Chapter 16: The Structure of Central Banks: The Federal Reserve and the European Central Bank

The Federal Reserve System (known as "the Fed") is one of the most controversial institutions in the United States, and even the world (see the optional links at the end of this lecture). It is not surprising, given the history of the U.S. and its central bank, and given the enormous power the Fed has over the U.S. and world economy. In this chapter we take a closer look at this institution.

Origins of the Federal Reserve System

"Between 1870 and 1907, the nation experienced 21 financial panics of varying severity." (401). The creation of the Federal Reserve came about in 1913 in response to a severe financial panic in 1907. The Fed was created to avoid the recurring financial crises and bank failures that plagued the U.S. banking system up to 1907.

After the panic of 1907, some of the great industrialists of that time (J.P. Morgan, Vanderbilt, Rockefeller, Carnegie) demanded that politicians put a central bank in place (private bankers even drew up their own plan, but it was rejected by Congress). This central bank would be a banker's bank, a lender of last resort . The Federal Reserve System stands ready to make loans and provide liquidity to banks facing unexpected despositor withdrawals.The largest obstacle to a central bank was the fear of centralized power by most Americans (remember, we revolted against a King!).

Because Americans tend to be very suspicious of centralized power and moneyed interests, the resulting central bank, the Federal Reserve System, has a very decentralized structure, with a system of checks and balances, much like our federal government.

Structure of the Federal Reserve System

There are basically 3 parts to the Federal Reserve System structure:

1. Federal Reserve Banks.

There are 12 regional banks, each covered a region or district of the United States. (Click here to see a map of the 12 Federal Reserve districts, also on page 404 of your textbook.) These regional banks serve the member banks that reside in the district. All national banks must be member banks. Membership is optional for state banks. About 33% of all commercial banks are member banks.

The member banks are part-owners of their district bank, and receive dividends. So the 12 regional banks are a hybrid of government institution and private firm.

As of 1980, all depository institutions, not just member banks, must keep reserve deposits with the Federal Reserve bank in their district, and in return they have access to emergency loans (discount loans) from their district bank. All proposed mergers and acquisitions by depository institutions in the district are evaluated by the Federal Reserve bank. District banks also play a role in monetary policy in setting the discount loan rate and sitting on the FOMC (see below).

They perform a variety of other services for their member banks, including check clearing, providing currency, and collecting and analyzing regional economic data. They are also the U.S. government's bank, managing U.S. Treasury accounts and borrowings.

The Federal Reserve Bank of New York (FRBNY) is the most important of the district banks, playing a special role with foreign central banks, international currency exchanges and Federal Reserve open market operations, described below.

2. The Board of Governors.

At the top of the Fed are 7 governors, appointed by the U.S. president (and confirmed by the Senate) to 14-year nonrenewable terms, and the terms are staggered. This long term gives the Fed governors some measure of political independence in their decisions, because they will hold office longer than the president that appoints them.

One governor is appointed by the president to serve as chairman for a 4-year renewable term. The current chair is Ben Bernanke, who has served since the beginning of 2006.  He replaces legendary chair Alan Greenspan, who served from 1987 to 2006 (being reappointed by several Presidents). Mr. Bernanke reports to Congress twice a year, and is probably the second most powerful man in the United States (some would put him first).

The Board is very important in setting monetary policy. All 7 members sit on the FOMC (see below) and vote on open market operations. The Board sets the reserve requirement and approves the discount loan rate in each district. The Board, with a huge staff of economists, conducts a large amount of data collection and economic research.

In addition, the Board has many regulatory functions with respect to financial institutions and markets. It has the final say in bank mergers and permissible activities for banks.

3. The Federal Open Market Committee (FOMC)

The Fed's real influence on the EconomyThe FOMC has 12 voting members which include all 7 governors, the President of the FRBNY, and 4 of the other regional bank presidents on a rotating basis. The FOMC meets every 6 weeks (and more frequently for emergencies, such as in the case of the 9/11 attacks), assesses the condition of the economy, and votes on monetary policy in the coming weeks.

The FOMC votes on open market operations, the Fed's buying and selling of Treasury securities in financial markets. In doing so they are able to control the federal funds rate, the rate banks charge each other for interbank lending. This is the most important policy tool of the Fed.. At each FOMC meeting, current economic conditions and forecasts are presented, policy options debated, and then the members vote. (The vote is actually for a federal funds rate target to be achieved through open market operations.) Since 1994, the FOMC has announced their decision shorting after the meeting that same day.

The FOMC decides on a federal funds rate target. Achieving this target through open market operations is the job of the Federal Reserve Bank of New York.

An Assessment of Fed Structure: Independence

The structure and financing of the Fed give it considerable independence from political pressures. As discussed above, the Fed governors serve 14-year nonrenewable, staggered terms. These long terms give the Fed governors some measure of political independence in their decisions, because they will hold office longer than the president that appoints them. Furthermore, when the chairman is very popular within the financial sector (such as Alan Greenspan), the president will be under considerable pressure to re-appoint him. Alan Greenspan has been appointed/re-appointed 5 times, by 4 different presidents, both Democrat and Republican.

But even more important for Fed independence is the source of its financing. The Fed funds its own operations through the profits from trading and holding Treasury securities and through revenue from discount loans. (The Fed made about a $30 billion profit in 2003, most of which is returned to the U.S. Treasury). This means that the Federal Reserve System does not depend on Congress for its funding. This lack of control by Congress gives the Fed considerable freedom.

Of course, Congress and the president do retain ultimate control, since they could pass laws limiting Fed power. The Chairman of the Board of Governors must report to Congress twice a year about its economic goals for monetary policy, but in the end Congress (or the president) cannot tell the FOMC what monetary policy to pursue.

Central bank independence may seem undemocratic, but it is not a unique idea. In fact, all industrialized countries give their central banks some degree of independence, including the European Central Bank, Germany, Switzerland, and more recently Canada, England and Japan. Given the Fed's independence, the question remains, is independence a good thing?

Federal Reserve Independence: The Pros

Basically, the main argument for independence is the notion that political goals are short-term and economic goals tend to be more long term. While Congress might be tempted to use monetary policy to maximize re-election, an independent Fed is free to pursue policy that promotes policies that pursue long-term economic goals, even if they are unpopular in the short-run.

An example of this the economic goal of low inflation or price stability. In order to control inflation, the Fed may need to pursue policies that actually slow down the economy and increase unemployment. While this will be painful and unpopular in the short-run, it will lead to greater economic growth in the long-run. In 1981-82, the Fed, under chairman Paul Volcker, actually contributed to (some say caused) a severe recession in an effort to bring down a very high inflation rate. Yet today, many economists credit Volcker for the long economic expansions of the 1980s and 1990s long after he left as chairman. No elected politician would ever deliberately cause a recession, no matter what the long-term benefits.

Federal Reserve Independence: The Cons

The basic argument here is that independence is undemocratic and makes the Fed accountable to no one if they do a lousy job. Voters can get rid of bad senators, but they are stuck with bad Fed governors. Furthermore, there are historical examples where the Fed, despite its independence, failed in its responsibilities. The bank failures of the Great Depression are a prime example.

Fed independence in general is well-supported by policy makers and there is some economic evidence in support of independence as well: Countries with the greatest amount of central bank independence tend to have the lowest rates of inflation.

The European Central Bank (ECB)

Your book discusses the structure of the European Central Bank, the central bank for the euro area, 12 European countries that have adopted the euro as their common currency. This structure mirrors the structure of the Fed but differs in some important respects. The ECB was formed only for monetary policy. It has no authority to regulate banks or the financial system. Also, while steps have been taken to safeguard ECB independence, the ECB does not control its own budget. Table 16.3 on page 420 summarizes the differences between the FOMC and ECB Governing Council.

FYI: Related Links

Multiple Choice Quiz Chapter 16 An interactive quiz from the textbook website.

The Federal Reserve Board of Governors

The Federal Reserve in "Plain English" An easy to follow description of the history and functions of the Fed.

powered by ANGEL Learning’s MindClickProcess Technology