3. The Structure of the Federal Reserve

The structure of the Federal Reserve System—which was enacted in December 1913 and opened its doors the following November—was at once cartelizing and inflationary.[30] The cartelizing nature of the Fed can be seen in its organization: an intimate partnership between the federal government and the nation’s banking community. There are 12 regional and district Federal Reserve Banks, the stock of which is held by the member banks in the district. Each Bank is governed by nine directors, of whom three are chosen directly by the banks in the district; three others are supposed to represent commerce, agriculture, or industry, but they too are chosen by the member banks in the district. That leaves only three directors appointed by the overall Federal Reserve Board in Washington. Furthermore, of the three publicly appointed directors, one—who becomes the chairman of the district Bank—must be a person of tested banking experience: in short, an ex-banker.

Not only are six—arguably seven—of each Bank’s directors private bankers, but the chief executive officer of each Bank (originally called the governor and now the president) is appointed by the Bank directors themselves, not by the central Reserve Board (even though the latter must approve the choice). The central board has seven members, two of whom must be former bankers; all are appointed by the president of the United States.

Some critics of the Federal Reserve assert that it is really and simply a private central bank, since it is owned wholly by its member banks and it makes profits from its policies. But this view ignores the fact that all profits made by the Banks are now taxed away by the treasury. The point of the cartel is not make profits directly as shareholders of each Reserve Bank, but to benefit from the cartelizing and inflationary policies of the entire system.

At the same time, those who maintain that the Federal Reserve System is a wholly government-controlled institution overstate the case. It is true that all members of the Federal Reserve Board are government appointed and that all district Bank officials are instructed to act within the guidelines set by the Board. But every governor (or president) of a Federal Reserve Bank is selected largely by the bankers of the district, and these governors can exert a considerable amount of influence on Fed policy.[31] As we will see below, the banker-elected governor of the Federal Reserve Bank of New York seized the reins of power from the Federal Reserve Board from the inception of the system in 1914 until his death 14 years later.

The Federal Reserve System, like all central banking systems, is inherently inflationary. In the first place, the central bank acts as a lender of last resort, a giant governmentally privileged institution standing ready to bail out banks in trouble. Second, by coordinating bank activities, the central bank can pump in new reserves throughout the system and thereby induce a multiple expansion of bank money and credit. Since the banks can inflate uniformly, individual expanding banks no longer suffer from the constraining redemptions by nonexpanding banks that prevail in a regime of free and decentralized banking. If a bank expands credit on its own, it will soon find that its expanded notes or deposits will be passed on from its own clients to clients of other banks and that in the normal course of business they will be returned to the expanding bank for redemption. Yet the expanding bank will not have the funds to redeem these claims. There is also a third reason, which might not be as evident: Even if legal reserve requirements remain the same, the centralizing of reserves into the hands of the Fed by itself permits a considerable inflation of money and credit. In short, if before the establishment of a central bank every bank keeps its own cash reserves, and if afterward most of the cash is deposited in the central bank, the bank can then pyramid its own liabilities on top of its cash, thereby exerting a multiple leverage effect on the previously existing cash. In an illuminating book on the Federal Reserve and the Great Depression, Phillips, McManus, and Nelson summarize this process:

Thus, if the commercial banks prior to the inauguration of a system of bankers’ banking are required to hold an average reserve, say, of 10 percent against deposit liabilities, their deposits may be ten times that reserve, or, they may expand credit roughly on a ten-fold basis. With the reserves of the commercial banks transferred to the Federal Reserve Banks, and with the latter required to maintain a reserve of only 35 percent against the deposit liabilities due to the member banks, credit expansion may, at its utmost, proceed to approximately thirty times the amount of the reserves. Thus is seen that the establishment of a central banking system [in the United States] magnified the former expansive power virtually three-fold.[32]

This statement overlooks the fact that the pre-Federal Reserve banking system was not free and decentralized, and it therefore exaggerates the quantitative inflationary effect of the creation of the Fed. But the basic point is correct.

A fourth inflationary effect of the creation of the Fed is inherent not so much in its structure as in the legal power to change the reserve requirement of the banks. Thus, before the enactment of the Fed, the average minimum reserve requirement for the nation’s banks was 21.1%. The Federal Reserve Act of 1913 slashed those reserve requirements to an average of 11.6%, a reduction of 45%. Four years later, in June 1917, reserve requirements were further lowered to an average of 9.8%—a cut of 54% since 1913. In short, added to whatever multiple inflation of money and credit was permitted by the centralization inherent in the existence of the Fed, a twofold expansion in four years was permitted by the slash in reserve requirements.[33] Furthermore, in an inflationary move that was to become highly significant in the 1920s, the Federal Reserve Act drastically lowered the reserve requirements for time deposits in the banks. Previously, there had been no distinction in the legal reserve requirements between demand and time deposits; both had therefore averaged 21.1%. Now, however, the requirement for time deposits was lowered to 5% and then to a negligible 3% in June 1917.[34]