Free To Choose: A Personal Statement – Charter 3 : The Anatomy of Crisis (5)

Another way to stop a panic is to enable sound banks to con- vert their assets into cash rapidly, not at the expense of other banks but through the availability of additional cash—of an The Anatomy of Crisis 75 emergency printing press, as it were. This was the way embodied in the Federal Reserve Act. It was supposed to prevent even the temporary disruptions produced by the restriction of payments.

The twelve regional banks established by the act, operating under the supervision of a Federal Reserve Board in Washington, were given the power to serve as “lenders of last resort” to the com- mercial banks. They could make such loans either in the form of currency—Federal Reserve Notes, which they had the power to print—or in the form of deposit credits on their books, which they had the power to create—the magic of the bookkeeper’s pen.

They were to serve as bankers’ banks, as the U.S. counterpart of the Bank of England and other central banks.

Initially, it was expected that the Federal Reserve Banks would operate mostly by direct loans to banks, on the security of the banks’ own assets, in particular, the promissory notes correspond- ing to loans by banks to businesses. In many such loans, the banks “discounted” the notes—that is, paid out less than the face amount, the discount representing the interest charged by the banks. The Federal Reserve in turn “rediscounted” the promis- sory notes, thereby charging the banks interest on the loans.

As time passed, “open market operations”—the purchase or sale of government bonds—rather than rediscounts became the main way in which the System added to or subtracted from the amount of money. When a Federal Reserve Bank buys a govern- ment bond, it pays for it either with Federal Reserve Notes that it has in its vaults or that it has freshly printed or, more typically, by adding on its books to the deposits of a commercial bank.

The commercial bank may itself be the seller of the bond or it may be the bank in which the seller of the bond keeps his deposit account. The extra currency and deposits serve as reserves for the commercial banks, enabling them as a whole to expand their de- posits by a multiple of the additional reserves, which is why cur- rency plus deposits at Federal Reserve Banks are designated “high-powered money” or the “monetary base.” When a Federal Reserve Bank sells a bond, the process is reversed. Reserves of commercial banks decline and they are led to contract. Until fairly recently the power of the Federal Reserve Banks to create cur- rency and deposits was limited by the amount of gold held by the 76 FREE TO CHOOSE: A Personal Statement System. That limit has now been removed so that today there is no effective limit except the discretion of the people in charge of the System.

After the Federal Reserve System failed in the early 1930s to do what it had been set up to do, an effective method of preventing a panic was finally adopted in 1934. The Federal Deposit In- surance Corporation was established to guarantee deposits against loss up to a maximum. The insurance gives depositors confidence that their deposits are safe. It thereby prevents the failure or finan- cial difficulties of an unsound bank from creating runs on other banks. The people in the crowded theater are confident that it is really fireproof. Since 1934 there have been bank failures and some runs on individual banks. There have been no banking panics of the old style.

Guaranteeing deposits in order to prevent a panic had frequently been used earlier by the banks themselves in a more partial and less effective way. Time and again, when an individual bank was in financial trouble or was threatened by a run because of rumors of trouble, other banks banded together voluntarily to subscribe to a fund guaranteeing the deposits of the bank in trouble. That device prevented many putative panics and cut others short. It failed on other occasions either because a satisfactory agreement could not be reached or because confidence was not promptly re- stored. We shall examine a particularly dramatic and important case of such a failure later in this chapter.

THE EARLY YEARS OF THE RESERVE SYSTEM

The Federal Reserve System started to operate in late 1914, a few months after the outbreak of war in Europe. That war changed drastically the role and importance of the Federal Reserve System.

When the System was established, Britain was the center of the financial world. The world was said to be on a gold standard but it could equally well have been said to be on a sterling standard.

The Federal Reserve System was envisioned primarily as a means of avoiding banking panics and facilitating commerce; secondarily, as the government’s banker. It was, taken for granted that it would operate within a world gold standard, reacting to external events but not shaping them.