federal reserve building

How Much Do You Know About the Federal Reserve?

It’s commonly assumed that paper money is backed by the government, but a closer look at the money in your wallet reveals otherwise. Check out any one of the bills in your wallet. You’ll see a notation across the top that reads “Federal Reserve Note,” which at one time said, “United States Note,”  as shown in the illustration below.

If you have a vested interested in currency, it is worth taking the time to read through these facts. But understanding the complex Federal Reserve System can be challenging.  To make the task somewhat less demanding, the website federalreserveeducation.org has created a chronology of bite-sized segments. The chronology has been summarized and compressed below, breaking it down into years and making it easier to digest.

1775-1791: U.S. currency

To finance the American Revolution, the Continental Congress printed fiat notes. (fiat is defined as an authoritative determination).  The nation’s first paper money came to be known as  “continentals,” and was issued in such large quantities that inflation resulted. As inflation accelerated throughout the course of the war, people eventually lost all faith in the notes.  As a result, the phrase “not worth a continental,” came to mean “totally worthless.”

1791-1811: first attempt at central banking

In 1791, Congress established the First Bank of the United States with headquarters in Philadelphia, due to urging by Treasury Secretary Alexander Hamilton. The country’s largest corporation, the First Bank was dominated by big banking and generated mistrust among the largely agrarian American population. When its 20-year charter expired in 1811, a vote to renew the charter for the First Bank failed in Congress by a single vote.

1816-1836: a second try fails

By 1816, the atmosphere of mistrust for a central bank had eased, and a charter for the Second Bank of the United States was approved by a narrow margin. But Andrew Jackson, elected president in 1828, vowed to kill the Bank. His attacks touched a still-raw nerve with Americans, and the charter for the Second Bank was allowed to expire in 1836.

1836-1865: the free banking era

Between 1836 and 1865, state-chartered banks and unchartered “free banks” dominated. They issued their own notes redeemable in gold or specie (money in coin, as opposed to fiat policies). During this period, banks also began offering demand deposits (funds held in an account from which deposited funds can be withdrawn at any time from the depository institution) to enhance commerce. The New York Clearinghouse Association was formed in 1853 to allow the city’s banks to deal with a rising volume of transactions by check.

1863: National Banking Act

The National Banking Act of 1863 was passed at the height of the Civil War. The Act established nationally chartered banks with circulated notes backed by U.S. government securities. An amendment to the Act created a uniform national currency by imposing taxation on state notes — but not national notes, providing for nationally chartered banks, whose circulating notes had to be backed by U.S. government securities.

1873-1907: financial panics prevail

Despite the passage of the National Banking Act of 1863, bank runs and financial panics prevailed through the last quarter of the 19th century. A banking panic in 1893 triggered the nation’s worst financial depression to date. The economy stabilized only through the direct intervention of financial titan J.P. Morgan.

1907: a very bad year

A particularly severe bank panic occurred in 1907, triggered by an unsuccessful bout of Wall Street speculation. J.P. Morgan intervened a second time to avert disaster. By this time, the calls for banking reform were widespread, but the structure of reform caused deep divisions within the country. Nonetheless, a growing consensus developed among all Americans that a central banking authority was the only means to maintain the health of the nation’s banks.

1908-1912: the stage is set for a decentralized central bank

As a direct response to the panic of 1907, the Aldrich-Vreeland Act of 1908 provided for issuing currency on an emergency basis to deal with financial crises. The act also established the National Monetary Commission to investigate a long-term solution to the nation’s banking and financial problems. The Republican-dominated commission created a banker-controlled plan, which Woodrow Wilson, a Democrat, killed after being elected in 1912. Nonetheless, the foundation was laid for the eventual creation of a decentralized central bank.

1912: Woodrow Wilson as a financial reformer

Lacking personal expertise in banking, Woodrow Wilson solicited advice from Virginia Representative Carter Glass, who would become the chairman of the House Committee on Banking and Finance. He sought additional guidance from the Committee’s expert advisor, H. Parker Willis, a former professor of economics at Washington and Lee University. During nearly all of 1912, Glass and Willis worked to a create a central bank proposal. In December 1912, they introduced what would become, with some modifications, the Federal Reserve Act.

1913: the Federal Reserve System is born

The Federal Reserve Act, signed into law by Woodrow Wilson on December 23, 1913, represents a classic example of compromise. The Federal Reserve Act established a decentralized central bank balancing the competing interests of private banks and the populist sentiment of mistrust against big banks.

1914: open for business

The Reserve Bank Operating Committee was tasked with fleshing out the bare bones of the Federal Reserve Act to allow the central bank to begin its operations.  By November 16, 1914, 12 cities were chosen as sites for regional Reserve Banks: Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York City, Philadelphia, Richmond, San Francisco, and St. Louis. (The Federal Reserve Board). These branches opened their doors just as World War I erupted across Europe.

1914-1919: Fed policy during the war

Thanks to emergency currency issued under the Aldrich-Vreeland Act of 1908, U.S. banks continued to operate normally throughout World War I. A greater impact on the U.S. economy resulted from the ability of the ability of the Reserve Banks’ to discount bankers’ acceptances.

The 1920s: the beginning of open market operations

Benjamin Strong, head of the New York Fed from 1914 to his death in 1928, recognized that gold was no longer the central controlling factor for credit. His aggressive pursuit of large purchases of government securities helped to stem a recession in 1923. Strong’s actions also provided clear evidence of how open market operations could influence the general availability of credit throughout the banking system.

1929-1933: the market crash and the Great Depression

The stock market crash in October 1929 plunged the nation into the worst depression in its history. Nearly 10,000 banks failed between 1930 and 1933, prompting newly inaugurated President Franklin Delano Roosevelt to declare a bank holiday in March 1933 while the government attempted to develop the means to ease the nation’s economic woes.

1933: the depression aftermath

The Banking Act of 1933, better known as the Glass-Steagall Act, was passed by Congress as a direct reaction to the Great Depression. Glass-Steagall mandated the separation of commercial and investment banking, and required government securities to be used as collateral for Federal Reserve notes.  At the same time, Roosevelt recalled all outstanding gold and silver certificates, effectively bringing an end to the gold standard.

1935: more changes to come

Federal Open Market CommitteeThe Banking Act of 1935 mandated the creation of the Federal Open Market Committee (FOMC) as a separate legal entity, from the Fed. The Act also required the removal of the Treasury Secretary and the Comptroller of the Currency from the governing board of the Fed, and limited the terms of governing board members to 14 years.

1951: The Treasury Accord

1940s US EconomyAfter the United States entered World War II in 1942, the Federal Reserve System formally committed to maintaining low-interest rates on government bonds. This commitment was made at the direct request of the Treasury Department so that the federal government could achieve cheaper financing of war debt.

The 1970s-1980s: inflation and deflation

1970s InflationInflation rates and consumer prices soared during the 1970s, which also witnessed a more than doubling of the federal deficit. Paul Volker was sworn in as chairman of the Fed in August 1979. He led the agency through a series of drastic steps through the 1980s that were ultimately successful in reining in double-digit inflation.

1980: setting the stage for financial modernization

1980s Bank DeregulationThe Monetary Control Act of 1980 required the Fed to price its services competitively compared to those of private sector providers. The Act also required the Fed to establish reserves for all eligible financial institutions. The 1999 Gramm-Leach-Bliley Act essentially overturned the Glass-Steagall Act of 1933 by allowing banks to offer financial services ranging from investment banking to insurance.

The 1990s: the longest economic expansion

1990s Economic ExpansionThe stock market crashed on October 19, 1987, two months after Alan Greenspan took office as the Fed chairman. In response to the crisis he issued a one-sentence statement on behalf of the Fed before trading began on October 20: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.”

The 1990s were defined by gradually declining inflation and the longest peacetime expansion of the economy in America’s history. This period of sustained prosperity came to a sudden halt in March 2001. A brief recession followed which ended in November of the same year.  After the bursting of the stock market bubble, the Fed lowered interest rates dramatically.

The financial aftermath of 9/11

The terrorist attacks on New York City, Washington, D.C. and the region near Shanksville, Pennsylvania tested the effectiveness of the Federal Reserve as a central bank. In response to the disruption to U.S. federal markets, the Fed issued a statement in the same vein as its 1987 announcement:  “The Federal Reserve System is open and operating. The discount window (the practice of sending a bank representative to a reserve bank teller window when a bank needed to borrow money) is available to meet liquidity needs.”

In the period immediately following the 9-11 attacks, the Fed lowered interest rates and provided more than 45 billion dollars in loans in an effort to stabilize the U.S. economy. Two years later, in 2003, the Fed changed its discount window operations to set rates at the window above the prevailing Fed Funds rate, and to use interest rates to ration loans to banks.

2006 and beyond: financial crisis and response

Easy credit and low mortgage rates made home-ownership possible for more people, driving up housing costs and fueling a tremendous housing bubble.  As the housing market continued to overheat, lenders began extending credit to sub-prime borrowers with questionable financial credentials. When house prices began falling in 2006, a new problem emerged: many homeowners actually owed more than their houses were worth. At the same time, many homeowners lost their jobs and began to fall behind on their mortgages. The ongoing financial crisis eventually led to a wave of foreclosures.

During the height of the housing bubble, individual mortgages had often been repackaged and bundled as securities traded on the open market. When housing prices began to fall, many investors lost money. As the financial crisis deepened, credit tightened and even major institutions found it difficult or impossible to borrow.

The Federal Open Market Committee, the Fed’s policy-making body, responded to the crisis by lowering the federal funds rate in stages, bringing the rate almost to zero by December 2008. This action helped lower the cost of borrowing for businesses and homeowners. The Fed purchased 300 billion dollars in Treasury securities and authorized the purchase of 1.25 trillion dollars worth of mortgage-backed securities guaranteed by Freddie Mac and Fannie Mae along with 175 billion dollars in longer-term debt. These actions by the Fed reduced mortgage rates, making buying a home more affordable and allowing many homeowners who were underwater on their mortgages to refinance their debt.