More on the US experience

Critique of Central Banking

By
Henry C K Liu

Part I: Monetary theology
Part II: The European Experience
Part III-a: The US Experience

Part III-b: More on the US experience

This article appeared in AToL on November 27, 2002

Most central banks, led by the US Federal Reserve (Fed), see their prime objective as the maintenance of "sound financial conditions", not economic growth, on the belief that the former must be a precondition for the latter, a belief not always validated by events.

It is sometimes said that war's legitimate child is revolution and war's bastard child is inflation. World War I was no exception. The US national debt multiplied 27 times to finance the nation's participation in that war, from US$1 billion to $27 billion. Far from ruining the United States, the war catapulted the country into the front ranks of the world's leading economic and financial powers. The national debt turned out to be a blessing, for government securities are indispensable for a vibrant credit market.

Inflation was a different story. By the end of World War I, in 1919, US prices were rising at the rate of 15 percent annually, but the economy roared ahead. In response, the Federal Reserve Board raised the discount rate in quick succession, from 4 to 7 percent, and kept it there for 18 months to try to rein in inflation. The result was that in 1921, 506 banks failed. Deflation descended on the economy like a perfect storm, with commodity prices falling 50 percent from their 1920 peak, throwing farmers into mass bankruptcies. Business activity fell by one-third; manufacturing output fell by 42 percent; unemployment rose fivefold to 11.9 percent, adding 4 million to the jobless count. The economy came to a screeching halt. From the Fed's perspective, declining prices were the goal, not the problem; unemployment was necessary to restore US industry to a sound footing, freeing it from wage-pushed inflation. Potent medicine always came with a bitter taste, the central bankers explained.

At this point, a technical process inadvertently gave the New York Federal Reserve Bank, which was closely allied with internationalist banking interest, preeminent influence over the Federal Reserve Board in Washington, the composition of which represented a more balanced national interest. The initial operation of the Fed did not use the open-market operation of purchasing or selling government securities as a method of managing the money supply. Money in the banking system was created entirely through the discount window at the regional Federal Reserve Banks. Instead of buying or selling government bonds, the regional Feds accepted "real bills" of trade, which when paid off would extinguish money in the banking system, making the money supply self-regulating in accordance with the "real bills" doctrine. The regional Feds bought government securities not to adjust money supply, but to enhance their separate operating profit by parking idle funds in interest-bearing yet super-safe government securities.

Bank economists at that time did not understand that when the regional Feds independently bought government securities, the aggregate effect would result in macro-economic implications of injecting "high power" money into the banking system, with which commercial banks could create more money in multiple by lending recycles. When the government sold bonds, the reverse would happen. When the Fed made open market transactions, interest rates would rise or fall accordingly in financial markets. And when regional Feds did not act in unison, the credit market could become confused or become disaggregated, as one regional Fed might buy while another might sell government securities in its open market operations.

Benjamin Strong, first president of the New York Federal Reserve Bank, saw the problem and persuaded the other 11 regional Feds to let the New York Fed handle all their transactions in a coordinated manner. The regional Feds formed their own Open Market Investment Committee for the purpose of maximizing overall profit for the whole system. This committee was dominated by the New York Fed, which was closely linked to big-money center bank interests which in turn were closely tied to international financial markets. The Federal Reserve Board approved the arrangement without full understanding of its full implication: that the Fed was falling under the undue influence of the New York internationalist bankers. This fatal flaw would reveal itself in the Fed's role in causing and its impotence in dealing with the 1929 crash.

The deep 1920-21 depression eventually recovered into the Roaring Twenties, which, like the New Economy bubble of the 1990s, left some segments of economy and the population in them lingering in a depressed state. Farmers remained victimized by depressed commodity prices and factory workers shared in the prosperity only by working longer hours and assuming debt with the easy money that the banks provided. Unions lost 30 percent of their membership because of high unemployment. The prosperity was entirely fueled by the wealth effect of a speculative boom in the stock market that by the end of the decade would face the 1929 crash and land the nation and the world in the Great Depression. Historical data showed that when New York Fed president Strong leaned on the regional Feds to ease the discount rate on an already overheated economy in 1927, the Fed lost its last window of opportunity to prevent the 1929 crash. Some historians claimed that Strong did so to fulfill his internationalist vision at the risk of endangering the national interest.

When money is not backed by gold, its exchange value must be managed by government, more specifically by the monetary policies of the central bank. Yet central bankers tend to be attracted to the gold standard because it can relieve them of the unpleasant and thankless responsibility of unpopular monetary policies to sustain the value of money. Central bankers have been caricatured as party spoilers who take away the punch bowl just when the party gets going.

Yet even a gold standard is based on a fixed value of money to gold, set to reflect the underlying economical conditions at the time of its setting. Therein lies the inescapable need for human judgment. Instead of focusing on the appropriateness of the level of money valuation under changing economic conditions, central banks often become fixated on merely maintaining a previously set exchange rate between money and gold, doing serious damage in the process to any economy out of sync with that fixed rate. It seldom occurs to central bankers that the fixed rate was the problem, not the economy. When the exchange value of a currency falls, central bankers often feel a personal sense of failure, while they merely shrug their shoulders to refer to natural laws of finance when the economy collapses from an overvalued currency.

The return to the gold standard in war-torn Europe in the 1920s was engineered by a coalition of internationalist central bankers on both sides of the Atlantic as a prerequisite for postwar economic reconstruction. President Strong of the New York Fed and his former partners at the House of Morgan were closely associated with the Bank of England, the Banque de France, the Reichsbank, and the central banks of Austria, the Netherlands, Italy, and Belgium, as well as with leading internationalist private bankers in those countries. Montagu Norman, governor of the Bank of England from 1920-44, enjoyed a long and close personal friendship with Strong as well as ideological alliance. Their joint commitment to restore the gold standard in Europe and so to bring about a return to the "international financial normalcy" of the prewar years was well documented. Norman recognized that the impairment of Britain's financial hegemony meant that, to accomplish postwar economic reconstruction that would preserve British privilege, Europe would "need the active cooperation of our friends in the United States".

Like other New York bankers, Strong perceived World War I as an opportunity to expand US participation in international finance, allowing New York to move toward coveted international-finance-center status to rival London's historical preeminence, through the development of a commercial paper market, or bankers' acceptances, breaking London's long monopoly. The Federal Reserve Act of 1913 permitted the Federal Reserve Banks to buy, or rediscount, such paper. This allowed US banks in New York to play an increasingly central role in international finance in competition with the London market.

Herbert Hoover, after losing his second-term US presidential election to Franklin D Roosevelt as a result of the 1929 crash, criticized Strong as "a mental annex to Europe", and blamed Strong's internationalist commitment to facilitating Europe's postwar economic recovery for the US stock-market crash of 1929 and the subsequent Great Depression that robbed Hoover of a second term. Europe's return to the gold standard, with Britain's insistence on what Hoover termed a "fictitious rate" of US$4.86 to the pound sterling, required Strong to expand US credit by keeping the discount rate unrealistically low and to manipulate the Fed's open market operations to keep US interest rate low to ease market pressures on the overvalued pound sterling. Hoover, with justification, ascribed Strong's internationalist policies to what he viewed as the malign persuasions of Norman and other European central bankers, especially Hjalmar Schacht of the Reichsbank and Charles Rist of the Bank of France. From the mid-1920s onward, the US experienced credit-pushed inflation, which fueled the stock-market bubble that finally collapsed in 1929.

Within the Federal Reserve System, Strong's low-rate policies of the mid-1920s also provoked substantial regional opposition, particularly from Midwestern and agricultural elements, who generally endorsed Hoover's subsequent critical analysis. Throughout the 1920s, two of the Federal Reserve Board's directors, Adolph C Miller, a professional economist, and Charles S Hamlin, perennially disapproved of the degree to which they believed Strong subordinated domestic to international considerations.

The fairness of Hoover's allegation is subject to debate, but the fact that there was a divergence of priority between the White House and the Fed is beyond dispute, as is the fact that what is good for the international financial system may not always be good for a national economy. This is evidenced today by the collapse of one economy after another under the current international finance architecture that all central banks support instinctively out of a sense of institutional solidarity.

The issue of government control over foreign loans also brought the Fed, dominated by Strong, into direct conflict with Hoover when the latter was secretary of commerce. Hoover believed that the US government should have right of approval on foreign loans based on national-interest considerations and that the proceeds of US loans should be spent on US goods and services. Strong opposed all such restrictions as undesirable government intervention in free trade and international finance.

In July and August 1927, Strong, despite ominous data on mounting market speculation and inflation, pushed the Fed to lower the discount rate from 4 to 3 percent to relieve market pressures again on the overvalued British pound. In July 1927, the central bankers of Great Britain, the United States, France, and Weimar Germany met on Long Island in the US to discuss means of increasing Britain's gold reserves and stabilizing the European currency situation. Strong's reduction of the discount rate and purchase of 12 million pound sterling, for which he paid the Bank of England in gold, appeared to come directly from that meeting. One of the French bankers in attendance, Charles Rist, reported that Strong said that US authorities would reduce the discount rate as "un petit coup de whisky for the stock exchange". Strong pushed this reduction through the Fed despite strong opposition from Miller and fellow board member James McDougal of the Chicago Fed, who represented Midwestern bankers, who generally did not share New York's internationalist preoccupation.

Frank Altschul, partner in the New York branch of the transnational investment bank Lazard Freres, told Emile Moreau, the governor of the Bank of France, that "the reasons given by Mr Strong as justification for the reduction in the discount rate are being taken seriously by no one, and that everyone in the United States is convinced that Mr Strong wanted to aid Mr Norman by supporting the pound". Other correspondence in Strong's own files suggests that he was giving priority to international monetary conditions rather than to US export needs, contrary to his public arguments. Writing to Norman, who praised his handling of the affair as "masterly", Strong described the US discount rate reduction as "our year's contribution to reconstruction". The Fed's ease in 1927 forced money to flow not into the overheated real economy, which was unable to absorb further investment, but into the speculative financial market, which led to the crash of 1929. Strong died in October 1928, one year before the crash, and was spared the pain of having to see the devastating results of his internationalist policies.

Scholarly debate still continues as to whether Strong's effort to facilitate European economic reconstruction compromised the US domestic economy and, in particular, led him to subordinate US monetary policies to internationalist demands. There is, however, little disagreement that the overall monetary strategy of European central banks had been misguided in its reliance on the restoration of the gold standard. Critics suggest that the deep commitment of Strong, Norman, and other international bankers to returning the pound, the mark, and other major European currencies to the gold standard at overly high parities, which they were then forced to maintain at all costs, including indifference to deflation, had the effect of undercutting Europe's postwar economic recovery. Not only did Strong and his fellow central bankers through their monetary policies contribute to the Great Depression, but their continuing fixation to gold also acted as a straitjacket that in effect precluded expansionist counter-cyclical measures.

The inflexibility of the gold standard and the central bankers' determination to defend their national currencies' convertibility into gold at almost any cost drastically limited the options available to them when responding to the global crisis. This picture fits the situation of the fixed-exchange-rates regime that produced recurring financial crises in the 1990s and that has yet to run its full course. In 1927, Strong's unconditional support of the gold standard, which emphasized the financial predominance of the United States, with the largest holdings of gold in the world, exacerbated nascent international economic problems. In similar ways, dollar hegemony does the same damage to the global economy today. Just as the international gold standard itself was one of the major factors underlying and exacerbating the Great Depression that followed the 1929 crash, since the conditions that had sustained it before the war no longer existed, the fixed-exchange-rates system set up by the Bretton Woods regime after World War II will cause a total collapse of the current international financial architecture with equally tragic outcomes.

The nature of and constraints on US internationalism after World War I had parallels in US internationalism after World War II and in US globalization after the Cold War. Hoover bitterly charged Strong with reckless placement of the interests of the international financial system ahead of US national interest and domestic concerns. Strong sincerely believed his support for European currency stabilization also promoted the best interests of the United States, as post-Cold War neo-liberal market fundamentalists sincerely believe its promotion enhances the US national interest. Unfortunately, sincerity is not a vaccine against falsehood.

Strong argued repeatedly that volatile exchange rates, especially when the dollar was at a premium against other currencies, made it difficult for US exporters to price their goods competitively. As he had done during the war, on numerous later occasions, Strong also stressed the need to prevent an influx of gold into the United States and consequent domestic inflation, by the US making loans to Europe, pursuing lenient debt policies, and accepting European imports on generous terms. Strong never questioned the parities set for the mark and the pound sterling. He merely accepted that returning the pound to gold at prewar exchange rates required British deflation and US efforts to use lower US interest rates to alleviate market pressures on sterling. Like Fed chairman Paul Volcker in the 1980s, but unlike Treasury secretary Robert Rubin in the 1990s, Strong mistook a cheap dollar as serving the national interest, while Rubin understood correctly that a strong dollar is in the national interest.

When Norman sent him a copy of John Maynard Keynes' Tract on Monetary Reform, Strong commented "that some of his [Keynes'] conclusions are thoroughly unwarranted and show a great lack of knowledge of American affairs and of the Federal Reserve System". Within a decade, Keynes became the most influential economist in modern history.

The major flaw in the European effort for post-World War I economic reconstruction was its attempt to reconstruct the past through its attachment to the gold standard, with little vision of a new future. The democratic governments of the moneyed class that inherited power from the fall of monarchies did not fully comprehend the implication of the disappearance of the monarch as a ruler, whose financial architecture they tried to continue for the benefit of their bourgeois class. The broadening of the political franchise in most European countries after the war had made it far more difficult for governments and central bankers to resist electoral pressures for increased social spending and the demand for ample liquidity with low interest rates, as well as high tolerance for moderate inflation, regardless of their impact on the international financial architecture. The Fed, despite its claim of independence from politics, has never been free of US presidential-election politics since its founding. Shortly before his untimely death, Strong took comfort in his belief that the reconstruction of Europe was virtually completed and his internationalist policies had been successful in preserving world peace. Within a decade of his death, the whole world was aflame with World War II.

Central bankers around the world nowadays may not know about Marriner S Eccles, the president of tiny First National Bank of Ogden, Utah, who became nationally famous through his successful effort to save his bank from collapse in the late summer of 1931. Eccles defused the panic of depositors outside of his bank by announcing that his bank would stay open until all depositors were paid. He also instructed his tellers to count every small bill and check every signature to slow the prospect of his bank running out of cash. A mostly empty armored car carrying all First National's puny reserves from the Federal Reserve Bank in Salt Lake City arrived conspicuously while Eccles announced that there was plenty of money left where it came from, which was true except for the fact that none of it belonged to First National. The crowd's confidence in First National was re-established and Eccles' bank survived on a misleading statement that would have been considered criminally fraudulent in a vigorous investigation.

Eccles was a quintessential frontier entrepreneur of the US West and politically a Western Republican. Beginning with timber and sawmill operations, his family's initial capital came in the form of labor and raw material. He learned from his father, an illiterate who immigrated from Scotland in 1860, that the way to remain free was to avoid becoming indebted to the Northeastern banks, which were in turn much indebted to British capital. Among Eccles' assets of railroads, mines, construction companies and farm businesses was a chain of local banks in the West. Immersed in an atmosphere of US populism that was critical of unregulated capitalism and Northeastern "money trusts", Eccles viewed himself as an ethical capitalist who succeeded through his hard works and wits, free of oppression from big business trusts and government interference. A Mormon polygamist, the elder Eccles had two wives and 21 children, which provided him with considerable human capital in the labor-short West. The young Eccles, at age 22 and with only a high-school education, had to assume the responsibilities of his father when the latter died suddenly. The Eccles construction company built the gigantic Boulder Dam, begun in 1931 and completed in 1936, renamed from Hoover Dam in the midst of the Depression and re-renamed Hoover Dam in 1941.

The market collapse of 1929 caught the inner-directed Eccles in a state of bewilderment and despair. Through eclectic reading based on common sense, he came to a startling awareness: that despite his father's conservative Scottish teachings on the importance of saving, individuals and companies and even banks, ever optimistic in their own future, tended to contribute to aggregate supply expansion to end up with overcapacity through excessive savings for investment. It was obvious to Eccles that the problem of the 1930s was that too much money had been channeled into savings and too little into spending. This new awareness, like Saint Paul's vision on the way to Damascus, led Eccles to a radical conclusion that contradicted all that his conservative father had taught him.

From direct experience, Eccles realized that bankers like himself, by doing what seemed sound on an individual basis, by calling in loans and refusing new lending, only contributed to the financial crisis. He saw from direct experience the evidence of market failure. He concluded that to get out of the depression, government intervention, something he had been taught was evil, was necessary to place purchasing power in the hands of the public which, together with the economy and the financial system, was in dire need of it. In the industrial age, the maldistribution (excessively unequal) of income and the excessive savings for capital investment always lead to the masses exhausting their purchasing power, unable to sustain the benefits of mass production that such savings brought.

Mass consumption is required by mass production. But mass consumption requires a fair distribution of new wealth as it is currently produced (not accumulated wealth) to provide mass purchasing power. By denying the masses necessary purchasing power, capital denies itself of the very demand that would justify its investment in new production. Credit can extend purchasing power but only until the credit runs out, which would soon occur without the support of adequate income.

Eccles' epiphany was his realization that Calvinist thrifty individualism does not work in a modern industrial economy. Eccles rejected the view of his fellow bankers that depressions are natural phenomena and that in the long run the destruction they wreak are healthy and that government intervention only postpones the needed elimination of the weak and unfit, thereby in the long run weakening the whole system through the support for the survival of the unfit. Eccles pragmatically saw that money is not neutral, and it has an economic function independent of ownership. Money serves a social purpose if it circulates through transactions and investments, and is socially harmful if it is hoarded in idle savings, no matter who owns it. Liquidity is the only measure of the usefulness of money. The penchant for capital preservation on the part of those who have surplus money has a natural tendency to reduce liquidity in times of deflation and economic slowdown.

The solution is to start the money flowing again by directing the money not toward those who already have a surplus of it in relation to their consumptive needs, but to those who have not enough. Giving more money to those who already have too much would take more money out of circulation into idle savings and prolong the depression. The solution is to give money to the most needy, who will spend it immediately. The only institution that can do this transfer of money for the good of the system is the federal government, which can issue or borrow money backed by the full faith and credit of the nation, and put it in the hands of the masses, who would spend it immediately, thus creating needed demand. Transfer of money through employment is not the same of transfer of wealth. Deficit financing of fiscal expenditure is the only way to inject money and improve liquidity in a stalled economy. Thus Eccles promoted a limited war on poverty and unemployment, not on moral but on utilitarian grounds.

Now, the interesting thing is that Eccles, who never attended university nor studied economics formally, articulated his pragmatic conclusions in speeches a good three years before Keynes wrote his epoch-making The General Theory of Employment, Interest, and Money (1936). John Galbraith in his Money: Whence It Came, Where It Went (1975) explained: "The effect of The General Theory was to legitimize ideas that were in circulation." With scientific logic and precision, Keynes made crackpot ideas like those promoted by Eccles respectable in learned circles, even though Keynes himself was considered a crackpot by New York Fed president Benjamin Strong as late as 1927.

In one single testimony in 1933, Eccles in his salt-of-the-earth manner convinced an eager US Congress of his new economic principle and outlined a specific agenda for how the federal government could save the economy by spending more money on unemployment relief, public works, agricultural allotment, farm-mortgage refinancing, settlement of foreign war debts, etc. Eccles also proposed structural systemic reform for achieving long-term stability: federal insurance for bank deposits, minimum wage standards, compulsory retirement pension schemes, in fact, the core program that came to be known as the New Deal. Eccles also helped launched the era of liberal credits, through government guarantee mortgages and interest subsidies, making middle-class and low-income home ownership a reality. It was not a plan to do away with capitalism as much as it was to save capitalism from itself.

Eccles also rescued the Federal Reserve System from institutional disgrace. For this, the Fed building in Washington has since been named after him. The evolution of political economy models in the early 1930s, a crucial period of change in the supervision and regulation of the financial sector, can be clearly seen in the opposing policies of the Hoover and Roosevelt administrations. It resulted in a change of focus in the Federal Reserve Board from orthodox sound money initiatives to a heterodox Keynesian outlook, and the push toward centralizing the monetary powers of the Federal Reserve System at the Board, away from the regional Federal Reserve Banks.

With support from Roosevelt, despite bitter opposition from big money center banks, Eccles personally designed the legislation that reformed the Federal Reserve System, the central bank of the United States founded by Congress in 1913 (Glass-Owen Federal Reserve Act), to provide the nation with a safer, more flexible, and more stable monetary and financial/banking system. An important founding objective of the original Federal Reserve System had been to fight inflation by controlling the money supply through setting the short-term interest rate, known as the Fed Funds Rate (FFR), and bank reserve ratios. By 1915, the Fed had regulatory control over half of the nation's banking capital and by 1928 about 80 percent. The Banking Act of 1935 designed by Eccles modified the Federal Reserve Act by stripping the 12 district Federal Reserve Banks of their autonomous privileges and veto powers and concentrated monetary policy power in the seven-member Board of Governors in Washington. Eccles served as chairman for 14 years while he continued to function as an inner-circle policy maker in the White House. The Fed under Eccles had no pretension of political independence. Galbraith described the Fed under Eccles as "the center of Keynesian evangelism in Washington".

The term "monetary policy" as used by the Fed nowadays refers to the actions undertaken by a central bank to influence the availability and cost of money and credit to help promote national economic goals. The Federal Reserve Act of 1913 gave the Federal Reserve responsibility for setting monetary policy.

The Federal Reserve controls the three tools of monetary policy: open market operations, the discount rate, and bank reserve requirements. The Board of Governors of the Federal Reserve System is responsible for the discount rate and bank reserve requirements, and the Federal Open Market Committee (FOMC) is responsible for open market operations, with transactions handled by the New York Fed.

Bank reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Within limits specified by law, the Board of Governors has sole authority over changes in reserve requirements. Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks. The dollar amount of a depository institution's reserve requirement is determined by applying the reserve ratios specified in the Federal Reserve Board's Regulation D to an institution's reservable liabilities. Reservable liabilities consist of net transaction accounts, non-personal time deposits, and eurocurrency liabilities. Since 1992, non-personal time deposits and eurocurrency liabilities have had a reserve ratio of zero. The reserve ratio on net transaction accounts depends on the amount of net transaction accounts at the depository institution. The Garn-St Germain Act of 1982 exempted the first $2 million of reservable liabilities from reserve requirements. This "exemption amount" is adjusted each year according to a formula specified by the act. The amount of net transaction accounts subject to a reserve requirement ratio of 3 percent was set under the Monetary Control Act of 1980 at $25 million. This "low reserve tranche" is also adjusted each year. Net transaction accounts in excess of the low reserve tranche are currently reservable at 10 percent.

Using these three tools, the Federal Reserve influences the demand for, and supply of, balances that depository institutions hold at Federal Reserve Banks and in this way alters the FFR. The FFR is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. Changes in the FFR trigger a chain of market events that affect other short-term interest rates, foreign-exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.

The FOMC consists of 12 members, comprising the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining 11 Reserve Bank presidents, who serve one-year terms on a rotating basis. The rotating seats are filled from the following four groups of Banks, one Bank president from each group: Boston, Philadelphia, and Richmond; Cleveland and Chicago; Atlanta, St Louis, and Dallas; and Minneapolis, Kansas City, and San Francisco. Non-voting Reserve Bank presidents attend the meetings of the committee, participate in the discussions, and contribute to the committee's assessment of the economy and policy options.

The FOMC holds eight regularly scheduled meetings per year. At these meetings, the committee reviews economic and financial conditions, determines the appropriate stance of monetary policy, and assesses the risks to the economic outlook, based on forecasts prepared by the Fed staff that are kept secret for five years. The committee's policy decisions are undertaken to foster the long-run objectives of price stability and sustainable economic growth, the definitions of which are constantly affected by the latest theories of monetary economics.

To this day, using the tools of monetary policy, the Fed affects the volume of money and credit and their price - interest rates. In this way, it influences employment, output, and the general level of prices. Commercial banks, despite their initial opposition to the National Banking Act of 1863, enacted during the Civil War, have benefited from double-layer protection: the Federal Deposit Insurance Corp (FDIC) and Fed discount lending. Non-interest-bearing checking accounts were another subsidy for the commercial banks prescribed by law at the expense of depositors. The Glass-Steagall Act of 1933, which was finally repealed in 1999 after almost seven decades, separated investment banking from commercial banking and forbade banks from participating in a whole range of other financial services. The repeal of Glass-Steagall has been identified as a key factor behind current bank scandals of conflicts of interest and their unsavory role in widespread corporate fraud.

The Federal Reserve Act of 1913 defines the goals of monetary policy. It specifies that, in conducting monetary policy, the Fed and its FOMC should seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates". In the past three decades, with the ascendency of monetarism, the central bank has increasingly focused primarily on achieving price stability by an interest-rate policy that allows unemployment to fluctuate. A sound money bias is now justified by the claim that a stable level of prices is the condition most conducive to maximum sustainable output and employment and to moderate long-term interest rates; in such circumstances, the prices of goods, materials, and services are undistorted by inflation and thus can serve as clearer signals and guides for the efficient allocation of resources. This is despite the fact that the boom-and-bust business cycle continues to plaque the economy. Also, a background of stable prices is thought to encourage saving and, indirectly, capital formation because it prevents the erosion of asset values by unanticipated inflation. This view of neglect-on-demand management has led to the precarious situation of overcapacity and speculative bubble we are facing today.

The concept of a natural rate of unemployment is a key contribution by monetarism to modern macroeconomics. Its use originated with Milton Friedman's 1968 Presidential Address to the American Economic Association in which he argued that there is no long-run tradeoff between inflation and unemployment: as the economy adjusts to any average rate of inflation, unemployment returns to its "natural" rate. Higher inflation brings no benefit in terms of lower average unemployment, nor does lower inflation involve any cost in terms of higher average unemployment. Instead, the microeconomic structure of labor markets and household and firm decisions affecting labor supply and demand determine the natural rate of unemployment. If monetary policy cannot affect the natural rate, then its appropriate role is to control inflation and, in the short run, help stabilize the economy around the natural rate. Doing so would be consistent with maintaining low and stable inflation.

A second important unemployment rate generally accepted by monetarist economists is the "Non-Accelerating Inflation Rate of Unemployment", or NAIRU. This is the unemployment rate consistent with maintaining stable inflation. According to standard neo-classical orthodox macroeconomic theory enshrined in most undergraduate textbooks of economics, inflation will tend to rise if the unemployment rate falls below the natural rate. Conversely, when the unemployment rate rises above the natural rate, inflation tends to fall. Thus, the natural rate and the NAIRU are often viewed as two names for the same economic phenomenon, providing an important benchmark for gauging the state of the business cycle, the outlook for future inflation, and the appropriate stance of monetary policy, identifying full employment and inflation are partners in economic crime, based on the assumption that the value of humans is inversely proportional to the value of money. In other words, money exists not to serve the welfare of people, but rather, people must be sacrificed to serve the stability of money. This explains why Paul Volcker, the US central banker widely credited with ending inflation in the early 1980s by administering wholesale financial bloodletting on the US economy, quipped lightheartedly that "central bankers are brought up pulling legs off of ants".

While the two terms are often viewed as synonymous, the natural rate is the unemployment rate that would be observed once short-run cyclical factors have played themselves out. Because wages and prices adjust sluggishly for social or legal reasons, the natural rate can be viewed as the unemployment rate when wages have had time to adjust to balance labor demand and supply. The NAIRU is the unemployment rate consistent with steady inflation in the near term, say, over the next 12 months.

The average long-run unemployment rate measured in the United States since 1961 is 6.09 percent, and during the 1980s and early 1990s, most economists placed the natural rate quite near that, in the 6-6.5 percent range. NAIRU has been subject to much criticism, yet it continues to appear in policy discussions. NAIRU or the natural rate of unemployment would be less obscene if the unemployment were not concentrated on the same group of people. But structural unemployment tends to create a permanent unemployed class, institutionalizing social injustice as a structural aspect of the economy.

The central bank, by adopting the natural rate of unemployment or NAIRU as a component of monetary policy, is condemning 6 percent of the labor force to perpetual involuntary unemployment. It seems self-evident that the population has a natural right not to be forced to be part of this 6 percent of unfortunate souls in the workforce. A natural rate of unemployment flies in the face of US political culture. The "inalienable rights" of all people (not some people) to life, liberty and the pursuit of happiness is a concept not compatible with chronic involuntary unemployment caused by government policy, aimed at protecting the value of money at the expense of a particular segment of the working class. One is reminded of the Declaration of Indepence: "... to secure these rights, governments [of which the privately owned central bank claims to be part] are instituted among men, deriving their just powers from the consent of the governed, that whenever any form of government becomes destructive of these ends, it is the right of the people to alter or to abolish it ..."

No worker has given any central bank his or her consent to be involuntarily unemployed so that the value of money can be preserved. The right to gainful employment in an industrial society where employment opportunities are systemically determined comes from this simple and direct relationship between the governed and the government. It is as sacrosanct as the right to vote. Governments that cannot guarantee full employment simply cannot legitimately claim the right to govern.

Full employment being defined as a level with 4 percent structural unemployment is an official policy of the Fed, as defined by the Full Employment and Balanced Growth Act of 1978, known as the Humphrey-Hawkins Act. The act introduces the term "full employment" as a policy goal, although the content of the bill had been watered down before passage by snake-oil economics to consider 4 percent unemployment as structural; and now full employment is defined as at or above that level, currently around 6 percent. Any level near or below that is deemed economically inconsistent, due to its impact on inflation (causing wages to rise! - a big no-no), thus only increasing unemployment down the road. Tragically, aside from being morally offensive, this definition of full employment is not even good economics. It distorts real deflation as nominal low inflation and widens the gap between nominal interest rate and real interest rate, allowing demand constantly to fall behind supply.

Humphrey-Hawkins has been described as the last legislative gasp of Keynesianism's doomed effort by liberal senator Hubert Humphrey to refocus on an official policy against unemployment. Alas, most of the progressive content of the law had been thoroughly vacated before passage. The one substantive reform provision: requiring the Fed to make public its annual target range for growth in the three monetary aggregates: the three Ms, namely M1 = currency in circulation, commercial bank demand deposits, NOW (negotiable order of withdrawal) and ATS (auto transfer from savings), credit-union share drafts, mutual-savings-bank demand deposits, non-bank traveler's checks; M2 = M1 plus overnight repurchase agreements issued by commercial banks, overnight eurodollars, savings accounts, time deposits under $100,000, money market mutual shares; M3 = M2 plus time deposits over $100,000, term repo agreements.

In 2000, when the Humphrey-Hawkins legislation requiring the Fed to set target ranges for money-supply growth expired, the Fed announced that it was no longer setting such targets, because money-supply growth does not provide a useful benchmark for the conduct of monetary policy. However, the Fed said too that "the FOMC believes that the behavior of money and credit will continue to have value for gauging economic and financial conditions. Moreover, M2, adjusted for changes in the price level, remains a component of the Index of Leading Indicators, which some market analysts use to forecast economic recessions and recoveries."

The Fed chairman is required to testify before both the House and the Senate to explain these goals and any deviant from the targets. Thus monetarism has now gained center stage, through the televised hearing on current chairman Alan Greenspan's testimony, riding on the legislative carcass of fading Keynesianism. Twice a year, the nation, and indeed the world, holds its breath waiting for the cryptic deliberations of Greenspan on his views on where the economy had been going and why and where he wants it to go. This ritual of esoteric transparence is neutralized by the cat-and-mouse game that the FOMC does with the market with its closely guarded secret on its FFR target until 2:12 pm on the day of its meeting. And its staff forecast on the economy on which the FFR target is derived is kept secret for a period of five years. It is a strange way to shoot for market stability, by institutionalizing policy surprises and keeping forecast analysis secret.

The US economy now sits on top of the pyramid of a globalized economy wielding the fearsome sword of dollar hegemony, sucking wealth from the rest of the world. Economic policy in the United States exerts a major influence on production, employment, and prices worldwide in what Greenspan calls US finance hegemony. The dollar, a fiat currency of the world's most heavily indebted nation that is most used in international transactions, constitutes more than half of other countries' official foreign-exchange reserves. A handful of US banks abroad and foreign banks in the United States monopolize a globalized international financial market. The policies and activities of the Fed control the globalized international economy. Thus, in deciding on the appropriate monetary policy for achieving basic economic goals, the Fed Board of Governors and the FOMC consider the record of US international transactions, movements in foreign-exchange rates, and other international economic developments, including war and economic sanctions, which are really economic warfare. And in the area of bank supervision and regulation, innovations in international banking require continual assessments of and modifications in the Fed's orientation, procedures, and regulations. The development of structured finance and the Fed's reluctance to regulate needed disclosure and management of risk associated with derivatives trading, particularly over-the-counter (OTC) derivatives, which are traded off exchanges directly between counterparties, has made transparency an illusion. Not only is the economy distorted by a debt bubble, it is also distorted by an invisible bubble.

Not only do Fed policies shape and get shaped by international developments, the US central bank also participates directly in international markets, being both market regulator and market participant, with inevitable conflict of interest. The Fed undertakes foreign-exchange transactions in cooperation with the US Treasury, compromising its "independence" in deference to national-security concerns. These transactions, and similar ones by foreign central banks involving dollars, may be facilitated by reciprocal currency (swap) arrangements that have been established between the Fed and the central banks of other countries.

US monetary policy actions influence exchange rates directly. Thus, the dollar's foreign-exchange value is one of the channels through which US monetary policy affects the US economy. In theory, when Fed actions raise US interest rates, the foreign-exchange value of the dollar should rise. An increase in the foreign-exchange value of the dollar, in turn, would raise the foreign price of US export goods traded on world markets and lower the price of goods imported into the US. These developments could lower output and price levels in the US economy. This may lead to a US trade deficit. But low-price imports would help reduce US inflation, allowing the Fed to lower interest rates. If the low-cost import is used as part of a US product, it may lower the export price of that US-made product, neutralizing the adverse impact of a strong dollar.

An increase in interest rates in a foreign country, in contrast, could raise worldwide demand for assets denominated in that country's currency and thereby reduce the dollar's value in terms of that currency. US output and price levels would tend to increase in directions just opposite of when US interest rates rise. But high US interest rates attract investment into US financial assets, producing a capital account surplus.

Therefore, in formulating monetary policy, the Board of Governors and the FOMC draw upon information about and analysis of international as well as US domestic influences. Changes in public policies or in economic conditions abroad and movements in international variables that affect the US economy, such as exchange rates, must be evaluated in assessing the stance of US monetary policy. The Fed also works with other agencies of the US government to conduct international financial policy, participates in various international organizations and forums, and is in almost continuous contact with other central banks on subjects of mutual concern, all to maintain what Greenspan proudly calls US financial hegemony. In other words, the free market is a mere figment of the conservatives' imagination and a propaganda slogan of neo-liberals. Central banking is the biggest private financial monopoly with governmental power in the world economy.

In the 1980s, recognizing their growing economic interdependence, the United States and the other major industrial countries intensified their efforts to consult and cooperate on macroeconomic policies. The Plaza Accord in 1985 forced Japan to raise the value the yen to reduce its trade surplus with the US. At the 1986 Tokyo Economic Summit, formal procedures to improve the coordination of policies and multilateral surveillance of economic performance were agreed upon among the Group of Seven (G7) industrialized nations. The Fed works with the US Treasury in coordinating international policy, particularly when, as has been the norm since the late 1970s, they intervene together in currency markets to influence the external value of the dollar.

Using the forum provided by the Bank for International Settlements (BIS) in Basel, Switzerland, the Fed works with representatives of the central banks of other countries on mutual concerns regarding monetary policy, international financial markets, banking supervision and regulation, and payments systems. (The chairman of the Board of Governors also represents the US central bank on the Board of Directors of the BIS.) Representatives of the Federal Reserve participate in the activities of the International Monetary Fund (IMF), on which the US has a controlling vote, discuss macroeconomic, financial-market, and structural issues with representatives of other industrial countries at the Organization for Economic Cooperation and Development (OECD) in Paris, and work with central-bank officials of Western Hemisphere countries at meetings such as that of the Governors of Central Banks of the American Continent. The dubious policies of the IMF around the world as an international lender of last resort to the world's troubled central banks in deep financial crisis have been essentially dictated by the United States.

The Fed has conducted foreign-currency operations, the buying and selling of dollars in exchange for foreign currency, for customers since the 1950s and for its own account since 1962. These operations are directed by the FOMC, acting in close cooperation with the US Treasury, which has overall responsibility for US international financial policy. The manager of the System Open Market Account at the Federal Reserve Bank of New York acts as the agent for both the FOMC and the Treasury in carrying out foreign-currency operations.

The purpose of Federal Reserve foreign-currency operations has evolved in response to changes in the international monetary system. The most important of these changes was the transition in the 1970s from the Bretton Woods system of fixed exchange rates to a system of flexible exchange rates for the dollar in terms of other countries' currencies. Under the latter system, while the main aim of Fed foreign-currency operations has been to counter disorderly conditions in exchange markets through the purchase or sale of foreign currencies (called intervention operations), primarily in the New York market, the net effect has often been high market volatility. During some episodes of downward pressure on the foreign-exchange value of the dollar, the Fed has purchased dollars (sold foreign currency) and has thereby absorbed some of the selling pressure on the dollar. Similarly, the Fed may sell dollars (purchase foreign currency) to counter upward pressure on the dollar's foreign-exchange value. The Federal Reserve Bank of New York also carries out transactions in the US foreign-exchange market as an agent for foreign monetary authorities.

Intervention operations involving dollars could affect the supply of reserves in the US depository system. A purchase of foreign currency by the Fed with newly created dollars, for instance, would increase the supply of reserves. In practice, however, such operations are not allowed to alter the supply of monetary reserves available to US depository institutions. That is, interventions are "sterilized" through open market operations so that they do not lead to a change in the market for domestic monetary reserves different from that which would have occurred in the absence of intervention.

The New Deal did not become fully Keynesian until after the 1937 recession, which most economists have since laid blame on Eccles' Fed policy of doubling the reserve requirement for commercial banks from 12.5 percent to 25 percent at the same time as the executive branch was tightening its fiscal policy. Gaining confidence from the recovery of 1935, Eccles permitted the Fed's institutional penchant to be activist in monetary policy. It was an error late in his career that would tarnish his earlier reputation as a New Dealer. The 1937 recession would re-establish monetary-policy passivity for the Fed for decades to come, until the chairmanship of Paul Volcker and now of Alan Greenspan. The focus on interest rates instead of stable money supply to stimulate aggregate demand became the Fed's operational mode for decades after.

The liberal economists of the Kennedy "New Economics" of the 1960s were in tune with the political wind of their time, that fiscal-policy-engineered government deficits were considered therapeutic to a slowing economy. Expansionist budgetary shortfalls can be compensated by increased economic activities that enlarge the revenue base. The pie gets bigger faster than the shrinking slice of tax take. At its peak, the New Economics managed to bring unemployment down to 3.5 percent, from 7 percent when president John F Kennedy took office, and sustained an uninterrupted economic expansion for 106 consecutive months.

However, this focus by the Fed on interest rates and credit conditions to accommodate the fiscal policies of the New Economics of Kennedy, instead of a focus on stable value of money and gradually expanding money supply, was attacked by Milton Friedman and his monetarist colleagues of the Chicago School. Besides attacking Keynesian fiscal policies as producing only ephemeral results, Friedman asserted that the only effective government influence over the private sector of the economy was its control of money. The Fed's short-term manipulation of the money supply was criticized as consistently destabilizing and damaging. Yet not until mid-1960s was Friedman taken seriously, when president Lyndon Johnson's Vietnam War spending was sinking the New Economics. The unraveling of the New Economics that began in 1968 was caused by the political system's unwillingness to follow Keynesian rules in good times.

Galbraith concluded that "Keynesian policy is unavailable for dampening demand if taxes cannot be increased except under the force majeur of war and public expenditure cannot be decreased for any reason". The failure of fiscal policy to slow an overheated economy left it to monetary policy to do its nasty chore.

Friedman emerged as the intellectual leader to challenge three decades of Keynesian supremacy. Wall Street analysts, following Friedman's theory, find the weekly fluctuation of M1 a more reliable indicator of economic swings than the slow-changing federal budget. Friedman's 1976 Nobel Price firmly enthroned the rise of monetarism as a mainstream concept, validated temporarily by recent events.

In 1966, the consumer price index (CPI) increased by more than 3 percent, the steepest in 15 years. By 1969, the annual price increase was above 6 percent. Even president Richard Nixon's brief wage-price controls failed to bring inflation below 3 percent, despite price-induced shortages in many industries, including toilet seats for restrooms in new office buildings. The Cold War was still going strong and there was no globalized trade to supply low-price imports and the Vietnam War was feeding inflation at home as well as exporting it to the non-communist world. By 1973, the CPI rose 8.8 percent and the Organization of Petroleum Exporting Countries (OPEC) embargo and price hikes pushed the 1974 CPI increase to 12.2 percent. The Fed tightened money and promptly produced a recession that lasted five months, with unemployment jumping to 9.1 percent and gross domestic product (GDP) shrinking by 15 percent. But inflation kept roaring toward double digits throughout the recession. A fundamental disconnect now confronted Keynesian theory - inflation and unemployment were moving in the same direction, which was not supposed to happen. There was plenty of blame to go around for the inflation, but none of it explained the high unemployment.

Friedman offered a simple and plausible alternative: he blamed the Fed for the inflation when it eased monetary policy over time and for the unemployment when the Fed tightened abruptly. A new term, "stagflation", came into common use. Friedman's slogans "money matters" and "inflation is everywhere and anywhere a monetary phenomenon" became headlines in the financial and even popular press. Friedman advocated a fixed expansion of M1 at 3 percent long-term to moderate the runaway business cycle overstimulated by Keynesian measures.

At its base, Friedman is against government intervention not merely because it may be ineffective, but because it is immoral. To him, the Fed has forgotten its institutional role as a stabilizer of the value of money, in a quest for power and influence. A strict-money rule, such as the later Taylor rule, would restore sanity to the Fed. The rule proposed by John Taylor, now Treasury undersecretary, is that if inflation is 1 percentage point above the Fed's goal, rates should rise by 1.5 percentage points, and if an economy's total output is 1 percentage point below its full capacity, rates should fall by half a percentage point.

Friedman's criticism of the Fed as protector of its constituent - the commercial banks - is populist but his willingness to allow the market to impose high interest rates and to allocate credit only to the creditworthy is biased toward the rich. It is the syndrome of the banker who offers umbrellas only when it is not raining. To carry Friedman's theory to its logical conclusion, there would be no need for a central bank in truly free financial markets, while the need for a national bank might be argued on nationalist political grounds.

As engineered by Eccles, the independence of the Fed is a peculiar, uniquely American institution. The institutional conflict between the Treasury and an "independent" Fed has yet to be resolved. Nixon accused Fed chairman William McChesney Martin of costing him the election loss to Kennedy, not without reason. As president finally in 1968, Nixon was to consider himself a Keynesian by proclaiming: "We are all Keynesians now."

The Fed's political base is the commercial banks. As more banks resigned from the Federal Reserve System, the system ran the risk of being exposed to political attack. The Fed's control of monetary policy technically requires membership of no more than the 400 largest banks. Universal membership brought in thousands of small regional and local banks that were crucial for the Fed's political protection, not for monetary policy requirement. Since its beginning in 1913, the Fed has been subjected to criticism that it is a captive institution of the big banks.

Arthur Burns, the Fed chairman appointed by Nixon, in trying to ensure the president's re-election, laid the seed of hyperinflation that left post-Watergate president Gerald Ford with having to fight inflation with his ludicrous WIN (Whip Inflation Now) lapel buttons. In hoping to get reappointed by Jimmy Carter, who defeated Ford as president in 1976, Burns continued to pursue an easy-money monetary policy in the first two years of the Carter administration. To Burns' disappointment, G William Miller became chairman of the Fed in 1978 when Burns' term expired.

Miller, chief executive officer of Textron, a high-tech defense contractor, true to the empire-building tendency of a CEO, decided to halt the membership decline in the Federal Reserve System. Commercial banks had been electing to withdraw from the Federal Reserve System in protest of the Fed not paying interest on reserve balances. Banks that withdrew could place their lower reserves, required by state banking regulations, in corresponding banks to earn income from securities.

During the '70s, as hyperinflation pushed up interest rates, the no-interest hidden "tax" on Federal Reserve member banks became proportionately more burdensome. Miller decided to pay interest to member banks for their reserves, over the opposition of Congress, which considered it another giveaway to the big banks. Not only were the big banks getting free safety-net protection through emergency borrowing at the Fed's discount window, they also enjoyed a free check clearing and payment system from the Fed. Congress thought the banks were pigs for complaining about the no-interest "tax" since the tax was lower than user fees for services the banks received. The effective tax rate in the 1980s for financial institutions was only 5.8 percent, compared with 34.1 percent for retail, 24.5 percent for electronics, 16.4 percent for aerospace, and 10.9 percent for utilities.

Senator William Proxmire, a Democrat from Wisconsin who chaired the Senate Banking Committee, and Representative Henry Reuss, his counterpart in the House, answered Fed interest payments with the Monetary Control Act of 1980 (a misnomer, since its real effect was to decontrol, just as the Full Employment and Balanced Growth Act of 1978 actually legitimized structural unemployment), enacted just when the Fed pushed interest rates to historical peaks, requiring all depository institutions, members and non-members alike, to maintain reserves with the Fed. Ostentatiously, since the Fed now paid interest on deposited reserves, the small banks ought at least to get the benefits of Fed services and protection and bypass the fee-paying correspondence relations with big banks.

It was amazing that the Fed was able to get a Congress increasingly hostile to government regulation to consolidate the Fed's institutional base at a time when the Fed was imposing intrusive conditions in the private economy. The rationale was based only marginally on economics and heavily on politics. Fed membership was a non-issue as far as monetary control was concerned, and governor Henry Wallich, the Fed's most scholarly economist, said as much publicly. The legislation favored the Fed's main constituent in the private sector, the large money center banks, forcing all other regional and local financial institutions to fall in line and accept the terms that are most operative for the big internationalist banks.

The Fed's legislative victory was delivered on the back of a larger issue - the deregulation of finance. In companion legislation, Congress repealed virtually all of the remaining government limits on interest rates and regulation on lending that had existed since the New Deal, much as the enactment of the Gramm-Leach-Bliley Act (GLBA) in November 1999 in effect repealed the Glass-Steagall Act, the long-standing prohibitions on the mixing of banking with securities or insurance businesses, and thus permitting "broad banking". The price of money was free at last to seek its "natural" equilibrium in the market place.

The prime rate rose above 15 percent in early 1980 when the deregulation legislation reached its final stage. The Democratic Congress voted overwhelmingly for a package that condemned borrowers to high cost and favored lenders with high returns, by arguing that the benefit of high interest on pension accounts justified the high cost of mortgage payments. In other words, as Pogo the cartoon character said: "The enemies, they are us." The populist Regulation Q, which regulated for several decades limits and ceilings on bank and savings-and-loan (S&L) interest, was phased out. Banks were allowed to pay interest on checking account - the NOW accounts, to lure depositors back from the money markets. S&Ls' traditional interest-rate advantage was removed, to provide a "level playing field", forcing them to take the same risk as commercial banks to survive. Congress also lifted restrictions on S&Ls' commercial lending, instead of the traditional home mortgages, which promptly got the whole industry into trouble that would soon required an unprecedented government bailout of depositors with tax money. But the developers who made billions were allowed to keep their profits. State usury laws were unilaterally suspended by an act of Congress in a flagrant intrusion on state rights.

The political coalition of converging powerful interests was evident. Virulent high inflation had damaged the holders of financial wealth, including small savers, created by a period of benign low inflation earlier, so that even progressives felt something has to be done to protect the middle class. The solution was to export inflation to low-labor-cost areas around the world, taming domestic inflation with the export of jobs and the domestic inflation devil - US wages. Neo-liberalism was born with the twin midwives of sound money and free financial markets, disguising economic neo-imperialism as market fundamentalism.

There was even a devious argument that universal Fed membership serves to dilute the institutional bias of the Fed toward big banks. Commercial banks of course argued for free market competition when they knew very well that predatory acquisition rather than fair competition was what unregulated markets sustain. Labor, small business and small local banks and S&Ls complained, to no avail. US labor, unlike its European counterparts, focused union contracts on wages and benefits on a shrinking unionized workforce while management shifted jobs overseas wholesale with the support of the internationalist banks as a painless way to control domestic inflation, in the name of free trade. Many Fed economists, Volcker included, actually knew that financial deregulation with the elimination of interest-rate ceilings would weaken the Fed's control over expansion of credit.

To gain support for the Monetary Control Act of 1980, the Fed offered member and non-member banks that, under universal membership, the existing levels of reserve would be lowered for every bank. Reserves required for demand deposits, the checking accounts that represented the core of bank funds, were reduced from 16.25 to 12 percent. This would mean a substantial loss of revenue for the Fed. The Fed had been paying a handsome dividend to the Treasury from surplus income from reserve holdings invested in government securities over operating expenses, $9.3 billion in 1979. According to the Board's 1999 Annual Report, the Federal Reserve System had net income totaling $26.2 billion, which would qualify it as one of the most profitable companies in the world if the system were a typical corporation. These profits were distributed as follows: $342 million, or 1.4 percent of the profits, was paid to member banks as dividends. Another $479 million, or 1.8 percent, was retained by the 12 Reserve Banks. The balance of $25.4 billion, or 96.9 percent of the profits, was paid to the Treasury.

The Fed started to charge banks for its services when the new reserve rules were fully phased in. The larger money center banks welcomed this development since they intended to provide their own service system for banks in competition with the Fed, and with the Fed charging a fee, it would make it easier for the big banks to lure away customers. To get the endorsement of the American Bankers Association, the Fed agreed to drop reserve requirements on time and saving deposits. This concession meant a vast benefit for the big banks whose balance sheet depends on large-denomination CDs (certificates of deposit).

Next: Still more on the US experience