On Monday, all eyes were on Janet Yellen, as she was sworn in as the first female chair of the Federal Reserve Bank since its founding in 1913. Yet at the same time, the stock market plunged. As the most important person governing the most powerful central bank in the world, anything she says in any occasion will heavily influence industrial sectors and economic agents’ expectations. In the same way, the market reflects people’s confidence in, or pessimism about, the Fed by stock commodity prices fluctuating.
People today see the role of the Federal Reserve in a way that departs from the original purpose of its founding. In 1913, Congress passed the Federal Reserve Act and President Woodrow Wilson signed it into law. The Act “provide[s] for the establishment of Federal Reserve Banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.”
But the Fed’s role has evolved from creating a way to regulate banks more effectively to stabilizing the economy, ensuring full employment and controlling inflation.
The creation of the Fed didn’t come without any controversy and opposition, but the concerns of the idea that the Fed is the biggest root of an unstable macroeconomic environment has been growing stronger after the stock market collapse in 1929. Every time a financial crisis comes along, the Fed always bears the blame. Doubts and fears of the Fed again were spreading after the supreme mortgage boom was busted in 2007. Many economists argued that it’s the Fed’s fault for keeping the interest rate artificially low for too long. It’s necessary to reinvestigate the reason why the Federal Reserve System came into existence by looking at the banking history in the late 19th century.
Throughout the 18th and 19th centuries, the U.S. didn’t have any federal law to regulate banks and other financial intermediary firms. All banks were regulated at the state level, and even at county level in some states. Thanks to the second industrial revolution in the late 19th century, different industries in the U.S. were booming and demanding more liquidity to fund their expanding projects. While still sticking with the Gold Standard, the supply of gold was no longer able to support a fast-growing economy without new discovery of gold. According to Ellis Tallman’s research of financial panic history, a group of New York brokers usually bought gold from England to temporary liquidate the excessive demand of currency. But when the economy grew up to a point that the brokers couldn’t afford to do this anymore, a limited amount of gold caused deflation in an expanding economy.
The primary function of the Fed in its first 20 years was to rediscount—that is, to make loans—to its member banks when the banks were short of liquidity. It has changed the fundamentals of how banks should be run in the U.S. From then on, the regulations of banks have not only been at the state level but also at the federal level. Some believed that this change would prevent the financial panics from happening because banks failed to self-regulate. But during the Great Depression, devastating bank failures still shocked many who supported the Fed. A tougher scrutiny on the Fed was on the rise, which led to a stronger regulation on the banking industry: the Banking Act of 1935.
Given all the history in the banking industry, the founding of the Federal Reserve System was a necessary evil. The establishment of the Fed was to meet the demand of a new level of economic development in the U.S. Though the notion that if the Fed is the root of many the financial crises is still an open question, the Fed absolutely plays an indispensable role in influencing the world economy to a large extent. As one of the government branches, the Fed would also grow dramatically without checks and balances. The expansion of the Fed’s power has become the main reason that it bears plenty of criticism from the public.
The professional nature of the jobs in the Fed also causes tremendous problems of supervising its action. Critics of the Fed are mostly from academic intuitions that have little say about the political process. But that doesn’t mean Congress can do nothing imposing more supervision and improving transparency of the Fed’s policy.
