Things You May Not Know 

    (And most Republicans don't want you to know)               

 

In the current environment of inflation, higher interest rates, and the hardships they can cause for American families, it should not be totally unexpected that many people blame the president of the United States for that problem. In fact, however, because of the way the national financial structure is organized, the president can do little or nothing to affect that. To understand why requires an understanding of how and why the American federal financial system has changed over time.

        The American War for Independence left the new country essentially bankrupt and the economy in widespread disruption because many of its citizens were heavily in debt and Continental Congress paper money that had been issued during the war was essentially useless. I can still remember my grandmother using the phrase that something was “Not worth a continental.” While her direct ancestors were not even in the country at the time of the revolution, the phrase had endured that long.

          At the same time there was no national consensus on whether the United States should be primarily agricultural, as it had been pre-war, or whether the government needed to encourage business and industrialization. By far, the strongest proponent of the latter point of view was Alexander Hamilton and he had some ideas that many considered radical. After considering what other nations had done to deal with the issue of massive national debt, Hamilton settled on the British model of a National Bank (as in the Bank of England). Like the Bank of England his proposed Bank of the United States was also to be stockholder owned.

In 1790, Hamilton submitted a report to Congress in which he called for the establishment of the first Bank of the United States. The function of such a bank would be to issue paper money, also called banknotes or currency, provide a safe place to keep public funds, offer banking facilities for commercial transactions and also act as the government's fiscal agent collecting government tax revenues. To assure a modicum of safety, he proposed that said bank would also be required to maintain a minimum ratio of loans to precious metals, which requirement did not exist in the Bank of England. He also stipulated the government should own 20% of the bank whereas the Bank of England was wholly privately owned. After some strenuous debate, President George Washington signed the bill to create the Bank over the strenuous objections of many of his Virginia colleagues including Jefferson and Madison.

Without going into greater detail, public sale of shares in the bank created a bubble and a subsequent financial collapse as speculators borrowed from the bank to buy shares in the bank, hoping the value of the shares would go up. Through its history there were other valid criticisms of the first Bank of the United States. From a modern perspective there were many flaws, one of the principal ones being that the bank actually did not set national monetary policy and, secondly, it did not regulate other banks. Its substantial holdings in gold reserves did, however, establish what passed for a stable national currency and, by managing its lending policies and the flow of funds through its accounts, the bank could — and did — alter the supply of money and credit in the economy and hence the level of interest rates charged to borrowers. If this last sentence sounds familiar it should, because to greater degree this is, somewhat analogous to, what the current Federal Reserve Board does.

When the First Bank’s request for a charter extension was rejected and the bank ceased to exist in 1811, conditions rapidly reverted to the post-revolutionary morass of state banks and other private banks issuing bank notes without the required amount of security. War debt following the war of 1812 was huge, inflation followed, and a panic thereafter. In 1816 President James Madison, who had adamantly opposed the creation of the First Bank of the United States, signed a bill creating the Second Bank of the United States with a twenty-year charter.

Many state banks envied the Second Bank because it received all of the government’s deposits and therefore could make more loans. This meant that private or state banks were in direct competition with the Bank of the US. Andrew Jackson hated banks in general, having lost money due to defaulted bank notes years before and determined to kill the Second US Bank by pulling federal deposits from it and placing them in “Favorite” State banks (known in the press at the time as his “pet banks.” In 1836, the Second Bank’s charter expired as Jackson refused to sign a renewal.

Over the next decades, in the absence of a national bank, there were five nationwide economic panics, inflation, and profiteering from wealthy bankers and investors. This culminated in a huge nation-wide panic in 1907. One of the lessons to be learned here is that most of these panics were the result of greatly underregulated banks being allowed to speculate in stocks and wealthy financiers having interests in both banks and corporations which conflicted. Banks failed, ordinary depositors lost their savings, it wasn’t pretty. (Numerous examples, too little space, just trust me on this one.)

The 1907 crisis was moderated, and banks rescued only when three specific events occurred. First, the US treasury intervened and pumped twenty-five million in government funds to shore up deposits in New York City banks. Second, John D. Rockefeller gave $10 million of his own fortune to the same service and, finally, J.P. Morgan extended $25 million in emergency funds. In the aftermath of this debacle there were widespread calls for major currency and banking reform.

Finally, after an intervening war (WWI) and, again primarily due to under-regulation of banking, financial, and commodities markets, the US economy once again soiled its linen. The Great Depression led to the eventual signing, by President Roosevelt, of the National Banking Act of 1935. Earlier, the Glass-Steagall Act of 1933 had effectively separated commercial banking from investment banking and created the Federal Deposit Insurance Corporation.

In vastly simplified language, the National Banking Act created the Federal Reserve System (“Fed” from here on) and banks. The Act created the Federal Open Market Committee, the Federal Reserve Board of Governors and stipulates that five representatives of the Federal Reserve Banks will be members of the Committee, which must conduct open-market operations according to specific regulations adopted by the Committee. The goal of open-market operations is to accommodate commerce and business with an eye to U.S. credit conditions.

The Fed’s mandate is to use their authority to control the money supply as needed by buying or selling federal securities and combat inflation, to the degree that they can, by adjusting the interest rate (known as the “discount rate”) charged by the Fed to private banks when, and if, they borrow from the Fed to meet the amount of funds they are required to have on hand. This is known as the reserve requirement. The discount rate is that interest rate we read about the Fed changing to fight inflation. That rate affects what lenders and other creditors charge.

All this detail and history may bore some of you, but the plethora of complainers publicly blaming anyone and everyone for the current economic situation clearly demonstrates a gross lack of understanding about economics on the part of a sizeable percentage of the population. Sadly, much of the partisan carping is aimed at the President.

Now to the crux of the matter: The Fed does not report to, nor are they accountable to, the President of the United States. The Chairman is nominated by the President and serves a four year term. Each member of the Board of Governors is appointed for a 14-year term; the terms are staggered so that one term expires on January 31 of each even-numbered year. After serving a full 14-year term, a Board member may not be reappointed. Jerome Powell, current Fed chair was nominated in 2018 by Donald Trump and reconfirmed by a Republican controlled Senate.    

The Fed is responsible to the Congress. Period. Understand, I am not being critical of Chairman Powell. I am simply pointing out that blaming President Biden is lunacy on the same level as blaming him for high gas prices. If this were simple math, two plus two would always equal four and boom, push a button and inflation would vanish. It simply doesn’t work that way. Never has, never will. This is a global problem, exacerbated, in part, by a Russian madman.