Many people take the Federal Reserve System for granted. The media overwhelms the public with titles such as "Why Greenspan is still worried", "Fed raises interest rates", "The Federal Reserve in action again". They are so common and natural that rarely anyone questions whether it has always been like that. Has there ever been time when there was no Fed to take care of the country’s finances and no Alan Greenspan to be accused of the successes or failures of the American economy?

The answer is yes. Such a time did exist and not too long ago. The Federal Reserve System was created in 1913 as a consequence of the failures of the former banking systems. During its 86-year lifespan it performed successful monetary operations and accurately oversaw the activities of the American banks. In order to understand how the idea of having a Federal Reserve System developed I am going to review the situation in the banking sector prior to the Federal Reserve. Next, I am going to look at how the Federal Reserve coped with the problems.

The first banks in United States appeared starting in 1686 because of the need for capital to invest. As opposed to the European banks, the colonial banks were a consequence of a lack of money rather than a result of the abundance of it. The function of the colonial banks was to print money and lend them out against land mortgages. They were land banks and as such were significantly different from the modern commercial banks. They did not have the functions of depositing or discounting and all they did was just print money and make loans against land.

The first commercial bank was established in 1782 in Philadelphia. Its functions included accepting deposits, making loans, and printing paper money. For a while it acted as a central bank by lending money to the government, holding its deposits and being its fiscal agent. It lost its role as a central bank in 1789 but as a commercial bank it was successful until 1923 when it was absorbed by a Pennsylvania Insurance Company.

The first central bank was created in 1791 when the congress granted a charter in the limit of twenty years to the first bank of the United States. The reason behind its creation was Hamilton’s argument that a national bank would make a triple contribution to the economy. First, it would create money and thus increase the active and productive capital of the country – for every dollar in gold the bank could issue two or three dollars in paper money because of the principle of fractional reserve. Second, a national bank would facilitate government borrowing, because it would increase the money supply and consequently the supply of capital. Third, it would for the same reasons help the payment and collection of taxes. Also, a national bank would promote lower interest rates by increasing the supply of money.

The Jeffersonians developed the argument against a central bank. They held that a central bank would be unconstitutional and would dangerously extend Federal power. Also, they did not believe that money equals capital, and although the bank would create money it would not create capital. Besides that, they believed that banks encouraged usury, diverted funds from agriculture, and by issuing paper money increased speculation and drove specie out of the country. Hamilton’s response to the latter argument was that the abundance of the country’s precious metals was not so important as the "quantity of the productions of its labor and industry".

The First Bank of the United States existed until 1811. Although it was successful in fulfilling its goals, the Jeffersonians were in power and its charter was not renewed. After its abolition the commercial banks in the United States periodically experienced difficulties. Failures in the banks could have been prevented more easily if a central bank existed, because in such case they would have been able to borrow from the central bank and avoid serious depletion of their reserves. The major problem of the commercial banks after the elimination of the First Bank of the United States was the overissue of paper money. Bank notes constituted a promise to pay the value of the note in specie on demand, but this did not always happen. Bankers sometimes issued large quantities of notes, and when the holders of these notes wanted to be paid back in specie, the banker did not have enough to redeem them. Overissuing happened mainly during periods of wars and prosperity because of the high demand for money. Logically, the first significant crisis of the redemption system occurred during a war – the war of 1812. The 250 banks in the country issued paper money far in excess of what could reasonably be redeemed with available specie, and the whole system of redemption broke down. As a consequence of the substantial increase in the money supply prices rose rapidly and by the end of the war they had doubled. The Federal Government attempted to tighten the money supply by persuading the state banks to resume specie payments voluntarily. The state banks were not willing to.

The next option was to create the Second Bank of the United States. It happened in 1816. The charter of the bank was again twenty years. This bank was much larger and had more power than the First Bank. It functioned as the Federal Government’s fiscal agent, issued notes and dealt with bills of exchange. Despite its extraordinary powers the Second Bank did not exercise them and tried to stay aside as much as possible. This led to a disaster since the state banks did not decrease their issuance of notes being aware of the fact that the Second Bank is not going to intervene. The Second Bank on the other hand was the one to help out the state banks with redemption of their notes. Consequently their reserves ran out of specie and trying to help them out the Bank too ran out of specie and was close to bankruptcy. The result was that the Bank stopped making new loans and refused to renew the old ones. The printing of paper money was finally reduced and the money supply tightened. This, among other reasons, led to the depression of 1819. The Second bank was accused as the main factor of the depression and thus it lost its supporters. The attempt to re-charter the bank in 1832 was vetoed by Jackson. By taking away the power of the Second bank Jackson gave freedom to the state banks. The number of the state banks together with the money supply increased enormously until 1837 when a new depression and panic occurred.

To enhance the disastrous situation several systems came into existence. First the Suffolk Banking System was created in 1824. After it the Safety Fund System was adopted by New York, according to which the strong banks protected the weak ones. The next system adopted was the free banking system. It was relatively successful but nevertheless bank failures increased. The wide variety of bank notes issued continued to accelerate. There appeared 1600 different banks issuing 7000 different currencies. Confusion as to which currencies are good and which are bad was common. To provide some organization in the free banking system in 1862 the National Bank Act came into existence. It obliged every national bank to maintain a reserve in lawful money against its deposits. City banks required 25 percent and country banks 15 percent. Following the National Bank Act national bank notes were created and it was hoped that they would substitute the rest of the circulating currencies. However, their issuance was based on the Federal debt and since the Government attempted to reduce the debt, it decreased the circulation of the national bank notes.

Besides that, the national bank currency was inelastic – it did not respond to the needs of the individuals and institutions, who required more money supply during booms and less of it during recessions. Not only was the national bank currency inelastic towards the changes of the business cycle but also it had the opposite characteristic – it increased during recessions and decreased during periods of prosperity. This phenomenon occurred due to the fact that during booms the bankers preferred to give out private loans rather than holding government bonds, in which case they started selling the bonds they had thus reducing the circulating money supply. In periods of recession the opposite happened – bankers bought government bonds since there wasn’t enough demand for loans. Buying bonds resulted in increasing the money supply. This feature of the national bank currency was considered detrimental to the economy. Empirical findings prove this. Without actually causing panics such as the ones of 1873, 1893 and 1907, the national bank system worsened them. The reason was that during booms the banks were unable to increase the money supply, which the economy needed. Due to the tight money supply interest rates rose, thus discouraging entrepreneurs from borrowing and consequently from investment. The lack of investment contributed to the developing recessions.

Another disadvantage of the national banking system was that it stimulated bank reserves to be sent to New York and this created currency immobility. It also had no central organization and it favored industry and commerce over agriculture because of the fact that national banks could not make long-term loans.

There was a need for a change. In this environment the Aldrich bill was passed in 1912. It did not succeed but it set the atmosphere for the establishment of the Federal Reserve System a year later.

A study by the National Monetary Commission recognized four major defects of the National banking system, which invoked the creation of the Federal Reserve System. Decentralization of the bank reserves was a disadvantage revealed by the absence of a responsible national conservator of the money market, reinforced by scattered and immobile bank reserves. Inelasticity of the American Bank Credit was a problem because a good banking system should be capable of contracting the money supply when business demands decline and expanding it when these demands increase. The Defects of the transfer-and-exchange system consisted in the fact that heavy shipments of currency back and forth over the country were expensive and complicated, while the exchange of currencies happened through London, which incurred additional exchange operations both expensive and risky, and gave inside information to the foreign competitors. The Defects of the banking machinery for the federal government were that it led to continual storage of large sums of money in Treasury vaults, involving substantial administrative expenses and a heavy loss of interest; it did not prevent large seasonal fluctuations in the money supply; and it made the depositary banks dependent on the Secretary of Treasury for support in the form of increased government deposits in times of financial pressure.

For these reasons the Federal Reserve Act was passed in 1913 and the Federal Reserve Banks started their operation in 1914.

Did the Federal Reserve System solve these problems? The answer is positive. The problem of decentralization of the bank reserves was solved by an amendment to the Federal Reserve Act, which required every bank belonging to the Federal Reserve System to maintain its legal reserve in the form of deposit at the Federal Reserve Bank of its district. Since then member banks stopped depositing their legal reserves in commercial banks. Reserve money is stocked in large reservoirs. Since these reservoirs are linked together through the Federal Reserve System, they are also mobile – the Fed provides numerous devices by which reserve money can be quickly moved from places of redundancy to places of scarcity. This solves the problem of the immobility of money. There are three ways of moving money between and within districts. These are through rediscounting by one Federal Reserve Bank for another, through open-market operations of Federal Reserve Banks, and through trade and bank acceptances.

Bank note currency as well as deposit currency became more elastic under the Federal Reserve System. Bank notes are defined as elastic if the supply expands and contracts readily in response to the economic situation. This was true of the supply of the Federal Reserve Notes, which replaced the old bank notes (the old bank notes were retired and came out of use after 1935). The Federal Reserve Act also increased the elasticity of the deposit currency by substituting the old rigid legal-reserve requirements with more flexible provisions and also by enabling member banks to borrow funds out of their Federal Reserve Banks.

In order to solve the problems of the domestic exchange the Federal Reserve System needed changes in the service of collecting and clearing of checks. After two years of experimentation in 1916 the Board of Governors in charge of the Federal Reserve System issued regulations for a clearing and collection system applicable and mandatory for all banks in the country. Having a uniform standard for these services maximized the mobility of the domestic exchange.

Shifting the transactions from sterling bills to dollars eliminated the problems of the foreign exchange. Under the Federal Reserve System the foreign operations no longer took place through London. Instead they were performed directly with the country of import or export. The Federal Reserve Board created its own foreign exchange division in 1917 to take care of foreign transactions.

The problem with the defective organization of the Federal Treasury was solved by a provision of the Federal Reserve Act according to which the funds held in the general fund of the Treasury may be deposited in Federal Reserve Banks, which banks, when required by the Secretary of the Treasury, should act as fiscal agents of the United States. Thus, the funds of the Treasury will earn interest by being part of the general flow of money in the economy.

The Federal Reserve System was successful in correcting the mistakes in the preceding banking systems. After centuries of experiments finally a relatively thriving system was found and adopted. Its development has incorporated the trials and errors of 300 years of banking, however that doesn’t mean that it is the final and ultimate version of the American central bank. It is just another trial that seems right at the present point of history.

• Kemmerer, Edwin Walter and Kemmerer, Donald L., The ABC of the Federal Reserve System, Harper, New York [1950]
• Board of Governors of the Federal Reserve System, The Federal Reserve System: its purposes and functions , AMS Press, New York [1978]
• Prochnow, Herbert Victor, The Federal Reserve System, Harper, New York [1960]
• Eastburn, David P., The Federal Reserve on Record, Federal Reserve Bank of Philadelphia, Philadelphia [1965]