Before the Fed was established in the 20th century, the United States of America experienced a long and protracted road to having a central banking system. The formation of the National Bank of the United States took place in 1791. Although this first national bank failed in 1811 as its charter was not renewed, it already fulfilled some of the main tasks of a modern era national bank such as supplying the state with credits. Since even today central banks often face a lot of criticism, it is not surprising that many people were sceptical towards a national bank. Even the Second bank only lasted from 1816 to 1832.
This bumpy road to the Federal Reserve System was ended when the United States suffered some severe banking panics up to the year of 1907. After this panic the National Monetary System was established to make proposals on how to strengthen the financial system which led to the founding of the Fed with its first primarily duties. The official title of the Federal Reserve Act of 1913 summarizes the purpose of this undertaking. The goal was to establish Federal reserve banks along with a flexible currency and a stronger supervision of the banking system in the United States. So this aim of having a flexible yet stable financial system led to Fed being a lender of reserves to the member banks, which flattened the volatility of the availability of money and interest rates. It is noteworthy to say that the act did neither consider employment issues nor the stability of the currency respectively inflation. The term flexible currency points to a banking system, which is able to prevent shortcomings of private banks money supply during economic shocks, bank runs or seasonal fluctuations. Those problems caused a lot of banking crisis and bankruptcies in the pre-Fed era. The United States were convinced of this attribute of their new system because they used the British national bank as their role model.
During World War I, the Fed lowered the discount rate for borrowing banks below the market rate, which led to an expansive policy of lending money. In the 1920s however, the board of the national bank decided to raise the rate of this borrowing window again. Not only did the policy change but also the image of the lenders; it was transformed into institutions that seemingly must have some problems – something that still to this day in the people’s heads to some extend.
The Fed’s role of not just being a lender of last resort (LOLR) but to also predict market crisis was soon to be tested in the great depression starting 1929.
The first 50 years
The still expansive fiscal policy held on until the late 1930s. Although no panics happened in the early 20s of that century, the Fed changed its thinking regarding the borrowing window, since it believed that also a considerable amount of that money would go in to speculative investments, respectively the reward of this policy was not evident to them. Putting banks under pressure not to borrow a lot of money, failing loans in banks and therefore the first bank runs caused the great depression. Although it was the Fed’s philosophy to secure financial stability, the United States witnessed one of the most severe financial crisis in history from 1929 to 1933.
This economic disaster led to the Banking Act of 1933. Its importance is underlined by the following quotation: “The banking Act of 1933 was the single most important piece of banking legislation in U.S. history. It established the federal deposit insurance, required a complete separation between underwriting and traditional and traditional commercial bank activities, and imposed “Regulation Q” interest ceilings on deposits, including zero interest on all demand deposits”. So the Fed was not only driven by ideal goals but also by changes in the economic and political environment as well as the results of its prior actions.
From World War II to the late 1970s the policy of the Fed drifted from a focus on financial stability to an era of “fiscal” dominance by abandoning the gold standard and strongly increasing fiscal financing. So instead of focusing on a flexible currency, the stability of the financial system or being a strict regulator of the banking system, the Fed was heavily involved in financing the expenses of the World War II for the United States. By buying a lot of government securities, this approach obviously lead to a very high level of government debt and after the War to a high inflation rate.
Following the aftermath of the World War II, the Bretton-Woods agreement was signed in 1944, which has had a great impact on the American fiscal policy. It marked the final rise of the American financial system an economy to the top of the world by imposing a system that centred the US Dollar in the international economy and created rules of on which other currencies could be exchanged to the USD. This dominance of the American currency and therefore also its economy strengthened the Fed’s role in the world economy to this day.
Further Evolution of the Fed’s role and mandate and the ongoing transformations in the world economy
As described above, the United States had to deal with a tremendous debt problem after the second World War. Even the mighty United Kingdom almost faced bankruptcy in that period of time. So once again the Fed had to adjust its goals to a changed environment and also to the result of its prior undertakings. Therefore it followed a principle of controlling the inflation and price stability from the 1970s to the latest financial crisis.
The financial crisis of 2008 seems to shift the Fed’s focus on the stability of the financial system again. However, it is still too early to say where their policy will lead. Saving financial institutions from bankruptcy and expanding the fiscal policy again seem to hint to that conclusion, however history will have to tell us again in the future how the Fed’s strategy really worked.
As a conclusion of this historic outline, one can state the Federal Reserve’s mandate has evolved strongly over the past hundred years. The initial idea was to provide financial stability, whereas the fiscal financing of World War II and its aftermath were targeted in a later stage. Later there was a strong focus on preventing inflation from the late 1970s. After the latest financial crisis, the Fed’s duty seems to be lying on the stability of the financial system again. Although history seems to repeat itself a bit nowadays, it is still difficult to predict how the further evolvement of the Fed’s mandate will look like in the future.
100 years Federal Reserve: A case of success or failure?
To verify if the Fed succeeded or failed in its specific aims, we need to look closer to the intents and the corresponding outcomes. The founding intents were to create an institution to prevent inflation, bank crisis and to finance exports of primary products. This mandate has evolved in the last 100 years. Right in the first years of the Fed, WW I started and the Europeans suspended the gold standard in their economies. Therefore, a lot of gold came to the States, seen as a safe haven. The Fed created money to purchase Treasure securities and helped finance the war. At the end of 1917, inflation in the States was more than 20%. The price of the Dollar compared to commodities fell drastically. The Fed has overseen this wartime inflation period and even after war, inflation kept at that level. To fight the inflation, the Fed raised discount rates to 6%, seen as a penalty. Within a year, production fell 20%. In the early twenties short deflationary depression, the Fed saw this phenomenon as a clear correction to the inflation before and lowered rates in mid 1921 again. The farmers could hardly sell their products in the short depression, they were very in favour of lower interest rates. In the time between 1922 and 1927, the average annual inflation rate was 1.4%. Concerning this, the Fed`s job can be seen as a failure in the wartime by financing war and producing high inflation and rather as a success in the time between 1921 and 1927, although the amount of uncovered dollars has risen from 42.1 bio. To 68.8 bio. USD.
Before the crisis in 1929, critics against the Fed came mainly from the Austrian economists. Especially Ludwig von Mises plausibly criticised in his 1928 published work Geldwertstabilisierung and Konjunkturpolitik the Fed to keep interest rates too low, provoking the meltdown. Milton Friedman and Anna J. Schwartz did so years later in Monetary History of the United States, 1867-1960. Their main argument is, that the Fed has nationalized the clearinghouse associations role and installed the lender-of-last-resort task. They criticise the Fed did “less to mitigate the multiple banking panics of the early 1930s, with their sharply deflationary and depressive effects, than the clearinghouses had done in earlier panics like 1907 and 1893”. Friedman and Schwartz argue, that the great depression was namely due to the Fed`s policy and the US economy would have been better off without having the Fed in power. The 30ies can be clearly seen as a failure, in case of financial stability and preventing bank crisis.
Between 1939 and 1945, the fed purchased government securities at fixed interest rates at 0.375% and helped finance WW II, resulting in a 300 billion debt in 1946, which was 129% of the US GDP. The inflation peak was in April 1947 at 19.7 percent. Although Fed officials were unhappy with the fixed interest rates, they did not change it. Finally in 1951, the “Accord” ended this debt-policy and until 1964, the Fed managed to more or less keep financial stability.
In 1965, the Fed started playing the Phillips Curve by trying to reduce the unemployment rate with monetary expansion. In the 70s, especially after Bretton Woods, the unemployment rate rose together with the inflation rate and the Fed lowered the interest rates, what resulted in an inflation of 14.8 percent in 1980. Between 1985 and 2001, the Great Moderation under the Taylor-rule, the Fed managed to get back to a constant inflation and no systematic bank failures, but a rise in debt. In 2001, the Fed started another interventionistic policy by lowering interest rates again and empowering the housing bubble. Between 2000 and 2007, there were more dollars printed than in all the years before. After financial crisis, the Fed started their near-zero nominal interest rates policy and bond purchase programs, the outcome is still questionable.
Christian Zullinger, Präsident Hayek Club Zürich
