Founding of the Federal Reserve System.docx
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Founding of the Federal Reserve System.docx
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FoundingoftheFederalReserveSystem
TheFoundingoftheFederalReserveSystem
MarkToma
DesigningaMonetarySystem
Mentallytransportyourselfto1913.Youhavebeenchargedwithdesigninganewmonetarysystem.Beforejumpingintothedetailsofthetask,youandyourco-foundersmustanswerthebasicquestionthateveryinstitutionalarchitectmustanswer:
Doyoucreateatop-downorabottom-upsystem?
Moreconcretely,doyoucreateasystemwhosepolicyisdeterminedatthediscretionofdecision-makersatthetopofahierarchy,ideallymotivatedtodowhatisbestfortheeconomy?
Ordoyoudoyouestablishcertainrulesofthegamewheredecisionsaremadebottom-upbyindividualspursuingtheirself-interest?
Forthediscretionarysolution,thechallengeistodesignthesystemsothatgoodleadersendupatthetop.Fortheself-regulatingsolution,thechallengeistodesignrulesthatconfrontself-interestedindividualswithincentivesthatinducethemtotakeactionsthatpromotethecommongood.
Oncethisissuehasbeensettled,youcanturntothedesigndetails.Nowyouandyourco-foundersmustconfrontaproblemthateverymonetaryarchitectmustconfront:
Howdoyouavoidtwobadoutcomes–toomuchortoolittlemoney?
First,considertheover-issueproblem.Ifthemoneysupplierissuesmorethanthepublicdemands,thentheresultisinflation.Themoneyholderfinds,throughnofaultofherown,thatthepurchasingpowerofhermoneybalancesdwindlesovertime.Theclassicsolution,benefitingbothsides,isfortheissuertocommittoredeemingnotesintoagood,likegold,whoserealvaluecannotbemanipulatedbytheissuerandtomakeredemptioneasy.Then,moneywillbeatleastasgoodasgold,implyingthatthepurchasingpowerofmoneycannotfallbelowthepurchasingpowerofgold.
Asecondproblemarisesintheformofpotentialunder-issue:
Themoneyissuermayfailtoaccommodatedemand,triggeringascrambleforliquiditythatmayresultinsomeorallofthefollowing:
(1)ariseinthepurchasingpowerofmoneyrelativetogold,
(2)ariseintherateofexchangebetweencurrencyanditsmoneysubstitute,demanddeposits,(3)ariseinshort-terminterestrates.Thesepriceadjustmentssignalthatcurrencyhasbecomescarcer–needlesslysoif,underalternativeinstitutionalarrangements,thecurrencysupplierwouldhavebeenincentivizedtoaccommodate.
WasthedesignproblemconfrontedbythefoundersoftheFederalReserveoneofover-issue,under-issueorboth?
Toanswer,wemustbrieflyexplorethenatureofthemonetarysystemthatexistedbeforetheFed’sfounding.Thatsystem,theNationalBankingSystem,wasestablishedbytheLincolnadministrationtosolveitsowndesignproblem–howtohelptheNorthwintheCivilWar.Solvingthewarfinancingproblem,however,didhaveadownside,producingaversionoftheunder-issueproblemorwhatcametobeknownastheproblemofaninelasticcurrency.ThecreationoftheFed,somefiftyyearslater,wasmeanttoaddressthisdownside,apointdrivenhomebytheopeninglineoftheFederalReserveAct:
“AnActToprovidefortheestablishmentofFederalreservebanks,tofurnishanelasticcurrency….”(italicsadded).BeforerecountingthestoryofhowthefoundersoftheFedcraftedanewsystemtofurnishanelasticcurrency,thenextsectionoutlinesthenatureoftheelasticityproblemundertheNationalBankingSystem.
TheNationalBankingSystem
Over-issue
LegislationgivingrisetotheNationalBankingSystemcreatedtwonationalcurrencies,U.S.notesandnationalbanknotes.TheU.S.notes(greenbacks)wereissuedbytheTreasuryandthenationalbanknoteswereissuedbyanewtypeofbank–nationallycharteredbanks–authorizedtoacquirethenotesfromtheTreasuryonlyafterpurchasing2%U.S.governmentbondsascollateralbacking.After1879,theU.S.noteswerebackedbyagoldreserveof100%housedattheTreasury,essentiallymakingthesenotescommoditymoney.Thenationalbanknotescouldberedeemedintolawfulmoney(goldorU.S.notes)eitheratthenationalbankofissueorthroughredemptioncentersestablishedbytheTreasury.Eachbankwasrequiredtocontributelawfulmoney,intoaredemptionfundattheTreasury,equalto5%ofitsoutstandingnotes.Intheeventthatanationalbankwentbankrupt,theTreasurywasobligatedtoimmediatelyredeemitsnotes.Forredemptionpurposes,theTreasurycouldusetheredemptionfundandthegovernmentbondcollateralandwasgivenfirstlienonalltheassetsofthebankanduponthepersonalliabilityofthestockholders(FriedmanandSchwartz1963:
21).Afterthat,theTreasurywouldhavetorelyonthefederalgovernment’staxandborrowingcapabilities.
TwoconsiderationscomeintoplayinassessingwhetherthesefeaturesoftheNationalBankingSystemprotectedthecurrencyholderfromtheover-issueproblem.First,wasredemptioncertain?
Second,wasredemptionlowcost?
ForholdersofU.S.notes,certaintyofredemptionwasguaranteedbythe100%goldbacking.Forholdersofnationalbanknotes,certaintyofredemptionwasaquestionofthemagnitudeofthefederalgovernment’staxingpowersrelativetoitsspendingobligations,sincetheU.S.governmentstoodastheultimatebacker.Ifthepresentvalueofcurrentandexpectedfuturemaximumtaxeswaslessthanthepresentvalueofcurrentandexpectedfuturespending,thenthefederalgovernmenthadnoexcesstaxpowersthatcouldbeused–bysellingbonds–toredeemnotesintogold.Noteholderswouldhavegoodreasontodoubtthefederalgovernment’sabilitytoraisefundsonshortnoticetoredeemnotes.
Howwouldalatenineteenthorearlytwentiethcenturynoteholderviewthenettaxpowersofthefederalgovernment?
Spendingobligationsweremodest,buttaxingpowersalsoweremodestsincethefederalgovernmentreliedontaxeswithnarrowbases,mainlyexcisetaxesandtariffs.Still,nationalnotesweresubstantiallybacked–byreservesattheTreasury,bythegovernmentbondcollateral,bytheassetsofthebankandbythepersonalliabilityofbankstockholders.Areasonableconjecture,therefore,isthatholdersofnationalbanknotes,whilenotperceivingredemptiontobecertain,wouldhaveperceiveditaslikely.
Wasredemptionalsolowcost?
Here,too,theanswerisaqualifiedyes.Anindividualwantinglawfulmoneyforanationalbanknoteissuedbyadistantbankcould,ofcourse,traveltothebankforredemption.Moreconveniently,shecouldtakethenotetoherbank,exchangeitforoneofherbank’snotes,whichshecouldthenredeemforlawfulmoney.Ifdesired,herbankcouldsendthosenotestoaTreasuryredemptioncenterandreceivelawfulmoneyfromtheredemptionfund.Significantly,thecostsofnoteredemption,e.g.,thesortingofnotesandthetransportationcosts,werenotincurredbythesendingbank;instead,theywereassessedagainsttheissuingbank(Champ,FreemanandWeber1999:
568).SoexceptforpossibledelaysinreceivingcreditfornotessenttotheTreasury,redemptioncostswerelow.
Thebottomlineisthat,whilenotsure-fire,theNationalBankingSystemdidrepresentacrediblesolutiontotheover-issueproblem.Thecostofinitiatingredemptionwasrelativelylow.Oncetriggered,thelikelihoodthatthenoteswouldinfactberedeemedwasrelativelyhigh.
Under-issue
Under-issue–thefailuretopromptlyaccommodatecurrencydemand–wouldproveabiggerconcernundertheNationalBankingSystem.Chronicscarcityofmoney–say,aconstantsupplyinthefaceofrisingdemand–wasnottheissue.Theoutcomeinthiscasewouldbeapersistent,equilibratingfallinthepricelevel,withnote-holdersexpectingandreceivingarisingpurchasingpower.Rather,theproblemwasthatsupplydidnotpromptlyincreaseinresponsetotemporaryincreasesindemand.
Thesourceoftheproblemwasthatneitherofthetwopartiesdirectlyinvolvedincurrencysupply–thenationalbanksthatissuedthenotestothepublicandtheTreasurythatprintedanddeliveredthenotestothenationalbanks–hadstrongincentivestoaccommodatedemand.Theincentiveproblemfacedbynationalbanksstemmedfromtherequirementthattheyfirstacquireaspecificbond–2%U.S.governmentbonds–beforeacquiringnewnotes.Therequirement“funneledthebanks’buyingpowerintoasinglebondmarketandraisedpricestoprohibitivelevels”(Horwitz1990:
640),aproblemmademoreseverebythefactthat,afteraround1880,thegovernmentusedpersistentbudgetsurplusestoretiredebt,thusreducingsupply.Anyunexpectedrelaxationofthecollateralrequirementoranyeasingofsupplyconditionsinthemarketfor2%governmentbondsmightimposepotentiallysignificantcapitallossesonbanks.Additionally,bymakingtheentirebankingsystemmorefragile,thecollateralrequirementreduceddepositorandnote-holderconfidence,increasingthelikelihoodthatarelativelymodesteconomicdownturnwouldtriggernumerousrequestsfornoteredemption,thusraisingtheoverallcostsofrunningthebankingsystem.Alltold,thecollateralrequirementimpliedthataccommodatingthepublic’sdemandforcurrencywasnotalwaysaprofitableactivityfornationalbanks.
TheincentiveproblemfacedbytheTreasuryarguablywasevenmoresevere.Unlikeprivatebanks,theTreasurywasanon-profitbureauthatfinanceditselffromagovernmentbudget.Whiletheout-of-pocketexpenseofprintinganddeliveringthenoteswascoveredbythenationalbankrequestingthenotes,theTreasurystillfacedancillarycostsstemmingprimarilyfromthemandatethatitverifyandapprovethegovernmentbondcollateralbackingnewnotes.VerificationandapprovalcostswouldbeparticularlyhighduringperiodswhentheTreasurywascalledu
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