The U.S. economy prospered from the American Revolution until the Great Depression despite financial crises roughly every 20 to 25 years. Most financial panics ushered in periods of stagnation. A wave of bank failures in 1906--1907 led to establishment of a third central bank, the Federal Reserve System, in 1913. Among the FED's objectives is to act as a "lender of last resort." This means the FED lends money to inherently sound banks so they can survive bank "runs" when financial panics drive armies of depositors to demand withdrawals.

 

            The seven members of the FED's Board of Governors are appointed to staggered 14-year terms because Congress feared the central bank might become highly politicized. Each president and Congress has limited power over the FED because they appoint only one new member of the Board of Governors every other year. Board members were traditionally bankers, causing some people to question how diligent they are as public "watchdogs." Recent presidents have drawn increasing numbers of governors from the

general public, including more than a few economists.

 

            The FED (in concert with the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and various state government agencies) audits banks to guard against fraud, and enforces a set of complex regulations. Among its other services to the banking community, the FED processes checks drawn on one bank and deposited elsewhere. The FED's key role, however, is to conduct monetary policy. Before we examine monetary policymaking, you need to know a bit more about the structure of the FED.

Federal Reserve Bank Districts

 

The 12 regional districts of the Federal Reserve System are depicted in Figure 1. Each district has a primary bank and one or more branch offices. Check any bills you have on hand; many bills travel far from their points of issue.

Figure 1  Federal Reserve Branch Banks

  The Federal Reserve System consists of 12 districts. Each district has a Federal Reserve Bank, and most also have Branch Banks.

Source: Federal Reserve Bulletin.

            Federal Reserve Banks and their branches do not serve the general public directly. These "bankers' banks" help member banks clear checks drawn on other banks, make loans to bankers, and try to facilitate efficiency in our economy's financial sector. The FED operates under the fiction that it is "privately owned" by federally-chartered private banks, but it is actually an arm of government created by Congress. Its decisions have the force of law, and all returns on its financial investments exceeding 6 percent annually must be paid to the U.S. Treasury.

 

Member Banks

 

Roughly 15,000 privately owned banks or other intermediaries that issue checking accounts (e.g., S&Ls) now operate in the United States, of which fewer than half are national banks chartered by the Comptroller of the Currency. National banks must be members of the Federal Reserve System; state banks (chartered by individual states) may, upon approval, qualify as member banks. The FED now sets legal reserve requirements on deposits in all bank-like financial institutions, so it has considerable direct power over most of our financial system.

 

Organization of the FED

 

            The chairman of the Federal Reserve System is supposedly only a "first among equals." Like the Supreme Court's chief justice, he nominally has only one vote but, in fact, exercises a  disproportionate amount of power. Of course, effectiveness in controlling monetary policy depends on the chair's personality, the effectiveness of the Federal Reserve staff, and on the dynamics of relationships among the various governors.

 

            Congress established the FED as a pseudo-private organization to shield it from political chicanery that could distort its regulatory and stabilization policies. As a "private" organization, FED member banks elect six of the nine directors of each District Bank; the other three are appointed by the Board of Governors. The Boards of Directors of District Banks elect District Bank presidents. But real policymaking power is exercised by the Federal Open Market Committee (FOMC)---all seven members of the Board of Governors plus the president of the New York District Bank. Four other District Bank presidents rotate on the committee. The FOMC has enormous control over our entire financial system through its conduct of monetary policy. Committee members' long terms of office and votes give the real clout within the FOMC to the Board of Governors, especially the chairman, as indicated in Figure 2.

Figure 2

This figure may look a bit like a formal organization chart, but it actually illustrates the FED's pivotal role in the conduct of monetary policy. Other government agencies help stabilize and shape financial activity by, for example, (a) chartering banks and other financial intermediaries, (b) auditing their books, or (c) steering flows of financial investments (into, e.g., low-income housing), but the FED's broad powers make it the dominant player in regulating financial intermediaries and controlling the money supply.

 

            Economists focus on incentives. Should our central bank maximize profits? Should monetary policymakers be subjected to political pressures in our democracy? Before we tackle these problems, let us see why the answers to these questions are so important.