The Federal Reserve Looks at 100

Okay maybe I am jumping the gun a touch. The Federal Reserve System, that is the Central Bank of the United States, was established by an act of Congress on December 23rd 1913. We can also use August 10th 1914, the day that Charles S. Hamlin became the first Chair of the Federal Reserve Board. The Federal Reserve has had an interesting history and today stands as a model of what an independent central bank looks like.

It did not start out very independently. The original law called for a Board of Governors of seven members, as we have today, but included on the Board was the Secretary of the Treasury and the Comptroller of the Currency. Therefore, the executive branch of the United States government was directly involved in making monetary policy. This notion is an intuitive one and it is not unusual to see Treasury representation on Central Bank Boards.

The Banking Act of 1935 eliminated the direct role of the Treasury Secretary and Comptroller of the currency altering the Board to consist of seven appointive members. However, it was not until early 1951 that the Federal Reserve Board then chaired by Thomas B. McCabe, signed the “Accord”, which might more properly be considered a discord, in which it was agreed that Federal Reserve Policy would be made independently of the wishes of the Treasury. The chief mediator in the discussions was William McChesney Martin, Jr, who is often given the most credit for the event. Mr Martin quickly moved to Federal Reserve Chairman in April of 1951 where he served until January 31st 1970. The accord surely did not and does not mean that the Federal Reserve does not work closely with the Treasury Department. Coordinated economic actions almost always yield better results. However, the accord created an independent Central Bank that created a legal right for the Board to go in a different direction than that desired by the Executive and Legislative branches when the Board believed that a different policy than that espoused by those groups was necessary.

There is little doubt that the quality of central bank management has risen since the Accord. Central Banks are allocated goals and need to have the policy power to carry out the strategies that lead to reaching those goals. Naturally, mistakes were made both prior to and after the Accord. The Central Bank was criticized by financial and economic historians for not flooding banks with reserves after the crash of 1929, though that very policy has had only limited effectiveness in the early part of this millennium. Mr Volcker’s successful policy breaking the stagflation of the late 1970s and early 1980s has been criticized for causing or at least exacerbating the Latin American debt crises of the 1980s. In addition, Mr Greenspan was roundly criticized for his inconsistent interest rate policies and his failure to blow the whistle as banks became tied to more volatile asset classes without the proper clearing mechanisms. In some sense, fairly or unfairly, Mr Greenspan was considered the chief oversight officer of the global financial economy, and he did not shine.

Alternatively, there has been great economic growth over the period since the Accord and a relatively efficient building of a global financial market system has taken place. The Federal Reserve along with its Central Bank counterparts around the world can be roundly applauded for that outcome. While the ultimate outcome of the current financial crisis will play into the judgment of Mr Bernanke’s term as Chair, arguably the Federal Reserve has stood tall so far during the current crisis.

In the end, as we have argued before, an independent central bank is a necessity if success is going to be achieved. The Federal Reserve history is not without its disappointments, but overall we can say that thanks to both the high quality of its Board members and, since 1951, its independence, the creation of the Federal Reserve has proven to be one of the best legislative actions in the history of the United States.

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