The early colonists left behind their well-devel- oped money system in Europe. North Ameri- can Indians accepted wampum as money.
These are beads of polished shells strung in belts. Soon, a group of settlers learned to counterfeit wampum, and it lost its value. This meant that the main method of trading with the Indians was to barter. Later, trade devel- oped with the West Indies, and Spanish coins called “pieces of eight” were circulated widely. Colonists often cut these coins into pieces to make change. Half of a coin became known as “four bits.” A quarter part of the coin was referred to as “two bits.” The first English colony to mint its own coins was Mas- sachusetts in 1652. A striking pine tree was engraved on these coins called shillings. Other coins such as a six-pence and three-pence were also produced at a mint in Boston. Several
other colonies followed by authorizing their own coin issues.
Thefirst national coin of the United States was issued in 1787 when Congress approved a one-cent copper coin. One side was deco- rated with a chain of 13 links encircling the words, “We Are One.” The other side had a
The organizational chart of the Federal Reserve System, given in Exhibit 3, shows that theBoard of Governors, located in Washington, D.C., administers the system. The Board of Governors is made up of seven members, appointed by the president and confirmed by the U.S. Senate, who serve for one nonrenewable 14- year term. Their responsibility is to supervise and control the money supply and the banking system of the United States. Fourteen-year terms for Fed governors create autonomy and insulate the Fed from short-term politics. These terms are staggered so one term expires every two years. This staggering of terms prevents a president from stacking the board with members favoring the incumbent party’s political interests. A president usually makes two appointments in a one- term presidency and four appointments in a two-term presidency. The president designates one member of the Board of Governors to serve as chairman for a four-year term. The chair is the principal spokesperson for the Fed and has con- siderable power over policy decisions. In fact, it is often argued that the Fed’s chairman is the most powerful individual in the United States next to the presi- dent. The current chairman is Ben Bernanke, who was appointed by President George W. Bush.
The Federal Reserve System receives no funding from Congress. This creates financial autonomy for the Fed by removing the fear of congressional review of its budget. Then where does the Fed get funds to operate? Recall from Exhibit 7 of the previous chapter that the Fed holds government securities issued by the U.S. Trea- sury. The Fed earns interest income from the government securities it holds and the loans it makes to depository institutions. Because the Fed returns any profits to the
Ben Bernanke
Chairman of the Board of Governors of the Federal Reserve System
sundial, the noonday sun, and the Latin word
“fugo,”meaning“time flies.” Later, this coin became known as the Franklin cent, although there is no evidence that Benjamin Franklin played any role in its design.
In 1792, Congress established a mint in Philadelphia. It manufactured copper cents and half-cents about the size of today’s quar- ters and nickels. In 1794, silver half-dimes and half-dollars increased the variety of available coins. The next year gold eagles ($10) and half-eagles ($5) appeared. The motto E Pluribus Unum (“out of many, one”) was first used on the half-eagle in 1795. The next year America’s first quarters and dimes were issued.
The first paper money in the Americas was printed in 1690. Massachusetts soldiers returned to the colony from fighting the
French in Quebec, where they had unsuccess- fully laid siege to the city. The colony had no precious metal to pay the soldiers. Hundreds of soldiers threatened mutiny, and the colony decided it must issue bills of credit, which were simply pieces of paper promising to pay the soldiers. Other colonies followed this example and printed their own paper money.
Soon paper money was being widely circulated.
In 1775, the need tofinance the American Revolution forced the Continental Congress to issue paper money called “continentals,” but so much was issued that it rapidly lost its value. George Washington complained, “A wagon load of money will scarcely purchase a wagon load of provisions.” This statement is today shortened to the phrase “not worth a continental.”
Board of Governors of the Federal Reserve System
The seven members appointed by the presi- dent and confirmed by the U.S. Senate who serve for one nonrenewable 14–year term. Their responsibility is to supervise and control the money supply and the banking system of the United States.
Treasury, it is motivated to adopt policies to promote the economy’s well-being, rather than earning a profit. Moreover, the Board of Governors does not take orders from the president or any other politician. Thus, the Board of Governors is the independent, self-supporting authority of the Federal Reserve System.
On the left side of the organizational chart in Exhibit 3 is the very important Federal Open Market Committee (FOMC). The FOMC directs the buying and sell- ing of U.S. government securities, which are major instruments for controlling the money supply. The FOMC consists of the seven members of the Board of Gover- nors, the president of the New York Federal Reserve Bank, and the presidents of four other Federal Reserve district banks. The FOMC meets to discuss trends in inflation, unemployment, growth rates, and other macro data. FOMC members express their opinions on implementing various monetary policies and then issue policy statements known asFOMC directives. A directive, for example, might set the operation of the Fed to stimulate or restrain M1 in order to influence employ- ment. The next two chapters explain the tools of monetary policy in more detail.
As shown on the right side of the chart, theFederal Advisory Councilconsists of 12 prominent commercial bankers. Each of the 12 Federal Reserve district banks selects one member each year. The council meets periodically to advise the Board of Governors.
Finally, at the bottom of the organizational chart is the remainder of the Federal Reserve System, consisting of only about 3,000 member banks of the approximately 8,000 commercial banks in the United States. Although these 3,000 Fed member banks represent only about one-third of U.S. banks, they have about 70 percent of all U.S. bank deposits. A sure sign of Fed membership is the word National in a bank’s name. The U.S. comptroller of the currency charters national banks, and they
EXHIBIT 2 The Twelve Federal Reserve Districts
San Francisco
Dallas
Minneapolis
Kansas City
Atlanta Chicago
Boston
New York Cleveland
St. Louis Richmond
Philadelphia WASHINGTON
12
11 10
9
6 8
7
4
3 2
1
5
NOTE: Both Hawaii and Alaska are in the Twelfth District.
Federal Open Market Committee (FOMC) The Federal Reserve’s committee that directs the buying and selling of U.S.
government securities, which are major instru- ments for controlling the money supply. The FOMC consists of the seven members of the Federal Reserve’s Board of Governors, the president of the New York Federal Reserve Bank, and the presidents of four other Federal Reserve district banks.
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are required to be Fed members. Banks that do not have“National”in their title can also be Fed members. States can also charter banks, and these state banks have the option of joining the Federal Reserve. Less than 20 percent of state banks choose to join the Fed.
Nonmember depository institutions, including many commercial banks, savings and loan associations (S&Ls), savings banks, and credit unions, are not official members of the Fed team. They are, however, influenced by and depend on the Fed for a variety of services, which we will now discuss.
What a Federal Reserve Bank Does
The typical bank customer never enters the doors of a Federal Reserve district bank or one of its branch banks. The reason is that the Fed does not offer the public checking accounts, savings accounts, or any of the services provided by commercial banks. Instead, the Federal Reserve serves as a“banker’s bank.”Following are brief descriptions of some of the principal functions of the Federal Reserve.
Controlling the Money Supply
The primary role of the Fed is to control the nation’s money supply. The mechanics of Fed control over the money supply are explained in the next two chapters. To most people, this is a wondrously mysterious process. So that you do not suffer in complete suspense, here is a sneak preview: The Fed has three policy tools, or levers, it can use to change the stock of money in the banking system. The potential macro outcome of changes in the money supply is to affect total spending and therefore real GDP, employment, and the price level.
EXHIBIT 3 The Organization of the Federal Reserve System
The Federal Open Market Committee (FOMC) and the Federal Advisory Council assist the Federal Reserve System’s Board of Governors. The 12 regional Federal Reserve district banks and their 25 branches implement broad policies affecting the money supply.
Regional Federal Reserve banks (12 district banks and
25 branch banks) Board of Governors (7 members)
U.S. banking system (commercial banks, mutual savings banks, savings and loan associations, and credit unions)
Regional Federal Reserve banks (12 district banks and
25 branch banks) Board of Governors (7 members)
U.S. banking system (commercial banks, mutual savings banks, savings and loan associations, and credit unions)
Federal Advisory Council (12 prominent
commercial bankers) Federal Open Market
Committee (FOMC) (Board of Governors, president of New York Federal Reserve Bank, and four additional Federal Reserve district bank presidents)
Clearing Checks
Because most people and businesses use checks to pay for goods and services, check clearing is an important function. Suppose you live in Virginia and have a checking account with a bank in that state. While on vacation in California, you purchase tickets to Disneyland with a check for $200. Disneyland accepts your check and then deposits it in its business checking account in a California bank. This bank must collect payment for your check and does so by giving the check to the Federal Reserve bank in San Francisco. From there, your check is sent to the Federal Reserve bank in Richmond. At each stop along its journey, the check earns a black stamp mark on the back. Finally, the process ends when $200 is subtracted from your personal checking account. Banks in which checks are deposited have their Fed accounts credited, and banks on which checks are written have their accounts debited. The Fed clearinghouse process is much speedier than depending on the movement of a check between commercial banks.
Supervising and Regulating Banks
The Fed examines banks’books, sets limits for loans, approves bank mergers, and works with the Federal Deposit Insurance Corporation (FDIC). The FDIC is a government agency established by Congress in 1933 to insure commercial bank deposits up to a specified limit. Congress created the FDIC in response to the huge number of bank failures during the Great Depression and set the insurance limit at
$25,000. If the government provides a safety net, people are less likely to panic and withdraw their funds from banks during a period of economic uncertainty. When deposits are insured and a bank fails, the government stands ready to pay deposi- tors or transfer their deposits to a solvent bank. Banks that are members of the Fed are members of the FDIC. State agencies supervise state-chartered banks that are not members of either the Federal Reserve System or the FDIC. To shore up confi- dence in the U.S. banking system in the wake of bank failures in 2008, the $700 bil- lion U.S.financial industry rescue law raised the FDIC coverage of bank deposits to
$250, 000 per customer from $100, 000 through 2009.
Maintaining and Circulating Currency
Note that the Fed doesnot print currency—itmaintainsandcirculates money. All Federal Reserve notes are printed at the Bureau of Engraving and Printing’s facilities in Washington, D.C., and Fort Worth, Texas. The Treasury mints and issues all coins. Coins are made at U.S. mints located in Philadelphia and Denver. The bureau and the mints ship new notes and coins to the Federal Reserve banks for circulation.
Much of this money is printed or minted simply to replace worn-out bills and coins.
Another use of new currency is to meet public demand. Suppose it is the holiday season and banks need more paper money and coins to meet their customers’shop- ping needs. The Federal Reserve must be ready to ship extra money from its large vaults by armored truck.
Protecting Consumers
Since 1968, the Federal Reserve has played a role in protecting consumers by enfor- cing statutes enacted by Congress. Perhaps the most important is theEqual Credit Opportunity Act, which prohibits discrimination based on race, color, gender, marital status, religion, or national origin in the extension of credit. It also gives Federal Deposit
Insurance Corporation (FDIC) A government agency established in 1933 to insure commercial bank deposits up to a specified limit.
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married women the right to establish credit histories in their own names. The Fed- eral Reserve receives and tries to resolve consumer complaints against banks.
Maintaining Federal Government Checking Accounts and Gold
The Fed is also Uncle Sam’s bank. The U.S. Treasury has the Fed handle its check- ing account. From this account, the federal government pays for such expenses as federal employees’salaries, Social Security, tax refunds, veterans’benefits, defense, and highways.
Finally, it is interesting to note that the New York Federal Reserve District Bank holds one of the oldest forms of money—gold.This gold belongs mainly to foreign governments and is one of the largest accumulations of this precious metal in the world. Viewing a Federal Reserve bank’s vault is not something that most tourists typically have on their list of things to do, but I strongly recommend this tour.
The gold vault at the New York Federal Reserve Bank is nearly half the length of a footballfield andfilled with steel and concrete walls several yards thick. Most cells contain the gold of only one nation, and only a few bank employees know the identities of the owners. When trade occurs between two countries, payment between the parties can be made by transferring gold bars from one compartment to another. Note that the Fed and the monetary system of the Yapese have a similar- ity. Recall from the Global Economics box that in Yap large stone wheels are not moved; rather they just change ownership.
The U.S. Banking Revolution
Prior to the 1980s, the U.S. banking system was simpler. It consisted of many com- mercial banks authorized by law to offer checking accounts. Then there were the other financial institutions, the so-called thrifts, which included S&Ls, mutual savings banks, and credit unions. The thrifts by law were permitted to accept only savings deposits with no checking privileges. The commercial banks, on the other hand, could not pay interest on checkable deposits. Moreover, a“maximum inter- est rate allowed by law” limited competition among commercial banks and other financial institutions. As will be explained momentarily, this relatively tranquil U.S.
banking structure changed dramatically, and the stage was set for a fascinating banking“horror story.”
The Monetary Control Act of 1980
A significant law affecting the U.S. banking system is the Depository Institutions Deregulation and Monetary Control Act of 1980, commonly called the Monetary Control Act. This law gave the Federal Reserve System greater control over non- member banks and made allfinancial institutions more competitive. The act’s four major provisions are the following:
1. The authority of the Fed over nonmember depository institutions was increased.
Before the Monetary Control Act, less than half the banks in the United States were members of the Fed and subject to its direct control. Under the act’s provi- sions, the Federal Reserve sets uniform reserve requirements forallcommercial banks, including state and national banks, S&Ls, and credit unions with check- ing accounts.
Monetary Control Act A law, formally titled the Depository Institutions Deregulation and Monetary Control Act of 1980, that gave the Federal Reserve System greater control over nonmember banks and made allfinancial institutions more competitive.
YOU’RE THE ECONOMIST The Wreck of Lincoln Savings and Loan Applicable Concept: deposit insurance
The case of Lincoln Savings and Loan is a classic example of what went wrong during one of the worst financial crises in U.S. his- tory. In 1984, the Securities and Exchange Commission charged Charles Keating, Jr., with fraud in an Ohio loan scam, but regulators later allowed him to buy Lincoln Savings and Loan in California.
Keating hired a staff to carry out his wishes and paid them and his relatives millions. Keating was also generous with politicians in Washington, D.C. Allegedly, five U.S. senators received $1.5 million in campaign contributions from Keating to influence regulators.
Where did Keating’s money come from? It came from Lincoln Savings depositors and, ultimately, from taxpayers because the federal
government insures deposits of failed S&Ls. When Keating took over Lincoln, it was a healthy S&L with assets of $1.1 billion. But because of deregulation mandated by the Monetary Control Act and other legislation and the lack of enforcement of regulations under the new laws, many S&Ls plunged into high-risk, but potentially highly profitable, ventures. Keat- ing therefore took Lincoln out of sound home mortgage loans and into speculation in Arizona hotels costing $500,000 per room to build, raw land for golf courses, shopping centers, junk bonds, and currency futures.
In 1987, after it was already too late, California regulators became alarmed at the way Lin- coln operated and asked the FBI and the FSLIC to take over Lin- coln. Keating responded by con- tacting his friends in Washington, and the regulatory process moved at a snail’s pace. Years passed before the government finally closed Lincoln and informed the public that their deposits were not safe in this S&L. During the time regulators were deciding what action to take, it is estimated that Lincoln cost taxpayers another $1 billion. Ultimately, the collapse of Lincoln cost U.S. taxpayers about
$3 billion, making it the most expensive S&L failure of all.
Keating and other S&L entre- preneurs say they did nothing wrong. After all, Congress and federal regulators encouraged, or
did not discourage, S&Ls to com- pete by borrowing funds at high interest rates and making risky, but potentially highly profitable, investments. If oil prices and land values fall unexpectedly and loans fail, this is simply the way a mar- ket economy works and not the fault of risk-prone wheeler-dealers like Keating.
In 1993, a federal judge sen- tenced Keating to 12 1/2 years in prison for swindling small inves- tors. The sentence ran concur- rently with a 10-year state prison sentence. The judge also ordered Keating to pay $122.4 million in restitution to the government for losses caused by sham property sales. However, the government has been unable to locate any sig- nificant assets. Keating served four years and nine months.
A N A L Y Z E T H E I S S U E
Critics of federal banking policy argue that deposit insurance is a key reason for banking failures. The banks enjoy a“heads I win, tails the government loses” proposi- tion. Several possible reforms of deposit insurance have been suggested. For example, the limit on insured deposits can be raised, reduced, or eliminated. Do you think a change in deposit insurance would prevent bank failures?
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