UNIT SEVEN READINGS
What is Money?
What do the following items have in common? Bronze knives, farm tools, cacao
beans, salt chunks, stone disks, fish hooks, beaver pelts, musket balls, nails and
cigarettes. Well the answer is that all of these items have been used as money! Money
you say oh wise one? Yes, money. Not money in the sense that you know it today but
Let’s think about what money really is:
Money: Anything accepted as payment for goods and services by most people in an
area at a given time.
Think about it, if most of the people in a region are willing to accept a certain item as
payment for goods and services then that item has a use as money. It is sort of like the
way cigarettes are portrayed as money in the movies. Now the reality is that these
types of money, informal money that has another basic use if you will, are not money
as you normally have thought of it. This type of money is called commodity money.
The origins of money can be traced back to ancient times. Then commodity money,
money that has an alternative use, was used. In the South Pacific and Africa, cowrie
shells were the common forms of currency while in New Guinea, it was dog teeth that
were used. At Santa Cruz, the feathers of hundreds of honey-eating birds were
attached to short sticks to make feather-stick money while in the Marshall Islands,
fishhooks were commonly used. In ancient China tea leaves were compressed into
"bricks" while the Russians used compressed cheese as their currency. Commodity
money was still present during the colonial age when many products such as
gunpowder, musket balls, corn, and hemp were commonly used.
In 1618 tobacco became the most famous type of colonial money because the
governor of colonial Virginia gave it a monetary value of three English shillings per
pound. However, fiat money, money by government decree, has come to replace
commodity money. In 1645 Connecticut established a monetary value for wampum, a
form of currency that the Narragansett made out of white conch and black mussel
shells. Because the Narragansett and the settlers used wampum in trade, certain shells
were made equal to 1 English penny. In the 1700's the Governor of the then territory
of Tennessee was paid a salary of 1000 deerskins a year! His secretary of state was
paid 500 raccoon skins. Quite a salary huh!
As time progressed, other forms of money were used. In some states, laws were
passed allowing citizens to print their own paper currency. Backed by gold and silver
deposits in banks, it served as currency for the immediate area. Some states passed
tax-anticipation notes that could be redeemed at the end of the year. The governments
printed the notes, which were used to pay salaries, buy supplies, and meet other
expenditures until taxes were received and the notes redeemed. The taxes though,
were collected in coins.
Paper money was really first seen around the time of the Revolution. In 1775 the
Continental Congress authorized the printing of Continental Currency which had no
gold or silver backing. By the end of the war nearly $250 million had been printed
Money as you know it today is not commodity money. Today most money is what we
call fiat money. Fiat money is money by government decree. Wampum was the first
fiat money used in the America's. It had a set value, equal to a certain amount of gold,
established by Connecticut in 1645. Since the government of Connecticut established
it as official money it is fiat money.
The concept of paper currency was not well regarded early on. Most Americans,
indeed most people world wide, felt that paper currency was risky since it had no
inherent value. As a result most fiat money was in the form of coins. This coined
money is known as specie. Specie was well regarded because it some metallic
content, either gold or silver. Due to scarcity this then had some inherent value of its
own. In fact paper currency was not even issued until 1775 when the Continental
Congress printed a very small amount of paper currency to pay its debts.
So, why do we use money at all? Well the reality is that the use of money is very
much tied to the Industrial Revolution. As the world grew increasingly modern
money became needed. Before money was used the world was primarily agricultural.
People living in traditional economies used barter as a means of exchanging goods
and services. Barter presented great difficulty in completing transactions and in fixing
value. With the Crusades and the corresponding growth of towns and villages and
increased trade money became a necessity. Industrialization would have been
impossible without money.
Money serves, therefore, three essential functions:
It is a Medium of Exchange - money is used so we can exchange goods and
services easily. In barter this is very difficult because transfer of large items
and perishable goods makes moving around a little tough.
It is a Measure of Value - money is used so we can assess fairly and
consistently the comparative worth of items. In barter this could not occur
because it is impossible to compare the value of different commodities
consistently. For example, trading two cows for a goat and a three legged dog.
Who’s to say what is worth more??
It is a Store of Value - money is used so that we can save our earning for a
later date in barter this cannot occur because often items might die or rot!
Money also has three essential characteristics.
Portability - Money is small and transportable. Imagine using certain types of
commodity money. What if Cows where accepted as commodity money. Can
you imagine walking around with a cow in your pocket??? A little difficult
Divisibility - Money can be broken down into smaller or larger units of
measure to make transactions easier. Can you imagine the cow scenario? Its
not like you can rip of a leg if the whole cow wasn't necessary as payment!
Durability - Money lasts. Specie lasts forever and even paper currency is
pretty durable. In class I ripped a twenty dollar bill in half once and then taped
it back together. It was still worth the same wasn't it? Imagine trying that with
a cow! Eventually even a dismembered cow would die, rot and stink. Not too
Stability of Value - Money, despite the influences of inflation and deflation
remains fairly stable in value. Money is not subjected to the natural forces of
weather as much early commodity was. In traditional economies when one
needed goods he would trade crops. If there was a drought, however, the value
of said crops would shoot way up. Since most money is in one way shape or
form tied to known gold reserves, it is stable in value.
Money in America
The advent of currency in America is very much tied to the industrial revolution
and the growth of trade. It was difficult to trade commodities for the reasons we
discussed yesterday. The problem with moving to currency, however, was that it
was a new system with few rules and those rules that existed were often vague
and untested. The new government needed to establish consistency so that the
economy would remain stable. These laws and changes were made over many
years. As the US moved to create a national currency there was still the question
of worth and stability. The bonds issued by the government to support the new
US Notes were ok but many still feared the solvency of the government could be
in jeopardy. Americans were still basically simple breed.
How was the use of the dollar originated?
In the late 1700's the Spanish had instituted the use of specie known as
pesos. The Spanish had long mined the silver in Mexico, melting and
creating bullion or ingots, The treasure ships stopped in the West Indies
and often fell prey to pirates who spent their stolen treasure in the
The Triangle Trade brought Pesos to America as well, Molasses to Rum
Pesos were known as pieces of eight because they were divided up into
parts of eight called bits. The pesos resembled Australian currency called
Talers, which the colonists had seen because Australia was also a colony
of England, the term became so popular that Franklin and Hamilton
decided to name the new currency Dollars,
The new Dollar was divided by units of 10, not 8, because it was easier.
How money was first issued in the colonies
The Constitution in Article 1, section 8 gives Congress the power to deal
Article 1 section 10 further states that no state shall have these powers
but it was basically understood at that time that the government could not
print paper money.
If the Federal Government could not print paper money, who could?
State Banks - Banks chartered by states. These banks printed paper
currency, mostly backed by gold or silver. Some banks abused this and
printed large amounts of currency to be spent in far away cities. These
wildcat banks presented a problem.
What did the federal government do at that time to regulate money?
Very little. The Bank of the United States, created by Alexander Hamilton
and then destroyed by Jackson, acted as a department of the treasury. It
had a federal charter and collected fees, taxes and made payments on
behalf of the federal government.
What problems arose as result of this lack of supervision?
By the civil war there were 1,600 different banks issuing over 10,000
different types of currency. Each bank was supposed to base their
currency on existing gold or silver reserves but this was often no the case.
As a result lists of "bad notes" were circulated and often a person went to
buy something and found they had bad currency. This meant that the
money they had was now essentially worthless.
When did the Federal government start printing currency?
When the Civil War began in 1861 the north needed currency so
Congress passed a law authorizing the printing of $60 million of demand
notes. These were declared legal tender even though they had no gold or
silver backing. In 1862 they printed another $150 million. These United
States Notes were known commonly as Greenbacks because they were
printed green on the front and back.
Why weren't people afraid the money would be worthless?
What did the government do to support the Greenback?
Created a National Banking System. Rigorously inspected banks were
chartered by the federal government. Each bank would issue national
currency or the US Notes. They were uniform in appearance and backed
by US Government Bonds.
State banks still existed and few could afford to buy the bonds and get a
In 1865 Congress passed a 10% tax on all privately issued currency. This
killed the state banks and left only greenbacks and national currency in
What did the government do to calm fears that US Notes weren't good?
It issued Gold Certificates (1863) printed in yellow. These became known
as Yellow backs. They were backed by gold reserves. They were originally
used by banks to settle differences but in 1882 the government printed
$20 bills for general use.
It issued Silver Certificates (1886) in part to support prices for silver
miners in the west. In 1878 the governments began buying huge silver
reserves and mint them into dollars. Later they kept the silver in reserve
and printed silver certificates (1886).
Treasury Coin Notes were printed from 1890 to 1913 and were
redeemable for gold and silver coin.
When did Congress start to back dollars with gold?
(1900) - This is known as the "Gold Standard" The government didn't
actually have all the gold for all the money in circulation but it was
acknowledged that all wouldn't redeem at one time.
Why was this done?
Support the currency and provide it with inherent value.
How much was a dollar worth in gold?
1/20.67 of an ounce
What are the advantages of being on the gold standard?
People feel more secure about their money.
Prevents the government from printing too much money and therefore
value remains high, this can also be a disadvantage.
What are the disadvantages if the gold standard?
Growing economy needs a growing money supply which requires growing
gold stocks. If these cannot be found then economic growth is stunted.
In event of financial crisis many may convert therefore depleting national
Why did the US go off the Gold Standard?
During the depression many began hoarding gold, banks began to fail and
people began to cash in their dollars for gold. In 1933, fearing the
government could not back the money supply a national emergency was
decreed and we officially went off the gold standard.
What happened to those that had gold?
Anyone with more than $100 of gold had to file a treasury form.
Citizens, Banks and businesses were required to hand over their gold and
gold certificates in exchange for Federal Reserve Notes and national
currency. Those who did not hand it in had their gold and certificates
What did it mean that we were no longer on the Gold Standard?
It meant we were on a inconvertible fiat money standard. The money
supply cannot be converted to gold or silver. It is fiat, decreed, money.
Since 1975 Americans have again been able to own gold.
The government now manages the value of money by regulating the
economy and the money supply.
What other types of currency exist today?
Silver Certificates - not redeemable
Money in America
When George Washington was sworn into office, one of his first obstacles was to
establish a new money supply. As one may recall, during the previous government,
the Articles of Confederation, many states printed their own currency, thus impeding
trade between colonies and separating the nation. The new Secretary of the Treasury,
Alexander Hamilton, was asked to design the new money, which he based on the
most plentiful coin in circulation, the Spanish peso.
Many years before the American Revolution, the Spanish were mining silver in
Mexico. They melted the silver into bullion or minted it into coins for shipment to
Spain. Oftentimes, the Spanish ships were stopped in the West Indies and were
victims of Caribbean pirates who spent their stolen money in America's southern
colonies. This led to the triangular trade where the colonies were importers of slaves
and exporters of rum. Nevertheless, the peso was considered the foundation for the
Pesos were known as pieces of eight, because they were divided into eight sub-parts
known as bits. They also resembled the Austrian taler so they were nicknamed talers,
which bore a resemblance to dollars. This term became so popular that Franklin and
Hamilton decided to make the dollar the basic monetary unit. Rather than divide the
dollar into eighths, they decided to divide it into tenths, which was easier to
In the 1780's there were only four banks in existence in the United States. Each bank
was allowed to issue its own money during the colonial period, and the Constitution
did not prohibit this practice. Therefore, banks began to grow.
By 1811 the country had approximately 100 banks, but only one was a state bank, a
bank that receives its charter to operate from a state government. That bank was the
Bank of the United States and was privately owned and operated. However, the Bank
of the United States was much larger than any of the state banks and had a federal
rather than a state charter. The Bank collected fees and made payments on behalf of
the federal government. State banks issued their own currency by printing their notes
at local printing shops. People who wanted loans borrowed these notes and paid them
back with interest. Because the federal government did not print money until after the
Civil War, most of the money supply was paper currency printed by these state banks.
While most of these state banks printed only the amount of currency that they could
back with their gold and silver, others overprinted their currencies. But even when
banks were honest, there were still problems with the currency. First, each bank
issued its own type of currency. Thus in times there were hundreds of different kinds
of notes in circulation in any given city. Secondly, because a bank could print more
money whenever it wanted, the temptation to overprint always existed.
During and after the Civil War, there was a shift in the types of currencies used in the
United States. When the Civil War began, the North needed to raise money to finance
the war. Congress tried to borrow money by selling bonds, but bond sales did not
raise enough money, so Congress decided to print money.
In 1861 Congress authorized the printing of $60 million of notes called demand notes
that were each signed by hand. Although these notes had no gold or silver backing,
they were declared legal tender. Because both sides of the notes were printed with
green ink to distinguish them from the state notes, the new notes were called
greenbacks. Greenbacks were of course used mostly in the North, but more money
was soon needed.
In 1862 Congress passed the Legal Tender Act, which gave the national government
the right to print $150 million of United States notes that had no gold or silver
backing. As the war progressed and the amount of greenbacks in circulation grew,
people began to fear that the currency might become worthless. They began to avoid
the greenback, and the government was forced to find another way to finance the war.
The National Currency Act of 1863, later amended and renamed the National
Banking Act, was enacted by Congress to establish a national banking system and a
uniform national currency. It created the National Banking System (NBS), which was
to consist of financially sound and rigorously inspected private banks. These banks
received their charters from the national government and were known as national
banks. The government hoped that this control over the banking system would restore
the public's confidence. Each bank would issue National Bank notes, which were to
be uniform in appearance, and backed by U.S. government bonds. If a group wanted
to establish a national bank, it had to first purchase government bonds as part of the
requirement to get the national charter. The bonds were then put on deposit with the
United States Treasury as backing against the currency. Initially, many of the state
chartered banks refused to join the system, claiming that it was easier for them to
have money printed at a local printer than to buy bonds, secure a charter, and then
exchange the bonds for national currency.
In 1865, the federal government tried to force state banks into the National Banking
System by placing a 10% tax on all privately issued bank notes. This tactic worked,
for the state banks were unable to afford the tax and they subsequently withdrew their
notes from circulation.
A few years before, the government issued gold certificates- paper currency backed
by gold on deposit with the Untied States Treasury. Initially these yellow backs were
printed in large denominations for banks to use in settling differences with each other
at the end of the business day. But by 1882, the government began printing gold
certificates in $20 denominations for the public's general use.
In 1886 the federal government issued the silver certificate. It was modeled after the
gold certificate and was backed by silver coins placed on deposit with the Treasury.
Silver certificates were printed as part of a program to support the silver prices for the
miners out West. The Bland-Allison Act of 1878 required the federal government to
purchase large amounts of silver and then mint the ore into silver dollars. Yet these
silver dollars proved to be too bulky and inconvenient to use, so the Bland-Allison
Act was amended in 1886 to provide for the printing of silver certificates. Under the
revision, the government agreed to buy silver and hold it in reserve against the silver
In 1890, the federal government printed the final type of currency before the banking
overhaul of 1913. The currency came in the form of Treasury coin notes, which were
currency that was redeemable in both gold and silver. The law was repealed in 1893,
and further issues of Treasury coin notes were ended.
In 1900 Congress passed the Gold Standard Act which backed the dollar with gold. It
did not affect the type of currency people used for people continued to use gold
certificates, silver certificates, United States notes, National Bank notes, and Treasury
There were disadvantages to this system. In a growing economy, there must be a
growing money supply, and thus a growing gold stock to back it. If new gold supplies
cannot be found, the growth of the money supply eventually begins to slow and
perhaps stop, hence restricting economic growth. Another disadvantage is that people
may decide to convert their currency into gold, thereby draining the government of its
Despite its disadvantages, the gold standards remained in force until the Depression
years of the 1930's. By that time, many banks had failed and many people could not
find jobs. Because people felt more secure by holding gold rather than paper
currency, they began to cash in their dollars for gold. In 1933 the federal government
feared the depletion of its gold supply, so it decided to go off the gold standard. That
same year, President Franklin Roosevelt declared a national emergency and decreed
that anyone holding more than $100 worth of gold or gold certificates file a disclosure
form with the United States Treasury. The following year, the Gold Reserve Act of
1934 was passed. It required citizens, banks, and businesses to turn their gold and
gold certificates over to the government. Those who did were compensated with
Federal Reserve notes and other forms of federal currency. Those who did not had
their gold and gold certificate holdings confiscated.
The United States has been under the incontrovertible fiat money standard since 1934.
Under this standard, the money supply is incontrovertible because U.S. citizens
cannot convert it into gold or silver. It is a fiat money standard because government
decree declared dollars legal money. The money supply of the United States is a
managed money supply. The government tries to control the quantity, composition,
and even the quality of the money supply. This task has proved to be easier since a
single currency has replaced the early forms of currency. National currency and
Treasury coin notes were withdrawn from circulation in the 1930's, and gold
certificates were confiscated in 1934. In 1968, the government last issued greenbacks
and stopped redeeming silver certificates for silver dollars. Today's money consists
largely of checking accounts, coins, and a single currency issued by the Federal
Banking and the Federal Reserve
In general, the rise of banks is also tied to the Crusades. With the advent of increased
trade routes, more readily available spending money and a growing middle class
banks became necessary to facilitate the growth of this trade. It was at this time that
several great banking families, like the Rothchilds, emerged to lend money to
merchants and traders. Since the United States is basically a new born nation banks
were in existence long before America declared its independence from Great Britain.
Banks in America, however, were rather infantile institutions in comparison to their
From the 1700's to 1863 banking in America was much a microcosm of America
herself. Banks were crude, basically unregulated and highly entrepreneurial. These
early American banks were state chartered and the states offered precious little
supervision. As was mentioned earlier banks came to issuing private paper currency.
This currency was supposed to be backed by gold or silver deposits but deposits often
failed to meet acceptable levels. In some cases there was never even an attempt to
maintain proper reserve levels. As these unscrupulous somewhat insolvent banks
proliferated they began to spread more and more "bad notes around the country.
These banks, known as wildcat banks were becoming an increasing problem.
Also during the early days of the American Alexander Hamilton proposed The First
Bank of the United States. In 1790, Congress proposed that the Bank of North
America take on the functions of a central bank. Its primary function would be to
control the economy's money supply. It would have the power to dictate what banks
could and could not do. Instead of the state-chartered Bank of North America acting
as the country's central bank, he proposed the creation of a nationally chartered bank
which would exercise control over the nation's money supply and be authorized to
extend credit to the government.
Thomas Jefferson and James Madison opposed the idea of a central bank altogether
because, in their view, establishing a central bank exceeded the powers of the federal
government under the strict interpretation of the constitution. Jefferson and Madison
were convinced that the central bank would favor the already powerful northern
merchant class. In fact, they were right and Hamilton knew it. Hamilton wanted the
bank to issue loans thus tying the wealthy to the stability of the nation. In effect he
was creating supporters tied to the new nation out of financial necessity.
Congress bought the Hamilton plan. In 1791, it set up the First Bank of the United
States. The bank's charter was designed to expire after 20 years but could be renewed
by Congress. Actually, the First Bank of the United States performed reasonably well.
It served as the government's fiscal agent and even succeeded in dampening the
inclination of the state-chartered banks to over issue notes. How? Since many of the
state bank notes found their way to the First Bank, the Bank could present the notes to
the state banks for payment in gold or silver. Aware of this prospect, the state banks
became more careful about issuing bank notes in excess of their gold and silver.
The Second Bank of the United States
In 1811, when the time came to renew its charter, Congress declined to do so. The
advocates of states' rights won out. Over the next five years, the number of state-
chartered banks almost tripled, from 88 in 1811 to 246 in 1816. Left without a central
bank's restraining influence on the issuance of bank notes, bank note depreciation and
fraud became rather commonplace. By 1814, most banks had suspended specie
payment. That is, they would no longer convert paper bank notes into gold and silver.
Would you put your gold into such a bank? It didn't take Congress long to regret
having disposed of the First Bank. It became painfully clear that something had to be
done to stabilize the money supply.
The answer, just five years after the demise of the First Bank, was to establish the
Second Bank of the United States. This time, Congress gave the national bank the
right to issue its own notes. These soon became the most widely accepted currency in
the nation, preferred to the less-trusted notes of the state chartered banks.
Recognizing the weakness of these issues, the Second Bank pressed for sounder
specie backing. The southern and western banks balked, viewing this pressure as
discriminatory. Animosity toward the Second Bank intensified when it instructed
northern banks not to accept bank notes from the southern and western banks which
could not back their currency with gold and silver.
Like the First Bank, the Second Bank was a success, unfortunately, like the First, it
was abandoned. When Andrew Jackson, an opponent of central banking, was
reelected to the Presidency in 1832, the Second Bank's existence was an election issue
and Jackson promised to destroy the Bank. Unable to convince Congress to terminate
the Banks charter, Jackson withdrew Treasury funds from the Second Bank and
deposited it in state banks. This undermined the Second Bank's ability to control the
issuance of notes by state banks. By 1836 it had become just another bank in
From the demise of the Second Bank as a central bank until Congress passed the
National Banking Act in 1864, the economy's money supply was once again left in
the hands of the state banks. Once again, unsound loans and over issuing of notes led
to an unhealthy climate of unreliable money.
The National Banking Act
The cost of the Civil War pushed Congress far beyond its financial capabilities. The
steady outflow of specie from the Treasury made it impossible for it to continue
buying back its notes. Congress reluctantly allowed the Treasury to begin to print
money. The Treasury printed Greenbacks, so called because of the ink used on the
back side of the notes. They became the economy's most common, but rapidly
depreciating, currency. Once again, the government faced two classic problems: How
to provide it self with the financial resources it needed to carry on the affairs of
government and at the same time, stabilize the monetary system.
This time, it came up with a novel idea that ultimately was legislated in 1864 as the
National Banking Act. The idea was to develop a national banking system. The act
created a new office, Comptroller of the Currency, housed in the Treasury, which
chartered national banks. A national bank had to buy Treasury bonds equal to one-
third of its capital, and could issue notes only in proportion to its Treasury bond
holdings. All nationally chartered banks had to have the words "national" or the
initials "n.a." in their title. You can identify some national banks just by name. The
Chicago First National, The First National of Toledo, the First National of Fresno,
and so on.
Now how do you reestablish people's confidence in the banking system? Banks were
no longer allowed to accept real estate as collateral for loans, nor lend more than 10
percent of the value of their capital stock to any single borrower. Also, each bank was
required to provide financial reports to the Comptroller of the Currency and was
subject to periodic bank audits. To encourage state banks to switch over to the
national system, the Comptroller levied a 10 percent annual tax on state-chartered
bank-note issues. This was a steep tax and it virtually eliminated the use of state
chartered bank issued currencies, but there wasn't a rush to conversion to become
nationally chartered banks. For one thing, not all state-chartered banks could afford
the minimal capital required to obtain a national charter. As a result, state-chartered
and nationally chartered banks coexisted within the banking industry. This has
become known as a dual banking system.
THE KNICKERBOCKER TRUST DISASTER
The 1907 Knickerbocker disaster was the final straw that broke the camel's back.
Both state and national banks, along with mushrooming financial trusts, were caught
up in a whirlwind of speculative loans. In October, frightened depositors looked in
horror at the collapse of the Knickerbocker Trust Company, a highly reputable and
seemingly sound financial institution. The thought in everyone's mind-as it would
have been in yours-was, Who's next? Panic spread. People ran to their banks to
withdraw their deposits, and hard-pressed banks in turn scrambled for liquidity by
calling in outstanding loans. Investment projects, in various stages of incompletion,
were all-at-once suspended. Sound businesses, drained dry of credit, were forced into
bankruptcy. The result was almost instant recession.
Once again, Congress was forced to intervene. This time, with Knickerbocker still
fresh in mind, Congress broadened its concerns from simply coping with the chronic
problems of over issue of bank notes and inadequate collateral to include a newly
perceived menace, the overreach of powerful financial trusts. The response came in
the form of the Federal Reserve Act of 1913.
THE FEDERAL RESERVE SYSTEM
The Federal Reserve Act of 1913 created the Federal Reserve System, commonly
referred to as the Fed. Why the Federal Reserve System and not the Federal Reserve
Bank? The Fed was designed as a system because Congress wanted a decentralized
central bank. The decentralization was essentially geographic, reflecting people's
desire for regional monetary independence.
The need for such regional autonomy has since dissipated, but the structure remains
intact. The Fed's structure is simple. It consists of 12 District Federal Reserve Banks,
each serving a region of the country. The larger District Federal Reserve Banks have
smaller branches. Under this arrangement, a bank in a specific district would use its
own District Federal Reserve as its central bank. In this way, banks in Omaha,
Nebraska, or Ocala, Florida would not have to depend upon banking decisions made
in New York. The map below shows the geographic domain of the 12 District Federal
Reserve Banks and their locations.
Who Owns the Fed?
The Federal Reserve System is not owned by the government. Although created by
and responsible to Congress, the Fed pursues an independent monetary policy which
at times can conflict with government's economic policy. For example, the
government may be pursuing a stimulative fiscal policy (lower taxes, increase
government spending) while the Fed may be more interested in controlling inflation.
Who owns the Fed, then, if not the government? Each District Federal Reserve Bank
is owned by its member banks. Each member bank contributes 3 percent of its capital
stock to the Federal Reserve Bank in its district and another 3 percent is subject to call
by the Fed. These are what are known as a banks "reserve requirements." Of the more
than 12,000 banks in the country, fewer than 5,000 are chartered nationally; the rest
remain state-chartered. When the law was first passed only nationally chartered banks
could join the Fed. Today, this is no longer the case and any bank can join.
All nationally chartered banks must be members of the Fed. The state chartered banks
can choose to be members. Even though less than 13 percent of he state-chartered
banks are members of the Federal Reserve System - 971 out of 7,653 banks in 1993 -
they, along with nationally chartered banks hold more than 50 percent of all deposits
in our economy.
The Fed's Purpose and Organization
The Federal Reserve System's main responsibility is to safeguard the proper
functioning of our money system. It is the watchdog of our money supply, our interest
rates, and the economy's price level. Obviously, if it's going to do that job at all, it has
to monitor the activities of the nation's financial institutions, anticipate what they will
do, prevent them from doing some things, encourage them to do others, and do all this
without interfering too much in the conduct of private business. Impossible? Some
people think so. But these same people are unable to imagine a modern economy
operating without a central bank.
The Fed's organizational structure is not very complicated. The nucleus of the Federal
Reserve System is its Board of Governors, which meets in Washington, D.C. The
Board consists of seven members, appointed by the President and confirmed by the
Senate. Each serves a 14 year term. Appointments are staggered, one every other
year, so that no President or Senate session can manipulate the composition of the
board. This also ensures continuity. The Chairman is a board member appointed by
the President to a four-year term. Chairmen may be reappointed, but they cannot
serve longer than their 14 years on the Board. Typically, chairmen are reappointed for
lengthy periods that overlap Republican and Democratic presidents. Paul Volcker,
who preceded current Chairman Alan Greenspan, was appointed by Jimmy Carter and
twice reappointed by Ronald Reagan. Greenspan has continued into the Clinton
administration. Much earlier, William McChesney Martin chaired through the
Eisenhower, Kennedy, and Johnson administrations and even into the early Nixon
More often than not, Board members are drawn from within the banking industry,
either from commercial banks or from the Fed's District Banks. Volcker, for example,
came from the New York Fed. Such ties to banking experience can be both helpful
and problematic. While members must understand the complexities of banking, their
strong connection to the industry seems to compromise, for some people, their role as
guardians of the public trust. But not all come from banking. Arthur Burns, for
example, left his professorship at Columbia University to serve as chairman during
the late Nixon years.
DISTRICT FEDERAL RESERVE BANKS
The 12 District Banks make up the second tier of the Fed's structure. Each is managed
by a board of nine directors, six chosen by the member banks of the district, the other
three appointed by the Board of Governors. The President of each district bank is
selected by its nine directors.
FEDERAL OPEN MARKET COMMITTEE
The nerve center of the Fed is its Federal Open Market Committee. Here, the Fed
exercises monetary control over the economy through its open market operations. The
12 person committee is composed of all seven members of the Board of Governors
who each have one vote, as do the President of the New York Fed, and four District
Presidents who rotate voting on the Committee. Its composition reflects the power of
the Board, the unique position held by the New York District, and the Fed's
commitment to regional representation.
THE EFFECT OF THE GREAT DEPRESSION
Despite the creation of the Federal Reserve System in 1914 American banking policy
was not fully developed. The reality is that many banks that had been only marginally
sound during the 1920's and had lent more in risky speculative investments then they
had in reserve. This was due to several reasons. One, federal law allowed banks to
invest in real estate financial services. Banks were not just savings institutions, they
were investment oriented. Two, only a small number of banks were members of the
Fed and were not subject to the Fed's reserve requirements. Three, Federal Reserve
policy was typically laissez faire in this period and did not take the policy steps
needed to intervene in a potential collapse. Fourth, and last, deposits were not insured.
In 1929 there were some 25,500 banks in America, none of which had any type of
deposit insurance. When the stock market crashed many banks lost investments that
were tied to the market. When what was in actuality a very small number of banks
closed and declared insolvency, people panicked and rushed to the banks to get out
their money. Lines that would ring around the block formed as there was a "run" on
the banks. No bank, no matter how solvent, can withstand such a run because banks
operate on what is known as fractionalized deposits, or the notion that only a fraction
of the deposits are held on to. The rest of the money is used to make investments and
a profit. Few could handle it the run and some had actually lost their depositors
money. The nation was in a full blown panic and looked to newly elected President
Franklin Delano Roosevelt for leadership. FDR declared a bank holiday closing the
banks, banks were reopened months later after significant legislation had been passed.
Banks were reformed and the panic had subsided. Insolvent banks were closed and
depositors who lost money received some compensation. The banks that remained
were more secure. They linchpin of FDR's plan was the creation of the Federal
Deposit Insurance Corporation (FDIC) and the Federal Savings and Loan Insurance
Corporation (FSLIC). The purpose of these acts was to insure depositors against loss.
Initially each depositor received coverage only $2,500 per depositor. Over the years it
has increased and the limit is now $100,000.
Banks, as you know, are financial institutions that accept deposits from citizens and
pay interest in return. What most students do not think about is the entrepreneurial
nature of banks. Banks are not all service institutions, most operate in order to make a
profit. Even if they are a non profit they do have to make money in their operation in
order to pay expenses. Banks do this in a variety of ways.
They charge interest on loans. Where do they get the money for the loans? The
answer is from their depositors and from the Fed. They pay interest to
depositors but charge a higher rate on money they lend out. For example, a
bank may pay 3% on a savings account but charge 9.5% in interest on a loan.
In the case of money borrowed from the Fed, banks pay a percentage rate on
money they borrow, called the discount rate. Banks then loan that money and
charge a higher rate on the loan then the rate that they paid. It’s called using
other people’s money!
Banks operate on fractionalized deposits. They do not keep all of the
depositor’s money on hand. They use depositor’s money to make money. They
do this usually by giving loans and earning interest. Usually these loans are
real estate loans, sometimes they are car loans, student loans etc. Some banks
make commercial real estate loans, others do not. Prior to the depression banks
were allowed to invest in the stock market. A law was passed after the bank
crash to end this practice and force banks and investment institutions to be
different entities. Recently that law expired and has not been renewed. What
does this mean? Well for certain we will see a wave of mergers. We may also
see banks stepping into rather dangerous territory of investing and being
connected to the stock market.
Banks charge fees. It used to be the case that checking and savings accounts
were free. Today banks have fees for minimum deposit, per check fees and
ATM fees. When ATM's were first introduced they were supposed to replace
bank branches, save banks operating expense and that savings would be passed
on to consumers. This has not happened. Instead, ATM's have become a
revenue stream for banks as they charge up to $1.50 per transaction. In some
cases you get hit with a double whammy. If you use the ATM of a bank other
than your own both your bank as well as the ATM's bank may charge you a
Specializes in helping business and making investments.
These were, until deregulation, the only banks that could make investments in
commercial real estate.
Were not interested in small depositors until mid 1800's
Were the only types of banks, until deregulation, which could issue checking
These are the big banks. They are for profit institutions.
Mutual Savings Bank Savings Bank
Depositor owned financial Many Mutual Savings Bank's eventually
organization. became Savings Banks when they
No owners or board of decided to go public and sell stock to
directors, instead there is an raise capital.
elected "Board of Trustees." These operate to make a profit.
Non Profit institutions These banks are owned by stockholders
and managed by a board of directors
The purpose of both was to have a safe place for depositors to save and earn
Until deregulation, these banks were not allowed to make investments in
commercial real estate.
In 1972 savings banks gained the power to issue checking accounts in New
England and by 1980 nationwide. They could now really compete with the big
Savings and Loan Association
Financial organization that invested the majority of funds in home mortgages.
Began as cooperative clubs with members taking turn borrowing to buy
In 1930's FSLIC created to insure deposits.
In the 1980's, with deregulation, many of these S&L's (or thrifts as they are
also called) emerged as aggressive entrepreneurial organizations. In many
cases S&L's were owned and run by individuals. The lack of regulations, as
we shall see, allowed these individuals to take unwise risks and defraud their
depositors and the government. This led to the Banking Crisis of the 1980's.
These are non profit institutions but were not always managed properly.
Owned and operated by and for their members. Like a mutual savings bank.
Usually organized by a union or employers to serve employees.
These are not technically banks and do not fall under federal banking
guidelines. This allows them to act in ways that banks cannot and gives them a
Historically Credit Unions would only allow members of the business or union
that formed it to be a member. Today outsiders can be "sponsored in." As a
result real banks have protested that credit unions should be brought under
federal banking guidelines.
In the past costs were kept low because they borrowed office space,
managerial help, etc. from the employer or union. This has changed as they
have become more like full service banks but are not faced with some of the
regulations other banks face. This gives Credit Unions an advantage that many
other banks are fighting on the state and national level
Direct deposit a major feature that only Credit Unions had because of their
unique relationships with the business or union. This also now exists with
many other types of banks.
Newest type of bank, really commercial banks.
Only loan money and make investments to business to buy, sell and merge.
They fund IPO's and LBO's.
For profit... BIG PROFIT!!
The mutual savings bank (MSB) is one of the oldest savings institutions in the United
States. It is a depositor-owned financial organization operated for the sole benefit of
its depositors. But because there were no stockholders, boards of trustees were made
up of businesspeople that served without pay. Later, many MSB's decided to sell
stock to raise additional financial capital. These institutions became known as savings
banks, because depositors did not mutually own them. Mutual savings banks got their
start in the early 1800's. At that time, commercial banks catered to the needs of
business and weren't interested in the accounts of small wage earners. That is when
savings banks emerged to fill that need. They were popular with consumers and began
to spread as westward expansion progressed. By the mid-1800's, commercial banks
began to notice the savings accounts of factory workers and other wage earners. They
bean to compete more heavily with the savings banks. As a result, savings banks did
not spread beyond their base in the industrial northeast. However, savings banks are a
powerful economic influence. In 1972 the Consumer's Savings Bank of Worcester,
Massachusetts, introduced a Negotiable Order of Withdrawal (NOW) account, which
is a type of checking account that pays interest. Because commercial banks had a
virtual monopoly on checking accounts at the time, NOW accounts were strongly
opposed. While NOW accounts were allowed to remain in New England, at the
national level, commercial bankers pushed for federal legislation that temporarily
prevented NOW accounts from spreading outside New England. The savings and loan
(S&L's) association is another type of financial institution, which invested the
majority of its funds in home mortgages. S&L's began as cooperative clubs for
homebuilders in the 1800's. The association's members promised to deposit a certain
sum regularly into the association. Members then took turns borrowing money to
build their homes. In short, people had arrangements for funding for home building in
areas where other sources of financing were not available. In the 1930's, the Federal
Home Loan Bank Board was created to supervise and regulate the individual savings
and loan associations. Created underneath it was the Federal Savings and Loan
Insurance Corporations (FSLIC) which insured savings and loan deposits. Credit
unions, which are owned and operated by and for their members, are another type of
depository institution. Costs are generally low because a sponsor often provides
management, help, and office facilities. Most credit unions are organized around an
employer, meaning that contributions generally are deducted directly from a worker's
paycheck. Recently, some credit unions began to offer checking deposits. Known as
share drafts, they look like any other check or NOW account and provide members
with a way to earn interest on deposits that are also available on demand. The positive
aspect of credit unions is that they make low interest loans to their members beacuse
they are non profit, member service organizations.
Banking Crisis and Reform
There are many people that feel that the government should remove much of the
regulations placed on banks and allow them to compete on the open market.
Regulations, they feel, destroy the ability of banks to make money, raises costs,
lowers interest rates paid to depositors and is not generally not good for the bank or
the consumer. This was the belief of the Carter and Reagan Administration's in the
late 70's and early 80's. The result of this rather laissez faire approach was a period of
deregulation. What is meant by deregulation is the removal of, or lessening of
government regulations restricting an industry. Deregulation has effected many
industries in recent years, including banking.
The Reagan Deregulation Program
Federal requirements that set maximum interest rates on savings accounts were
phased out. This eliminated the advantage previously held by savings banks.
Checking accounts could now be offered by any type of bank.
All depository institution could now borrow from the fed in time of need, a
privilege that had been reserved for commercial banks. In return all banks had to
place a certain % of their deposits in the fed. This gave the FED more control and
stabilized state banks.
Garn - St. Germain Act of 1982 allowed savings banks to now issue credit cards,
make non residential real estate loans and commercial loans; actions previously
only allowed to commercial banks.
The Effect of Deregulation - The S&L Crisis
Deregulation practically eliminated the distinction between commercial and
Deregulation caused a rapid growth of savings banks and S&L's that now made
all types of non homeowner related loans. Now that S%L's could tap into the huge
profit centers of commercial real estate investments and credit card issuing many
entrepreneurs looked to the loosely regulated S&L's as a profit making center.
As the eighties wore on the economy appeared to grow. Interest rates continued to
go up as well as real estate speculation. The real estate market was in what is
known as a "boom" mode. Many S&L's took advantage of the lack of supervision
and regulations to make highly speculative investments, in many cases loaning
more money then they really should.
When the real estate market crashed, and it did so in dramatic fashion, the S&L's
were crushed. They now owned properties that they had paid enormous amounts
of money for but weren't worth a fraction of what they paid. Many went bankrupt,
losing their depositors money. This was known as the S&L Crisis.
In 1980 the US had 4,600 thrifts, by 1988 mergers and bankruptcies left 3000. By
the mid 1990's less than 2000 survived.
The S&L crisis cost about 600 Billion dollars in "bailouts." This is 1500 dollars
from every man woman and child in the US.
In summary, the S&L crisis was caused by deregulation which led to high interest
rates that then collapsed. Other causes included inadequate capital and defrauding
shorthanded government regulatory agencies (less regulators and inspectors).
Steps Taken to Solve the S&L Crisis
Passed the Financial Reform, Recovery and Enforcement Act (FIRREA)
Abolished the independence of the S&L industry.
Abolished the Federal Home Loan Bank Board which gad been in charge of
New agency Office of Thrift Supervision (OTS) created as part of the
Changed Federal Insurance.
o FSLIC eliminated and responsibilities transferred to FDIC.
o Two separate funds were created within the FDIC:
SAIF - Savings and Loan Insurance Fund - for all savings type
BIF - Bank Insurance Fund - for commercial banks.
Resolution Trust Company (RTF) created to dispose of failed thrifts.