Introduction - An Attempt to Stabilize (Control) Nature

In economic history, few institutions have wielded as much influence as the United States Federal Reserve. The Federal Reserve, often simply called the Fed, stands as the cornerstone of the US financial system, playing a pivotal role in steering the nation's monetary policy, supervising banks, and maintaining the stability of the economy. But how did this powerhouse of economic regulation and oversight come into existence? And how did an impartial, non-federal government entity become exceedingly centralized? To understand its creation and original use case, we must journey back to a time of financial turmoil and uncertainty.

Some Key Terms (I promise they’re not that bad!)

Inflation – The rate at which the value of a US dollar loses value. If inflation is 5%, then $100 in January is worth $95 relative to goods and services purchased

Reserve ratio – The percentage of cash a bank needs to hold relative to total deposits. The US operates on a fractional reserve banking system, so if someone deposited $100 with a bank then that bank only needs to actively hold $10 and it can loan out the other $90 (to earn more money)

Federal Reserve Rate – This is the target interest rate that banks can borrow from each other, set by the Federal Reserve

Discount Rate – This is the price that the Federal Reserve charges banks if they borrow money from the Fed. This is a necessary function since the Federal Reserve is the lender of last resort (when banks fail bad)

Interest Rate - The cost of borrowing money

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The Historical Backdrop

The late 19th and early 20th centuries were marked by a series of financial panics and economic crises in the United States. To be specific, there were eight – 1884, 1890, 1899, 1901, and 1908. Imagine that roller coaster… These episodes exposed the fragility of the nation's banking system, which lacked centralized control and coordination. The existing monetary framework was backed by the gold standard, which made the economy vulnerable to wild fluctuations and destabilizing shocks.

As a response to these challenges, the concept of a central banking system gained traction. The Panic of 1907, a particularly severe financial crisis, created a sense of urgency to establish a more stable financial infrastructure.

The Visionaries Behind the Fed

The groundwork for the Federal Reserve was laid by multiple visionary economists and policymakers. Including Paul Warburg, a German-American banker, Nelson Aldrich, a Republican leader at the time, and Woodrow Wilson, who would later become the 28th President of the United States. Paul Warburg was instrumental in shaping the conceptual framework for the Federal Reserve. Drawing from his familiarity with European central banking systems, Warburg advocated for a decentralized structure composed of regional Reserve Banks, underpinned by a strong central authority. We will come back to this point – but at conception the influential political arms of Washington had no say over the Fed, or the actions it took with the free market.

The Birth of the Federal Reserve

After years of intense debate and political wrangling, the Federal Reserve Act was signed into law on December 23, 1913. This landmark legislation marked a turning point in the nation's financial landscape. The Act established the Federal Reserve System as the United States' central banking authority, charged with a three-fold mission: maximizing employment, stabilizing prices (aka inflation), and moderating long-term interest rates. Just to highlight on a high level, these are competing interests from an economic theory standpoint. When employment goes down, prices go up, and vice versa – and we’ve all seen how unstable interest rates can drastically impact the entire economy. This is why you’ll hear things like “our target inflation rate is x%” because this is a near impossible balancing act in isolation of any other external variables (like an election year….).

The Federal Reserve System was designed as a compromise between other competing interests. Its structure aimed to strike a balance between centralized control and regional autonomy by creating twelve regional Reserve Banks scattered throughout the country – each of which has a governor, and they are all overseen by a central governing body, the Federal Reserve Board.

Functions and Powers

The Federal Reserve was given a range of tools to fulfill its mandate. It could influence the money supply through open market operations(aka go to Wall Street and buying bonds from large banks to inject cash into the economy – in theory spurring economic growth), adjust the discount rate to affect borrowing costs for banks (lower rate of borrowing increases economic growth), modify the Federal Funds Rate, and establish reserve requirements to control lending (you may also hear reserve ratio) – meaning that if the reserve ratio is 10% then a bank could lend out $9 out of $10. Lower reserve ratio also spurs economic growth. These tools provided the Fed with the means to counteract financial crises, stimulate economic growth, and curb inflation. It’s important to remember, nothing is ‘free’ – so the fed doing everything its power to spur the economy and create growth might sound great, but it inevitably leads to high inflation which eats away at the value of our hard-earned savings.

Evolution and Impact

Over the decades, the Federal Reserve's role and functions expanded in response to evolving economic challenges. The Fed played a pivotal role in stabilizing the economy during the Great Depression, World War II, and subsequent financial crises – including the 2008 recession. Its ability to act as a lender of last resort and its influence over monetary policy made it a lynch pin of economic stability, and ultimately a massive target of political influence. This has impacted the Fed's ability to impartially navigate the treacherous waters of the free market, and has added a degree of centralization not originally intended.

Increasing Controversy

While this is a short post on the origination of the Fed, I think it would be irresponsible to not include some comment on its current reputation. The version of the Federal Reserve today is much more influenced by politics, and you can see (as recently as this year) many influential politicians calling out the Chair of the Fed for decisions that are necessary in the face of high inflation, but negatively impacting the immediate American experience in this economy. Jerome Powell's words move the global market and have become so influential that countless people analyze the specific words, the order of those words, the tone of his voice, and his facial expressions while speaking in order to predict how the Fed will handle the existing economic environment. Any time there is a single figure in the public eye making these absolutely monumental decisions, that will stir the pot with the same public eyes - but that also become a pawn (indirectly or directly) in the broader political landscape within the US.

Conclusion

The creation of the United States Federal Reserve in 1913 was one of the most important moments in the nation's history. Born out of a pressing need for financial stability and centralized control, the Federal Reserve has evolved into a dynamic institution that wields immense powerover the nation's economy – and therefore the entire world. Its actions and decisions ripple through financial markets, impacting the lives of billions of people. Understanding its origins and evolution allows us to appreciate the ongoing efforts to balance economic growth and stability — a delicate dance guided by a select few who (are supposed to) act objectively in the interest of the United States economy.

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