AFTER full use of the presidential influence to get the
legislation adopted, President Woodrow Wilson signed the act
establishing the Federal Reserve System, on December 23, 1913. The
Reserve Banks opened their doors for business on November 16, 1914.
Why? What was the origin of this new System? How does
it work? What are its good points, if any, and what are its dangers?
Trade cycles had been an unhappy experience in the
United States as well as in Western Europe. The panic of 1907 and the
subsequent lethargy of business and finance had increased the widespread
clamor for banking and currency reform. "We need a more flexible
currency," the advocates of a reorganization of the American banking
system asserted; "a currency that can be made to expand or contract in
accordance with the needs of business." This flexibility was to
eliminate the recurring periods of financial stress and disorder.
The "reformers" pointed approvingly at the currency
systems in Western Europe. There was, for example, the Bank of England.
It enjoyed a partial monopoly of note issue, and served the government
as banker and as agent. All other banks kept accounts with the Bank of
England because its currency notes commanded the greatest confidence and
widest circulation. At the end of each clearing period, the claims of
all other banks were settled through transfers among their respective
deposits with the Bank of England. It was the "lender of last resort."
In times of financial crisis it was expected to stay liquid, and to
grant accommodation to the most essential credit needs. It had done so
during the crises of 1873 and of 1890. And in 1907 it had allayed alarm
in England by merely increasing its discount rate.
There also was the Reichsbank of Germany. It, too,
conducted a discount policy for the protection of general banking
liquidity. But the Reichsbank differed from the Bank of England in one
important respect, which had great appeal for the planners in the United
States. This was the "elasticity" in its note circulation. So our
central banking institution was fashioned, in general, after the
Reichsbank.
While the Bank of England always held a full gold
reserve f or its notes issued, the Federal Reserve System was required
to maintain a gold reserve of only forty per cent against its issue
notes; sixty per cent could be held in trade and agricultural paper
discounted by member banks. And the Reserve Banks had to keep on hand,
in "lawful money," only thirty-five per cent of all their deposits. In
an emergency the full reserve requirements could be suspended for thirty
days, with renewals of suspension for further periods of fifteen days
each -but at a penalty of a graduated tax on the deficiency in reserves.
All these features were to give the new bank flexibility and elasticity.
Economic control over the new System was given to seven
governors who are appointed by the President and approved by the U.S.
Senate. Of course, ultimate control lies in the hands of the President
who makes the appointments. In all important policy matters pertaining
to American money and credit, his decision prevails.
In this age of radical interventionism and socialism, a
sharp distinction must always be made between economic control that is
decisive, and legal ownership that is empty and meaningless. The 1913
Congress that created the Federal Reserve System gave control to the
President acting through his seven governors, but rested the legal
ownership with the commercial banks that were to join the System. The
member banks thus could be made to finance the System through the forced
sale to them of "stock" that lacked any right of control. After all, the
new System was to afford support and stability to commercial banks. Why
shouldn't they be made to finance such benefits? At least, this was the
rationale of government in 1913.
If the legal ownership of the System should ever be
placed with the Federal government -which the U.S. Congress, the creator
of the System, may legislate at will -the meaning and substance of the
System will remain unaltered.
The Federal Reserve was to accommodate its member banks
with emergency reserves and credits. After 50 years of rapid growth of
government it now holds complete powers over our money and banking. It
works with three important instruments to suit whatever its purposes may
be at any given time. In the beginning it had or at least used -only
one. This was the rediscount instrument.
Rediscount Rate
Promissory notes, drafts, and bills of exchange,
growing out of actual commercial transactions and with a maturity not to
exceed ninety days, accepted by the commercial banks and then
rediscounted with the Federal Reserve - this constituted, by law, the
base and the boundary for the money the Federal Reserve could create.
Thus a direct causal connection was to be established between the money
supply and the demand for money. Since the total of commodity bills
rediscounted was supposed to be determined by the intensity of economic
life, basing the money supply on that total was supposed to bring about
a perfect adjustment of this supply to the fluctuating "needs of
business." This arrangement was to make money "neutral," smoothly
rendering the vital service of a medium of exchange without itself
affecting prices.
Of course, it did no such thing. The volume of "paper"
thus offered the Federal Reserve for rediscount - and hence the amount
of currency and credit it could feed into the economy -was determined
primarily by the rediscount rate which the Federal Reserve itself
established and could change at will. As so often happens, the planners
had put the cart before the horse.
Also, by 1935, the boundaries in this channel of
operations had been materially widened. The paper presented to the
Federal Reserve for advances to its member banks no longer had to arise
out of commercial transactions. It could even be government securities.
If the notes, drafts, or bills of exchange had been drawn "for
agricultural purposes," they could now have a maturity of nine months
instead of three. Not only banks, but individuals, partnerships, and
corporations also had been given access to the discounting facilities of
the System. Finally, in 1942, the Federal government was authorized to
borrow up to five billion dollars directly from the Federal Reserve. And
every loan the Federal Reserve System made to any borrower, for any
purpose, under these relaxed conditions, allowed it to issue that much
more currency, or credit in the form of a bookkeeping entry subject to
the check of the borrower.
Open-Market Operations
The second tool of the Federal Reserve System is its
authorization to buy or sell certain securities in the open market. The
original Act granted it this power to buy and sell obligations of the
United States, and of any state, county, district, political
subdivision, or municipality in the United States.
By the 1920's it was recognized that these open-market
transactions by the Reserve Banks offered an important method of central
credit control. So a concentration of this power into the hands of one
regulatory body was advocated. Legislation enacted in 1933 decreed that
no Federal Reserve Bank should engage in open-market operations except
in accordance with regulations adopted by the Federal Reserve Board. To
improve and formalize this centralization, the Open Market Committee was
organized. And in 1935 an amendment to the 1933 Act finally provided
that "no Federal Reserve Bank shall engage or decline to engage in
open-market operations ... except in accordance with the direction of,
and regulations adopted by, the Committee.
With this tool in familiar use, the Federal Reserve
System no longer had to wait for member banks to ask for discounts and
advances, at whatever rate it might have set, in order to affect the
money supply. It could do so directly, on its own initiative, by buying
or selling securities to make the money and capital markets more liquid
or more tight, as it might wish. In payment for securities the Federal
Reserve merely draws, on itself, a check which constitutes newly created
money. Then, as this check is deposited by the recipient in his bank,
and redeposited by that bank, it winds up as an addition to the reserve
account of some bank with the Federal Reserve.
Open-market operations of the Federal Reserve may deal
in long term securities. Thus they may affect, directly and immediately,
long-term interest rates and yields. They are, therefore, a quite
comprehensive instrumentality of control. For this reason such
operations have high prestige and preference in the plans of the money
managers.
Reserve Requirements
The third and perhaps most powerful instrument of
credit control in the hands of the Federal Reserve System is its
authority to change the reserve requirements of its member banks. Both
the rediscount process and the open market transactions either increase
or decrease member bank reserves, and hence the amount of credit which
these banks can make available. But changing the percentage of its
deposits which a bank must keep as a reserve is an even more drastic
form of influence over the money and credit supply.
Suppose a bank has one million dollars of demand
deposits. If the reserve requirement is ten per cent, it must keep one
hundred thousand dollars in its Reserve Bank. It may loan out or invest
the rest. But if the reserve requirement should now be lowered, let us
say, to five per cent, our bank would need only fifty thousand dollars
as a reserve against its demand deposits. It can now lend or invest the
remaining $50,000.
If this were the only effect, only $50,000 of
additional money would enter the economy. In reality, however, this is
merely the beginning of a chain of money creation. Let's assume that our
bank decides to hold the reserves thus set free as "excess reserves." It
may then extend more credit to its customers. Of course, it would have
to proceed very slowly lest it lose its reserves to other banks or
customers demanding cash. It cannot proceed any faster than other banks
that also are expanding their credits on the basis of their newly won
excess reserves.
This is an oversimplification, of course. But the
impact on the capital and money markets of changes in reserve
requirements is extremely potent. It is estimated that at present a
fluctuation of only one per cent tends to increase or decrease the total
volume of bank credit by more than six billion dollars. This authority
to vary reserve requirements was given to the Federal Reserve System in
1933, as a special emergency power. Since 1935 it has been a permanent
instrument of credit control.
A Most Important Tool in the Armory of Intervention
An appraisal of the good points and bad points of the
Federal Reserve System depends on the political and economic philosophy
of the appraiser. If he favors government control over our economy he
will regard the Federal Reserve most favorably, for it holds absolute
power over the people's money and credit.
If one is convinced of the beneficial nature of an
enterprise economy, he will unconditionally reject the Federal Reserve
System. He will condemn it as the controlling body of an important
industry. He will blame it for having shattered the American dollar; for
having caused booms, busts, recessions, and depressions; and for having
made the fifty-six years of its existence a period of unprecedented
economic instability.
In the opinion of this writer, this instability has
fostered the growth of ideologies that are hostile to individual
liberty. The Federal Reserve, through its policies of "boom and bust,"
helped to usher in the New Deal. And it now acts as midwife to ever more
extensive government controls.
Since it began operating in 1914, the Federal Reserve
System has put some $55 billion in circulation, has extended some $65
billion in credit, and thereby has depreciated the dollar by almost
three-fourths. And it continues to inflate the money supply at an
accelerating rate.
First, the economic planners in Washington clamor for
an expansion of the volume of money and credit, in order to bring about
or sustain - a boom, prosperity, and full employment. They rejoice over
wage boosts, but dislike the parallel price rises and the hardships
wrought upon those with fixed incomes. They approve of additional
housing construction, but disapprove of higher prices for houses. They
like one set of inflationary effects, but decry the inevitable twin set.
And the economic planners are always most anxious indeed to do something
about these undesired effects. In order to "fight" inflation, they want
to curb economic actions with credit controls, price controls, wage
controls, and all kinds of other government controls over our economic
lives. They want socialism. In my opinion, an acceleration of the
present long range credit expansion will lead us rapidly into the
controlled economy they desire.
Under these conditions, the Federal Reserve System is
the most important tool in the armory of economic interventionism. In
the Governors' own words, it is the system's objective "to help
counteract inflationary and deflationary movements, and to share in
creating conditions favorable to sustain high employment, stable values,
growth of the country, and a rising level of consumption." This is plain
interventionism, with all of the planner's usual assumption of
benevolent omniscience. An institution which was established as a
cooperative undertaking by the banks of the country to pool their
resources has developed into the right hand of the government in
promoting its "New Deal" and "Fair Deal" objectives. The beautiful
fallacies of socialist "central planning" are being substituted for the
hard, but lasting and productive, truths of a free market. And the
Federal Reserve System supplies the magician's cloth under which the
substitution is made.
Its part in the colossal metamorphosis of our country
is not limited to the maintenance of cheap money, in order to prolong or
create a boom. It also provides the government itself with the money the
planners think they should have, beyond the amount they dare take
directly in taxes.
The Federal Reserve System facilitates the government's
own inflationary financing "in periods of emergency." It makes easy the
inflationary financing of budget deficits and the inflationary refunding
of government loans. It stabilizes the government bond market through
inflationary methods and manipulates this market to the advantage of the
government. It does all of this by wrecking the purchasing power of the
dollar; by subtly stealing from the people of this country what it thus
provides for the government, through a process similar to the
coin-clipping of ancient kings but much more diabolical because so much
less visible.
Emergency Banking Laws
No matter how grave our indictment for past and present
evils, we must anticipate an even more ominous role of the System in the
future, For periods of national emergency, all administrations since
that of Eisenhower have issued emergency banking regulations that grant
extraordinary powers to the Federal Reserve System. Although these may
differ in detail, in substance they are much alike.
For instance, let us look at Emergency Banking
Regulation No. 1, issued on January 10, 1961. It is probably the most
radical order that ever emanated from an American government. Yet, few
voices of protest are heard, for few would dare oppose government
preparations for a national emergency.
Emergency Banking Regulation No. I is just one of a
number of emergency measures that would impose government control over
rentals, prices, salaries and wages, and introduce rationing. The
Regulation orders the instant seizure of most bank deposits "in the
event of an attack on the United States." The Regulation is based on The
Trading with the Enemy Act of October 6, 1917, and covers all banking
institutions, including every commercial bank, trust company, private
bank, savings bank, mutual savings bank, savings and loan association,
building and loan association, cooperative bank, homestead association,
credit union, and United States postal savings office.
Section 2 of Chapter V is most shocking in its wanton
denial of individual freedom and private property, Lest we be suspected
of misinterpretation, we quote:
"(a) No depositor or share or savings account owner may
transfer in any manner or by any device whatsoever any balance to his
credit on the date on which this Regulation becomes effective, except
for the payment of (i) expenses or reconstruction costs vital to the war
effort, (ii) essential living costs, (iii) taxes, (iv) payrolls, or (v)
obligations incurred before the date on which this Regulation becomes
effective, to the end that the best interest of the war effort and the
public will be served.
(b) Banking institutions shall prohibit the transfer of
credit in any case where there is reason to believe that such transfer
is sought for any unauthorized purpose.
(c) After this Regulation becomes effective, banking
institutions shall retain until released by Federal authority the
original or a photographic copy (face and reverse sides) of each check
and other evidence of transfer of credit in the amount of $1,000 or
more."
In short, your money in the bank is blocked unless you
propose to spend it toward the war effort, i.e., buy U.S. Treasury
obligations or finance expenditures deemed "vital" by the government.
You may withdraw your money for living expenses, but only sums deemed
"essential." You may pay taxes and wages, and discharge old obligations.
But any other use of your money is prohibited. Let us assume that you
were saving for another car, new furniture, or a house, or for your
children's college education. As such objectives can hardly be called
"essential," neither for the war effort nor individual living, your
money could be blocked.
The Emergency Regulation would permit business to pay
taxes and wages, but deny all other expenses of doing business. After
all, manufacturers need materials, tools, and equipment in order to
produce goods and services. Merchants need ever new supplies of
merchandise in order to stay in business. Even professional people, such
as doctors and dentists, have expenses other than taxes and wages. This
is why the Regulation would halt all economic activity but that of
government. In fact, no enemy attack no matter how devastating to human
life and property could conceivably have a more disruptive effect than
the Emergency Banking Regulation.
Chapter VI, Section 1, of the Regulation would
radically change the very nature of banking.
"No banking institution may make any loan, extend any
credit, or discount or purchase any obligation or evidence of debt,
unless it is established and certified in writing by the borrower and a
banking institution that the purpose is to pay (i) expenses or
reconstruction costs vital to the war effort, (ii) essential living
costs, (iii) taxes, or (iv) payrolls, to the end that the best interests
of the war effort and the public will be served."
It is ironic that the stated purpose of the Regulation
is "continuance of operations and functions" of all banking
institutions. Indeed, banks would be required to "remain open and
continue their operations and functions." (Chapter IV, Section 1). In
reality, the stated purpose should read "cessation of all banking
operations and assumption of the exclusive function of government
finance." After all, what is banking? It is negotiating credit between
lenders and borrowers, and maintaining cash balances for the convenience
of depositors. It is obvious that banking ceases to exist if credit can
no longer be negotiated and cash no longer be paid upon demand by the
depositors. The Emergency Regulation would make all financial
institutions agencies of the U.S. Treasury, with the Federal Reserve
System as a subtreasury that polices the banking system.
At the time of the original publication, Dr. Sennholz
headed the Department of Economics at Grove City College and is a
noted writer and lecturer on monetary and economic principles and
practices.
Reprinted with permission from The Freeman, a
publication of The Foundation for Economic Education, Inc., April,
1972, Vol. 22, No. 4.
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