Financial History 144 Winter 2023 - Page 17

By Mark Higgins
On December 23 , 1913 , President Woodrow Wilson signed the Federal Reserve Act into law . Most people believe that this marked the birth of the nation ’ s first central bank , but it was , in fact , the third . The first two , the First and Second Banks of the United States , disappeared when their 20-year charters expired in the early 1800s . The Federal Reserve has endured for more than 100 years and has played a more important role in the expansion of the US economy and stabilization of its financial system .
Despite the importance of central banking , public opinion regarding its utility has fluctuated over time . In the 21st century , skepticism has intensified once again , as evidenced by the popularity of movements such as “ End the Fed .” Moreover , the very existence of decentralized finance and cryptocurrencies reflects growing distrust of central bankers .
This brief synopsis of the 232-year history of central banking in the United States reveals how a central bank protects the public from financial perils which can only be appreciated when one ’ s knowledge of financial history extends beyond the bounds of the human lifespan . Many financial risks that inspired the return of a US central bank in 1913 have faded from our collective consciousness , rendering Americans vulnerable to the false perception that the Federal Reserve is no longer needed . The lessons from history will remind Americans why the Federal Reserve exists and why its integrity and independence must be maintained .
Four Functions of a Central Bank
Before reviewing the history of central banking , it is important to first explain the primary functions of a central bank . Using a modern central bank as a reference , these functions include :
1 . Currency Stability — Everyday , Americans conduct billions of financial transactions denominated in US dollars . The value of a dollar is always accepted at face value , but this was not always the case . In the 1790s , individual banks issued proprietary bank notes , which customers redeemed for specie ( typically gold or silver ) that was held in the issuing bank ’ s reserves . Although bank notes were denominated in dollars , they were not necessarily accepted at face value by different banks and businesses . The value of a US dollar , therefore , depended upon the relative strength of the bank issuing bank notes . The result was an unstable currency . A central bank eliminates this problem by issuing bank notes that are accepted universally at face value .
2 . Bank Regulation — Fractional-reserve banking systems face the perennial risks of insolvency and illiquidity . Preventing reckless banking practices that increase these risks requires the construction of a well-regulated banking system . A central bank is generally regarded as the ideal regulatory authority to enforce such regulations , and thereby ensure that banks employ sound lending practices , maintain adequate reserves and refrain from committing fraud .
3 . Lender of Last Resort — Fractionalreserve banking systems are structurally vulnerable to financial panics and bank runs . These events can force otherwise healthy banks to renege on their promise to convert bank deposits into cash simply because they lack the liquidity to satisfy large , but temporary , withdrawals . Central banks play a critical role in stopping these crises by serving as a lender of last resort . This entails expanding the supply of currency and providing it to the banking system in exchange for less liquid securities until the crisis subsides .
4 . Monetary Policy — Finally , a central bank governs the monetary policy of a nation . The stated mandates vary by nation and over time . In 2023 , the Federal Reserve ’ s mandate is to balance the competing demands of maximum employment and price stability .
The Four Eras of US Central Banking , 1791 – 2023
The evolution of US central banking can be categorized into four distinct eras . It was not until the signing of the Federal Reserve Act that all four functions of a central bank were present in the United States .
1 . The First and Second Bank Era
“ Credit is an entire thing . Every part of it has the nicest sympathy with every other part . Wound one limb and the whole tree shrinks and decays .”
— Alexander Hamilton , January 1795
The United States ratified the Constitution in 1788 , but the financial system remained in disarray . Both the federal and state governments had amassed a mountain of unserviceable war debt , and many veterans were not even fully paid for their service . In 1790 , the nation ’ s first Treasury Secretary , Alexander Hamilton , devised a three-pronged strategy to restore the nation ’ s creditworthiness . First , all state and federal debts were consolidated and backed by the full faith and credit of the United States . Second , Congress established new tariffs to provide revenue to service the debt . Finally , Congress approved a 20-year charter for the nation ’ s first central bank , the First Bank of the United States .
The First Bank ’ s powers were more limited in comparison to those afforded to the Federal Reserve . The primary objective was stabilizing the currency , as constant fluctuations in the value of bank notes issued by state-chartered banks created unnecessary frictions and risks in trade . Bank notes issued by the First Bank maintained a uniform value , which was bolstered by its eight bank branches , sizeable reserves and stable deposit base . It also served as the nation ’ s fiscal agent and provided commercial banking services to individuals .
The First Bank played an important role in facilitating strong and stable economic growth in the United States from 1791 to 1811 , yet many politicians failed to appreciate its value . Fierce opposition from the Democratic-Republican party led Congress to reject a bill to renew the charter in 1811 . Over the next five years , the United States experienced persistently
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