Founding of the Federal Reserve System.docx

Founding of the Federal Reserve System.docx

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FoundingoftheFederalReserveSystem

TheFoundingoftheFederalReserveSystem

MarkToma

DesigningaMonetarySystem

Mentallytransportyourselfto1913.Youhavebeenchargedwithdesigninganewmonetarysystem.Beforejumpingintothedetailsofthetask,youandyourco-foundersmustanswerthebasicquestionthateveryinstitutionalarchitectmustanswer:

Doyoucreateatop-downorabottom-upsystem?

Moreconcretely,doyoucreateasystemwhosepolicyisdeterminedatthediscretionofdecision-makersatthetopofahierarchy,ideallymotivatedtodowhatisbestfortheeconomy?

Ordoyoudoyouestablishcertainrulesofthegamewheredecisionsaremadebottom-upbyindividualspursuingtheirself-interest?

Forthediscretionarysolution,thechallengeistodesignthesystemsothatgoodleadersendupatthetop.Fortheself-regulatingsolution,thechallengeistodesignrulesthatconfrontself-interestedindividualswithincentivesthatinducethemtotakeactionsthatpromotethecommongood.

Oncethisissuehasbeensettled,youcanturntothedesigndetails.Nowyouandyourco-foundersmustconfrontaproblemthateverymonetaryarchitectmustconfront:

Howdoyouavoidtwobadoutcomes–toomuchortoolittlemoney?

First,considertheover-issueproblem.Ifthemoneysupplierissuesmorethanthepublicdemands,thentheresultisinflation.Themoneyholderfinds,throughnofaultofherown,thatthepurchasingpowerofhermoneybalancesdwindlesovertime.Theclassicsolution,benefitingbothsides,isfortheissuertocommittoredeemingnotesintoagood,likegold,whoserealvaluecannotbemanipulatedbytheissuerandtomakeredemptioneasy.Then,moneywillbeatleastasgoodasgold,implyingthatthepurchasingpowerofmoneycannotfallbelowthepurchasingpowerofgold.

Asecondproblemarisesintheformofpotentialunder-issue:

Themoneyissuermayfailtoaccommodatedemand,triggeringascrambleforliquiditythatmayresultinsomeorallofthefollowing:

（1）ariseinthepurchasingpowerofmoneyrelativetogold,

（2）ariseintherateofexchangebetweencurrencyanditsmoneysubstitute,demanddeposits,（3）ariseinshort-terminterestrates.Thesepriceadjustmentssignalthatcurrencyhasbecomescarcer–needlesslysoif,underalternativeinstitutionalarrangements,thecurrencysupplierwouldhavebeenincentivizedtoaccommodate.

WasthedesignproblemconfrontedbythefoundersoftheFederalReserveoneofover-issue,under-issueorboth?

Toanswer,wemustbrieflyexplorethenatureofthemonetarysystemthatexistedbeforetheFed’sfounding.Thatsystem,theNationalBankingSystem,wasestablishedbytheLincolnadministrationtosolveitsowndesignproblem–howtohelptheNorthwintheCivilWar.Solvingthewarfinancingproblem,however,didhaveadownside,producingaversionoftheunder-issueproblemorwhatcametobeknownastheproblemofaninelasticcurrency.ThecreationoftheFed,somefiftyyearslater,wasmeanttoaddressthisdownside,apointdrivenhomebytheopeninglineoftheFederalReserveAct:

“AnActToprovidefortheestablishmentofFederalreservebanks,tofurnishanelasticcurrency….”（italicsadded）.BeforerecountingthestoryofhowthefoundersoftheFedcraftedanewsystemtofurnishanelasticcurrency,thenextsectionoutlinesthenatureoftheelasticityproblemundertheNationalBankingSystem.

TheNationalBankingSystem

Over-issue

LegislationgivingrisetotheNationalBankingSystemcreatedtwonationalcurrencies,U.S.notesandnationalbanknotes.TheU.S.notes（greenbacks）wereissuedbytheTreasuryandthenationalbanknoteswereissuedbyanewtypeofbank–nationallycharteredbanks–authorizedtoacquirethenotesfromtheTreasuryonlyafterpurchasing2%U.S.governmentbondsascollateralbacking.After1879,theU.S.noteswerebackedbyagoldreserveof100%housedattheTreasury,essentiallymakingthesenotescommoditymoney.Thenationalbanknotescouldberedeemedintolawfulmoney（goldorU.S.notes）eitheratthenationalbankofissueorthroughredemptioncentersestablishedbytheTreasury.Eachbankwasrequiredtocontributelawfulmoney,intoaredemptionfundattheTreasury,equalto5%ofitsoutstandingnotes.Intheeventthatanationalbankwentbankrupt,theTreasurywasobligatedtoimmediatelyredeemitsnotes.Forredemptionpurposes,theTreasurycouldusetheredemptionfundandthegovernmentbondcollateralandwasgivenfirstlienonalltheassetsofthebankanduponthepersonalliabilityofthestockholders（FriedmanandSchwartz1963:

21）.Afterthat,theTreasurywouldhavetorelyonthefederalgovernment’staxandborrowingcapabilities.

TwoconsiderationscomeintoplayinassessingwhetherthesefeaturesoftheNationalBankingSystemprotectedthecurrencyholderfromtheover-issueproblem.First,wasredemptioncertain?

Second,wasredemptionlowcost?

ForholdersofU.S.notes,certaintyofredemptionwasguaranteedbythe100%goldbacking.Forholdersofnationalbanknotes,certaintyofredemptionwasaquestionofthemagnitudeofthefederalgovernment’staxingpowersrelativetoitsspendingobligations,sincetheU.S.governmentstoodastheultimatebacker.Ifthepresentvalueofcurrentandexpectedfuturemaximumtaxeswaslessthanthepresentvalueofcurrentandexpectedfuturespending,thenthefederalgovernmenthadnoexcesstaxpowersthatcouldbeused–bysellingbonds–toredeemnotesintogold.Noteholderswouldhavegoodreasontodoubtthefederalgovernment’sabilitytoraisefundsonshortnoticetoredeemnotes.

Howwouldalatenineteenthorearlytwentiethcenturynoteholderviewthenettaxpowersofthefederalgovernment?

Spendingobligationsweremodest,buttaxingpowersalsoweremodestsincethefederalgovernmentreliedontaxeswithnarrowbases,mainlyexcisetaxesandtariffs.Still,nationalnotesweresubstantiallybacked–byreservesattheTreasury,bythegovernmentbondcollateral,bytheassetsofthebankandbythepersonalliabilityofbankstockholders.Areasonableconjecture,therefore,isthatholdersofnationalbanknotes,whilenotperceivingredemptiontobecertain,wouldhaveperceiveditaslikely.

Wasredemptionalsolowcost?

Here,too,theanswerisaqualifiedyes.Anindividualwantinglawfulmoneyforanationalbanknoteissuedbyadistantbankcould,ofcourse,traveltothebankforredemption.Moreconveniently,shecouldtakethenotetoherbank,exchangeitforoneofherbank’snotes,whichshecouldthenredeemforlawfulmoney.Ifdesired,herbankcouldsendthosenotestoaTreasuryredemptioncenterandreceivelawfulmoneyfromtheredemptionfund.Significantly,thecostsofnoteredemption,e.g.,thesortingofnotesandthetransportationcosts,werenotincurredbythesendingbank;instead,theywereassessedagainsttheissuingbank（Champ,FreemanandWeber1999:

568）.SoexceptforpossibledelaysinreceivingcreditfornotessenttotheTreasury,redemptioncostswerelow.

Thebottomlineisthat,whilenotsure-fire,theNationalBankingSystemdidrepresentacrediblesolutiontotheover-issueproblem.Thecostofinitiatingredemptionwasrelativelylow.Oncetriggered,thelikelihoodthatthenoteswouldinfactberedeemedwasrelativelyhigh.

Under-issue

Under-issue–thefailuretopromptlyaccommodatecurrencydemand–wouldproveabiggerconcernundertheNationalBankingSystem.Chronicscarcityofmoney–say,aconstantsupplyinthefaceofrisingdemand–wasnottheissue.Theoutcomeinthiscasewouldbeapersistent,equilibratingfallinthepricelevel,withnote-holdersexpectingandreceivingarisingpurchasingpower.Rather,theproblemwasthatsupplydidnotpromptlyincreaseinresponsetotemporaryincreasesindemand.

Thesourceoftheproblemwasthatneitherofthetwopartiesdirectlyinvolvedincurrencysupply–thenationalbanksthatissuedthenotestothepublicandtheTreasurythatprintedanddeliveredthenotestothenationalbanks–hadstrongincentivestoaccommodatedemand.Theincentiveproblemfacedbynationalbanksstemmedfromtherequirementthattheyfirstacquireaspecificbond–2%U.S.governmentbonds–beforeacquiringnewnotes.Therequirement“funneledthebanks’buyingpowerintoasinglebondmarketandraisedpricestoprohibitivelevels”（Horwitz1990:

640）,aproblemmademoreseverebythefactthat,afteraround1880,thegovernmentusedpersistentbudgetsurplusestoretiredebt,thusreducingsupply.Anyunexpectedrelaxationofthecollateralrequirementoranyeasingofsupplyconditionsinthemarketfor2%governmentbondsmightimposepotentiallysignificantcapitallossesonbanks.Additionally,bymakingtheentirebankingsystemmorefragile,thecollateralrequirementreduceddepositorandnote-holderconfidence,increasingthelikelihoodthatarelativelymodesteconomicdownturnwouldtriggernumerousrequestsfornoteredemption,thusraisingtheoverallcostsofrunningthebankingsystem.Alltold,thecollateralrequirementimpliedthataccommodatingthepublic’sdemandforcurrencywasnotalwaysaprofitableactivityfornationalbanks.

TheincentiveproblemfacedbytheTreasuryarguablywasevenmoresevere.Unlikeprivatebanks,theTreasurywasanon-profitbureauthatfinanceditselffromagovernmentbudget.Whiletheout-of-pocketexpenseofprintinganddeliveringthenoteswascoveredbythenationalbankrequestingthenotes,theTreasurystillfacedancillarycostsstemmingprimarilyfromthemandatethatitverifyandapprovethegovernmentbondcollateralbackingnewnotes.VerificationandapprovalcostswouldbeparticularlyhighduringperiodswhentheTreasurywascalledu