Brent Buddensee

Mr. O’Leary English 11 Honors

Mr. Houston AP US History

21 December 1997

American Financial Institutions and the Federal Reserve

Through history men have sought ways to store labor. Stored labor, in the form of gold, or other medium, is the basis of wealth. Money represents this, in a form that is portable for everyday use. Suppose that a man builds a chair and later sells it for one piece of gold. The reason that this exchange works, is that the time and labor taken to find one piece of gold is equal to the time and effort taken to build a chair. Exchanging a piece of gold, as opposed to a turkey or table, is beneficial because it will fill a trading gap if nothing is possessed that is in demand. This concept has been in use for thousands of years.

In ancient Greece, the word okonomos is the origin of the word economics, which literally means household (Forman 2). Other types of money in use over the years, have been wampum and tobacco. The problem with both, as opposed to gold, is that they are regionally restricted. Wampum was primarily used by northern Native American’s, and later colonists, and tobacco was a means of money in the South. Since they were limited to only certain regions, they could not become widely used (Galbrath 47). This complexity, has made money take on many forms though out history.

The earliest known use of a metal as a medium of exchange was by the Kings of Lydia, in the 8th century B.C. It is even possible that Hindus predated this by hundreds of years (Galbrath 8). Following their example, precious metals have been in use, and are still in use, until today. The reasons that this has changed, is that gold still lacked some properties for ease of use.

The very reason gold is used as a money medium, is the very reason that means have been sought to find something easier: its rarity. Gold, though easier to exchange than a chair, is still a weighty element. This brought about a change called the Gold Standard. Beginning in England, goldsmiths would hold large amount of gold to be made into a variety of things. They would offer receipts to people wishing to store gold with them. These receipts became a form of money. If one person traded his receipt for labor, the person then holding it could retrieve the amount of gold it represented from the goldsmith. Banks were eventually born to replace the goldsmith’s and paper money, called specie, were issued to represent the gold that was stored at the bank (Galbrath 136). This is considered the safest form of banking, as the money supply is regulated by the gold, a rare and stable element, supply.

The gold standard as a viable currency has tended to die out over centuries, and in its place something called fractional currency has come. Fractional currency operates under a similar guise, and a note for one gold piece can be redeemed for such, but the amount of specie are allowed to far surpass the gold supply. The problem with this is obvious: what if everyone holding a note for one gold piece attempts to redeem it for the gold it is supposed to represent? The answer is called a bank run. People literally run to the bank to get the real value behind their dollar before somebody else does. When this happens, the bank goes bankrupt and shuts down. Fractional currency was commonly issued during wars to help finance the effort (Galbrath 136). In a tight situation like that, the government cannot have bank runs on their reserves of real money. So they issue an edict that states that the money must be used. That is called fiat money, because the money is issued by fiat. During World War I, fractional money was issued by all nations involved in the war. After the war was over, a move was made to return to the gold standard. With the money supply much inflated beyond its value, this action precipitated the Great Depression (Forma 27). The gold standard would have balanced things out eventually, a stable monetary system will do that, but it would have been too painful for an already hurting nation. This arbitrary regulation of money, is considered to be somewhat undemocratic (44).

When fractional money is issued, other than the possibility of a bank run, the money becomes inflated. Inflation happens when the supply of money increases faster than the supply of goods it can buy, a process previously regulated by the gold standard (Forman 14). This means that where a note could once buy a chair, it might now take two notes of the same value to purchase the chair. As the amount of specie to gold increases, the more notes it will take to buy a chair. The money is not worth what it once was. During the gold standard, the prosperity of a nation depended on factors such as a favorable balance of trade. With the use of fractional money, it is possible for a country to destroy itself by over inflating its money supply. The greatest inflation of money, to date, was in Germany in 1923. Prices were 1,422,900,000,000 times higher than the previous peacetime ( Galbrath 155). It was once pointed out that the Reichsmark was not worth the paper it was printed on (160). Germany’s partial solution to this, was to issue a form of currency, available at different rates. Thus the Rentenmark and Deutchmark replaced the incredibly inflated Reichsmark (161). Here is a modern story of inflation in America:

The historian was speaking of a $100,000 gift to the Nixon campaign, and its return many years later. The money, when given back, was worth only $64,000 by 1975! (Galbrath 1). Not all people believe inflation to be bad, only when it is excessive or out of control like Germany in the 1920s (Forman 15). Inflation in general, however, it is not looked upon fondly. It is in reality a hidden theft on the prudent who save their money. Those people who had squirreled away retirement money before Germany when to war, were broke within a year. One million pre-war Reichsmarks were worth less than pennies during the war. Being wary of a similar trend in America, ways have been sought to find a solution to inflation.

John Meynard Keynes, the European financial genius, had a theory towards ending a depression, or the milder recession. He advised that a country spend its way out of the problem, as opposed to printing (money) its way out (Forman 30). An example for this theory can be seen here:

Other notable ways of stopping inflation include: stoppage of printed money, and price and wage control. The results of stopped printing, are that the dollar is worth more and a near certain recession (possibly a depression) and lost jobs (minorities are hit hardest) (Forman 68). Price and wage control will work with less dramatic results, it is, however, considered too harsh for peacetime, as history shows. (Forman 76)

In the 1700s, bank experimentation across Europe had run rampant. All nations were experiencing the insipidness of bank runs. Of the European superpowers, England was the first country to take the banking problem head on. The solution was as simple as the gold standard was, which was actually what it was. The Bank of England, unlike others, quickly exchanged gold or silver for paper notes issued. The result was an unparalleled confidence in England banking, and by 1770 it was nearly the sole distributor of notes (Galbrath 34). Ironically, the Continental Congress followed the Bank of England’s suit initially and issued strongly backed money to help finance the revolution. Its fractional reserve notes, as the war continued, became increasingly inflated, however (Griffin 323). To continue the war effort, the Continental Congress had to issue the first fiat money in American History (Forman 5). This bank was founded by Robert Morris December 31, 1781 to help finance the end of the revolution. Other banks began to spring up with the Bank of Massachusetts on February 7, 1784 and the Bank of New York June 9, 1784. They were the first, second, and third banks in the country (Dictionary 156).

The late 1700s, notably the Constitutional Convention, were probably the most ground breaking time in American History. The same is said for the financial system composed in that period. After that convention, Alexander Hamilton, perhaps a financial genius, spoke for a national bank. In this, he was chiefly opposed by Thomas Jefferson (Griffin 328). The debate revolved around the constitutionality of a central bank. Jefferson spoke out saying that it was not specified in the constitution, and therefor not allowed. Hamilton quoted the constitution, saying: "Let the end be legitimate, let it be within the scope of the Constitution, and all means which are appropriate, which are plainly adapted to that end, which are not prohibited, but consist with the letter and spirit of the Constitution, are constitutional." (Blum 206). Hamilton won the debate, but a National bank was not the only outcome; the first party system had been born: Federalists and Anti-federalists. (Griffin 329). The bank was to be financed by 80% private investment and 20% federal (the 20% federal investment was actually loaned immediately back for no net deposit). A large amount of the private investment came from the Rothschild banking dynasty in Europe. Such is one reason people are wary of a national bank funded and partially controlled by foreign countries (Griffin 331). Thus a 20 year charter was given to the Bank of the United States (BUS) in 1791. It issued notes that were originally not forced to be ‘legal tender’ for private debts, but it was mandatory for government debts. The BUS had the sole right to issue money, and soon became a common medium of exchange (Griffin 330). The BUS, as opposed to wildcat banks, those remotely located that had a tendency to have inflated notes and runs, would only accept money from state banks that had a proven medium of exchange. The public followed the example of the government and many of the wildcat banks closed down. The American economy as a whole improved (Griffin 334).

After the initial success of the BUS and American finance in general, things started to take a turn for the worse in the 1800s. State banks, a federal too, were required by law to keep a minimum amount of specie on hand. Specie is the actual hard metal (gold) that a note can be redeemed for. This minimum was loosely enforced as it became a political politeness not to check on certain banks (Griffin 343). The classic example of this is the Second Bank of the United States (BUS). Before it could be officially opened, it was required by law to have $7 million in specie. By the second year the BUS was open, it still had only accumulated $2.5 million in specie! (Griffin 342). A Massachusetts bank, possibly a record setter, printed $500,000 backed by only $86.48 in gold! (Griffin 367). This type of banking set the country quickly on a road of depression. The wildcat banks that went bust (bankrupt) were becoming a hindrance to commerce. The Panic of 1819 was made by the choice to bankrupt investors rather than bankrupt the bank. William Gouge said, "The Bank was saved, and the people ruined." (Griffin 345). The Panic of 1819 angered the states against the federal bank, and they began to put a tax on all notes issued by it. They had hoped to protect themselves while destroying the beast that had ruined them. John Marshall, the Supreme Court justice, ruled in McCulloch vs. Maryland that the state tax with the intent to destroy the bank was unconstitutional. He said, "The power to tax, it the power to destroy." (Griffin 347). A safety fund was created to bail out banks when a run was in progress. All banks were required to give .5% per year to a national fund, until they had contributed 3% of their specie. This money would then be used when a bank was being run on. This fund, however, was immediately depleted in the Crisis of 1837. The saved banks were punished by having to pay back the banks that had supported them. The safety fund never accumulated to what it was, and it died out a few years later. Though this movement was a forerunner to the Federal Deposit Insurance Company (FDIC), it actually encouraged recklessness at the time (Griffin 364). Even prior to the Crisis of 1837, Andrew Carnegie stated in 1832 that America had "the worst [bank] in the civilized world.". (Galbrath 84) This was such a hotly debated topic, because 1836 fell in an election year, the same year the BUS was up for re-charter.

The Bank War was hosted by President Andrew Jackson, and the chairman of the BUS, Nicholas Biddle. Biddle, a college graduate at age 13, was arguably the most powerful man in the country. Jackson believed him to be too powerful, as he had the power to make or break any state bank merely by stating if their money was reliable (whether it was or not) (Griffin 348). Jackson, a Democrat (as the party was then called), put his presidency on the line as he vetoed a bill for an early re-chartering of the BUS. Conforming to some Jeffersonian philosophy, he quoted him saying, "a Federal bank is more to be feared than standing armies." (Galbrath 28), in what is one of the greatest political moves in American history (Griffin 348). Biddle, feeling his position not quite tenable, decides to incite public opinion against Jackson by deliberately precipitating a Crisis. He forced banks to call in loans, which at the time were being paid for rampant land speculation, and hurt the economy which was dependent on them.(354). Congress, and America in general began to side with Biddle and blame Jackson. Jackson, using this as proof of Biddle’s abusive power, orders Secretary of Treasury, William Duane, to remove money from the central bank and place it in state banks, thereby rendering the BUS powerless. Duane refused the presidential order, and in a heated letter, Jackson writes, "Your further services as Secretary of Treasury are no longer required." (353). Thus marking the first time a President pointedly fired an official for disagreement. Congress was incited at this behavior and voted 26-20 to censure Jackson, another first in American history. Biddle at this point held the upper hand, while Jackson was further weakened.

The turning point in the Bank War, was when governor George Wolf of Pennsylvania, Biddle’s home sate, denounced both Biddle and the Bank. The tide turned, with votes of 134-82 to not re-charter the BUS, 118-103 that the deposits now in pet banks not be restored to the BUS, and 175-42 that an investigation be made to the possible instigation of a panic. Several years later the censure on Jackson was removed (356). Biddle refused to allow the books to be examined, and eventually died while under investigation (358). Jackson, meanwhile, managed a number of remarkable feats. Having killed the BUS, he proceeded to pay of the war debt from 1812, and then having a surplus of money, gave back $35 million in taxes to the states! Which was used for public works. Thus the bank expired, useless, in 1836 (359). It is only around major events (re-chartering, wars), that truly do economic revolutions occur.

The War of 1812 is considered by many to be a senseless war. It was considered such because a driving force behind the congressional vote to wage war was to further the American economy. Encouraged expansion, as a result from any war, is also a dramatic expansion in economy (Griffin 337). Prior to the war, there were 26 banks in 1800, and 86 in 1811. Hamilton was fighting vigorously for the national bank, because it could provide money, hold money, and regulate a fluctuating currency (Dictionary 156). Proof enough was that after the war, banks numbered 246! So when the British stopped impressment of American sailors, it was seen as unsoundly motivated when Congress waged war on the greatest of world powers. The Hartford Convention attests to this, though it ended up looking sheepishly as victory in New Orleans stole the spotlight . America emerged as a world power, and possessing a stronger economy, despite the motives. (Blum 192).

With the southern secession from the Union, the Civil War began. Inflation was up slightly, and this increased with the issue of fiat money to finance the war (Forman 6). The money supply, suprisingly enough, was regulated by who was winning on the battle field. Whenever the Union side or Confederate side seemed likely to be the victor, the value in their printed money increased. Of course, after a losing battle, the value decreased and more money had to be printed to offset this, thus increasing the inflation more (7). Northern industrialists prospered excellently in the making of arms, which after the war meant that the North would have a stronger industry and economy (7). On July 17, 1861 an Act was passed by the Union to issue $60,000,000 to help finance the war, and suspend specie, the payment in coin for notes. The money would thereby be worthless, but it was the law that the fiat money be accepted (Friedberg 8). Russia entered the war by giving aid with ships to help in Union naval blockades. England and France, favoring the Confederates, were cautious about entering a war against the Union and Russia’s naval blockade. They opted to remain neutral, silently following the Monroe Doctrine established earlier that century (Griffin 378). After the Union victory in the war, the immediate economy following the war was in a very good state. Purchasing power increased in both northern and southern cities, though the south tended to lag behind perpetually, as prices lowered. The income tax needed for the war was abolished, and reunited country prospered (Galbrath 101). Another result of the war, was that the Treasury Seal has been on every peace of paper money since 1862. Seals come in a variety of sizes, shapes, and colors, dependent on the bill they are one, and have become collectors items (Friedberg 8). Since then the Federal Reserve has tried to keep the seal somewhat uniform.

During the time with no central bank, state banks took reign and the resultant wildcats and busts were not unexpected. With too many failed banks, in Michigan in particular, the Panic of 1907 ensued (Dictionary 156). The Federal Reserve (Fed), came into being after the said Panic. The structure was formed and it was voted into power in the Federal Reserve Act of 1913, and was signed by President Wilson (Galbrath 116). It’s mission is to protect the integrity of the nation’s money by giving a solid banking and financial system for price stability (Rosenblum 37). It has the power to set reserve and margin requirements, expand credit to prevent crashes, and regulate depression and expansion (Greenwald 166). Among the original board members, were W.P.G. Harding and Charles S. Hamlin (Galbrath 124).

The Federal Reserve consists of 12 Federal Reserve Banks (FRB), in the 12 Federal Districts across the nation (World Book 65). Each FRB must have in reserve 35% lawful money, and each Federal Reserve Note must be backed by 40% gold (Galbrath 126). Besides founding FRB’s, the Federal Reserve Act states the amount of money to be held in reserve by state banks. When the Federal Reserve Act was passed, it was stated that banks within large cities need to contain 18% specie on demand, medium cities to have 15%, and small cities only 12%. This runs backwards to logic, as a strong state banks in large cities are trusted more because they run conservatively and thus there are fewer bank runs. This means that they only need a small amount of reserve on hand. Small city banks should be required to keep a large amount of specie, and they are more prone to busts (Galbrath 127). The three primary functions of the Fed are Open Market Operations, Reserve Requirements, and Discount Rate (World Book 66). Open Market Operations is the sale or purchase of government securities by the Fed. This means that when it sells securities, they are paid for buy checks from banks. This lowers their money supply, which leads to less loans. Fewer loans means a slowing of financial speculation, something that should not run rampant like the speculation during Biddle’s reign. The Purchase of securities, is paid to banks, which then have more money to issue loans with, which increases speculation (66). Reserve requirements are the amount of money banks must hold in reserve. This controls how much banks can loan out into the economy. A raised requirement means that banks must set aside more money that could have gone for loans, which is how banks make their money. Lowered requirements increase the money supply going into the economy as banks have to keep less money on hand (66). Discount Rate is the fee which is paid to borrow money from a FRB. A raised rate means it costs more to borrow money and speculation goes down. Lowered rates mean the opposite. Because of this, banks rarely borrow from FRB’s. It is used mainly to notify banks of the Fed.’s current financial policy (66). These responsibilities work in tandem, and a change in one will affect the others. This is how the Fed influences the economy (Greenwald 66).

To date, no Federal Reserve officer has ever been arrested for theft or embezzlement, and no Federal Reserve officer has ever been found to influence the system for his personal use, as Biddle once did (Galbrath 119). There are is composed of two committees: the Board of Governors, and the Federal Open Market Committee. The Board of Governors has 7 members, each with a 14-year term chosen by the President. The chairman is also selected by the President for a 4-year term (World Book 65). The Open Market Committee, which makes the main monetary policies, is made up of the Fed governors, the President of the New York City FRB, and four other FRB presidents (65). There is also a Federal Advisory Council, which monitors business and financial conditions, and a Consumer Advisory Council, that has responsibilities under consumer credit protection laws (65). The current Chairman of the Federal Reserve is Alan Greenspan (Davis).

Reforms over the years, include a multitude between 1933 and 1935, and some as recent as the early 1980s (Galbrath 196). Many people are shaky about reforms in a system that has been relatively successful. The problem with reform, says Harvey Rosenblum, is that "it will probably make the Fed to weak to be effective." (Rosenblum 37). Possible proof of the opposite, is that in 1979 the Fed was allowed to control the money supply more directly, instead of just interest and reserve manipulation. The result was a crash in the early 1980s. The Fed returned to its previous powers afterward (Greenwald 66). The Monetary Control Act of 1980 made the Fed charge explicit prices for its services, and if it couldn’t function that it should shut down. The Fed worked (Rosenblum 37). Alan Greenspan has taken on a somewhat radical approach to inflation. He feels that any action has always been, "too little, too late." (Greenwald 47). It was also said by John Galbrath that "fear of inflation is the greatest motivator." (Galbrath 186). Greenspan’s stance of aggressively attacking inflation has apparently worked thus far, as inflation is down and work is up. Some prices have been reduced voluntarily. General Mills, for example, took 10% of Wheaties (Greenwald 47).

Whatever the Federal Reserve, and any American financial institution in general, is, it is not consistent. Hamilton, hundreds of years ago, said that a country without a national bank would be in a state of perpetual weakness. He was proved correct with the rampant bank runs, wildcats, busts, and inflation during such periods. However, his opponent Thomas Jefferson, said that the fearful creature presiding over America, the National Bank would become a monarchical power of its own. Biddle very obviously proved him to be correct. The very name Bank of United States left such a bad taste in the mouths of American citizens, that before a new central bank come into being in 1913, that they name had to be something other than Bank of United States. Such is why it is called the Federal Reserve. Other historians proclaim that the bank or lack thereof not be blamed, but the way they operate be. Fractional and fiat money has been the cause of all the banking hardships, a problem the gold standard kept at bay. Where will the BUS (Federal Reserve) be tomorrow? Following a historic pattern, America tends to flow through times with and without a central bank. Perhaps it will again be so.

Blum, John M, ed. The National Experience. Toronto: Harcourt Brace Jovanovish College Publishers, 1993.

Forman, James D. Inflation. New York: Franklin Watts, 1977.

Friedberg, Robert. Paper Money of the United States. New York: Coin and Currency Inc., 1962.

Galbrath, John K. Money: Whence it Came, Where it Went. Boston: Houghton Mifflin Company, 1975.

Greenwald, John. "Fighting the Right Foe." Time 23 May. 1994: 47-51.

Griffin, Edward G. The Creature from Jekyll Island. Westlake Village: American Media, 1994.

Rosenblum, Harvey. "It’s not broke, so don’t fix it." Business Economics October 1994: 37-46.