The Federal Reserve System

Read this section about the Federal Reserve system.


In 1906, an earthquake of 7.9 magnitude rocked San Francisco, California causing mass destruction of life and property; over 3,000 people died and most of the city was destroyed. In a roundabout way, this earthquake caused the Federal Reserve System's creation. During these years, much of San Francisco's property was insured in London. British insurers paid out an enormous portion of San Francisco's colossal insurance claims as a result of the earthquake, and a flurry of capital was sent to California. In order to defend the pound-to-dollar exchange rate, the Bank of England dramatically raised interest rates by 2.5% in late 1906 in an effort to attract capital away from the dollar. It worked, and the American economy entered a contractionary period, which in turn led to a financial crisis. What ensued was an all-out scramble to ditch second- and third-layer money issued by any American financial institution whose creditworthiness came even remotely into question. As Americans climbed the money pyramid in the Panic of 1907, depositors across the nation withdrew bank deposits to seek out higher-layer forms of money, like gold coins or U.S. Treasuries. These withdrawals across the country caused regional banks to run on New York banks. As the crisis escalated, banking titan J.P. Morgan stepped in, organized a financial salvation of faltering banks, and saved the financial system. Morgan didn't have a choice: a United States central bank and lender of last resort didn't exist.

The next year, United States Senator Nelson Aldrich set up the National Monetary Commission, the job of which was to study Europe's monetary system and make recommendations on how to overhaul and modernize what had become a sloppy and disjointed dollar system without a central bank. Without a government sponsored lender of last resort and clearly defined money pyramid, the dollar's internationalization remained elusive. After years of study, published reports, and congressional testimony, Aldrich finally achieved his pursuit of a central bank when Congress passed into law the Federal Reserve System on December 23, 1913.

The word reserve is in the title of the institution itself, but what exactly are reserves, and how do they fit into the narrative of layered money? The word implies a safety mechanism, something to help in case of a crisis. Indeed, the Federal Reserve System (the Fed) was founded to combat financial crises, and it would do this with a second-layer money called reserves. Fed reserves are another way to say deposits, but these deposits were issued by the Fed only to private sector banks. Fed notes (or the "dollar cash" we know today), the Fed's other form of second-layer money, were available to the people. Fed notes were issued as a public good, a reliable paper currency that could be easily used as a medium of exchange. But reserves are the real tool the Fed uses to wield its monetary power. They are the monetary construct we must under- stand to interpret the difference between wholesale money and retail money.

Wholesale money (Fed reserves) is money that banks use, and retail money (Fed notes) is money that people use. Fed reserves are deposits for banks only and do not have any retail access: no individual can spontaneously open up an account at their local Federal Reserve branch and acquire them. The difference between wholesale and retail money becomes more important when discussing the future of central banking, but in the historical context, the Fed's mandate was to provide wholesale money, or money for the banking system, when the instability of credit stoked financial unrest. The name said it all; the Federal Reserve system was intended primarily to be a wholesale rescue mechanism of reserves.

The Fed

The Federal Reserve Act's full name is:

An act to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.

The first stated purpose, "to provide for the establishment of Federal reserve banks," immediately establishes a federally unified and accepted second-layer money, "reserves," underlying all banking activity in the United States. Reserve banks would replace the existing decentralized mix of second-layer money and end the ability for private sector banks to issue it. The Act monopolized the second layer of money in the United States under the Fed, and firmly placed all private sector money issuance on the third layer.

The second stated purpose of the Act, "to furnish an elastic currency," confirmed that the Fed would have the ability to issue money in a fractionally reserved way and allow banks within its system to do the same.

The third purpose of the Act was the Walter Bagehot provision, giving the Fed the "means of rediscounting commercial paper". Commercial paper refers to short-term debt issued by banks and corporations. This allowed the Fed to act as a lender of last resort for the financial system by creating second-layer reserve balances in order to purchase distressed financial assets.

The last major stated purpose of the Act was "to establish a more effective supervision of banking in the United States," in an attempt to sort through the monetary disarray of the day, establish the Fed's financial surveillance on the banking industry, and give the Fed sole power to issue bank charters that came with the ability to create third-layer money.

Finally, the Act decreed that the Fed maintain a gold- coverage ratio of at least 35% against the liabilities it issued on the second layer, meaning at least 35% of the Fed's assets must be held in gold. In actuality, gold represented 84% of the Federal Reserve's assets upon its founding, a number that would dramatically fall over time. Today, for reference, gold represents less than 1% of the Fed's assets.

Initially, the Federal Reserve did not own nor intend to own U.S. Treasuries on its balance sheet. The beginning of the first World War in 1914 swiftly ended this original intent, which became irrelevant in the face of war finance. Only two years after the launch of the Federal Reserve System in 1916, the Federal Reserve Act was amended to effectively help the United States government finance its war effort, and the Fed subsequently created ample reserves in order to purchase U.S. Treasuries.

The process of building an enormous portfolio of U.S. government debt had larger implications for the dollar pyramid. U.S. Treasuries joined gold on the first layer of money because of the Fed's new asset composition: by the end of World War I in 1918, the Fed's gold-coverage ratio fell from 84% to less than 40%, as over half the Fed's assets were now held in U.S. government bonds. It was the first indication that U.S. Treasuries would eventually replace gold altogether as the dollar pyramid's only first-layer asset.

Figure 10

Figure 10 shows the three-layered dollar pyramid a few years after the Fed's creation.

Source: Nik Bhatia: Layered Money
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Last modified: Tuesday, April 26, 2022, 7:54 PM