By now it should be apparent that money and the money supply are complicated and somewhat tenuous. American money is not backed by anything of real value, such as gold, and banks are allowed to lend and re-lend the same stack of currency over and over again. It’s not hard to imagine a scenario in which this whole system falls apart. What if everyone woke up tomorrow, looked at their money, and realized it was just a bunch of green paper? What if everyone went to their banks and demanded the money they had deposited and discovered that their money had been loaned out to others? And what if these depositors panicked and also demanded their money, triggering a “run” on the bank?
The Federal Reserve System was established to make sure that these very things do not occur. It was created by Congress in 1913 to ensure that the public retained confidence in its money and the financial institutions where it is held.
The Federal Reserve System, also known as “the Fed,” is actually a network of twelve Federal Reserve Banks located in major cities across the country. The Fed is administered by a Board of Governors. Its seven members are appointed by the president of the United States, but as the Fed is supposed to remain an independent economic institution, each member serves a fourteen-year term and is not eligible for re-appointment. The Board of Governors is assisted by the Federal Advisory Council whose members are selected by the directors of the twelve Federal Reserve Banks, and the Federal Open Market Committee, which consists of the Board of Governors and representatives from five of the Federal Reserve Banks.
The Federal Reserve System
The Federal Reserve System serves several functions. It operates as the federal government’s bank; it receives Treasury deposits and extends short-term loans to the government if necessary. But its most critical responsibility is to oversee banks and the nation’s money supply and make sure that the public retains confidence in both. To accomplish this, the Fed pursues several interrelated tasks.
1) The Fed serves as a centralized clearing house for checks. We have already seen that checks are a critical part of our money supply—what would happen if your bank refused to honor a check written against funds deposited in some small bank on the other side of the country? The Federal Reserve System facilitates the transfer of funds from one bank to another by serving as an intermediary bank. Since banks are required to deposit a certain portion of their funds in the Federal Reserve Bank, funds from one bank’s reserves can simply be transferred to the reserves of another. Not all checks are cleared in this way. Some banks use different types of intermediary institutions—either clearinghouse corporations or correspondent banks.
2) The Federal Reserve System sets reserve requirements. It determines the percentage of a bank’s deposits that it must keep on hand or place in the District Federal Reserve Bank and, consequently, what percentage the bank is allowed to lend out.
3) The Fed serves as “the bankers’ bank.” The nation’s banks are required to keep a portion of their reserves in the District Federal Reserve Bank. In return, the Federal Reserve Banks extend loans to local banks when they do not have enough cash on hand to handle daily transactions or, more commonly, to meet their reserve requirement. When the Fed loans money to a private bank, it charges them interest known as the discount rate. Commercial banks can also borrow from one another in order to meet the reserve requirement. When they do, the interest rate charged for these short-term loans by the lending bank is known as the federal funds rate.
Why It Matters Today
In 2010, we find ourselves in the middle of an intense debate over the political independence (or lack thereof) of the Federal Reserve. The Fed deliberately operates largely outside the highly politicized space of electoral politics. Once appointed to office, its governors serve 14-year terms and cannot be recalled or reappointed. The idea is to ensure that they can make rational economic decisions without worrying about which political factions their policies anger or appease.
From the time of the 2008 economic collapse, the Fed played a very aggressive role in trying to stabilize the economy, bailing out some struggling firms and injecting huge flows of capital liquidity into the system. And, by design, it did it all with minimal political oversight.
In the aftermath of those decisions, some (mostly on the political left) have harshly criticized the Fed as an antidemocratic institution, exercising huge influence over the state of the American economy without "we, the people" having much if any power over the banking giant. (This fear of centralized banking power is an old theme in American politics, dating back to Andrew Jackson and even Thomas Jefferson.)
So some Democrats have pushed to change the rules of the Fed, turning the powerful position of New York Fed Governor into one appointed by Congress. Opponents of this plan, which include most Republicans and bankers, along with many moderate Democrats, decry the scheme as dangerous politicization of the Fed. If Congress gains control over the Fed, they argue, the politicians will surely turn monetary policy into a tool for narrow partisan political gain.
What do you think?
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