239 Reading: The Federal Reserve System
What Is the Federal Reserve System?
The Federal Reserve System was established by Congress nearly a century ago to serve as the U.S. central bank. President Woodrow Wilson signed the Federal Reserve Act into law on December 23, 1913. Prior to the creation of the Fed, the U.S. economy was plagued by frequent episodes of panic, bank failures, and credit scarcity. The history of the Federal Reserve is bound up in the effort to build a more stable and secure financial system.
The American colonists were limited to using European coinage, barter, and commodity money as their primary means of exchange before independence from British rule. Troubled by foreign coin shortages and the inefficiencies of barter and commodity money, many colonies began minting coins and issuing paper currency by the end of the 17th century. This was ineffective. People lacked faith in colonial currency and the authority of the colonies to issue money was periodically interrupted by their British rulers.
Colonial banks were not like modern banks. They did not take deposits from the public or make loans. Instead, they issued paper currency backed by land or precious metals such as gold. Merchants and other individuals were the primary sources of credit.
The origins of central banking in the United States began with the ratification of the Constitution in 1789. Secretary of the Treasury Alexander Hamilton developed a plan for a federal banking system to solve the nation’s credit problems after the War of Independence. This was controversial. Hamilton’s plan, backed by commercial and financial interests centered in the northeastern states, called for the creation of a federal bank to provide credit to government and businesses, and to establish a national currency. The federal bank would act as the government’s fiscal agent and provide a safe place to store government funds.
Secretary of State Thomas Jefferson led the opposition to Hamilton’s plan. Jefferson represented the country’s agrarian interests, which looked with suspicion at a central government bank and generally favored state over federal powers. He argued that the Constitution did not expressly authorize the federal government to charter a national bank or issue paper currency.
Hamilton, supported by the Federalist Party, won the debate. The First Bank of the United States was chartered in 1791. A bill to re-charter the bank failed in 1811. Without a centralized banking and credit structure, state banks filled the vacuum, issuing a multitude of paper currencies of questionable value. Congress attempted to solve the country’s financial problems by chartering the Second Bank of the United States in 1816. This second bank lasted until President Andrew Jackson declared it unconstitutional and vetoed its re-charter in 1836.
A period known as the Free Banking Era followed the demise of the Second Bank of the United States. Over the next quarter century, U.S. banking was a hodgepodge