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Panics and the FedA crowd gathers on Wall Street during the bank panic in October 1907.

OverviewBanking basicsMore than you want to know about the Panic of 1907The Federal Reserve Act of 1913How the Fed works

Money BasicsWhat is Money?Anything generally accepted in payment for goods and services.Medium of ExchangeStore of ValueUnit of AccountFiat system

Measuring Money- 2010

Banking BasicsBanks are not money warehouses.Banks pool money that might otherwise be idle.Then they lend money from the pool to customers who are likely to repay it. Individual customers can buy goods and services with the money they borrow.Business customers can use loans to expand their operations. In this way, the money banks lend produces additional goods and services. Banks can also earn a profit: 3-6-3 ruleThe Money Creation ProcessI walk into Bank A and deposit $1,000 cash into my checking account.What does Bank A do?They put $100 in reserves and make a $900 loan.What does the person that takes out the $900 loan do with the money?Deposit in Bank B. Bank B puts $90 into reserves and makes an $810 loan.$1,000 cash has turned into: $1,000 + $900 + $810 = $2,710 and it keeps going.

The Money MultiplierMoney Multiplier = 1/reserve requirement = 1/0.10 = 10$1,000 deposit creates $10,000 in money At least thats the theoryNo excess reservesNo cash

The Money Multiplier

First Bank of the United StatesThe First Bank of the United States was approved by Congress in 1791. Alexander Hamilton, President Washingtons Secretary of the Treasury was the architect. Hamilton modeled it after the Bank of England.At the time, there were also state chartered banks.

First Bank of the United StatesThe First Bank of the United States was a quasi-public institution: Private bank = making loans by issuing notes. Public bank = the federal government provided 20% of the $10 million that was used to establish it.

First Bank of the United StatesThe First Bank also handled the federal governments finances. Much like the Fed today, the First Bank of the United States served as the federal governments fiscal agent, holding its deposits and paying its bills. The federal government borrowed from the First Bank of the United States.

First Bank of the United StatesThe anti-Federalists, feared that the First Bank would become a monopoly.They challenged its constitutionality.The charter of the First Bank of the United States was allowed to expire in 1811.

Second Bank of the United StatesThe War of 1812 severely curtailed international trade.This restricted federal tax revenues. The war also caused the federal government to take on more debt, and the government relied heavily on state banks to obtain loans. As a result, state banks expanded their printing of banknotes, which contributed to a severe increase in inflation.

Second Bank of the United StatesCongress chartered the Second Bank of the United States in 1816. It was substantially larger than the First Bank, with an initial capitalization of $35 million (with, again, 20 percent coming from the federal government and 80 percent coming from private investors).

Second Bank of the United StatesThe Second Bank also acted as the fiscal agent of the federal government. It had branch banks in every state. It acted as a bankers bank and occasionally lent money to state chartered banks to preserve their liquidity.

Second Bank of the United StatesNicholas Biddle was appointed as the Banks president in 1823. Biddle led efforts to control the nations money supply.He reduced the amount of notes issued by the state chartered banks.

Second Bank of the United StatesAndrew Jackson was elected to the presidency in 1828.In his view, the Second Bank was an:Anti-democratic institutionAnti-frontier institutionAnti-states rights institution He also denounced the Second Bank as unconstitutional.After his reelection in 1832, Jackson removed federal deposits from the Second Bank.It closed in 1836.

Second Bank of the United StatesAfter the Second Bank of the United States went out of business, in 1836, the U.S. was without any sort of central bank.

The bank, Mr. Van Buren, is trying to kill me, but I will kill it.

U.S. Financial SystemNew York was the nations financial center. Interest rates fluctuated with the country's annual agricultural cycle. Farmers borrowed money in the spring and paid back loans in the fall.Purchasers of agricultural products borrowed money in the fall to purchase harvests. Foreign investors placed funds in New York banks to take advantage of the seasonal higher rates.

Fears of PanicsA financial panic could start with the failure of a single large industrial firm with money on deposit in a major New York bank.By pulling out its money, one company could endanger the New York banks health. To come up with enough reserves in the face of such a failure, the bank might try to sell their holdings of stocks and bonds causing the prices of stocks and bonds to fall. Then the problem worsened, as banks realized they had to sell still more stocks and bonds to replenish reserves.U.S. Financial SystemThe result would be a full-blown panic among the banks trying to raise cash. The banking system would collapse like a house of cards.

Panic of 1907F.A. Heinze, owner of a Montana copper mine arrived in New York with $25 million in cash and stocks he obtained in an out-of-court legal settlement with a rival mining company. He soon made a lot of friends - - aggressively purchasing interests in several New York banks.

Panic of 1907Heinze tried to corner the stock of United Copper Company.In less than 24 hours, he dropped $50 million.On October 14, the stock of United Copper soared to $62 a share. On October 16, it closed at $15 a share.Heinze failed in his attempt to corner the companys shares.

It Gets WorseHeinze resigned as president of Mercantile National Bank. Mercantile Nationals depositors panic and begin withdraw their money.Heinzes Butte (Montana) Savings Bank fails.The brokerage firm of Otto Heinze &: Co., which is owned by the brother of F.A. Heinze also fails.

And WorseOn October 18, nine banks form an emergency pool of funds to aid Mercantile National. But depositors at Knickerbocker Trust Company begin to withdraw their money.Depositors were worried because Knickerbockers president, Charles T. Barney, was an associate of (wait for it) F.A. Heinze.

25J.P. Morgan to the RescueJ. Pierpont Morgan had the capacity to control the outcome of the situation.Even at age 70, he was still the dominant figure in American finance.He was neither elected nor appointed to the task. He simply decided to take action.

J.P. Morgan to the RescueHe started by designating a committee of bankers to audit the books of Knickerbocker Trust.Morgan decided not to bail out Knickerbocker Trust.He blamed its problems on bad management.Morgan did decide to help Trust Company of America

J.P. Morgan to the RescueTreasury Secretary Cortelyou met with Morgan in New York.Cortelyou announced that $25 million of U.S. government funds would be deposited in New York Citys banks to meet any further emergencies that might arise.

Rockefeller to the RescueJohn D. Rockefeller, nearly 70 years old, pledged to deposit $10 million of his own money in New Yorks financial institutions.

J.P. Morgan to the RescueUnder heavy pressure from J.P. Morgan, New York bankers contributed to a $25 million rescue pool for cash-strapped stockbrokers, who have been unable to borrow and were facing ruin.

J.P. Morgan to the RescueIn response to New Yorks Mayor, a Morgan-led syndicate bailed out the City by agreeing to place $30 million worth of its revenue bonds with investors.Morgan also pressured trust company presidents into putting up funds to support the Trust Company of America and Lincoln Trust-Company.Morgan and his associates also devised a plan to save the brokerage firm of Moore & Schley from failure.

Calls for ReformThe Panic of 1907 proved to be a defining moment in U. S. financial history.It demonstrated the problems of an uncoordinated fractional-reserve banking system.It prompted widespread calls for reform.

The Panic of 1907

Why a Federal Reserve System?Central Bank of the United StatesCreated in 1913 by Congress (Federal Reserve Act)Response to nations recurring bank panics

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34Severe panic in 1907 bank failures, business bankruptcies, economic downturns

The United States lacked a central bank until the twentieth century, although there were two attempts to establish a central bank in the early 1800s (killed by politics).

Without a money manager, the nation's financial system was like the nation itself--diverse and subject to uneven growth. As a result, there were frequent economic depressions and financial panics state chartered banks had their own currency back then 10,000 different bank notes in circulation in 1912.

Reform was difficult. In the more established eastern cities, business leaders wanted to create a national financial system. In the West and South, small businesses and farmers feared a national financial system would not provide enough easy credit to support their developing economies. In 1913, after considerable debate, Congress passed the Federal Reserve Act to balance the financial needs of the country. think about how different parts of the US were at that time big cities on east coast, little in the west, etc.

Difficulty in establishing was an American problem distrust of centralized power still some that believe its creation was a big conspiracy from big business part of the military, etc. will explain why structure is so unique web search tons of conspiracys next slide.The Federal Reserve System35

35Three Parts:

Board of Governors building on the leftFederal Open Market Committee meeting room in this building12 Federal Reserve Member Banks 12 banks on the right

Show White House and Congress appointment and oversight relationships. Fed GoalsSafe, flexible and stable financial and monetary system.Dual Mandate:Stable PricesMaximum Employment

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37Structure of the Federal Reserve

37Overall structure of Federal Reserve System we will look at each of these in more detail

Board of Governors - The seven-member Board of Governors, located in Washington, D.C., oversees the Federal Reserve System. Appointed by the President of the United States and confirmed by the Senate, Board members serve 14-year terms, which are arranged so that one expires in every even-numbered year. FOMC The FOMC has 12 voting members--the seven members of the Board of Governors and five Reserve Bank presidents. The Chairman of the Board of Governors serves as the permanent Chairman of the FOMC.Federal Advisory Committee The Federal Advisory Committee (FAC), which is composed of twelve representatives of the banking industry, consults with and advises the Board on all matters within the Board's jurisdiction. The council ordinarily meets four times a year, the minimum number of meetings required by the Federal Reserve Act. Federal Reserve Banks - See where they are located in a second. Public Private institutions owned by commercial banks in their district through stock.

12 Federal Reserve Banks3811 1Boston 2New York 3Philadelphia 4Cleveland 5Richmond 6Atlanta 7Chicago 8St. Louis 9Minneapolis10Kansas City11Dallas12San Francisco12111019678542338We are in the 7th visiting the Chicago Bank.

See what cities were important in 1913 few people lived in the West. Richmond VG was a major city.

NY Federal Reserve Bank is special district contains most of the largest banks in the world. Conducts the sale of government bonds monetary policy represents US in world banking meetings.

One state has 2 banks? Missouri39Board of GovernorsLocated in Washington DC.Responsible for setting and implementing the nations monetary policy.Consists of 7 members appointed by the president and confirmed by the Senate.Each member serves one 14-year non-renewable term with one member appointed every two years and one member is appointed as the chair for a 4-year renewable term.Board membership is relatively stable since a new president can be sure of appointing or reappointing only two members in a presidential term.Board structure was designed to insulate monetary authorities from short-term political pressure by elected officials.

39The seven-member Board of Governors, located in Washington, D.C., oversees the Federal Reserve System. Appointed by the President of the United States and confirmed by the Senate, Board members serve 14-year terms, which are arranged so that one expires in every even-numbered year.

The terms were designed to be long enough to prevent day-to-day political pressures from influencing the formulation of monetary policy and the supervision of the operations of the 12 regional Reserve Banks.

The President of the United States designates a Chairman and Vice Chairman from the Board to serve four-year terms. These designations are approved by the Senate and can be renewed during the terms of the Board members, subject to Senate confirmation. Heading the Board are a chairman and vice chairman, who are appointed by the U.S. president to serve four-year terms. The chairman of the Board of Governors has a highly visible position. Indeed, when the chairman speaks, Wall Street and the public listen!

The chairman reports twice a year to Congress on the Fed's monetary policy objectives, testifies before Congress on numerous other issues and meets periodically with the Secretary of the Treasury. Other Board officials are also called to testify before Congress, and they maintain regular contact with other government organizations as well.

40Federal Open Market CommitteeConsists of the 7 board governors plus 5 presidents of the Reserve Banks (one is always NY Fed president and the rest rotate next slide)Sets monetary policyMeets 8 times per yearConducts open market operationsPurchases and sales of U.S. government securities by the FEDMost important tool of monetary policyConducted by NY Fed Bank

40The Federal Open Market Committee (FOMC) has increasingly become a household word as the media reports its activities, but few people know much about the committee itself.

Met on Wednesday read news report

The FOMC has 12 voting members--the seven members of the Board of Governors and five Reserve Bank presidents. The Chairman of the Board of Governors serves as the permanent Chairman of the FOMC. The president of the Federal Reserve Bank of New York serves as the permanent Vice Chairman of the FOMC and is, therefore, always a voting member. The 11 other presidents serve one-year terms on a rotating basis. While all 12 Reserve Bank presidents participate in every FOMC meeting, only those serving as FOMC members may vote.

The FOMC meets eight times a year in Washington, D.C. For each session, economists at the Board of Governors and the Reserve Banks prepare extensive economic analysis of statistics from every region and industry in the country. The FOMC also gets valuable grassroots information from the boards of directors of the Reserve Banks. For each meeting, Reserve Bank presidents bring reports on their Districts' economies, based on information from Reserve Bank directors, other District residents, and the Banks' Research departments. These reports are part of the briefing materials used by the FOMC in formulating monetary policy (Beige Books look at in a second).

Twice a year, the Chairman of the Board of Governors reports to Congress on the FOMC's economic views and projections, as well as the issues likely to affect near-term monetary policy decisions. The long-term goals of the Fed remain constant: a strong economy with stable prices, maximum sustainable employment, and ample opportunity for sound economic growth (more later). 41The Reserve BanksConduct research on their local economySupervise banks in their regionEarn revenue through bank services (clear checks, issue new currency, withdraw damaged currency)Economic education programs for teachers

41Handout current Beige Book for Chicago region

Reserve bank activities serve primarily three audiences--bankers, the U.S. Treasury and the public. Reserve banks are often called the "bankers' banks," because they store commercial banks' excess currency and coins and they process and settle their checks and electronic payments. Reserve banks also supervise commercial banks in their regions. As banks for the U.S. government, Reserve banks process the Treasury's payments, sell its securities and assist with its cash management and investment activities. Finally, Reserve banks conduct research on the national and regional economies, prepare Reserve bank presidents for their participation in the FOMC and disseminate information about the economy through publications, speeches, educational workshops and web sites.

9 board of directors for each bank 3 professional bankers from area; 3 leaders from industry, labor, agriculture, etc.; 3 appointed by Board of Governors not allowed to be involved in banking: trying to diffuse power make bank act in the interest of all Americans. The Feds (Normal)Tools of Monetary PolicyOpen Market Operations buy and sell government bonds to set federal funds rate.Discount Loans loans from the Fed to banks.Reserve Requirements amount of reserves banks must hold.42

42Much more later

Read about in my Fed Year of Transition article students explain each one.

Open Market Operations NY Fed buys and sells government bonds from banks to influence FFR. Recall, banks must hold a certain % of their deposits in reserves (cash actually at fed). If a bank is short (M&I) they can borrow to meet their requirement from a bank that has extra and pay the FFR (overnight lending). If Fed wants to lower FFR they buy bonds from banks and pay $ - this increases supply of $ and interest rates fall, vice versa, sell bonds to banks, take $ and raise the rates.

Discount Policy interest rate banks can borrow from Fed.

Reserve Requirement could change amount of reserves banks have to hold. Hold less, increase supply of money and visa versa.

Much more detail on TU.How do Open Market Operations Work?The Fed uses Open Market Operations to exert control over the Federal Funds Rate.The Federal Funds Rate is the interest rate paid in the Federal Funds Market.The Federal Funds Market is the market for overnight loans, between banks, within the Federal Reserve System.

Lowering the Federal Funds RateWhy would they do this?Economy is weak and they want to increase business and consumer borrowing/spending.How do they do this?Instruct New York Fed Bank to buy treasury bonds from banks.The Fed pays these banks by crediting their reserve accounts.This increase in the supply of reserves (money) lowers the price of money (Federal Funds Rate).Other interest rates in the economy then typically follow.

Fed IndependenceNormally considered quite independent:Serve long termsFinancially independent from CongressChallenged today

Questions

http://www.youtube.com/watch?v=PTUY16CkS-k&feature=player_embedded