Creation of the Federal Reserve System

2. Creation of the Federal Reserve System Bank of the United States created in 1791 with a 20-year charter as a central bank. Local banks resented Bank’s supervision. It ceased operations in 1811. In 1816, Congress established the Second Bank of the United States. Its charter expired in 1836 due to the same controversies as the First Bank. Federal Reserve Act of 1913 created Fed (originally to control amount of currency outstanding & volume of discount loans to member banks as lender-of-last-resort). Over time Fed has expanded its role in fin system (after severe nationwide fin panics in late 1800’s raised fears that US fin system was unstable without a central bank). Fed’s Econ power divided: 1. Among states & regions 2. Among bankers & business interests 3. Between government & private sector Four groups within the system were empowered to perform separate duties: 1. The Federal Reserve Banks 2. Private commercial member banks 3. The Board of Governors 4. The Federal Open Market Committee (FOMC) All national banks (federally chartered) required to join the system. State banks (state chartered) were given the option to join.

3. Federal Reserve Bank is a district bank of the Federal Reserve system that, among other activities, conducts discount lending. Originally district banks intended to have much more independence than today. Reserve Bank Organizing Committee tasked with district boundaries. Agreement about six cities: Boston, Chicago, NY, Philadelphia, St. Louis & SF. Others based on econ study not political power. Now odd that St. Louis & Kansas City are in Missouri but it made econ sense in 1914.

4. District Banks Banks joining Fed required to buy stock in their District Bank. So member banks own District Bank & receive fixed 6% dividend on stock they own in District Bank. To prevent a constituency exploiting central bank’s power at expense of another, Congress restricted composition of boards of directors of District Banks to represent: 1. Member banks elect three bankers - Class A directors 2. Member banks elect three business leaders (ind, commerce & agro) - Class B 3. Fed’s Board of Governors appoints three public interest directors - Class C. Functions of District Banks: Manage check clearing in payments system Manage currency in circulation by issuing new (withdrawing damaged) Fed notes Making & administering discount loans to banks within the district Supervise & regulate state member banks and evaluating merger applications Collect & publish data on business activities, & articles on monetary & banking topics Serve on FOMC, Fed’s chief monetary policy body Monetary policy directly (discount loans) & indirectly (membership on Fed committees) In recent decades, discount rate set by the Board of Governors, not District Banks Influence policy through representatives on FOMC & Federal Advisory Council

5. Member Banks Currently only ≈ 16% of state banks & ≈ 1/3 of all banks are members of Fed. State banks see membership as costly & to avoid Fed’s reserve requirements. The opportunity cost of Fed’s membership ↑ in 1960s & 1970s as nominal % ↑, fewer state banks elected to become or remain members. Fed argued that declining membership eroded its ability to control money supply & urged Congress to compel all commercial banks to join Fed. Congress has not legislated such a requirement, but DIDMCA of 1980 required that all banks maintain reserve deposits with the Fed on the same terms. How Costly Are Reserve Requirements to Banks? Suppose PNC pays 1% interest on checking accounts, w/ 10% reserve requirement. Assume Fed pays PNC 0.25% interest on its reserves & PNC earn 5% on its loans. How reserve requirements affect PNC’s earnings on $1,000 in checking account? With 10% reserve requirement PNC holds $100 in reserves earning 0.25% instead of 5%. So reserve requirement reduces PNC’s return by $4.75. Is opportunity cost of reserve requirements higher during a recession or expansion? The higher interest banks earn on loans, the higher opportunity cost of holding reserves. Rates tend to ↓/ ↑ during recessions/ expansions. So, opportunity cost of reserve requirements is likely higher during expansions.

6. Board of Governors 7-member (professional economists from business, government & academia) POTUS appointed, Senate confirmed, for 14-year nonrenewable staggered terms (same POTUS cannot appoint a full Board) headquartered in DC. The Board of Governors: Runs monetary policy (sets reserve requirements & discount rate on bank loans) Influences the setting of guidelines for open market operations Informally influences national and international economic policy decisions Advises the president and testifies before Congress on economic matters Responsible for some fin regulation, e.g. margin requirements, setting permissible activities for bank holding companies Exercises administrative controls over individual Federal Reserve banks

7. The Federal Open Market Committee (FOMC) 12-member (7-member Board of Governors, NY Fed president, presidents of 4/11 other Feds - on a rotating basis, other 7 presidents attend & discuss but do not vote) directing open market operations, meets in DC, eight times each year. Prior to each meeting, FOMC members access data from: 1. Green Book: national economic forecast for the next two years 2. Blue Book: projections for monetary aggregates 3. Beige Book: summaries of economic conditions in each district. FOMC sets target for federal funds rate by trading Treasuries (through NY Fed’s trading desk) with primary dealers (private fin firms) to adjust bank reserves. Sunshine Act of 1976 requires federal government agencies to announce meetings. If > 4 members of Board of Governors meet to consider policy action, it cannot be held without prior public notice. The unintended consequence of the Sunshine Act was to drastically limit input of members of Board to monetary policymaking. Since Bernanke could not meet with > 3 he relied on an informal group of advisers (two Board of Governors members & NY Fed’s president). The “four musketeers” were the key policymaking body at the Fed during 2007-09 crisis. As normal econ conditions return, the FOMC will likely resume its importance

8. Power and Authority within the Fed During 1st 20 years decentralized District Banks inadequately respond to econ & fin disturbances. The Banking Acts of 1933 & 1935 centralized Board of Governors’ control, giving it a majority of seats (7/12) on the FOMC. Secretary of Treasury & comptroller of currency removed from Board ↑ independence. Informal power structure is more concentrated, chairman is most powerful in Fed. Clear ownership/control distinction: Member banks owners but w/ no shareholders’ rights.

9. Changes to the Fed Under the Dodd-Frank Act Passed in 2010 to reform regulation of fin system. Provisions that affect Fed: Member of new Financial Stability Oversight Council, prevent failure of large fin firms. One member of Board of Governors will coordinate the Fed’s regulatory actions. Government Accountability Office to audit Fed’s emergency lending programs. Class A directors no longer participate in elections of bank presidents. Fed ordered to disclose fin institutions to which it lends & trades securities. New Consumer Financial Protection Bureau at Fed protect consumers from fin firms.

10. How Fed Operates Fed designed to operate largely independently of external pressures. For: Monetary policy too important & technical for politicians concerned with short-run benefits (reelections) disregarding long-term costs & Control of Fed by politicians ↑ influence of political business cycle (Fed lowers % before election for favor with POTUS running for reelection) on money supply. Against: In a democracy politicians (accountable to public) make public policy. If Fed controlled by politicians monetary & fiscal policies could be coordinated. Criticisms: failed to assist banks during contraction of early 1930s. Fed policies were too inflationary in the 1960s and 1970s. Fed ignored housing bubble & moved too slowly to contain effects of bubble burst. Fed is profitable organization (transferred to Treasury) doesn’t need $ from Congress. Earnings from interest on securities it holds, discount loans & fees, e.g. check-clearing. But not completely insulated from external pressure: POTUS can control membership & appoints chairman every four years. Congress can abolish it since Constitution doesn’t specifically mandate central bank (Federal Courts upheld FED as delegated by Congress to regulate the value of $) Greenspan earned reputation of “Fedspeak” ambiguous, vague & confusing language. Bernanke more transparency on monetary policy intentions (welcomed by economists for helping make better decisions, critics argue transparency impedes Fed’s respond to changes in econ & that Fed is providing more info than anyone can interpret).

11. Examples of Conflict between the Fed and the Treasury No formal control of monetary policy occasionally resulted in Fed v POTUS conflicts. Roosevelt ↑ control over Fed (hold Treasuries % low to finance WWII budget deficits). After WWII Treasury wanted to continue policy but Fed disagreed for fear of inflation. Treasury-Fed Accord of 1951 formally ended fixing Treasuries % => Fed independent. Reagan & Fed Chairman Volcker argued over fault for econ recession of early 1980s. Similar conflicts during Bush senior & Clinton, Treasury wanted lower short-run %. Over 07-09 fin crisis Fed & Treasury worked closely, questioning Fed’s independence. Early 2010 proposal that POTUS appoint District Banks’ presidents ↑ further concerns. Dodd-Frank Act did little to undermine Fed independence.

12. Factors That Motivate the Fed Public interest viewholds that officials act in the best interest of the public. Fed seeks econ goals in public interest (low inflation & unemployment, high growth). Economists argue over Fed’s effect on stability of prices & other econ indicators. Principal–agent view holds that officials max personal not public well-being. Fed acts to ↑ its power & independence subject to POTUS & Congress constraints. Fed convinced Congress to strip most of Dodd-Frank anti-independence provisions. According to principal–agent view Fed’s monetary policy could assist reelection of POTUS unlikely to limit its power, resulting in political business cycle. Evidence doesn’t support political business cycle in US but POTUS’ desires may subtly influence Fed. One study found high correlation between monetary policy changes & signals from POTUS that policy change is desired. Concluding Remarks There is no universal agreement on the merits of Fed independence. Debates focus on limiting, not eliminating Fed’s formal independence entirely. Debate over Dodd-Frank Act gave critics opportunity to propose changes to the existing laws, but relatively minor changes were passed by Congress in the end.

13. Central Bank Independence Outside the United States The degree of independence varies greatly from country to country. Fed board members serve longer (↑ independence), head shorter (↑ political control). Independent central bank can more freely focus on keeping inflation low & pursue goals w/o direct governmental &/or legislative interference. European Central Bank (ECB), in principle, extremely independent. Traditionally less independent but more so by late 1990s are Bank of England (sets % independently since 1997) & Bank of Japan (more inflation autonomy since 1998). Canadian government responsible for monetary policy but Bank of Canada generally controls it & has an inflation target as a goal. In most of industrialized world push for central bank independence to pursue low inflation increased in recent years. Many analysts believe that an independent central bank improves economy’s performance by lowering inflation without raising output or employment fluctuations. More independent central banks had lower average inflation during 1970s and 1980s. Central bank must be able to set goals for which it can be held accountable. The leading example is a target for inflation (Canada, Finland, New Zealand, Sweden, UK & ECB have official inflation targets, Fed has only informal inflation target).

14. European Central Bank (ECB) Charged with policy for 16 countries in European Monetary Union & use euro. Organization similar to Fed. Six members executive board work exclusively for ECB. Board members (serve nonrenewable 8-year terms) appointed by heads of state & government, after consulting European Parliament & ECB’s Governing Council. Governors of member national central banks serve a term of at least five years. Long terms for board members & governors designed to ↑ ECB political independence. In principle ECB highly independent, with clear mandate for price stability, but national central banks have considerable power in the ECB. During 2007-09 fin crisis countries argued over monetary policy. Greece, Spain & Ireland urged more expansionary policy, while Germany were reluctant to abandon inflation target. ECB & 2010 Sovereign Debt Crisis. 2007-09 fin crisis affected European Union countries forced to follow common policy. During crisis they suffered large budget deficits, financed by bonds (sovereign debt). Sovereign debt crisis when Portugal, Ireland, Greece & Spain debt was questioned. On May 10, 2010 ECB intervened by buying bonds. ECB President argued that it was necessary to ensure that affected governments are able to raise funds & to protect European banks’ solvency.