The Federal Reserve System, Its History and Function, Part 1

This is a special post in two parts on the U.S. Federal Reserve System. It is in response to the rise of the Occupy Wall Street movement. Part 2 will be published on November 6, and the next regularly scheduled reply on the crisis of the dollar system will be published on November 20.

The last weeks in the United States have seen a sudden surge of anti-Wall Street demonstrations that have targeted the policy of the U.S. government of “bailing out banks and not people.” The occupation movement has since spread first across the United States and now the world.

The followers of Ron Paul, a right-wing Republican congressman and presidential primary candidate from Texas, have appeared at some of the occupations and raised the slogan “End the Fed.” Paul believes that not only “the Fed” but democracy in any form should be abolished. Paul’s followers blame the Federal Reserve System for virtually all the problems faced by the lower 99 percent—high unemployment, the high cost of living, mass indebtedness, “underwater” homes, and foreclosures.

But what actually is the Fed, or to use its formal name, the Federal Reserve System? Is it some kind of privately owned bank, or is it a government agency? What is the difference between the Federal Reserve Board and a Federal Reserve bank? Is the Fed really to blame for the problems of the lower 99 percent of the population? And if the answer is yes, why would such an evil institution have been established in the first place?

If you consult a high school or college introductory economic textbook, you will learn that the Federal Reserve System is the U.S. version of a “central bank.” The job of the Federal Reserve, the textbook will explain, is to determine the levels of interest rates and the “money supply” and act as a “lender of last resort.”

According to U.S. law, the Fed is also mandated to follow policies that ensure “full employment” and “price stability.” If so, it is doing a lousy job of ensuring full employment and a not-so-great job at price stability, as recent surges in the price of gasoline and food have shown.

Politicians and many economists often blame the Fed for unemployment and or inflation. If only the Fed would do its job properly, they claim, these evils would be avoided and “our free enterprise” system would generate jobs, stable prices, and justice for all. But somehow the Fed never gets it right.

The Federal Reserve System is what economists call a “central bank,” or rather the Federal Reserve is part of a central banking system. In reality, under current law the Federal Reserve System is not a complete central bank. It carries out its central banking functions alongside the U.S. Treasury Department, which holds a huge hoard of gold bullion—gold bars—at the famous U.S. government depository at Fort Knox, Kentucky. Less well known is the even larger gold hoard that is held in the vaults of the Federal Reserve Bank of New York on behalf of international organizations such as the International Monetary Fund, which is effectively controlled by the U.S. Treasury, and foreign governments.

The central banking system that the Federal Reserve System is a part of under the current international monetary system functions not only as the national central bank of the United States. It in effect is also the central bank of the world. The majority of U.S. dollar bills issued by this central banking system circulate outside of the United States.

A brief history of central banking in the United States

Among the American people, there has always been a considerable distrust in banks in general and central banks in particular. This distrust has tended to surge in periods of economic hardship like we are going through at the present time, and has tended to die down somewhat during periods of economic prosperity.

The first attempt at creating something like a central banking system in the U.S. was the First Bank of the United States, sponsored by George Washington’s secretary of the treasury, Alexander Hamilton. Its charter ran from 1791 to 1811 and was then allowed to expire. A Second Bank of the United States began operations in 1816. After a bitter conflict known in U.S. history as the “Bank War,” its charter was allowed to expire in 1836.

Both of these banks were highly unpopular among the mass of the American people. For one thing, both banks were owned not by the government but private stockholders, many of them English. The two banks were therefore seen not without reason as stalking horses for Britain’s powerful Bank of England and the City of London—London’s financial district or “Wall Street”—which dominated world finance at the time. This was in an era when the American War for Independence was still a living memory and anti-English sentiment was widespread.

Struggle between the ‘free labor system’ and the system of slave labor

The First and Second Banks of the United States also fell victim to the struggle between the slaveowners of the U.S. South and the merchants and rising industrialists of the North. The merchants and industrialists of the North, also known as capitalists, based themselves on the system of “free wage labor.”

The system of wage labor was sharply opposed to the slave labor of kidnapped Africans and their descendents that dominated the economy of the U.S. South. The southern-based slaveowners feared that if the federal government fell under the domination of the northern capitalists, it would no longer support the expansion of African slavery.

Since the mode of production based on African slavery quickly exhausted the fertility of the soil, the southern slaveowners needed to conquer new lands in warm climates that would support their wasteful and destructive mode of production. In order to expand in this way, the slaveowners needed the support of the federal government in Washington.

The slaveowners were therefore playing with the idea of seceding from the United States if and when the central government fell under the control of the northern industrialists and merchants. The southern slaveowners, realizing they would likely rebel against the federal government sooner or later, naturally wanted to keep the federal government as weak as possible. For this reason, they opposed a central banking system that would bring with it a modern unified “paper currency” backed by the credit of the entire nation. Such a currency system is part of the foundations of every modern capitalist state.

Therefore, the U.S. Civil War was needed not only to abolish, at least formally, the legal enslavement of African-Americans, but also to create the uniform currency that people in the United States take for granted today. Before the Civil War, under the system of “free banking” that Ron Paul would like to return to, each commercial bank issued its own banknotes—currency—which were convertible into gold and silver coins called “specie” to the bearer on the demand.

At least that was the theory. It often turned out, however, that these banks were little more than swindle companies (1) with very little gold or silver on hand to redeem their banknotes. Their banknotes became worthless whenever the owners of the banknotes panicked and demanded gold or silver coins.

The supporters of Ron Paul should realize that the system of fractional reserve banking did not start with the establishment of the Federal Reserve System in 1914 but was already well established under the “free banking” system that Ron Paul would like to re-establish today in place of the Federal Reserve System.

The National Banking System

Out of the U.S. Civil War, there emerged the National Banking System, the direct ancestor of today’s Federal Reserve System. Unlike the Federal Reserve System, the National Banking System had no central bank. Though the legal details of the National Banking System are too complex to explain here, the economic essence was far simpler.

During the era of the National Banking System—1862-1913—the world monetary system was increasingly dominated by the international gold standard. The international gold standard was centered on the Bank of England, which was and still is Great Britain’s version of a central bank. Under this international monetary system, gold would flow from countries that were spending more money than they were taking in to countries that were taking in more in money than they were paying out.

Therefore, when the U.S. experienced a positive balance of payments, as the economists put it, gold would flow into the U.S. banking system. In addition, gold was also mined and refined in the United States, and the bulk of this gold also made its way into the commercial banks.

The banks could do two things with the gold that was deposited with them. If the gold wasn’t already in the form of U.S. gold coins that could function directly as currency within the United States, the commercial bank could send the gold to the the United States mint, where it would be coined into official U.S. gold currency. Alternatively, the commercial banks could deposit the gold with the Treasury—often at a high interest rate—in exchange for currency or “paper dollars” printed by the U.S. Treasury. To this day, U.S. dollar bills bear the signature of the secretary of the treasury on the lower right and the treasurer of the United States—also an official the U.S. Treasury—on the lower left.

The point of these two signatures is to indicate that unlike the situation under the old “free banking system” the credit of the United States as a whole stands behind these dollar bills.

Therefore, when the U.S. ran a positive balance of payments, gold would flow in from abroad, the reserves of the commercial banks—whether they were made up of gold directly or Treasury-issued currency—would rise. The commercial banks would then have the money to expand loans and sooner or later—not necessarily immediately—the economy would “boom.”

When the economy boomed, unemployment declined and the farmers got good prices for their crops. Times were “good.” However, when the U.S. ran a balance of payments deficit, gold would flow out of the U.S. banking system and the Treasury to other countries. Unless domestic gold production was high enough to make up the difference, bank reserves would fall, money would get “tight,” interest rates would rise, and industrial production would decline.

This meant rising unemployment for the workers and falling prices for farmers. The economy would fall into a what was called in those days a depression. In those days, the word depression did not mean a disaster like the Great Depression of the 1930s—an economic collapse on such a scale had never occurred so there was no special word for it. Instead, the word depression simply meant a period of sluggish business, high unemployment and usually falling farm prices—what today we call a “recession.”

Panics and bank runs

This brings us to greatest weakness of the National Banking System from the viewpoint of the capitalist class, which had dominated U.S. policies ever since the Civil War. During recessions, to use the modern word, creditors tended to demand immediate repayment of loans they had made both to their fellow capitalists and to non-capitalists such as working farmers. In addition, during or sometimes right before a recession the stock market experienced a crash, also called a panic.

Under the National Banking System, just like under the earlier free banking system, large-scale runs on the banks would sometimes develop. Bank depositors would fear that their banks would go out of business causing them to lose all or part of the money they had on deposit with them. Long lines of depositors would then form in front of banks. (2)

In a desperate attempt to stave off failure, the banks would call in their loans, and refuse to make new loans. Credit would dry up, and cash would vanish into private hoards. This would greatly worsen the recession. As a general rule, recessions without bank runs were less severe than those with them.

Countries that unlike the U.S. had central banks could meet an extraordinary demand for currency during a recession by temporarily issuing additional banknotes in excess of the gold they held in their vaults. Doing this made bank runs unlikely and prevented the deepening of recessions that bank runs caused. Once the crisis or “panic” was over, the central banks would then withdraw this extra currency from the banking system in order to safeguard the continued convertibility of their currency into gold that was required under the rules of the international gold standard.

In Europe by the late 19th century, the very knowledge that the central banks could issue currency in excess of their gold reserves usually made the issuing of such extra currency during recessions unnecessary in the first place. But because the National Banking System was so prone to bank runs in the late 19th century, American recessions were often far worse than they were in Europe.

The nature and functions of money under the capitalist system

Central banking is about money, so in order to understand central banking and the role of the Federal Reserve System we have to understand the nature and role of money.

Money has several roles under the capitalist system. First and most important, it acts as the measure of value—and the standard of price—of all commodities. Indeed, not only commodities but all incomes—wages, profits, interest and rent—as well as debts are measured in terms of money. In addition, as every child knows, money is what we use to buy commodities we need to remain alive, though nowadays many people use debit or credit cards rather than cash.

In addition to buying commodities, we need money in order to pay the debts we owe. For example, we need money to pay taxes, as well as pay off our credit card balances (or make the minimum payment) and meet the monthly rent or mortgage payments.

During a recession, the capitalists who extend credit become fearful that their debtors will not be able to pay them back. They therefore tend to call in existing loans if they can and are reluctant to extend additional credit. Most capitalists are debtors and creditors at the same time. When a recession begins, the credit system behaves like a chain that begins to break in a thousand and one places.

No type of capitalist enterprise depends more on both borrowing and lending money than the banks that stand at the center of entire credit system. Banks borrow from their depositors and then grant loans with this borrowed money. They then re-borrow the same money over again and grant additional loans with it. The result is the system of fractional reserve banking system that so upsets the supporters of Ron Paul.

Under a fractional reserve banking system, the banks have far more deposit liabilities than they have cash to redeem them. If all the depositors attempt to withdraw their money at the same time, the bank quickly runs out of money and goes bankrupt. In the absence of deposit insurance or central bank intervention, most of the depositors lose part or all of the money they deposited with the bank.

Why do the banks behave in such a seemingly reckless way? The reason is that the more a bank loans—and re-loans—the same money over and over again, the greater its profits will be. And like all businesses under the capitalist system, banks strive to make as much profit as they possibly can. This is what the Occupation movement calls corporate greed and what the economists call the profit motive.

Whatever you call it, the drive to make the greatest profit possible is central to the capitalist system of production. You cannot have a capitalist system without it. When the supporters of the extremely pro-capitalist Ron Paul complain about the fractional reserve banking system, they are really complaining about the driving force of the entire capitalist system, the profit motive itself.

Therefore, the banks tend to maintain remarkably low “reserves” to meet demands for payment on their deposits in the form of bank withdrawals. If a bank should run short of cash, it will borrow money overnight from other banks at what is called in the United States the federal funds rate, or internationally the “libor”—London inter-bank overnight rate. However, if the banking system as a whole runs short of cash, as happens periodically under the capitalist system, a run on the banks will develop unless the central bank—assuming it exists—is able to stop it by issuing additional currency.

In Europe, as we have seen, by the late 19th century people pretty much realized that the central banks would issue additional currency beyond their gold reserves if a serious threat of a bank run developed. As a result, Europe entered into an era of prolonged relative financial stability that has never been matched since.

World’s worst banking system

The U.S., however, did not share in this era of relative financial stability. As we saw above, this was because the National Banking System had no way to issue additional dollars not directly backed by gold reserves during panics. Unlike Europe, America continued to periodically experience paralyzing bank runs. Such runs occurred in 1873, 1893 and finally 1907. Because of these recurrent banks runs, despite the rapid overall growth of the U.S. economy, the banking system was widely described in financial circles as the “worst in the world.”

This “worst in the world banking system” was tolerable when the U.S was still largely an agrarian nation. Workers who lost their jobs in droves during bank runs could always return to their family farms until “good times” returned. In addition, a wave of bank runs in the United States had only limited effects internationally. The European countries went right on enjoying their relative financial stability and gladly left bank runs to the central bank-less United States.

But by the early 20th century, the U.S. had become an industrial nation. Increasing numbers of workers had no families that owned farms that they could retreat to during “hard times.” In addition, the U.S. wasn’t just an industrial nation, it had become the leading industrial nation. If a massive wave of bank runs hit the United States under these changed conditions, soaring interest rates in the U.S. combined with temporarily depreciated corporate stock and real estate prices would provide many “bargains” for European capitalists eager to take advantage of the distress of their American cousins.

The European capitalists would lend money at high interest rates to American capitalists who were desperate for cash or snap up U.S. stocks and real estate at bargain basement prices. This would throw the balance of international payments, as the economists put it, violently against Europe causing gold to flow out of the European central banks and into the United State. This would undermine the ability of the European central banks to issue additional banknotes that were necessary to prevent bank runs in their own countries.

Though European central banks could issue banknotes in excess of their gold reserves in a crisis, there was a limit on how many additional banknotes they could issue before they would face a run on their gold reserves. The continued lack of a central bank in the United States threatened to bring back bank runs with all their consequences to the European countries.

The crisis of 1907 and the creation of the Federal Reserve System

In 1907, after several years of an unparalleled economic boom, a recession hit the world capitalist economy. In the United States, still lacking a central bank, this recession led to a massive wave of bank runs in October and November of that year. Fortunately for the capitalist world, the runs were halted relatively quickly, but it had been a close call. The creation of a U.S. central bank could no longer be postponed. In 1913, the Federal Reserve Act, which created the Federal Reserve System, was passed and the new U.S. central banking system began operations the following year.

The early Federal Reserve

Originally, the American capitalists and their European advisers had planned to create a single U.S. central bank modeled on the Bank of England and other European central banks. Whatever it would officially be called, this would be in effect the Third Bank of the United States. But there was still much opposition to a central banking system among farmers and small businessmen, who feared not without reason that such a central banking system would represent the interests of the big Wall Street banks such as J.P. Morgan and Company, a forerunner of today’s J.P. Morgan Chase.

The moves to create a central banking system was further complicated by the results of the U.S. presidential elections of 1912. Due to a split in the Republican Party between the supporters of former President Teddy Roosevelt and his successor William Howard Taft, the Democratic candidate Woodrow Wilson was elected. The Republican party was in those days, as it still is today, quite openly the party of big business, Wall Street and the rich. In contrast, the Democrats in those years claimed to represent the white workers, farmers and small businessmen.

The post-Civil War Democrats were therefore an extremely racist party and depended on the votes of politically backward white workers and farmers who voted for what they saw as the “white man’s party.” (3) Exactly as is the case today, there was widespread distrust of “Wall Street” and the banking system among workers, small farmers and small businessmen. In order to capture this anti-Wall Street sentiment and direct it in a way that was harmless to Wall Street and the banks, the Democrats claimed to oppose central banking just as they had done in the days of slavery before the Civil War.

Is the Federal Reserve privately owned?

When the Federal Reserve act was passed in 1913, the now-governing Democrats and the newly elected Democratic president—the extreme racist Woodrow Wilson—claimed that the Federal Reserve Act had not created a central bank. The Democrats claimed that instead of creating a Third Bank of the United States, the Federal Reserve Act created 12 Federal Reserve Banks, none of them an actual central bank. The U.S. was divided into 12 districts, each with its own Federal Reserve bank that was and still is owned by the commercial banks in its district.

You sometime hear complaints from right-wing demagogues that the Federal Reserve that issues U.S. currency is “privately owned.” The 12 Federal Reserve banks that issue paper dollar bills are indeed privately owned—owned by the commercial banks in their districts. When the Federal Reserve System was first created, the commercial banks in each district were encouraged to deposit their individual gold reserves with their district Federal Reserve Bank. In addition, the legislation created a Federal Reserve Board—now officially called the Board of Governors but  still commonly referred to by it original name—located in Washington, D.C.

This board supervises the 12 commercial bank-owned regional Federal Reserve banks. Unlike the Federal Reserve banks, the Federal Reserve Board is a government body. Its members are appointed by the U.S. president with the consent of the Senate for fixed terms. The current chairman is Ben Bernanke, who before his Federal Reserve career was a professor of economics at Princeton University. Bernanke, a Republican, was originally appointed by President George W. Bush and then reappointed by Democratic president Barack Obama.

In addition, the Federal Reserve banks do not have equal power. The most powerful by far is the Federal Reserve Bank of New York, located in lower Manhattan near Wall Street. The bulk of the central banking operations carried out by the Federal Reserve System are actually carried out by the Federal Reserve Bank of New York. This bank is owned by the New York “money center” banks headquartered on or near Wall Street.

Current U.S. Secretary of the Treasury Timothy Geithner was previously head of the Federal Reserve Bank of New York. This shows how the Federal Reserve System—especially the Federal Reserve Bank of New York, which towers over the other 11 Federal Reserve banks—the U.S. Treasury Department, and the Wall Street “money center” banks are all closely intertwined forming the real central banking system.

Here we see the complete interpenetration of government and private capital. It is virtually impossible to see where, within this central banking complex, private capital ends and government begins. The 12 commercial bank-owned Federal Reserve banks issue the U.S. paper currency, officially called Federal Reserve Notes. If you have a U.S. one dollar bill handy, you will notice that at the top it says Federal Reserve Note. On the left hand, it states which Federal Reserve bank issued the note. This is actually a vestige of the time when individual commercial banks issued their own banknotes.

Technically, the U.S. doesn’t have one but 12 currencies—all equally legal tender for debts public and private—each issued by one of the 12 Federal Reserve banks. But this has no real significance and never did. This is indicated by the signatures of the secretary of treasury and the treasurer of the United States on the dollar bills. Indeed, all U.S. currency has been backed up by the credit of the U.S. Treasury since the days of the National Banking System, giving the U.S. a single unified currency.

The Federal Reserve banks also act as the fiscal agents of the United States Treasury. They manage the sale, redemption and payments of interest on the types of IOUs that the U.S. Treasury issues when it borrows money—which it does quite a bit these days. In addition, the government keeps checking accounts with Federal Reserve banks. When the Treasury sends you a check for a tax refund, for example, the check is drawn by the U.S. Treasury against its checking account with one the Federal Reserve banks.

How the early Federal Reserve created currency

The most important function of the Federal Reserve System is to issue currency. Originally, this was done when either money in the form of gold was deposited with a Federal Reserve bank or through the re-discounting of commercial paper. A business, whether a manufacturing or trading company, will generally sell its commodities on credit in exchange for a promise to pay by the buyer by a certain date, perhaps three months into the future.

These type of promissory notes are called commercial paper. Instead of waiting three months to receive payment, the business may if it chooses discount the promissory note—sell it at a certain “discount” from what its value—principle plus interest—will be when it comes due.

The “discount” represents the interest rate that will be earned by the commercial bank that buys the note. If the commercial bank needs more reserves to back up its deposits and grant additional loans, it can (re)discount the commercial paper with its district Federal Reserve bank. The Federal Reserve bank buys the note at a discount called the re-discount rate.

Originally, each Federal Reserve Note that was issued by one of the 12 Federal Reserve banks had to back up the note with collateral that had to be at least 40 percent gold. The rest of the collateral could consist of either gold or re-discounted commercial paper that was backed up by actual inventories—commodities. The idea was that if a wave of bank runs threatened, the Federal Reserve banks under the supervision of the Federal Reserve Board in Washington, D.C., would transform a large part of the commercial paper held in the banking system into actual dollar currency.

The subsequent increase in currency held by the banks, it was believed, would end the threat of widespread bank runs just as had been the case in Europe. The system’s creators and the economists of the time explained that due to the creation of the Federal Reserve System, bank runs, with their soaring unemployment and plunging farm prices, were now a thing of the past. The Federal Reserve System would see to it that bank deposits held in the commercial banking system would always be convertible into cash on demand.

The economists and bankers predicted that America would now finally begin to enjoy the relative financial stability that Europe had enjoyed under the pre-World War I international gold standard. There might still be “mild recessions” but really serious economic depressions with their waves of bank runs, the bankers and economists predicted, would not recur.

The Federal Reserve and the Great Depression

The first real test of the new Federal Reserve System was the infamous economic crisis of 1929-33. When a recession began in 1929 and the stock market crashed in October-November of that year, there were no runs on the banks. To this extent, the Federal Reserve System worked. However, this did not prevent sharp cuts in industrial production and massive layoffs combined with plunging farm prices. Indeed, farm prices had been falling even during the “prosperity” years of the 1920s. Even in the absence of bank runs, the U.S. was facing one of the worst recessions in its history. But things were about to get far worse.

Starting in 1931 and climaxing in February-March 1933, a wave of bank runs, unprecedented in both duration and extent, hit the United States as well as some European countries, especially Germany and Austria. Unlike the bank runs of 1907, which lasted for only a month or so, this time the bank runs lasted almost two years. During this wave of banks runs, what today we might call the “Great Recession” of 1929-30 was transformed into the “Great Depression.”

The Federal Reserve System appeared to be a complete failure. In 1963, Professor Milton Friedman along with economist Anna J Schwartz (4) published a book entitled “The Monetary History of the United States 1867-1960.” In this book, the two economists claimed that it was the Federal Reserve System that transformed an ordinary “recession” into the “Great Depression.” Friedman and Schwartz tried to prove that a government agency—the Federal Reserve Board—had caused the “money supply” to contract by one-third between 1929 and 1933.

Didn’t the members of the Federal Reserve Board realize that if you contract the potential purchasing power of the country by one-third during a recession, something very nasty was bound to happen? For this “great discovery,” Friedman won the Nobel Prize for economics.

These claims are often repeated in many high school and college history and economics classes as though they are established fact and are used by the supporters of Ron Paul today when they raise the slogan “End the Fed.”

The money supply, the Fed, and the Depression

Since capitalist production is production for profit, not human needs, capitalism has a far greater capacity to expand production than it has to expand the market for commodities. The vast majority of the world’s population is far too poor to buy the commodities that modern industry is capable of churning out when it operates at its full capacity. But how can such a seemingly ridiculous situation arise?

Before the capitalist system of production, the market economy took the form of simple commodity production. This type of market economy was quite different than today’s capitalist economy. Under this system, the people who used the means of production owned the means of production as their own individual private property. This meant that production was necessarily carried out on a small scale and could only expand gradually as the number of worker-owners increased.

This system of production was far less productive than today’s capitalist system with its large-scale socialized production. The world was far poorer than it is now and the overall population was far lower. But one advantage of the old system of simple commodity production was that there was no danger that a sudden increase of production could flood the market leading to a general crisis of overproduction of commodities—or what is now called a recession.

Surplus value and the origin of profit

But as the means of production grew more powerful, they required many people to operate them and not a just a single worker-owner perhaps assisted by his family. This led to a split in society between those who own the means of production and those who actually do the work. (5) The workers—the great majority—ended up owning only one salable commodity: their ability to work, their labor power.

The value of labor power is determined by the amount of labor it takes to maintain the workers and reproduce the next generation of workers. However, the capitalist owners of factories, mines and large farms will not hire workers unless they perform more labor than the labor it takes to produce their labor power. This extra unpaid labor is called surplus labor and when it becomes embodied in a product produced for sale on the market it becomes what Karl Marx called surplus value. Surplus value is the source of all profit in the broad sense, or income from property. This is true whether the profit takes the form of profit of enterprise, interest on capital or rent on land.

However, to make a profit it is not enough for a business owner to produce a commodity that contains surplus value. The business person must then find a buyer who has both the desire and the money to purchase the commodity at a price that corresponds to the commodity’s actual value. If the capitalist cannot find a buyer, the capitalist makes a loss and not a profit no matter how much surplus value the commodity contains.

During the upswing in what the economists call the business cycle—what Karl Marx called the industrial cycle—there is a period of capitalist prosperity where production expands faster than the capacity of society to buy all the commodities that are produced. For a while this gap is papered over by the extension of credit. People lack the money to buy all the commodities that are being produced, so they purchase commodities with credit.

This inflation of credit allows the overproduction of commodities to go on for a certain period of time. But about every 10 years, a point is reached where credit can no longer be further inflated. A crisis of overproduction, or recession, then breaks out that halts the overproduction. During the crisis of overproduction, commodities pile up in warehouses unsold, workers are laid off and farm prices usually fall. Sometimes, though not always, a major financial crisis occurs. If this happens, the resulting recession is more severe. To use today’s terminology, instead of an ordinary recession we get a “Great Recession” instead.

The only way out of the crisis of overproduction as long as we keep the capitalist system is for industry to “compensate” for its previous “overproduction” by a period of “under-production,” or recession. Eventually, the overproduced commodities are sold off and a new period of prosperity sets in that inevitably ends in a new crisis of overproduction. It is these crises—recessions—that in the long run keep capitalist production within the limits of the market.

What transformed the recession of 1929 into the Great Depression?

This explains why a cyclical recession occurred in 1929, but why was the recession that began in 1929 so much worse than any other recession that has so far occurred in the history of capitalism—indeed, so bad that we have a special name for it, the “Great Depression.”

During the 1920s and earlier, special factors were at work that were to transform the normal cyclical crisis of overproduction, or recession, that was due at the end of the decade of the 1920s into something much worse. Beginning in 1896, commodity prices had entered into a strong upswing. By 1914, prices had already risen above the underlying values of commodities.

Then, just as a global recession was setting in, World War I broke out. The developing recession was replaced by the war economy of World War I. In a war economy, everything is in short supply and prices—even prices measured in gold, not just depreciated paper money—soar. After the war ended, there was a brief but sharp recession in 1920-21 that lowered these inflated prices considerably but not all the way back to their underlying values.

The problem was that there had not been the usual “overproduction” during the war. The war economy was geared to destruction and not the expansion of production that is normally the case in a capitalist economy. Inventories were exhausted during the 1920-21 recession before prices had fallen all they way back to the values of commodities. (6)

As a result, during the 1920s the global gold supply was in short supply relative to the total quantity of commodities in circulation, the prices of these commodities, and overall world trade. These high commodity prices reduced the  purchasing power of the existing gold supply. The high level of commodity prices translated into high costs for the gold mining and refining companies reducing their profits and keeping gold production below what was the already inadequate levels in the period immediately preceding World War I. After World War I, world gold production was lower but the total production of commodities and their prices were considerably higher than they were in the period that preceded the war.

Unusual credit inflation

Before World War I, the international monetary system had been centered on Britain and its Bank of England. The Bank of England was required to maintain an almost 100 percent gold reserve behind the pound banknotes it issued. After the war, the center of the international monetary system shifted to the United States and the new Federal Reserve System. Unlike the Bank of England, as we have seen the Federal Reserve System needed to hold only 40 cents in gold for each dollar it issued. In addition, U.S. government regulators decided that since there was now little danger of bank runs, banks could maintain less cash behind their deposit liabilities. This was the 1920s version of financial “deregulation.”

To make matters worse, the victorious allies had forced Germany to repay huge reparations to the victorious “allies,” which bankrupted the German government and led to the 1923 hyperinflation that wiped out the savings of the German middle class. This created still further debt. These debts not only further destabilized the already extremely unstable global financial system but played a key role in the rise of Adolf Hitler and his Nazi Party to power a few years later. In the post-World War I era, the entire world capitalist financial system was transformed into a house of cards.

Therefore, the 1920s was a time of unprecedented overproduction of commodities relative to the unusually restricted ability of the market to expand. The only way that the capitalist system had of getting out of this mess was to dramatically lower the prices of commodities in terms of gold. Such a lowering of prices would increase the purchasing power of existing gold and stimulate the production of new gold creating the possibility once again of expanding markets sufficiently to make possible another era of prosperity. But to achieve this, a crisis of overproduction of unprecedented severity was required. And this is exactly what happened.

The new Federal Reserve System would have been able to handle a recession on the scale of the recessions that occurred before World I, but it was bound to be overwhelmed by the scale of the crisis that had to occur as soon as the 1920s business cycle expansion had run its course.

The Federal Reserve tries to stave off disaster and fails

Supporters of the Friedman-Schwartz thesis often point out that the Federal Reserve Board decided to raise its re-discount rate—the rate at which the Federal Reserve Banks bought commodity-backed promissory notes—in 1928. Wasn’t this a stupid thing to do? Other historians point out that the Federal Reserve Board was frightened by the powerful rise in the prices of corporate stocks on Wall Street that preceded the stock market crash that occurred the next year. In an attempt to stave off the stock market crash, the Fed hoped to lower the overvalued stock market in an orderly way before a crash occurred.

There is another factor that is ignored by all our stock market-obsessed historians. Starting in 1928, industrial production in the United States—and other capitalist countries—suddenly began to rise sharply. This powerful industrial boom was on a head-on collision course with the very limited ability of the world market to expand.

The Federal System was hoping that the high re-discount rate would lower the prices of corporate shares on Wall Street and thus release more scarce money into the real economy. The Fed was hoping to end the boom on Wall Street in order to maintain at least some measure of prosperity on Main Street. However, the speculative momentum on Wall Street was so great that stocks kept right on rising. It was Main Street, not Wall Street, that first felt the effect of high interest rates.

Starting in June 1929, industrial production began to decline but on Wall Street the Dow Jones Industrial Average kept setting records right up to the beginning of September. The stock market finally crashed in October-November, but by then the recession in the real economy was rapidly gaining momentum. Therefore, contrary to what is often claimed in high school and college history books, the crash in stocks did not cause or even trigger the Depression. The recession that was to become known as as the Great Depression was already well underway before Wall Street crashed.

Did the Fed cause a one-third contraction of the money supply?

In their “Monetary History of the United States,” Friedman and Schwartz claimed that the Federal Reserve System caused the  “contraction of the money supply” by one-third.

In reality, the Federal Reserve Board does not control what economists call the money supply. Economists mean by the money supply cash plus checkable bank accounts that are created not by the Federal Reserve System but by the commercial banks when they loan money and discount commercial paper. Indeed, the quantity of Federal Reserve Notes—cash—greatly increased during the Depression. But the bulk of the money supply as defined by economists consists not of cash but checkable bank accounts.

For the first two years of the Depression, perhaps the existence of the Federal Reserve System lulled people into a false sense of confidence, and most depositors did not withdraw money from their banks. Then, starting in 1931, their confidence in the Fed’s ability to prevent massive bank runs suddenly began to crumble.

While this is not the place to provide a detailed history of the Depression, it can be said that claims that the Federal Reserve System followed a “tight money” policy is false. (7) The Fed did move to expand the quantity of dollars it was issuing, but it was simply not enough. As lines formed in front of banks, many were forced into bankruptcy, wiping out much of checking account deposits that economists define as money.

In addition, facing long lines of people demanding their money in cash, the commercial banks—not the Fed—called in loans and refused to grant additional loans. It was this that greatly contracted the quantity of checking account balances—the money supply that Friedman and Schwartz refer to.

The extra dollar bills that the Federal Reserve did create instead of circulating commodities were hoarded outside the banking system and vanished from circulation just like had happened during the bank runs under the free banking system and the National Banking System. But this time, this occurred on a far larger scale and for a much longer period of time. Money flowed into private hoards and vanished from sight.

Schwartz and Friedman simply reversed cause and effect. The one-third decline in the “money supply” as defined by the economists did not cause the Depression, it was caused by the Depression. For this, Friedman but not Schwartz won the Nobel Prize in economics.

Depression-era changes in the Federal Reserve System

In early 1932, when Herbert Hoover was still in the White House, the first change was implemented in the Federal Reserve System that was to be followed by a series of changes that transformed the central banking system into the one we have today. As we have seen, under the original Federal Reserve System all Federal Reserve Notes—dollar bills created by the Federal Reserve System—had to be backed at least 40 percent by gold—a commodity—and by commercial paper—itself backed by commodities. The Federal Reserve was not allowed to issue currency that was not backed by real values—gold or other commodities.

But starting in 1932, the Federal Reserve System was allowed to count as collateral behind the dollar bills it issued not only gold and commercial paper backed by real commodities but also government bonds—merely claims on future tax revenue—that is, fictitious capital. Because the Federal Reserve System could now issue a greater quantity of Federal Reserve Notes than before, the bank runs began to subside, and starting in July 1932 business began to pick up. This pickup in business was noted not only in the United States but around the world.

Indeed, the international business cycle had now passed its lowest point. This is shown by the fact that in most countries the rise in business that began in the middle of 1932 continued.

But in the U.S., the cyclical upswing was to be violently interrupted before a more sustained rise in business set in the following year. We have to remember that the fact that there was an initial rise in business in the summer of 1932 didn’t mean that the Depression was over either in the United States or other capitalist countries. The unemployed generally remained unemployed. At most, the growth in the number of unemployed tapered off. Real prosperity was still a long way off.

The year 1932 was a presidential election year in the U.S. Not surprisingly, voters were completely fed up with Herbert Hoover and his Republican Party. Not only had Hoover presided over the worst economic crisis in U.S. history, but he had done virtually nothing to help the unemployed or the farmers who were losing their farms. Under the circumstances, it is not surprising that many U.S. voters who had traditionally voted Republican shifted their votes to the Democrats. Roosevelt and his Democratic Party couldn’t be any worse than Hoover and his Republicans, these former Republican voters figured.

Roosevelt elected and the bank runs resume

The Democratic Party, in addition to its racist core that included not only the “solid South” but the big city Democratic machines in the North, also included a populist wing that was opposed to the gold standard, which they blamed for depressions and low farm prices. (8) Other Democratic currency reformers favored the “free coinage of silver.” These reformers believed that if the dollar was based on cheap silver rather than expensive gold, the quantity of currency would expand, farm prices would rise and prosperity would return.

Other more “radical” Democratic reformers argued that it was a mistake to base currency on a single commodity like gold or even on two commodities—silver as well as gold. Instead, currency should be based on all the commodities that constitute the material wealth of society. If this were done, these reformers argued, society would always have the purchasing power necessary to buy back its total commodity output. Not only Great Depressions but even “ordinary” recessions would be a thing of the past.

These arguments seem reasonable and indeed contain a rational core. Under a socialist planned economy where all labor is directly social, currency will indeed be based on the wealth of society as a whole, and not on a precious metal alone like gold. But this cannot work under the capitalist system. Why can’t it? Under any type of market economy, both simple commodity production and capitalism, each producer or under capitalism each factory owner, mine owner and large capitalist farmer carries out production for his or her own account.

Whether the private labor that was used to produce a particular product ends up meeting anybody’s needs—is really social—can only be determined on the market. If the commodity sells at a profitable price, the labor that was used to produce it was socially necessary. If the commodity does not find a buyer, the labor that was used to produce it was wasted. If we could somehow guarantee the sale at profitable prices of every product that was produced under the capitalist system, the capitalist owners of industry would have no idea what to produce. The economy and society with it would completely disintegrate.

Hoover’s attempt to get re-elected in the 1932 election.

In an attempt to get re-elected despite the Depression, Hoover strongly defended the existing gold standard. Hoover claimed that fooling around with the gold standard would only make matters worse. This approach had worked for William McKinley when he ran against William Jennings Bryan, a “monetary reformer” who advocated the “free coinage of silver” during an earlier recession in the 1890s. But the recession of the 1890s was presided over not by a Republican but by Bryan’s fellow Democrat Grover Cleveland. Cleveland, however, was not a silver advocate like Bryan but a pro-Wall Street “gold Democrat.”

Like Hoover, Cleveland had done virtually nothing to help the unemployed or the farmers. Bryan was therefore forced to run against the record of his own party and lost. Roosevelt simply ran against the record of the increasingly hated Republican Party and won. Unlike the Republicans who promised to maintain the gold standard, the Democratic platform simply promised to maintain a “sound dollar at all costs.”

But what was a “sound” dollar? The Democrats didn’t say. It was widely assumed that the Democrats would at the very least devalue the dollar—raise the dollar price of gold—like Britain had already done in 1931. Roosevelt was elected in November, but he wasn’t scheduled to assume office under existing laws until March 4, 1933. Until then, the strongly pro-gold standard Republican Herbert Hoover was president.

Since it seemed almost inevitable that the price of gold would rise in dollar terms once Roosevelt assumed office, some of the people who still had bank accounts decided that an easy way to make money—in dollar terms—was to go to their banks and demand gold coin instead of paper dollars, something they were entitled to do under the then existing gold standard. Soon, they figured, the price of gold would rise from $20.67 per troy ounce and they would make an easy dollar profit.

They were right about the devaluation. Between March 1933, when he assumed office, and 1934, Roosevelt ordered the U.S. Treasury—not the Federal Reserve System—to buy gold on the open market at ever higher prices, pushing up the dollar price of gold to $35 an ounce, which then became the new official dollar price of gold—or actually the new lower gold value of the dollar. (For more on the relationship between the dollar price of gold and the gold value of the dollar, read this earlier post.)

But he punished those who had withdrawn gold from the banks—and indirectly the Federal Reserve banks—by forcing them—and everybody else who owned gold coins or bullion—to sell the gold to the U.S. Treasury at the old price of $20.67. Indeed, he went further and made the mere ownership of monetary gold by private U.S. citizens in the U.S. illegal, and it remained so until the Reagan administration in the 1980s.

But that was only after Roosevelt actually assumed office. As gold was withdrawn from Federal Reserve banks in expectation of the dollar’s devaluation, the ability of the Federal Reserve System banks to issue additional currency was curtailed. This was because they still had to back up each dollar they issued with a least 40 cents in gold—and in practice more since there was little commercial paper around after three and half years of the Depression. Therefore, it wasn’t only the commercial banks that were experiencing runs now, it was the Federal Reserve banks themselves. These speculators didn’t know that Roosevelt would double-cross them after he assumed office by forcing them to sell their gold to the U.S. at the old price.

Since bank deposit owners knew that the ability of the Federal Reserve banks to issue additional dollars had been crippled due to the speculation over the price of gold, a new wave of bank runs occurred just when it seemed that things were getting better. The economy resumed its decline, unemployment again rose sharply as bank runs swept the nation. These runs became so extreme, that the entire banking system was nearing complete collapse just as Roosevelt assumed office. The first thing the new president did upon assuming office was to close the banks and reopen only those banks that could prove that they were solvent—that their assets exceeded their deposits and other liabilities.

Hoover was not blameless either. He could have insisted that Roosevelt issue a joint statement with him promising not to devalue the dollar and when Roosevelt refused suspend the convertibility of the dollar into gold himself. This would have allowed the Federal Reserve banks to issue the additional dollars while he could then blame Roosevelt for the collapse of the old gold standard. If this had been done, the economic recovery that had begun in July 1932 would probably have continued. Perhaps Hoover was hoping that the dollar devaluation would backfire opening the door for the election of a Republican—maybe himself—in the 1936 elections. But as it turned out Roosevelt was the winner.

This wave of bank runs climaxed in March 1933 just as Roosevelt was assuming office. The bank runs had forced businesses to run their inventories down to almost nothing. If the 1920s had seen unprecedented overproduction, the beginning of 1933 witnessed unprecedented under-production. As soon as Roosevelt suspended the gold standard and enabled the Federal Reserve banks to issue additional dollars, the bank runs halted and business picked up sharply. Dollars that had been hoarded were gradually returned to the banking system expanding the reserves of the banks.

Since the economic situation began to improve as soon as Roosevelt assumed office, the new president’s popularity soared and it became impossible for a Republican to win a presidential election again for the next several decades. For a generation to come, the Democrats ran against Herbert Hoover much like Republicans had run against Grover Cleveland for an earlier generation.

The pickup in business that began in 1933 did not mean that Depression was over. Far from it. But the lowest point of the Depression had now passed. Roosevelt took personal credit for this just like other U.S. presidents both before and after him for what in reality was simply a natural upswing in the capitalist business cycle.

Roosevelt revamps the U.S. central banking system

Under Roosevelt their were sweeping changes in the Federal Reserve System. First, Roosevelt shifted power from the Federal Reserve Bank of New York to the Federal Reserve Board. Even more importantly, he shifted some important central banking functions from the Federal Reserve System to the U.S. Treasury. Each Federal Reserve bank was obliged to sell its gold to the U.S. Treasury receiving in return gold certificates that were exchangeable for ordinary currency—not gold—at the U.S. Treasury. To this day, the Federal Reserve banks still hold these gold certificates on the asset side of their balance sheets.

In addition, any foreign currency owned by Federal Reserve banks was also sold to the U.S. Treasury, and a special foreign exchange stabilization fund was established. While in most countries it is the central bank that buys and sells foreign currencies, in the U.S. this central banking function is carried out by the U.S. Treasury, though it carries it out, to make things more complicated, through the Federal Reserve Bank of New York.

The gold reserves—which were and remains the bulk of the reserves behind the U.S. dollar—were shifted from the vaults of the individual Federal Reserve Banks to the U.S. Treasury. This is the reason why the Federal Reserve System is not a complete central banking system but acts as such along with the U.S. Treasury.

(To be continued)


1 In American lore, these types of banks were nicknamed “wildcat banks.” They were located in remote areas where wildcats roamed. The idea was to make it as difficult as possible for the owners of their banknotes to actually attempt to redeem them.

2 During bank runs, the bankers would also sometimes pay depositors in pennies. The idea was to buy time while the bank scrambled for extra cash.

3 During the the 20th century, the U.S. two-party system underwent a limited transformation. Starting with the New Deal of Franklin Roosevelt, significant numbers of African-Americans began to support the Democratic Party as opposed to the party of Lincoln, the Republican Party. This was because African-Americans were strongly pro-trade union and supported Roosevelt because the trade union movement, especially the new Congress of Industrial Organizations—the CIO—supported Roosevelt and his Democratic Party.

As the Democratic Party became dependent on the votes of African-Americans—many of them members of the new trade unions in the North—the Democrats came under pressure to support civil rights bills, which gradually undermined the traditional Jim Crow legal segregation that prevailed in the South and in federal institutions such as the U.S. armed forces. These institutions had remained racially segregated through the Roosevelt years.

This undermining of Jim Crow segregation angered the southern “Dixiecrats”—the historical core of the Democratic Party. Eventually, the southern Democrats as well as the racist Democratic Party machine politicians in the North decided to shift their support to the Republican Party. The Republican Party, which had had difficulty winning national elections since the Depression and New Deal, was now reinforced by an influx of racist white historically Democratic voters.

Today it is the Republican Party that is generally seen by many politically backward U.S. voters as the “white man’s party” and not the Democrats. However, both the present-day Democrats and Republicans, each in their own way, serve the interest of Wall Street as they have since the Civil War.

4 Both Friedman and Schwartz were known for taking their support of the capitalist system to extremes. They claimed, in contrast to the views of the  English economist John Maynard Keynes, that left to its own devices a capitalist economy is extremely stable. If recessions occur, Friedman and Schwartz held, it is because of government interference and not any inherent instability of the capitalist system.

Arguing along these lines, Friedman and Schwartz claimed it was the reduction of what economists call the money supply—currency plus checking account balances—by one-third between 1929 and 1933 that caused the Great Depression. They reasoned that since the Federal Reserve Board is a government body, and since the board followed policies that caused the money supply as defined above to fall by one-third, it was the government and not the the capitalist system that caused the Great Depression. The supporters of Ron Paul sometimes refer to Friedman and Schwartz’s work when they raise the slogan “End the Fed.”

5 This separation of the workers from their means of production was not always peaceful and gradual. The state power increasingly under the domination of the capitalist class stepped in and used force to accelerate the process. Indeed, this process is still occurring today as the global capitalist class engages in mopping up what is left of the old system of simple commodity production.

6 How do we know that prices were high relative to underlying commodity values? We can see this was the case because the production of gold during the 1920s was below the already inadequate level of gold production that prevailed during World War I. When commodity prices are too high relative to underlying values, gold production is low, but when the prices of commodities fall below the values of commodities, gold production rises sharply. (See this post for more explanation.)

7 It is true that in late 1931 the Federal Reserve Board did order a rise in the re-discount rate charged by the Federal Reserve Banks. The reason they did this is that in September 1931 in response to a run against the Bank of England, which issues the British currency, the British pound had been devalued. The devaluation gave British exports a temporary advantage over U.S. exports largely because the wages calculated in terms of dollars as opposed to pounds had suddenly been slashed as a result of the devaluation. There was speculation that the U.S. would devalue the dollar to match the British devaluation. This type of devaluation is sometimes called a “competitive devaluation.”

However an examination of U.S. industrial production in 1931 shows that after rising slightly during the first months of 1931 it had started to fall sharply once again as the wave of bank runs gained force. Even before the Federal Reserve Board ordered the Federal Reserves banks to raise their re-discount rates, industrial production and employment in the U.S. was once again in free fall. The rise in the Fed’s re-discount rate, though it could hardly have helped the course of business, was not the cause of the renewed decline of the U.S. economy that transformed the recession of 1929-30 into the “Great Depression.”

8 Many of the people in the populist wing of the Democratic Party supported many progressive measures. But they had a terrible blind spot: The Democratic Party was largely built on racism against the descendants of the kidnapped Africans that had been brought to the United States by force to perform slave labor. They didn’t understand that a party or a movement that is based on racism cannot possibly play a progressive role. These progressives, however, do have the excuse that they were still living before the rise of Adolf Hitler and his Nazis further clarified this question.


3 thoughts on “The Federal Reserve System, Its History and Function, Part 1

  1. Do some more research and maybe you will be able to better grasp what you are trying to discuss. Too opinionated and too few real facts. The truth is our current economic decline is entirely to blame on the Fed system and war mongering.

  2. That’s an absurd statement, Paul. Crises started before the introduction of the Fed and so did American military aggression.

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