The Federal Reserve System, popularly called the Fed, is the central banking system of the United States. The Fed serves as the banker to both the banking industry and the government of the United States. The monetsary and banking system of the United States is regulated by the Fed. The Fed issues the national currency and regulates the monetary and banking system. The Fed is really a part of the U.S. government,with the government being responsible for its cost of operation. Many economic textbooks inappropriately treat the Fed as being owned by member banks. It is not.

Before the passage of the Federal Reserve Act in 1913, there was for a 50-year period of frequent economic crises, often accompanied by collapses of the banking system. The American banking system was not able to respond with flexibility to business cycles. The National Bank Act (1864) divided the banking system into

(1) central reserve city banks, first in New York City and Chicago and Saint Louis were added in 1887,

(2) resewrve city banks in 16 large cities other than New York and Saint Louis, and (p> (3) Country banks.

All national banks were required to hold reserves, and country banks could hold a proportion of their deposits in reserve city banks. If country banks needed additional reserves to meet the cash demands of their customers, they would go to reserve city banks, which in turn would demand funds from central reserve city banks. There was frequent collapses of this awkward system, with susdpension of specie, ie., gold coin, payment. Banking crises occurred in 1873, 1883, 1893, and 1907. After the 1907 panic, a bipartisan congressional body, National Monetary Commission, was formed in 1908.

The Federal Reserve Act of 1913

It was the report of the National Monetary Commission that led to the Federal Reserve Act of 1913. Instead of establishing a system under which the government would issue fiat currency under appropriate regulations of the Federal government that would fulfill the needs of flexibility and stability, a system masquerading as a private banking system was established, with nearly all risks assumed by the American taxpayer and all profits going to the banking industry. Thus, responsibility for the costs of policy decisions were separated from the profit motive, with the result that decisions could be, and were, made, that led to immense profits to the banking industry while at the same time immense expense to the American taxpayer. If a monetary system is based on fiat currency, there is no need for the government to become indebted to the banking industry in the process of the issuance of fiat currency. The process of multiplying currency under a so-called reserve ratio, with government securities serving as a basis for multiplication, as established by the Federal Reserve Act of 1913 is nothing but a disguised gift of billions of dollars each year to the banking industry. It had become clear that a sound monetary system must be the responsibility of government and cannot result from the activities of numerous banks constituting the banking industry. To have those dedicated to the profit motive making banking decisions for which the government is responsible is absurd. The so-called independence of the Fed encourages decisions being made by persons not accountable for their decisions.

Board of Governors

The powers of the Federal Reserve System are administered by a board of governors, which is responbsible for all policy issues relating to bank regulation and supervision as well as to most aspects of government control. Rhe board is not an opersating agency and the day-to-day implementation of policy decisions is the responsibility of the district Federal Reserve banks. Most economic textbooks state, and many professors of ecomomics believe, that the district banks are by owned by the commercial banks that are members of the Federal Reserve System. In reality they are owned by the government and in final analysis by the American people. Although the members banks have what is termed stock in the reserve banks of which they are members, the stock has no attributes of ownership whatsoever, with the profits of the reserve banks going to the U. S. Treasury and with the losses being borne by the U. S. Governmen and the American people. The profits of member banks necessarily go their stockholders, even though member banks make no contribution towards the expenses of the Fed. The ownership illusion is apparently for cosmetic purposes only and to obsure the extent of government subsidization of the banking industry. The members banks have no control over the System, with the control being in the Board of Governors and the heads of the Reserve banks. There is, however, no doubt that the Board of Governors, and the heads of reserve banks, generally act in the interest of the member banks. The lack of formal control of the Fed by member banks is an essential part of the governmental subsidization of the banking industry. It needs no formalized control for its interests to be fulfilled.

Complex Regulatory Apparatus

In General

In some instances the authority of the Federal Reserve is shared with other federal agencies. The Comptroller of the Currency and the Federal Deposit Insurance Corporation (FDIC) share power, for example, with the Federal Reserve in the mergers or examination of banks. In the highly significant area of regulating the nation`s money supply, pursuant to either national goals or the goals of the special-interests of the banking industry, the Federal Reserve acts alone and is solely responsible for violations of the public interests.

Freed from Congressionsl Supervision

Congress has no control over the income and expenditures of the Federal Reserve banks and over the Fed`s Board of Governors. The Fed is self-financing with revenues coming mainly from Reserve bank holdings of income-earning securities, consistinbg primarily those of the U.S.Government. Although not understood by many economists and politicians, these government securities are in fact owned by the American people. After deductions of all expenses of the Reserve banks are debited, any income in excess of expenditures by a booking keeping transaction goes to the U. S. Treasury. It does not go to the member banks since they have no incidents of ownership over the securities. Much of the expenses of the Reserve babks are operational expenses in providing services to its member banks and regulatory expenses.

Structure of the Fed

The base of the Federal Reserve system consists of the member commercial banks. All national banks are required to join the system and state-charted banks may join the system. Members purchase so-called capital stock in their district Reserve bank and are entitled to a statutory six percent stock "dividend", which is payable whether the Reserve bank has any profits whatsoever. They also have the right to vote for the directors of their Reserve bank. Membership also permits a bank to obtain many services, sometimes without charge, such as to request and usually obtain short-term credit from the Reserve babk, to have its checks cleared by that bank, and to obtain currency and other services from the Reserve bank. The member bank, in return, is required to maintain a non-interest bearing deposit, the "required reserve," with the reserve bank. Instead of being a "required reserve" it is really a privilege that allows the member bank to create money on the credit rating of the American people. For example, if the reserve ratio is ten to one, the member bank can lend out ten dollars for every one dollar it actually has and to do this with the back-up of the Federal Reserve system. Although the money is created using the credit rating of the American government and the American people, the bank does not pay any interest for this privilege. Only banks may do this not credit unions, savings and loan associations, or ordinary American citizens.

Expansion and Contraction of Currency

The expansion and contraction of currency is primarily achieved only by the selling and buying of government securities. Even though the American currency is a form of fiat money, fiat money in America is only created by the government`s becoming indebted to the members banks who buy government securities. This indebtedness need not be created, and the currency might be expanded or contracted by means other than the issuance of interest paying government securities.

Borrowing of Reserves

Since the Monetary Control Act of 1980, banks can borrow reserves from their reserve bank, that is, they can, in effect, purchase the privilege of creating money under the applicable reserve ratio. The act imposes the so-called reserve "requirement" on all depository institutions and also requires that the Reserve bank charge a fee for services previously available without charge. The stated reason for allowing banks to borrow reserves from the Reserve banks was to increasde the liquidity of the entire banking system. During the 1990s it was to fuel the Dow-Jones industrial averages. During the year 1999, before the stock market collapse, the Reserve banks lent interest-free reserves to member banks and allowed them to repay the loan of reserve with money created by the loans themselves. For exampole, by borrowing a million dollars in reserve, if the reserve ratio was ten to one, the bank could create ten million dollars and use one million of this created money to repay the loan to the Reserve bank. The money created during 1999 did not increase the over-all liquidity of the economy, and it had no place to go but into the Dow-Jones industrial average. The borrowing of reservces is a means that money can be created without the government`s becoming indebted to the member banks. In fact, borrowed resreves could become the major means of expanding the currency and the paying back of borrowed reserves the major means of contracting the money supply. By reliance on borrowed reserves to enlarge the money supply instead of interest-paying governmrnt securities, the American government would save billions of dollars each year.

The Twelve Reserve Banks

The twelve district Reserve banks are located in the following cities: Boston; New York; Phildelphia; Cleveland, Ohio; Richmond, Va.; Atlanta, Ga.; Chicago; St. Louis, Mo.; Minnneapolis, Minn.; Kansas City, Mo.; Dallas, Tex.; and San Francisco. Each bank has a nine-member board of directors, divided into three classes. Class A and B diectors are elected by the member banks, and Class C directors are appointed by the Board of Governors. The board is responsible for the administration of the bank and, subject to approval of the Board of Governors, for the appointment of the bank`s president and vice-president. The directors also set the discount rate, subject to review by the Board of Governors, which is the interest rate charged to banks for borrowing from the Reserve banks.

Implementation of Decisions of Board of Governors

Reserrve banks implement decisions made by the Board of Governors and by Reserve babk officers. State member banks are examined by the staff of Reserve banks, with national banks being examined by the staff of the Comptroller of the Currency. The FDIC examines insured non-member banks. Sales and purchases of securities for Federal Rerseve System`s own account are handled by the Federal Reserve Bank of New York, which also handles international financial activities.

Monetary Control by Fed

The Fed has two types of monetary controls, which are:

(1) General controls, which are controls over open-market operations and the required reserve ratio; and

(2) Selective control, which is control over the margin requirement or the ratio of cash required to purchase securities.

With open-market operations, the Federal Open Market Committee (FOMC) first determines a money supply target. The FOMC consist of the seven governors, the president of the Federal Reserve Bank of New York, and four other Reserve bank presidents serving on a rotating basis. If the money supply grows too slowly, the Fed purchases government securities, or sells to member banks securities already held by the Fed, thereby increasing reserves by allowing the banks to create more money. The purchase of securities by member banks is inflationary in nature. If the growth of the money supply is considered to be too rapid, the Fed will sell securities held by it on the open market instead of to member banks. Open-market operations are the most frequently used method of monetary control; but similar results might be achieved by changing the required reserve ratio. An increase in the reserve ratio by allowing less money to be created is deflationary while a decrease in the reserrve ratio by allowing more money to be created is deflationary. Among its minor general controls, the Fed can decrease or increase the discount rate. An increase in the discount rate, makes borrowing more expensive, thereby reduces bank demand for reserves.

MP=Py

The basic responsibility of the Fed is to achieve to the greatest extent possible price stability. From the formation of the Fed to the middle 1980`s the Fed, instead of achieving price stability, became a major source of price instability. See edirorial by Milton Friedmam, WSJ, August 18, 2003. From the middle 1980`s, the Fed has been much more successfull in achieving price stability. The formula MP=Py is a way of expressing that the quantity (M) of money times the velocity of circulation (V) equals the price level (P) times output (y). None of these variables are directly controlled by the Fed. Under the present setup, the Fed primarily controls the volume of its own obligations, which is the base of the monetary system.

Open-Market Operations and Lending of Reserves

Where the Fed through its open- market operations buys securities, it adds to the base, and when it sells securities it subtracts from the base. Although generally ignored by most economists, when the Fed lends reserves to member banks, the Fed is also adding to the base. The power of the Fed to change the discount rate and, to a degree, reserve requirements are of minor significance compared to its open market operations or its lending of reserves. By its control over monetary aggregates, such as M1, M2, or M3, it can determine the annual percentile rate by which these aggregates raise or fall.

Pegging of Interest Rates

As a part of the Fed`s control over the base, it is enabled to peg various interest rates, such as the federal-funds rate, or the three-month Treasury bill rate. The fund rate in practice is pegged by open-market operations, and in this process the rate of monetary growth is determined. In order to keep prices stable, the Fed must have the quantity of money change in such a manner as to offset movements in velocity and output.

Disadvantage of use of Government Securities for Bank Reserves

For the government to sell securities to the Fed as a means of increasing bank reserves is a very expensive means of increasing reserves and results in iummense subsidization of the banking industry. There is no sound reason for the American government to accumulate debt to the banking industry in order control the liquidity of the economy. In effect, the banking industry is creating money by the use of the credit rating of the United States without the industry paying interest on the use of money the American government allows it to create, and the American govetrnment then pays interest to the banking industry on the money we allowed the industry to create. The reality of what is going on is obsured by calling a privilege a "reserve requirement" and by the implication that the banking industry is somehow extrending a favor to the American government by the purchase of securities with funds we allowed the industry to create. The American government could sell to the members banks the privilege of creating funds along with the banking inmdustry being required to surrender the privilege of creating money when the economy is over-heated. Memnbers of both political parties are beholden to the banking industry, and it would be very negative to the ambitions of politicians to attempt to further the public interest in our credit based economy. Instead of using a reserve requirement for expansion of the money supply, or instead of selling to member banks the privilege of money creation, the government could instead issue currency as needed for monetary liquidity and stability.

CONCLUDING REMARKS

To understand the American economy, a person not only should have a sound understanding of economics as a social scoence but also a detailed understanding of the American monetary system and the American Federal Reserve System. With such an understanding, a person would probably realize that the United States could issue fiat money without the need of becoming indebted to the banking industry and the unnecessary accumulation of a large national debt. The important thing is that fiat money is created pursuant to rational and highly controlled regulatory procedures. A person also needs to understand the difference between budgeted and non-budgeted revenues and expenditures of the government and of government agencies. He needs to become adapt at analyzing the Comprehensive Annual Financial Reports of government entities for the reason that these CAFRs are usually completely ignored by even the financial press.

©Wilson Ogg