving them the Banking fever of the United States. Pre-Fed

7. The second Bank of the United States (continued) In 1816, the charter for the second Bank of the U.S. was approved hard-money Federalists and Old Republicans opposed it It was to be capitalized at $35 million $7 million in specie $28 million in government bonds Was it a financial windfall for politically connected bond holders? Paid-in capital $35 million $2 million in specie $21 million in government bonds $12 million in stock notes 19 branches opened throughout the nation by the end of the year It formed collusive agreements with private banks of the Atlantic cities It encouraged southern and western banks to inflate It backed $43 million with $2 million in specie With reserves all but depleted by mid-1818, its actions below lead to the panic of 1818-1819: curtailed lending contracted their notes to avoid suspending payment called in loans required balances due them by the state banks be paid in hard money or national bank notes Pre-Fed

8. The second Bank of the United States (continued) In 1816, the charter for the second Bank of the U.S. was approved In the two years previous to the panic of 1825 It lent its own notes and accepted state bank paper as payment to increase its circulation and subdued state banks increased its circulating notes by 105 percent while the state banks did so by only 57 percent During the 1830-1831 period, it increased its circulation by 64% The banks of NY and PA increased their notes by 29% and 21%, respectively The bank that was charged with regulating other banks inflated at twice their rate. The more it inflated, the more state banks inflated President Jackson withdrew deposits from the Bank of the U.S. in 1833 Its federal charter expired in 1836, but survived as a PA state bank (under Nicholas Biddle) It helped fuel the inflation of 1835-1836 It opposed the resumption of specie payments Its inflationary policies soon wrecked the bank and it closed its doors for good in 1841 A fractional-reserve profit-making institution’s tendency is to inflate A quasi-government bank’s tendency is to allow government to borrow and finance wars. Samuel Tilden (Sen. NY): “How could a large bank… be expected to regulate beneficially the lesser banks… Has concentrated power been found less liable to abuse than distributed power?” Pre-Fed

9. The second Bank of the United States (continued) Historians and economists have lauded this institution (e.g., Hammond, 1957) beneficial control over the currency It successfully regulated and restrained the state banks It was a good steward of government funds It was an example of fruitful private/public partnership Austrians and hard-money critics It was inflationary It did not prevent the destructive business cycle It inhibited the emergence of a system of noninflationary private banking It was an institution that behaved much as the Federal Reserve System does today Pre-Fed

10. The Federal Reserve System Source: Federal Reserve Bulletin.

11. The Federal Reserve System • The Fed • Established in 1913 • Regulates banks • Supervises the payments system • Sets reserve requirements • Is the lender of last resort • comprised of twelve district banks • is managed by the Board of Governors (BOG) • 7 BOG members • appointed by the President • confirmed by the Senate • each serves for 14 years, cannot serve more than 1complete term, and cannot be removed for political reasons. • terms are staggered every two years • provides a modicum of certainty to market • hinders political influence from elected officials. • is funded by • check-clearing fees • interest collected on loans to commercial banks and government • Hinders political influcencefrom elected officials

12. The Federal Reserve System • Independence of the Fed • allows it to pursue policies that are ‘best’ for the economy, not the President or Congress • is somewhat limited by • the President appointing and the Senate confirming a board member to serve as chair every four years. • submitting biannual reports to Congress • being annually audited by Government Accountability Office • BOG members testifying before Congressional committees • BOG members meeting or working with the • Council of Economic Advisors • Treasury • Federal Advisory Council • Federal Deposit Insurance Corporation

13. The Federal Reserve System • The Federal Open Market Committee (FOMC) • sets monetary policy for the Fed • is chaired by the chair of the BOG • is comprised of • 7 members of the BOG • the President of the New York Federal Reserve Bank • four presidents of the other eleven District Bank Presidents • The first is from Boston or Philadelphia • The second is from Dallas, Atlanta, or Kansas City • The third is from Cleveland, Chicago, or Richmond • The fourth is from San Francisco, Minneapolis, or St. Louis • All sit but only four of the remaining 11 presidents vote • meets once every six weeks (on Tuesdays) to set monetary policy: • low steady inflation • 2-3 percent per year • Not bad in the short-run, a $1 turns into a penny over 100 years • full-employment • 5-6 percent unemployment • u = 1 – E/L • real GDP = potential output if u= un

14. The Federal Reserve System • The strongest argument for an independent central bank rests on the view that subjecting it to more political pressures would impart an inflationary bias to monetary policy • Political pressure would impart an inflationary bias to monetary policy • Political business cycle • Could be used to facilitate Treasury financing of large budget deficits: accommodation • Too important to leave to politicians—the principal-agent problem is worse for politicians • Proponents of the Fed being controlled the President or Congress argue that it is not wise to allow an elite group that is responsible to no oneconducting monetary policy • Undemocratic • Unaccountable • Difficult to coordinate fiscal and monetary policy • Has not used its independence successfully

15. The Federal Reserve System • The Chairman of the BOG has the power because • Spokesperson for the Fed and negotiates with Congress and the President • Sets the agenda for meetings • Speaks and votes first about monetary policy • Supervises prof • Is it wise to have one person with this much power?