“And? If we win our independence? Is that a guarantee of freedom for our descendants? Or will the blood we shed begin an endless Cycle of vengeance and death with no defendants? I know the feelin' in the street is excitin’ But Jesus, between all the bleedin’ ‘n fightin’ I’ve been readin’ ‘n writin’ We need to handle our financial situation Are we a nation of states? What’s the state of our nation?”
Um, okay, so I may be a little obsessed with “Hamilton,” the hit Broadway musical.
What a fantastic way to present a story that seemed a little dry in history class, right?
Alexander Hamilton was amazing in many regards. He came to this country as an immigrant, with nothing in his pockets and a “top-notch brain.” While watching the musical and knowing he was the first Secretary of the Treasury under the new Constitution of the brand new United States of America, I couldn’t help but wonder about the details of how he actually handled our financial situation. Turns out, he was the mind behind the creation of “The Fed.”
It’s hard not to hear about “The Fed” if you’ve been listening to any financial news recently. During the COVID pandemic and the resultant shutdown, the federal government had to take drastic measures to keep the economy alive. They pumped lots of money into people’s pockets, which had the desired effect of keeping businesses and households functioning. The stock market also recovered nicely. But all that extra money had the expected result of raising inflation; each dollar was now worth less.
So, that’s when the Fed stepped in. The Fed, or The Federal Reserve, is the central bank of the United States and regulates monetary policy by influencing the money supply and interest rates. The Federal Reserve, while not his direct creation, was the brainchild of our friend, Alexander Hamilton. Alexander Hamilton fathered the First Bank of the United States.
Why did he think it was such a big deal to form some sort of a central banking entity?
After the War of Independence, the new nation’s leaders faced high inflation, a mountain of war debt to pay back, and stagnating commerce and industry, much like during the pandemic. The country needed an institution to collect taxes, pay its bills, and affect monetary policy.
So, Alexander Hamilton advocated for and succeeded in creating the First Bank of the United States, ironically modeled after the Bank of England. I mean, why hurl their good ideas into the sea, along with the tea?
There was resistance to a central federal bank, as you can imagine, from the states' rights advocates, the most prominent of whom was Thomas Jefferson. Thomas Jefferson thought the central bank would favor financiers and industrialization instead of the agrarian, state-based society he had in mind.
But George Washington signed the First Bank into existence with a charter of 20 years. The First Bank acted as a commercial bank, collecting revenues, making loans, and printing money. Its notes were backed by substantial gold reserves. Since it was the largest bank, it could influence the economy by altering the money supply and the credit in the economy.
When the First Bank’s twenty-year charter expired in 1811, Thomas Jefferson had reached the height of his influence as America’s third President, and another opponent of the bank, Thomas Madison, was the new president. Alexander Hamilton had passed in that fateful duel with Aaron Burr in 1804 (tear emoji). With its champion gone, the First Bank’s charter was allowed to expire, and banking was mostly taken over by state banks.
But time went on, and people started to notice the absence of a central federal banking authority. When financial panics happened, people tended to rush banks and withdraw all their money. The problem is that banks don’t keep all their money liquid. They make money by lending out money to other people, so they don’t always have cash on hand to give to customers if they all request money from their checking accounts at the same time.
Banks needed emergency reserves (think emergency fund). There needed to be some entity to regulate this and lend banks money when they were in trouble. The idea of the First Bank started to look good again. Thus, in 1913, the Federal Reserve was created.
Unlike the First Bank that acted as a central federal bank dealing with consumers, the Fed was structured as the “Bank of banks.” It lends money to and otherwise deals with other banks to maintain price levels and long-term growth, tame inflation, and encourage full employment in the economy.
It is comprised of the Board of Governors and 12 regional federal reserve banks and meets eight times a year to set monetary policy. The Fed reports to Congress.
The Fed’s main tools to affect the money supply and interest rates are manipulating the reserve requirement, the discount rate/Federal funds rate, open market operations, and excess reserve deposits.
We often hear of the Fed raising or lowering “interest rates.” People think this is the mortgage rate, but that’s not exactly right. The interest rate being referred to here is the Federal Funds rate, which is the interest rate charged from the Fed to the banks that will ultimately make the mortgage loans. Currently, the federal funds rate is set to 5.25-5.50%. When the federal funds rate rises, the banks then increase their prime rates they offer to their consumers to keep a profit margin. So, the federal funds rate indirectly affects lending rates charged to consumers and businesses.
In 2008, during the Great Recession, and in 2020, at the beginning of the COVID pandemic, the Fed lowered the funds rate to 0% to help keep the economy from sinking into a recession. That’s when the lucky among us got 2% and 3% mortgage rates. When the executive branch increased spending by sending out stimulus checks and inflation began to rise, the Fed counteracted by raising the funds rate to decrease the money supply and keep inflation in check.
Why do banks need to borrow money from other banks, you might be asking. One reason is the reserve requirement. Since the Fed is the bank of banks, it can require certain things from regional banks. The Fed requires that banks keep a certain percentage of their deposits liquid in the form of cash, usually about 10%. The rest, they can lend out to others and use as money-producing assets. When people make withdrawals from their accounts or when loans are made or repaid, the capital held by banks fluctuates. Banks often need to borrow money overnight from the Feds to meet the federal reserve requirement. That’s why the federal funds rate matters on a daily basis to banks.
The Fed can also manipulate the economy by increasing or decreasing the reserve requirement. For example, at the beginning of the pandemic, when the economy was looking bleak, the Fed reduced the reserve requirement to zero to free up cash in the economy.
I’ll also mention a couple of other ways the Fed regulates monetary policy. Open market operations refer to the Fed buying and selling Treasury bills and bonds to affect the money supply. Another way the Fed can affect banks is by increasing or decreasing the interest it pays banks on the Reserve balance they have to maintain with them.
Phew! That’s a lot of information.
We often attribute how the economy is doing to just the executive branch, but there is a lot more to it, as you can see. The president can definitely affect the economy through fiscal policy. The executive branch can increase or decrease spending to manipulate the economy.
Congress can also affect fiscal policy by increasing or decreasing taxes and changing tax incentives. But the Fed was created as a third party, ultimately reporting to Congress, not the president, to make monetary policy. The Fed is charged with helping keep our economy out of trouble by keeping inflation in check and the job market healthy.
As you have seen in the last four years, this system of checks and balances has really worked, and we have survived COVID economically in a fantastic fashion. Inflation measured by the consumer price index dropped to 3% from a high of 9% in June 2022. The S&P is up 48% from the start of the pandemic. Thanks must go to Alexander Hamilton for handling our financial situation and masterminding the systems that helped us get through the biggest worldwide upheaval we have seen in quite some time.
“The tendency of a national bank is to increase public and private credit. The former gives power to the state, for the protection of its rights and interests: and the latter facilitates and extends the operations of commerce among individuals. Industry is increased, commodities are multiplied, agriculture and manufacturers flourish: and herein consists the true wealth and prosperity of a state.”—Alexander Hamilton
Alexander Hamilton (1851). “The works of Alexander Hamilton: comprising his correspondence, and his political and official writings, exclusive of the federalist, civil and military,” p.237.
Bibliography
Federal Reserve History. (n.d.). First Bank of the United States. Retrieved from https://www.federalreservehistory.org/essays/first-bank-of-the-us
Federal Reserve History. (n.d.). Federal Reserve History. Retrieved from https://www.federalreservehistory.org/essays/federal-reserve-history
St. Louis Federal Reserve. (n.d.). History and Purpose of the Fed. Retrieved from https://www.stlouisfed.org/in-plain-english/history-and-purpose-of-the-fed#:~
Forbes. (n.d.). Federal Funds Rate. Retrieved from https://www.forbes.com/advisor/investing/federal-funds-rate/#:~
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