A Century of Federal Reserve Monetary Policy

Issues and Implications for the Future

Thomas R Saving

• Publisher: WSPC
• Year: 2019
• ISBN:
  9789811201790
• Topic: Economics
• Subtopic: Macroeconomics
• Index: Economics

The Federal Reserve System, created in the early 20th century, is now more than a hundred years old. This book takes the reader through the founding and first century of Federal Reserve monetary policy, and uses the analysis of the past to address the present and future issues of central banking.

With its focus on the actual policies, rather than the politics or individuals that determined those policies, this book addresses issues that have plagued monetarists since the onset of the Great Recession. Then, it proceeds to discuss the issues that will affect the efficacy of policy in the future. This section of the book is relevant for all central banks as central bank behavior post the onset of the Great Recession was similar throughout the world.

The book presents an analysis of the path of inflation that puzzled the experts. It adds an analysis of central banking's ability or lack thereof to influence market interest rates. Lastly, it explains the current exploding crypto-currency craze, its potential to supplant traditional transactions media, and the future of these so-called currencies.

Contents:

• The Federal Reserve: A Century of Monetary Policy:
  • The Advent of Central Banking in the United States
  • The Early Years of the Federal Reserve: A Limited Role for Independence
  • A Wartime Federal Reserve
  • The Federal Reserve's First Decade Free of the Treasury
  • The Federal Reserve in the Vietnam Decade: The 1960s
  • The Federal Reserve and the Rise of Inflation: The 1970s
  • The Federal Reserve and the Taming of Inflation: The 1980s
  • The 1990s: Turning Deficits into Surpluses
  • The Federal Reserve in the Early 21 st Century
  • The Federal Reserve and the Great Recession Financial Crisis
  • Expanding the Federal Reserve's Mission
• Issues from the Past and Problems for the Future:
  • The Federal Reserve: An Independent Central Bank or an Arm of Government?
  • The Federal Reserve's Role in Market Interest Rates
  • The Federal Reserve, the Great Recession and the Lost Inflation
  • Federal Reserve Monetary Policy when Reserves Pay Interest
  • The Fed Funds Market in an Interest on Reserves World
  • Can Monetary Policy Exist in a Zero or Very Low Interest Rate World?
  • The Federal Reserve and the Federal Debt
  • Measuring the Federal Reserve's Net Worth
  • Is There a Path Back to Your Parents' Federal Reserve?
  • Estimating a Path to Your Parents' Federal Reserve
  • Cryptocurrencies and Monetary Policy
  • Some Concluding Issues in the History and Future of the Federal Reserve
• References

Readership: Undergraduate and graduate level students, lecturers and professors of macroeconomics. Federal Reserve;Monetary Policy;Money;Currency;Interest Rates;Inflation00

Part I

The Federal Reserve: A Century of Monetary Policy

Chapter 1

The Advent of Central Banking in the United States

Introduction

The debate concerning the wisdom of an independent central bank has been with us virtually since the founding of the republic. Among the powers delegated to Congress in Section 8 of Article 1 of the Constitution of the United States is the power “to coin money, regulate the Value thereof, …”. Thus, to the extent that a central bank can do the equivalent of coining money and by the rate at which it does this, regulate the value thereof, it would appear that the Constitution precludes us from having a truly independent central bank.

That said, however, Congress can delegate powers to agencies and as a result can establish a central bank and give it the power to coin money and regulate the value thereof. This delegation of the right to coin money and regulate the value thereof meant little during the period of our history where we were on a metallic standard. During that period, the value of domestically coined money was determined by the world price of gold and the rate of exchange between the dollar and gold as determined by Congress.

Except for those periods where the free exchange of money for gold was curtailed, the value of domestically produced money was determined by Congress in its setting of the exchange rate for gold or silver or both. One such period of the suspension of free exchange of money for gold was the greenback era during and following the Civil War. During this period, both gold coins and greenbacks circulated with continuously changing exchange rates reflecting the course of the war. Since Congress authorized the printing of greenbacks and by the extent of the issue it regulated the value thereof, it was certainly within its Constitutional right. In contrast, the amount of gold coinage was outside the ability of Congress to regulate.

It could be argued that the issues involving the establishment of an independent central bank that could do the equivalent of coining money and regulate that value thereof would only be relevant in a world without a metallic standard. Thus, even though the Federal Reserve System began operation as a central bank in 1914, as long as the United States remained on the gold standard, it was limited in its power to coin money and regulate its value. However, for the question of an independent central bank, the past is irrelevant. For all practical purposes, once the nation eliminated the rights of citizens to exchange currency for gold in the 1930s, we left the gold standard. Without the discipline of the gold standard, the Federal Reserve would seem to have all the makings of a central bank that has the ability to coin money and regulate the value thereof.

A Brief History of Pre-Federal Reserve United States Central Banking

In the United States, central banking began with the “First Bank of the United States”, chartered in 1791 for 20 years. The First Bank of the United States had a national charter but was essentially a private bank with private citizens owning 80% of the ownership shares. The bank was the fiscal agent for the government, collected tax revenues and paid government bills.¹ To ensure the bank’s independence from the Treasury, the First Bank of the United States was forbidden from purchasing government bonds.² This prohibition on buying government debt is not surprising as the founding fathers had a mistrust of central banks. This mistrust was due in no small part to their experience with the Bank of England, a nationally chartered but privately owned bank, and its role in financing British wars. The First Bank was allowed to die in 1811 after the expiration of its 20-year charter.

The First Bank was succeeded in 1816 by the “Bank of the United States” that operated much like a central bank. Unlike the Bank of England that was entirely privately owned, the federal government owned 20% of the Bank of the United States. At the time, the nation’s paper currency was issued by private banks and was convertible into specie, i.e., gold or silver coinage. This convertibility was what controlled the issue since if a bank increased its issue of paper money, the increased issue would find its way back to the bank of issue to be exchanged for specie.

A principal role played by the Bank of the United States was to expedite the return of any specific bank-issued currency to the bank of issue for specie. This practice expedited return of currency and reduced what used to be called float, defined as currency in the process of being returned for conversion. It is not surprising that the banks whose profitability was most affected by the reduction of float were opposed to the Bank of the United States. While Congress reauthorized the Second Bank of the United States, President Jackson vetoed the legislation. Since Congress was unable to override President Jackson’s veto, the Second Bank died, leaving the United States without a central bank from 1836 until the Federal Reserve went into operation in 1914.

The primary goal of both the First and Second Banks of the United States was to control the issue of paper money that was, without them, the sole province of private state banks. In one sense, however, the Banks were unnecessary since privately issued paper money would not circulate without the promise of convertibility into specie.

While banks of this period are often referred to as “wildcat” banks, no bank’s notes would circulate if their notes could not be redeemed. In fact, notes issued by the various state-chartered banks when spent at locations distant from the issuing bank were discounted. The discount was related to the time required to return the notes to the issuing bank in exchange for specie. In fact, the reality was that a bank located in a remote location in order to make its notes difficult to return would quickly fail, as its notes would be unacceptable by all.

The requirement by users of the notes that they be convertible into specie served to control the issue at each of the independent issuing banks. The Second Bank was especially involved in speeding up the process of submitting currency to issuing private banks for conversion into specie. The effect of this accelerated note redemption ultimately led to the bank’s demise as the Jackson Administration ran for re-election on this issue.

Until the Civil War, the nation was essentially on a metallic standard as the value of a dollar was defined by an Act of Congress. Specifically, Congress set the dollar price of an ounce of silver or gold. This bimetallic standard led to the exodus of one or the other metal as the relative world gold–silver price changed. As a result of this, which was essentially a shifting metal standard, Congress adopted in 1833 a one-metal standard, gold.

For all practical purposes, the United States had no national paper currency until the Civil War when “greenbacks” were issued as a national currency to aid in financing the war.³ These greenbacks were not convertible into gold, but were legal tender so that taxes could be paid with them. Thus, at least for all domestic purposes, the gold standard was abandoned. In addition to greenbacks, the Civil War saw the establishment of the National Banking System to help finance the mounting federal debt.⁴ By the close of the war, the only paper currencies still in circulation were greenbacks and national bank notes as the notes issued by state banks were taxed out of existence.

From the demise of the Second Bank of the United States in 1836 until the Federal Reserve Act of 1913 that authorized the establishment of the Federal Reserve System, the nation had no central bank. This period was one of relatively stable prices, with the exception of the Civil War period’s inflation and subsequent deflation from 1867 to 1879 when the greenback price of gold was once again fixed. Interestingly, the post-Civil War period was one of declining prices, or deflation, but was also a period of rapid economic growth.

Subsequent to the immediate post-Civil War period of growth and declining price levels — the period from 1897 to the opening of the Federal Reserve in 1914 — there was a period of rising price levels. This period of price rises was primarily the result of gold discoveries in South Africa, Alaska and Colorado that led to rapid increases in the world’s gold stock. Given that the United States was on the gold standard, the Treasury stood ready to buy gold at the official price. As a result, the increase in the stock of gold corresponded to an increase in the money stock and prices.

Why a Central Bank?

Considering the long history of prosperity in the United States without a central bank, what led to the establishment of our first real central bank? One reason was the increasing complexity of the financial system including the rise of the importance of near banks, the loan and trust companies, what we now refer to as shadow banks. The expanded financial sector opened financial markets to small asset individuals. These financial institutions, for simplicity we shall categorize all of them as banks, take in small deposits and collect them into larger bundles and make loans. This activity allows the banks to pay small depositors for their deposits and make income on the difference between payments to depositors and income from loans.

It is fractional reserve banking that makes all this possible. Banks borrow short, that is, they take in deposits that are available to depositors on demand. Then banks use these funds to lend long, that is, make loans that are not payable on demand. As a result, banks must keep currency as reserves for the contingency that depositor withdrawals exceed additions.

But fractional reserve banking can also be the cause of financial distress. The financial distress comes when the public wants to change the form of their money from deposits at banks to currency. While the banks in one sense are solvent, meaning that their assets are greater than or equal to their liabilities, they hold very little currency. So, when many more depositors than usual want to convert to currency, the bank must find currency. When bank customers cannot get currency now the result can lead to a “run” on the bank and if other banks are similarly affected, it can result in a liquidity crisis.

Such liquidity crises are when a central bank that has the ability to essentially costlessly print currency can come into play. The central bank can then use this freshly printed currency to make short-term purchases of bank assets, called repos, and when the public’s desire for more currency passes, they can sell the assets back to the banks.

The cause of this form of liquidity crisis is the fact that in a fractional reserve banking system, deposits become loans to borrowing customers and currency reserves. Then when there is a surge in the depositor demand for their money, the currency reserves will be inadequate if the surge is large enough. This ability to transition between deposits and currency is referred to as form elasticity of the money supply. Importantly, this same issue applies to what we might term near banks. A near bank is a financial institution that takes in money from investors and allows these investors to withdraw some or all of their investment in a specified time frame, perhaps even overnight. Because the near bank liabilities are not demand liabilities, these institutions require smaller cash reserves, but are nonetheless fractional reserve institutions.

Money market funds are an example of a common investment at a financial institution.⁵ Such funds borrow short and lend short. However, the investors treat their investment as having nearly instant availability. Thus, a significant increase in the investors demand for cash, either in the form of currency or demand deposits at their bank, forces the fund to sell assets. Even though these assets are short term in nature, it may be difficult for a fund to instantly sell off a significant share of these assets.

This lack of the ability of the system to transform one form of money, bank deposits, to another form of money, currency, has led to a series of financial crises. A financial crisis occurred whenever the public decided for any reason that it desired to hold its money as currency rather than deposits. In the rush to get currency, the financial institutions had to suspend the convertibility of their deposits into currency on demand.

But this form of crisis does not imply that the financial institutions were insolvent, but only tha...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• About the Author
• Part I The Federal Reserve: A Century of Monetary Policy
• Part II Issues From the Past and Problems for the Future
• References
• Index