About · Press · Contact · Write For Us · Top Personal Finance Blogs
Featured In:

What Is the Federal Reserve System – History & How It Affects You

By Michael Lewis

federal reserveThe words of Saint Paul to Timothy in the Christian Bible have resonated throughout the ages: “For the love of money is the root of all evil.” Therefore, it should come as no surprise that the Federal Reserve System (otherwise known as the “Fed”), the mother of all money in the United States, has been publicly reviled since its formation in 1913.

Charles A. Lindbergh, Sr., father of the famed aviator, claimed that “This [legislation] establishes the most gigantic trust on Earth…the worst legislative crime of the ages is perpetrated by this banking and currency bill.” Henry Cabot Lodge, Sr. said the Federal Reserve Act “seems to me to open the way to a vast inflation of the currency,” a consequence abhorrent to anyone with significant wealth that would be devalued as a result.

History & Formation of the Federal Reserve

At the same time, the inability of the country to reduce or eliminate the impact of wide gyrations in the economy – booms and busts – with accompanying financial panics and economic depressions persuaded most Americans that a change in the country’s banking system was necessary. While there was considerable disagreement about the solution, public officials – both Republicans and Democrats – agreed that the existing monetary system was inflexible and incapable of meeting the needs of a country destined to become the world’s greatest beneficiary and exemplar of free enterprise.

Republicans, led by Senator Nelson Aldrich, favored a private banker-owned central bank based in Washington, D.C. which could expand or contract currency as needed based upon the gold standard. Democrats distrusted the Wall Street bankers and favored a public, government-controlled system to solve the problem. The need for a central, coordinated system was understood by all parties; the argument was over who controlled the system: private bankers, who understood the nuances and complexity of banking and currency, or the public through their elected representatives (members of Congress) who would protect the average citizen from the avarice of the bankers.

The compromise incorporated many of the Aldrich Plan’s basic ideas, but ceded control to a board of directors, some of which are elected by member banks, and the chairman and vice chairman appointed by the President of the United States and approved by the Senate. The Federal Reserve system is unique among industrialized countries, an independent central bank with the government having no control over its decisions, nor responsibility for its operations (the Fed pays its costs through open market operations and remits all income to the Treasury). Proponents of the system claim it is isolated from partisan politics, yet serves the public interest since it is ultimately accountable to the Legislature.

Role of the Federal Reserve System

Essentially the “banks’ banker” whose only customers are nationally-chartered commercial banks, the Fed operates through 12 District Reserve banks located in different regions of the United States. The goals of the Fed’s monetary policies are spelled out in the Federal Reserve Act amended in 1977:

  • “Maximum employment ” of citizens in the United States
  • “Stable prices” of products and services to foster savings and capital formation
  • “Moderate long-term interest rates” to encourage consistent growth of the nation’s economy

The American economy is generally and greatly influenced by Congress’s fiscal policies of taxation and government spending and/or the monetary policies implemented by the Federal Reserve affecting the supply of money.

The Fed can do the following:

  • Buy or sell United States Government debt to affect the amount of money available in the economy. Purchasing government debt, for example, increases the amount of cash in the system and stimulates a reduction in interest rates (supply and demand), while selling debt has the opposite effect.
  • Change the reserve requirements of the member private banks, which is the amount of security that must be maintained by banks to guarantee repayment of their obligations. Raising reserve requirements forces a bank to curtail lending, driving up rates and dampening the enthusiasm for unfettered growth.

Historically, the governors of the Federal Reserve have been most likely to use their open market transactions – buying and selling government debt – to affect the economy, rather than changing reserve requirements since the latter can cause immediate liquidity problems for any bank with low reserves, potentially forcing bank closures and rescue operations.

federal reserve building

Criticisms of the Federal Reserve System

Critics on both sides of the political spectrum have lambasted the Fed since its formation. The criticism has ranged from its status as an independent body, to its role in the recent bailouts of large financial institutions.

Some maintain that the goals of the Fed should be amended to exclude any responsibility for maximum employment – “It’s time that the Fed focus solely on price stability and the dollar,” according to Republican Representative Mike Pence – while others, such as Democratic Representative Dennis Kucinich, assert that “the Fed should be financing government investment in badly-needed infrastructure repair. This would create jobs and help the Fed fulfill its mandate of promoting low unemployment, instead of being an elite unaccountable institution that exists solely for the benefit of bankers.” Representative Ron Paul, a candidate for the Republican Party’s 2012 presidential nominee, would like to abolish the central bank altogether.

There are three general modern complaints about the Federal Reserve:

1. Its Position as a Quasi-public, Independent Institution

Conservatives have come full circle since the Federal Reserve Act was enacted, initially favoring a strict private system in which banks would regulate themselves. The National Monetary Commission’s Report to the Senate on January 8, 1912 (subsequently known as the Aldrich Plan) proposed a strict private organization titled the National Reserve Association of the United States, whose stock was owned by individual banks and whose operations were directed solely by association officers elected by the banks.

However, in recent years, politicians on both sides of the aisle have called for audits of the Fed’s operation, claiming that more oversight is necessary. Milton Friedman, Nobel Prize winner in Economic Sciences and a member of President Ronald Reagan’s Economic Policy Advisory Board, suggested in Richard Ebeling’s book “Monetary Central Planning and the State” that “leaving monetary and banking arrangements to the market would have produced a more satisfactory outcome than was achieved through government involvement.”

According to a Bloomberg News poll, a majority of Americans think the Fed should be reined in or abolished.

2. Its Performance as the National Bank Regulator

The collapse of major financial institutions and subsequent taxpayer losses led to much criticism of the Fed in its performance as a “lender of last resort.” Simply stated, it is the Fed’s responsibility to prevent banks from engaging in risky behavior that might lead to their collapse and subsequent defaults and bankruptcy.

As a consequence of the financial crisis of 2007-2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act on July 21, 2010 to strengthen the Fed’s position as chief regulator of the banking system. Virtually every part of the banking and financial services industries is affected by the law, with some claiming that the act continues the “too big to fail” environment, which is what led to the enormous taxpayer losses. According to Jesse Eisinger, writing for the New York Times, the “country’s biggest banks look much like they did before the 2008 financial crisis – only bigger,” thereby keeping the country at risk of having to again bail out big banks in the future with tax dollars.

Some, like Republican Representative Spencer Bachus, advocate bankruptcy for the big banks when necessary, and less regulation over banks’ proprietary trading operations. Bachus called the Fed rule “a self-inflicted wound on this country and its financial markets.”  The Act has yet to be fully implemented, with many rules and regulations to be instituted during 2013.

3. Its Ability to Increase Federal Debt With No or Limited Oversight

The Fed has an unlimited ability to expand or contract currency to meet the country’s economic needs – with limited government oversight. Issuing government bonds effectively increases federal debt. Congress and the president often use the Fed as a scapegoat for their unwillingness to deal appropriately with government spending or taxes, the underlying reason for the burgeoning debt. However, blaming the Fed for the increased national debt is akin to an individual blaming the bank when he is unwilling to live within his income.

Fed-bashing is clearly more popular with the electorate wishing to add government programs or reduce taxes rather than reducing spending or raising taxes. Neither increasing oversight nor linking money to a hard commodity such as gold is an effective remedy for irresponsible governing.

federal reserve

Final Word

Whether or not you like the Federal Reserve or approve of its actions generally rests upon your perspective and opinion about the role of government in business and the everyday lives of American citizens.

For every advocate of greater government control and transparency in decision-making, there is a corresponding antagonist for small government and unfettered free enterprise. For those who promoted the infusion of government funds into the large financial firms because “they were too big to fail,” others were equally adamant that allowing their failure would more quickly address the problems of excessive risk-taking and lead to more effective long-term industry reform. For every borrower receiving the benefits of inflation, there is a creditor who is repaid with dollars of less purchasing power.

Many critics just mistrust the government and its ability to represent their interests fairly: “What populists on the right and the left have in common is a distrust of the establishment, and to them the Fed personifies the establishment,” said Bob McTeer, former Federal Reserve Bank of Dallas president and a fellow at the right-leaning National Center for Policy Analysis.

For the most part, the Federal Reserve has an impossible job with conflicting goals and limited powers. It is unlikely that its critics will ever be satisfied because the Fed, at its core, reflects our political system, an imperfect arrangement where conflicting powers, interests, and desired outcomes are in constant struggle. While most believe the Federal Reserve System has failed in a matter of degree, a better solution has yet to appear.

What is your opinion on the Federal Reserve System?

Michael Lewis
Michael R. Lewis is a retired corporate executive and entrepreneur. During his 40+ year career, Lewis created and sold ten different companies ranging from oil exploration to healthcare software. He has also been a Registered Investment Adviser with the SEC, a Principal of one of the larger management consulting firms in the country, and a Senior Vice President of the largest not-for-profit health insurer in the United States. Mike's articles on personal investments, business management, and the economy are available on several online publications. He's a father and grandfather, who also writes non-fiction and biographical pieces about growing up in the plains of West Texas - including The Storm.

Related Articles

  • William_Drop_Dead_Money

    What a great overview! Thanks. I’ve bookmarked this post because I just know I will need to come back and refer to it again.

    • MLewis

      Thanks, William, I’m glad you enjoyed the article. In case you missed it, you might also appreciate my comments on the National Debt. http://www.moneycrashers.com/us-federal-debt-effects/
      Thanks for writing.

  • http://mydebtucation.blogspot.com/ Mario

    Great write-up! Regarding #3, I’ve never been able to fall squarely on one side or the other as to whether this is good or bad. Obviously, the lack of oversight means there is a lot of space for them to mess up. On the other hand, it means that Congress doesn’t have a chance to mess them up even more…

The content on MoneyCrashers.com is for informational and educational purposes only and should not be construed as professional financial advice. Should you need such advice, consult a licensed financial or tax advisor. References to products, offers, and rates from third party sites often change. While we do our best to keep these updated, numbers stated on this site may differ from actual numbers. We may have financial relationships with some of the companies mentioned on this website. Among other things, we may receive free products, services, and/or monetary compensation in exchange for featured placement of sponsored products or services. We strive to write accurate and genuine reviews and articles, and all views and opinions expressed are solely those of the authors.

Advertiser Disclosure: The credit card offers that appear on this site are from credit card companies from which MoneyCrashers.com receives compensation. This compensation may impact how and where products appear on this site, including, for example, the order in which they appear on category pages. MoneyCrashers.com does not include all credit card companies or all available credit card offers, although best efforts are made to include a comprehensive list of offers regardless of compensation. Advertiser partners include American Express, U.S. Bank, and Barclaycard, among others.