ECONOMICS AND TRADE | Achieving growth through open markets
28 April 2008
U.S. Central Bank Benefits Self-Regulating Economy
The U.S. Federal Reserve grew out of clashing economic interests
This is the first article in a series on the U.S. financial system and market regulation.
Washington -- Five days a week, throughout the year, special presses that belong to the U.S. Bureau of Engraving and Printing in Washington and Dallas roll out 38 million pieces of paper currency totaling approximately $750 million.
Yet this massive amount of currency and coin (manufactured by different facilities) is only a small fraction of the nation's total money supply -- an estimated $7.6 trillion in March 2008. (This figure reflects the "M2" definition of the money supply comprising paper currency and coin-plus-checking accounts, short-term savings accounts and small certificates of deposit.)
MONETARY POLICY
The nature and functioning of the vast and complex system of money and credit in the United States is vital not only to the health of the U.S. economy but to the well-being and growth of the international financial system as well. (See "World Finance Leaders to Meet as Concerns on Global Economy Grow.")
And today, with financial markets under stress from severe losses in the housing and credit sectors, America's monetary system is under more scrutiny than ever before -- particularly the Federal Reserve of the United States, which functions as the nation's central bank. (See "U.S. Government Moves to Meet Challenges in Capital Markets.")
The free market economy of the United States is largely self-regulating. As Ben Bernanke, chairman of the Federal Reserve Board of Governors, said in a 2007 speech:
"Market forces determine most outcomes in our economy, a fact that helps explain much of our nation's success in creating wealth. ... Markets aggregate diffuse information more effectively and set prices more efficiently than any central planner possibly could."
At the same time, Bernanke observed, "targeted government regulation and intervention" can benefit the economy, especially in the case of financial markets, to promote economic stability and growth and to protect consumers and investors.
Governments in market economies influence economies in two broad ways. One is monetary policy, the purview of the Fed, which deals with the amount of money and availability of credit in the economy. The other is fiscal policy -- the tax and spending activities of government that typically draw far more attention and headlines than monetary policy.
BANK BATTLES
Political battles over the nature of banking and money in the United States are as old as the nation itself. These early divisions typically reflected the tension between agricultural and small business interests in the western part of the country, on one hand, and corporate and banking interests mostly in the eastern part of the country, on the other. The western, rural interests opposed a strong central bank, while the eastern financiers and corporate leaders favored one.
When the Federal Reserve was founded, says Donald Kohn, vice chairman of the board of governors, "The legislation that Congress ultimately adopted in 1913 reflected a hard-fought battle to balance these two competing views and created the hybrid public-private, centralized-decentralized structure that we have today." (See "Debate Begins over U.S. Government Role in Capital Markets.")
The nation's first central bank was established in 1791, but it drew strong opposition from rural interests and the emerging Democratic Party led by Thomas Jefferson, who charged that it was dominated by large commercial and financial interests.
The Second Bank of the United States, chartered for 20 years in 1816, triggered an epic battle between eastern financial interests, led by bank president Nicolas Biddle, and President Andrew Jackson, who led the populist forces. Jackson’s opposition to centralized financial control had wide support among many farmers and working class Americans, especially in the rapidly growing West.
Jackson may have employed dubious economic arguments against the bank, but his views about the bank's centralized power have echoed through economic debates to the present.
"Many of our rich men have not been content with equal protection and equal benefits but have besought us to make them richer by act of Congress," he declared of the bill to re-charter the bank.
Jackson prevailed by pulling all federal funds out of the bank and allowing its charter to lapse in 1836.
BANKING PANICS AND THE FED
The United States operated largely through independent and state-chartered banks in the 19th century. However, even the establishment of nationally chartered banks in 1863 could not prevent the regular outbreak of financial panics that often led to widespread economic downturns.
The banking panic of 1893, for example, triggered the nation's worst economic depression to that time, and another severe panic in 1907 gave impetus to the Federal Reserve Act of 1913, which created the Federal Reserve (Fed) as a kind of "decentralized central bank" -- a classic compromise balancing both consumer and commercial interests and containing public and private elements.
The Fed proved unable to prevent the Great Depression of the 1930s, during which nearly 10,000 banks failed. But the Banking Act of 1935 provided several vital reforms. Among them was establishment of the Federal Deposit Insurance Corporation to insure bank deposits.
The Federal Reserve Web site provides an excellent summary and explanation of its operations. There is also an interactive explanation of Fed history, functions, operations and financial services called Fed 101.
For a general overview, see Outline of the U.S. Economy and USA Economy in Brief .
