Section 1: Early History of Central Banking
Early on, Alexander Hamilton was a huge proponent of establishing a central bank and ultimately won that argument with the First Bank of the United States, although it wasn't called the First Bank at the time. The Bank of the United States was actually opposed by Jefferson, who thought that Congress had no authority to establish a central bank or mess around in the banking sector.
Now the First Bank of the United States did more than the Federal Reserve does. It was in many ways much more of a commercial bank than a purely central bank. But the arguments weren't wildly different at the time. The First Bank was established to help finance government after the Revolutionary War and as the economy was getting going.
Hamilton was really big on the idea that you really needed a sophisticated financial market to really get an economy functioning in a sophisticated way. That's been borne out academically. But if you look in academic literature, there's a striking relationship between developed financial markets and developed economies, [and] that it's very difficult to get a really developed industrial economy going without a pretty sophisticated financial sector.
So, in that sense, Hamilton was right, but that doesn't mean that Jefferson was wrong in saying that it couldn't have happened outside of establishing the First Bank of the U.S. So, I mean, that's just a debate that's going to be carried on forever. It is true that most or all developed economies have central banks and a lot of undeveloped economies have central banks. But it is something that we've struggled with since kind of the beginning of time.
The First Bank died in 1811, when its charter wasn't renewed. There was a deep suspicion of kind of concentrated financial power, so that killed off the First Bank. The problem was the next year we had the War of 1812, and again there were a lot of financial problems for the government, and so by 1860, we got the Second Bank of the United States to mitigate the difficulties of being able to pay for the war and the kind of aftermath of it.
That charter was not renewed after its 20 years expired, and we went to what was known as the period of free banking. The free banking era was kind of interesting because it was really up to the states to determine what went on, and different states did different things. A lot of state banks issued their own currencies. A lot of these currencies were counterfeited rather profusely so there was actually, at one point, I think in the mid-1800s, about a third of the currency in circulation was fake. That's a big problem.
There was a big problem in that it was not necessarily the case that checks or even bills would necessarily clear at par. So if you had a check for a dollar, when you went to cash it in, you may get something less than that. Those were big issues that kind of go back to the kind of core of the central bank to be the kind of coordinated and unified, organized banking system that facilitates transactions in a relatively smooth way.
In 1863, we got the National Banking Act. We established the dollar as the nation's currency in a unified way, put a heavy tax on state banknotes that pretty much drove them out of business.
Section 2: Panic of 1907
It was really the Panic of 1907 and the subsequent crisis in 1908 that led to overcoming the political reticence to a central bank. We'd had a number of these crises on a fairly regular basis since the end of the Civil War. And the financial panic in the fall of '07 and the really terrible fallout from it in 1908 led to a number of proposals that ultimately ended up in establishing the Federal Reserve in 1913.
In the Panic of 1907, we observed a lot of things that are directly comparable to what goes on in the central bank, in the Federal Reserve today. There were institutions in the banking world called clearinghouses, and the idea was that you have these banks and they're all independent—there isn't a central bank to organize clearing financial transactions. But the fact is that when checks are written, most are written on either your own bank or another local bank.
So cities formed these associations called clearinghouses, and the idea was that you'd get together every day, and you'd bring your checks together. It's not very efficient to clear one check at a time. What you really want to do is kind of add up all the checks that are drawn on one bank and another bank, and kind of net out the difference and have them settle up in a net basis at the end of the day.
That was the purpose of the clearinghouse was to clear checks. You can do it on a net basis and it's pretty efficient if you're organized about this. Now, the trick was, to clearinghouses, that in any one day, it could be that lots of money is drawn from one bank and not another, and you know that this is going to balance itself out over time. But it just might happen that one big check is written off of one account and has to be paid to another.
So, clearinghouses would frequently lend to one another on a very short-term basis, because you didn't want to bankrupt the bank that had an enormous check today, because tomorrow the check is going to be in the opposite direction. If you're a solvent institution, the idea of kind of, well, let's just do some short-term lending here across banks just to facilitate the transaction, and we really don't want to disrupt the overall economy just because of this one blip today—there was a lot of lending that went back and forth.
The problem with that, though, is that you have to make sure that the bank is actually solvent. It may be that the reason that they can't honor the check today is because they really are broke, and you don't want to lend to those guys. So, the clearinghouse established a process for examining one another's books in kind of a nonthreatening way.
During the Panic of 1907, the clearinghouse banks came out of it, particularly in New York, fairly well, where JP Morgan personally stepped in and did an awful lot of lending to various member institutions acting as a lender of last resort. He personally did this. You can map that directly into what the Federal Reserve does now, that we clear checks. That used to be a much bigger deal than it is now, but the process still occurs here.
We examine banks, not just for solvency, but also for safety and soundness, kind of going into the deeper issue of trying to promote financial stability. And we lend. We lend at the discount window and in times of serious financial panic, and can take extraordinary lending actions so that we're not dependent on one very wealthy, goodhearted person stepping up and saving the financial system. All of that is directly mappable into the kind of best outcomes that occurred during the panic of '07, '08.
Again, a lot of that also is reflected in what was going on in central banks in Europe that avoided a lot of these problems with kind of the same institutional arrangements, but that were already in the form of a central bank. So the Panic of '07 and the clearinghouses and kind of the actions of JP Morgan gave a pretty good signal of the efficacy of the central banking model as we'd seen it in some other countries.
Section 3: Creation of the Federal Reserve System
The way the Fed was set up was really a means of addressing the concerns of the United States. The U.S. central bank is different than a lot of others in that we are a federal system and not a concentrated individual entity. We have 12 Federal Reserve Banks scattered across the United States, with the Board of Governors as a coordinating agency.
But the idea was specifically that financial power should not be concentrated in either D.C. or New York, that the rest of the nation mattered a lot, and that concentrating financial power in the hands of very few bankers was not a politically appealing idea. So we established this federal system of banks that were the central bank as a means of kind of compromising between the needs of a central bank that could intervene in times of financial distress and kind of stop the panics, and the needs to avoid concentrated financial power.
The Federal Reserve was actually capitalized by the banks that were members. This was kind of always the case. Even in the Second Bank of the U.S., the capital came from the private sector.
We are independent and self-funded, but with a government structure that is really accountable to the Congress and the Senate through the Board of Governors, but not funded by Congress or the Executive Branch.
That was deliberate in its intent in terms of keeping us kind of at arm's length. The issue of independence in monetary policy is critical. We were charged and have been charged in a legal way by Congress with promoting price stability and maintaining maximum sustainable employment. I think this is a clear reflection of the nature of the founding of the Fed. Of course you need the central bank to be concerned about price stability—that's a basic tenant of central banking—but at the same time, providing stability in the macroeconomy with the objective of maximum sustainable employment is critical for giving a mandate to the central bank being able to act when financial crises erupt.
Section 4: The Federal Reserve and the Great Depression
During the Great Depression, as Chairman Bernanke has pointed out, there were really two mistakes—I kind of think of it as one: being overly tight monetary policy—but it really did break down into kind of two phases where, as the recovery started to begin, a lot of people saw kind of the need to tighten policy in response to potential problems and prices. The economy was doing somewhat better then. The equity markets were booming.
So there was a willingness to tighten policy. Then, in the mid-thirties, when the banking panics began again, we didn't step up as lender of last resort to provide the liquidity that may have—you never know in the counterfactual world—but that may have really stemmed a lot of the panic, and consequently shortened the recession.
I think it's a fair characterization to say that the mistakes in monetary policy really led to the Great Depression being as long as it was. The initial collapse was pretty horrific. But then as recovery began again, policy missteps brought us back into a depressed state and really caused the extraordinary length of the Great Depression.
When the Federal Reserve was established, monetary policy was conducted pretty much exclusively by the 12 Federal Reserve Banks through discount windows. A big part of that objective was to eliminate seasonal fluctuations in interest rates. When the Fed was established, almost half of the nation was involved in farming, so you had this huge seasonality associated with borrowing, due to just the needs of agriculture. So there is still today a special provision for lending for banks for seasonal credit.
Taking that seasonality out of the credit markets was an important role of the Federal Reserve, and we did it, and we did it through lending in the various banks to various agricultural banks. But that was how monetary policy was conducted generally across the economy.
In the '30s, we had no Federal Open Market Committee. We were not doing open market operations, as is commonly taught now in money and banking. What we were doing was just increasing or decreasing the money supply through discount window lending.
In the '30s, it became apparent through actions in the New York Fed that we didn't have to wait for financial institutions to come to us wanting to borrow money. We could instead go to them offering to buy Treasury securities from them and achieve the same result in terms of increasing the money supply.
That is, who initiates the transaction isn't all that important. A bank would take a security to the Fed and borrow against it and receive money. Well, the Fed could take money to the financial institution and buy a security. That realization, that sort of invention of open market operations happened in the '30s, when not a lot of discount window borrowing was occurring. And some banks, particularly New York, thought that it would be a good idea to try and increase the money supply.
As a consequence of that, in 1935, the Federal Open Market Committee was established in the National Banking Act that coordinated these activities across all banks because it looked, and indeed was, an extremely powerful tool for the conduct of monetary policy. It no longer was up to the banks to kind of idiosyncratically come to the Federal Reserve and use that as a means of using the lending rate as a means to try to induce banks to borrow. But we could actively go out and inject reserves by initiating the transactions ourselves. Hence, the Federal Open Market Committee was born.