Lesson 14: Organization of Central Banks

Upon completion of this lesson, you should be able to do the following:

• Describe how the Federal Reserve System is organized.
• Define the Board of Governors.
• Define the Federal Open Market Committee.
• Explain why it is important for a central bank to be independent of its government.

Introduction

The United States was a late comer to the world in the creation of its cental bank. The U.S. central bank was permanently established in 1913 and is called the Federal Reserve System. Most European countries started central banks in the 17, 18, and 19^th centuries. Congress, government officials, and the public did not want to create a powerful financial institution, so the Federal Reserve System was created to have many checks and balances.

Organization of the Federal Reserve System

The Federal Reserve System is composed of 12 Federal Reserve banks. The United States is broken down into 12 regions and each region has a Federal Reserve Bank. The reason is that each section of the country is economically different. For example, all U.S. cars were originally made in Michigan, while Texas and Oklahoma supplied oil and natural gas. Therefore, a Federal Reserve Bank can provide services to its unique region. Originally, each Federal Reserve bank was to provide the following functions:

• Perform check clearing.

• Regulate member commercial banks.

• Manage currency.

• Prevent financial panics by being a source of liquidity (i.e. loans) for banks during a financial crises.

• Collect and publish data for the public.

One of the most important reasons for the creation of the Federal Reserve System is to prevent financial panics. The Fed was not created to alter the money supply, manipulate interest and currency exchange rates, or manipulate the financial markets to achieve economic goals. It learned to do this during the 1920s.

The unique feature of a Federal Reserve bank is each bank is a federally chartered corporation. Each bank has stockholders, directors, and a president. Every national commercial bank has to purchase stock of the Federal Reserve bank in its district, which is equal to 6% of the commercial bank's net equity (capital). The national commercial banks are banks that have a carter from the U.S. government. These national banks are also called member banks and they earn 6% annual dividends on their shares of stock of the Fed bank.

Each Federal Reserve bank has 9 directors. The member commercial banks elect 6 directors, which 3 directors are bankers and the other 3 are from business. The last 3 directors are appointed by the Board of Governors of the Federal Reserve System. In turn, the 9 directors elect the president of the Fed district bank. Of course, this is not a free election. A Fed Bank president has to be approved by the Board of Governors, which holds most of the power at the Fed.

Even though the Fed district banks are privately owned, the commercial banks have no control over the Fed banks. A Fed bank is not like a corporation where the stockholders can freely elect the board of directors and vote on major corporate policies. The reason the Fed has this odd structure was that Congress didn't want the Fed to be part of government or controlled by the banks, but somewhere in between. Now days it is a part of government or quasi-government.

Board of Governors

The Board of Governors is the entity that controls the Federal Reserve System, determines monetary policy, reserve requirements, and discount policy. Originally the Fed was decentralized and the power was dispersed among the 12 Fed banks. The board consists of 7 members, who serve a 14-year term. The members are appointed by the U.S. President. The U.S. President also appoints the chairperson and vice-chairperson of the board. The Comptroller of the Currency and Secretary of the Treasury cannot be members of the board, because if the government is running up a massive debt and the Treasury is unable to increase taxes or borrow, you do not want the Treasury to "print money" to cover deficits. "Printing money" leads to inflation.

The Board of Governors is independent of the U.S. federal government. The Fed is independent from the U.S. government in three ways.

1. Revenue - the Board of Governors gets its revenue from the 12 district banks. The Fed does not have to go to Congress for money. (Whoever controls the money is directly or indirectly in charge).

2. Terms of Service - the terms of the governors are staggered. Every two years, the U.S. President appoints one director to the Board of Governors (7 - members, 14 years). This prevents a President coming into office and appointing all members at once, so the members would be loyal to the President.

3. Audits - the government cannot completely audit the Fed. (The less government knows, the less it can tamper with things.) Please do not think the Fed is completely independent! If the Federal Reserve angers Congress too much, Congress can rewrite the laws that created the Fed.

Federal Open Market Committee

The Federal Open Market Committee (FOMC) makes decisions concerning open-market operations. After a decision is made, a directive is sent to the manager at the New York City Federal Reserve bank to actually buy and sell U.S. government securities. The FOMC consists of the Board of Governors, plus 5 Fed district bank presidents. The chairperson of the Board of Governors is also chairperson of the FOMC. This person is a powerful man. This person can advise the President, informs Congress of the Fed's actions, and spokesperson of the whole Federal Reserve System. When he speaks, the financial markets listen. Currently the chairperson is Alan Greenspan and is considered the second most power man in the United States right next to the U.S. president.

The president of the Federal Reserve bank of New York City is a permanent member of the FOMC and always the FOMC vice-chairperson. The reason is New York City is the financial center of the U.S. and the Fed buys and sells government securities through the New York Fed Bank. The four other positions for the FOMC is rotated among the other 11 Fed district bank presidents.

Also the Fed buys securities from the secondary markets. It buys existing U.S. government securities. If the Fed bought securities directly from the primary market, then it would be too close to the Treasury. The Treasury issues new securities in the primary market.

Does the Fed serve the public interest or does it act by its own self interest? There are two views on that question.

1. Public interest view - the Fed serves public interest by implementing monetary policy that causes stable prices, low unemployment, and economic growth. Many economists argue that the Fed does not serve the public interest, because it has not emphasized price stability and growth.

2. Principal-agent view - this view is that government bureaucracies do not serve the purpose that they were created for. They are only concerned about maximizing their power, influence, and prestige. For example, a new computer corporation is created. If the new corporation creates new computers for a low price that consumers want, then the corporation earns profits. However, if the corporation builds computers that nobody wants, then the corporation will eventually bankrupt. The role of profits ensure businesses to produce goods and services that consumers want. Government agencies are not governed by profits. There is no mechanism that keeps a government agency in check. Every year, government agencies receive more funding, regardless of the agencies' performance. Over time, bureaucrats become more concerned with funding, job security, and prestige, instead of following its original function. That is why many government agencies are poorly rated in terms of customer satisfaction.

Independence from Government

Foreign countries differ in how independent their central banks are. For example, Germany and Switzerland have the most independent central banks in the worlds. These countries also have some of the lowest inflation rates in the world. Central banks in New Zealand, Italy, and Spain have less independent central banks and these countries experienced significantly higher inflation rates.

Essentially, the Fed is independent of the U.S. Treasury Office, even though many Presidents have tried to influence it. However, a government budget deficit can lead to money creation. If the Fed want to keep interest rates stable and the U.S. government has a budget deficit ,the U.S. Treasury department can finance the deficit by issuing T-bills. However, the increase of supply of T-bills causes the market price of T-bills to decrease, which causes interest rates to increase. If the Fed wants the original interest rate, it has to buy the T-bills that the Treasury issued. This will cause bank reserves to increase, and the money supply increases too. Then increases in the money supply leads to inflation.