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Overview of the Federal Reserve

We’ve been hearing a lot about the Federal Reserve lately. Indeed, the last couple of years the Fed has risen to a new place in the nation’s mainstream consciousness. Here is basic overview of the Federal Reserve:

Brief History Leading up to the Federal Reserve

The history of the Federal Reserve has its roots in the country’s long history of paper currency. Massachusetts Bay Colony issued its own paper currency in 1690; this is widely considered the first “American” paper currency. Notes were in circulation from other colonies as well – and not all the currency was backed by gold or silver. Even the Continental Congress tried to issue a unified currency, not backed by gold or silver, in 1775.

Over the years, numerous currencies cropped up all over the country. Any state, bank or store could issue its own notes. Even though two different central banks, based on the Bank of England model, were chartered prior to the Federal Reserve, both of them came to an end with different presidents refused to renew their charters. The first bank lasted from 1791-1811 and the second bank was in effect from 1816-1836. There was an era known as the free bank era, which lased from 1837-1862, an era which overlapped with the establishment of the Independent Treasury System (1846-1921).

Prior to the establishment of the Federal Reserve, different notes were backed by gold, silver, government bonds, or nothing at all. Some currencies used in the U.S. were more valuable than others, and rates of exchange were difficult to establish. The economy swung wildly between extremes as banks (and their currencies) failed. In response to a number of financial panics, particularly that in 1907, the Federal Reserve was created in 1913 by the Federal Reserve Act. Originally, the Fed was meant to provide a way to standardized the monetary system in the U.S., and help keep the whole system liquid and elastic.

Since 1913, we have seen the Fed adjusting monetary policy in efforts to rein in inflation or to stimulate growth, depending on what the body feels the economy needs. The scope of the Fed has widened somewhat since those days. According to the Federal Reserve’s web site, its main duties include:

  • Conduct monetary policy for the United States
  • Maintain the stability of the nation’s financial system
  • Regulate and supervise banking institutions
  • Provide financial services to the U.S. government, foreign official institutions and depository institutions.

Some argue that the Fed is doing too much, meddling in the markets, and becoming too involved with quantitative easing, as well adopting policies that could harm some of the smaller banks.

Basic Structure of the Federal Reserve

The Federal Reserve is more than just a single building. It is an entire system. The Federal Reserve System has aspects that are both public and private. The Federal Reserve makes decisions about monetary policy without permission from the government, getting its authority from the 1913 act that created it. However, the seven members of the Board of Governors are appointed by the president and confirmed by the Senate. Terms are 14 years long and staggered. The Chairman of the Board, and the Vice Chairman, are appointed (from the sitting governors) to serve four year terms in those positions. The president can re-nominate Chairs as many times as desired during their terms on the Board.

The Federal Reserve Board oversees 12 Federal Reserve Banks, who are in turn in charge of the member banks in their districts. Districts were created at the time of the Federal Reserve Act, and based on population. The 12 Federal Banks are located in New York, Boston, Philadelphia, Chicago, San Francisco, Atlanta, Minneapolis, Kansas City, Dallas, St. Louis, Richmond and Cleveland. The boards for these banks have presidents, and boards with nine members each. Member banks are private institutions that own stock in the appropriate regional Federal Reserve Bank. State chartered banks can choose to become members of the Federal Reserve System when they meet certain requirements.

It is important to note that Federal Reserve Bank stock cannot be sold or traded. Profits from the Federal Reserve System are broken down in two ways:

  1. Regional bank profits are paid out in dividends to member banks equal to 6% of the stock a member bank owns in its regional Federal Reserve Bank.
  2. The rest of the profits from regional banks are given to the U.S. Treasury.

The Federal Reserve reports that in 2009 it paid out $1.4 billion to its member banks, and sent $47 billion on to the Treasury. It is interesting to note that the Federal Reserve is one of the few central banks in the world that is not in charge of creating the physical currency that is used in the country – the Treasury Department does that.

When most of us think of the Fed, though, we think of the Federal Open Market Committee (FOMC). This is the committee that sets the Fed Funds Rate and makes other monetary policy decisions. The FOMC decides how much money should be made available to depository institutions, and is in charge of the Fed’s participation in foreign exchange markets. The FOMC consists of all the members of the Board of Directors, plus five presidents from among the 12 regional bank presidents. The president of the New York Federal Reserve Bank is a permanent voting member of the FOMC, and the other five president slots are filled by rotation from the other regional banks. Non-voting bank presidents can participate in policy discussions, but they do note actual cast deciding votes.

Regulation D

When it comes to deposit accounts, the Federal Reserve sets forth most of its rules in Regulation D. These regulations are, ostensibly, meant to help protect consumers, and ensure that banks are operating in a manner that does not threaten the stability of the banking and financial system. When a bank tells you that it can’t allow more than six outgoing transfers a month on savings accounts, it comes from Regulation D. The bank can set its own limits on outgoing transfers, but the upper limit is set by the Fed.

Since the beginning of the Federal Reserve, there have been numerous calls for its demise. However, it is such an entrenched part of our financial system that the Fed is not likely to be dissolved anytime soon.

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Previous Comments
  |     |   Comment #2
This post is somewhat inaccurate about the monetary history of the United States.  The Federal Reserve Note dollar is just one version of the U.S. dollar.  It has NEVER been backed by gold, but, rather, has always been backed by debt.  That was the reason the Fed was chartered.  A secretive group of bankers, most notably J.P. Morgan, and the banking interests of John D. Rockfeller, joined to create a bank to bail out other banks.  Since neither gold nor silver can be printed, they could not serve as the backing of the Federal Reserve Note dollar.  Hence, it was decided that the "Fed" would buy U.S. government debt instruments, and that these would "back" the new "dollar".

Before the FRN dollar was introduced, however, there was another dollar that had circulated since the Revolutionary War was won.  It was known as the United States Note dollar.  It ALWAYS maintained the exact same value, which was approx. 1/20th of one ounce of gold or 371 grains of silver, depending on whether the U.S. was on the silver or gold standard during the period in question.

Under the terms of the Federal Reserve Act of 1913, FRN dollars were backed by United States Notes, to the extent that the U.S. Treasury was obligated to pay back the debt obtained by the Fed with United States Notes.  The United States Note, in turn, was convertible to gold at 1/20th per ounce per dollar.  Thus, indirectly, the FRN dollar was also convertible to gold, and the Fed was given a large stock of gold to perform the conversions, which was stored at the NY Fed, separate from any gold owned by the USA stored at Fort Knox and other official repositories.  In order to increase acceptance of the FRN dollar, Congress made it "legal tender" for the payment of all debts, public and private."

During the 1920s, the fundamental problem of having a currency based on debt began to manifest itself.  Wall Street wanted stocks to go up.  To do that, they needed more money to circulate, and the Fed, which was controlled by Wall Street investment banking firms came to their aid.  It monetized U.S. Treasury debt by issuing far more Federal Reserve Note dollars than it could possibly redeem in gold, flooding the market with them, and destroying the limiting concept that the gold standard was supposed to impose on irresponsible spending.  This resulted in the "Roaring 20's" during which there was an incredible boom in stock prices, and the price of just about everything else.

The "Roaring 20s" were followed by a deep recession starting in 1929, which reached the stock market a few months later, in October or 1929, resulting in crashing stock prices.  People began to become nervous as the recession deepened, and began to demand redemption of their FRN dollars.  The Fed had printed many times more notes than it had gold, and could not redeem them without help from the U.S. Treasury.  So, for a while, the Treasury opened Ft. Knox to the bankers, and began to lend gold freely to the Fed for redemption purposes.

Meanwhile, a frightened Fed started to withdraw liquidity (the unbacked dollars they had previously issued in such abundance) by approximately 1/3rd, resulting in more stock price declines, and a perceived shortage of dollars.  Prices began to deflate even more, leading to more uneasiness among the population, and more redemption for gold requests.  Finally, in 1933, the drain upon the nation's gold reserves had become unbearable, as the demand for redemption of the FRN dollars far exceeded the amount of gold held by the Federal Reserve's vaults plus Fort Knox.

U.S. government bankruptcy was not far off.  In 1933, the nation went bankrupt, reneging on the obligation to pay off debt denominated in gold bullion and/or coin stock.  Henceforth, it would pay ONLY in paper money printed by the government and backed by nothing but the "fiat" of the sovereign.

President Franklin Roosevelt, fearing that the entire national gold stock would be depleted to zero, issued an order ending redeemability of both FRN dollars and United States Notes.  This was followed, shortly after, by another order stripping Americans of their right to own gold, and confiscating all the gold then owned by them.  Americans were ordered to turn over their gold bullion to the U.S. government, for a payment of approx. $20 per ounce, under penalty of 10 years of imprisonment if the order was refused. 

About 6 months later, after having confiscated all the gold, Roosevelt ordered the conversion rate of gold to dollars, for purposes of foreign trade (Americans were now forbidden from owning gold), raised to $35 per ounce.  In 1973, Richard Nixon ended the convertibility of the dollar to gold for foreign trade, also, but restored the right of Americans to own gold.
  |     |   Comment #4
Stop censoring the comments, Miranda.  You can't solve your problems by trying to silence those who point out your shortcomings.
  |     |   Comment #5
@#4: I don't censor comments. Ken decides which comments to take down. As you see, the history presented by #2 remains as an alternate version and viewpoint. That comment is actually productive, constructive and helpful, whereas many of the comments that Ken takes down are mean-spirited and do nothing to advance any sort of knowledge. Anonymous negativity for the sake of tearing someone else down with rudeness and innuendo  -- especially someone willing to put it out there and on the line -- accomplishes nothing. It doesn't help me learn (which I am trying to do), nor does it help anyone else learn. All it does is create a hostile environment.

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