History of the Federal Reserve

The Federal Reserve has been in existence for over 110 years. While most Americans probably don’t know much about it, most have at least heard of it. People assume it has to exist because it has existed for their entire lives. So what exactly is the Federal Reserve, and what is its purpose? The Federal Reserve, also known as The Fed, is the United States’ central bank and is easily the most powerful in the world. The Federal Reserve is made up of three key entities: the Federal Reserve Board of Governors, a Federal agency in Washington, D.C.; 12 Federal Reserve Banks, spread across the nation; and 12 voting members from around the system who serve on the Federal Open Market Committee.

According to the Fed, it has five functions. First, and probably the most well-known, they set the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy. Secondly, they promote the stability of the financial system and minimize systemic risk. Next, it regulates banking institutions. It provides financial services to the U.S government. Lastly, it monitors and protects consumers’ credit rights. Another key element of the Federal Reserve Act is that it is to act as the lender of last resort. And when the lender of last resort actions fail, we get bailouts.[8]

Anyone familiar with the American economy over the last 100 years knows that the Fed has not been very successful in its purpose. So, how did we get to this point in our nation? Why is the Federal Reserve the most powerful central bank in the world? And why does the US have a central bank? To answer that, we will discuss the history of banking in the United States and the factors that led to the Federal Reserve Act of 1913.[2]

Early History of Banking in the United States

The Revolutionary War and the Bank of North America

To understand why we have a Federal Reserve in this country, we first must go back in history and understand our banking system. Going back to the Revolutionary War against Great Britain, the Continental Congress needed to find a way to finance the war. The Continental Congress turned to paper money. The person behind this drive was Gouvernor Morris. From 1775 on, they printed more and more fiat money. Before the war, the money supply was estimated to be $12 million. Then, from 1775 to 1779, Congress drastically increased the money supply. In five years, they added $225 million to the pre-existing $12 million. The result was rapid price inflation in terms of paper notes, and a corollary, accelerating depreciation of the paper in terms of species. And by 1781, the Continental paper currency, known as a Continental, became virtually worthless. The collapse of the currency led to the saying “not worth a Continental,” referring to the currency’s worthlessness.[2][9]

In 1781, the Continental Congress appointed Robert Morris to head the Finances. And by the Spring of 1781, Morris introduced a bill to create the first central bank in the history of the newly formed Republic. This new bank, the Bank of North America, would be the first fractional reserve commercial bank in the United States. It would be a privately owned central bank, modeled after the Bank of England. The money was to be grounded upon specie, but with a controlled monetary inflation, pyramiding an expansion of money and credit upon a reserve of specie. The Bank of North America opened its doors in 1782. It received the privilege of its notes being receivable in all duties and taxes to all governments, at par with specie. Additionally, no other banks were permitted to operate in the country.

The Bank of North America had a monopoly on issuing paper currency, and in return, it lent most of the money to the Federal Government to purchase public debt. The taxpayers would be on the hook for this. Soon after it began operations, the bank’s notes quickly became inflated in value relative to specie. The market’s lack of confidence in these bank notes led to their depreciation outside of Philadelphia, their home base. With Robert Morris’ power and influence slipping, he moved the Bank of North America from a central bank to a Pennsylvania state-chartered commercial bank. By the end of 1783, all the federal government’s stock in the bank, 5/8 of its capital, had been sold into private hands, and all the federal government’s debt to the Bank had been repaid. Thus ended the first experiment with a central bank in the United States.[2][1]

Thomas Jefferson vs Alexander Hamilton

Fast forward a few years, in 1789, the United States Constitution was ratified, establishing a more powerful central government than had existed under the Articles of Confederation. President Washington would be inaugurated that year. He would pick two cabinet members who would basically define the political party structure for the next 250 years.

Enter Alexander Hamilton, a young, intelligent, and ambitious gentleman with a particular vision for America. He wanted the United States to have a strong central government, similar to Great Britain, ruled by an aristocratic class. He would champion a central bank and believed that National debt was good to establish credit. Washington would appoint him as the Secretary of the Treasury. On the other side, we have Thomas Jefferson. Jefferson was extremely intelligent, more subtle than Hamilton, but also ambitious in his vision for the newly formed Republic. He envisioned the United States as an agrarian society with decentralized power, putting power in the hands of the common man. He was strongly opposed to central banks because he felt they favored merchants while working against farmers. Washington would appoint him as the Secretary of State.

Jefferson and Hamilton would clash on multiple issues, but economics was a major point of contention between them. Hamilton and his proponents would mold into the Federalist Party, while Jefferson and his allies would form the Democratic-Republican Party. Alexander Hamilton was a disciple of Robert Morris. In December of 1790, Hamilton submitted a report to Congress outlining his proposal for a National Bank. He used the Bank of England as the basis for his plan. Hamilton believed that a national bank could issue paper money, provide a safe place for public funds, act as the government’s fiscal agent, and collect tax revenue and pay government debt. Jefferson strongly disagreed. He believed that a National Bank would favor the financiers and merchants, who tended to be creditors. In contrast, farmers and plantation owners, who tended to be debtors, would be unfairly treated. He also thought that a national bank would undermine state banks by creating a financial monopoly.[2][5][10]

The Bank Bill passed Congress in February of 1791. Now all that was needed was for President Washington to sign the bill into law. Jefferson strongly urged President Washington to veto the bill. He wrote an opinion on the matter called “Opinion on the Constitutionality of the Bill for Establishing a National Bank, 15 February 1791.” Washington considered Jefferson’s opinion, and he gave Hamilton one week to rebut Jefferson. Hamilton, in response, wrote a lengthy 15,000-word opinion against Jefferson’s. Jefferson argued that the Constitution did not explicitly authorize the federal government to create a national bank. The phrase Jefferson focused on is “to make all laws necessary and proper for carrying into execution the enumerated powers.” While a national bank might make collecting taxes and other matters more convenient, convenience does not equate to necessity.