The US Federal Reserve for Dummies: What is the Federal Reserve System and What is the Gold Standard?

This is the story of a bank that is not a bank as well as a government regulatory agency that is not government. The following explanation of the Federal Reserve is simpler than more complete versions you can find all over the web, but that's why I'm writing it. It's hard to find a simple explanation of this unusual institution that has been around for a hundred years.

(See A Moron's Guide to Money for a history of the United State's monetary and banking system prior to the creation of the Federal Reserve.)

What is the U.S. Federal Reserve System and how does the Federal Reserve System work?

The Federal Reserve System is the central bank of the United States of America. It was chartered in 1913 via the "Federal Reserve Act" of congress. While it operates as the nation's central bank, it is not one bank but a dozen regional Federal Reserve banks. It is also a management/ regulatory system. Because its twelve regional banks are privately owned, it is not really government. It is chartered by the government but not directly controlled by either congress or the executive branch. So, while it regulates the U.S. money supply, it is not quite a U.S. agency because of the fact that no branch of government controls it, though it does have to operate within its charter. That's it in a whirlwind.

All earlier central banks in the U.S. ended with economic crashes that devalued the currency or broke the bank. The Federal Reserve System was invented as an answer to a particularly bad financial panic in 1907 in one of the periods in which the U.S. had no central bank. That panic was only put to rest when several private parties banded together to form what they called the "lenders of last resort" to banks that were in trouble. Because this eased the panic and normalized money again, a call went out to create a national bank that would serve the same purpose these private parties did of lending to banks during financial crises. The Federal Reserve is really a compromise between a completely nationalized banking/monetary system and a completely private one.

Here is how the government connects with this institution of oxymorons: The U.S. Federal Reserve is composed of a presidentially nominated Board of Governors of the Federal Reserve System, which has seven directors. It manages money through the twelve regional Federal Reserve banks, which conduct all of their business through privately owned "member banks." They are banks for banks, not banks for people or businesses.

The seven members of the Board of Governors are appointed by the U.S. president and confirmed by the Senate. They are appointed for terms of fourteen years, with one person rotating off every even year, and no one can be removed from his or her position because of policy decisions or views.

What is the Federal Reserve bank?

That's how the question is often asked, but it should be "What is A Federal Reserve bank?" The twelve banks mentioned may be the most controversial part of the system because of the fact that they directly receive all money created in the U.S. but are privately owned. They are probably closer to economic fascism, in that the banks are own by private entities but are required to give all their profits to the government. "Fascism," is, however, a loaded term that implies more socially than is meant here. They are, in other words, non-profit corporations whose sole beneficiary is the U.S. government. Their stock is not publicly or privately traded, yet they are made up of private investors.

This is all raising more questions than it answers, but the answers will continue to follow.

If the profits have to go to government you might naturally ask why would anyone want to become a stockholder in any one of them? Simple. The stockholders are the banks in each region that choose to be part of the national banking system for the benefits the system offers. While the twelve Federal Reserve banks must give all of their profits to the U.S. government, the national banks that are members obviously keep all of their individual profits from their own operations. What they gain is influence over the nation's money supply and the most immediate access to it. These corporate investors derive the unique benefit of being the only ones to whom all U.S. dollars flow directly from the mint (and on computer accounts). Naturally, bankers like to be close to that supply.

Many banks want to be national banks because of the strength customers perceive in a institution that is backed by the U.S. government. If any bank in the US wants to call itself a "National Bank" it has to by law become a member of the Federal Reserve System. Other private banks could bank with the Federal Reserve System through these reserve banks, but a bank cannot call itself a "National Bank" without being a member of the Federal Reserve System, which means adhering to set regulations; but it is this regulatory system that gives potential depositors added assurance of the strength and integrity of the bank.

So, who owns the Federal Reserve banks?

When a bank decides it wants to become a "national bank" and a member of the Federal Reserve System, it must also by law become a stockholder in one of the twelve regional Federal Reserve banks. That stock cannot be bought and sold, nor traded or pledged as security because the amount the bank holds is a mandate of its membership. The member banks must pay for this stock by investing a certain amount of their funds as a reserve to be held in their regional Federal Reserve Bank. While they cannot make a profit off of how they run their regional reserve bank, they do receive stock dividends of 6% a year on each member bank's capital investment in a Reserve bank. Most of that 6% is considered payment for the money they must keep "in reserve," since they are not directly paid interest on that money.

Because all the profits in theory belong to the U.S. government, the Reserve banks are tax-exempt. This system also holds all the U.S. government's operating monies and processes payments for the government, including payroll.

The United States Court of Appeals, Ninth Circuit, ruled that the Federal Reserve Banks "are independent privately owned, locally controlled corporations" when it comes to law suits. The court said these banks are only "federal instrumentalities for some purposes."

What is the Federal Open Market Committee (FOMC)

The Federal Reserve's most prominent and powerful committee is the Federal Open Market Committee (FOMC), created by the reforms instituted during the Great Depression. The FOMC is charged under U.S. law with buying and selling United States Treasury securities and setting U.S. monetary policy. All members of the Fed's Board of Governors sit on the FOMC. The FOMC also includes committee members who are presidents of the regional Federal Reserve banks (five of the twelve banks at any one time on a rotating basis). So, it is through these five positions on the FOMC (one of which -- the president of the Federal Reserve Bank of New York is permanent) that all the national banks that are members of the Federal Reserve System get their influence on the nation's money supply. Thus, seven governors are appointed by the government and typically are not directly a part of the banking community, and fiver are appointed by the banks in the system but must be confirmed by the government.

These twelve people (the seven governors and five bank presidents) are the only voting members on the powerful FOMC, but all the other Federal Reserve bank presidents generally attend and give input. Of the twelve regional banks, only the Federal Reserve Bank of New York always has its president as one of the give reserve bank presidents on the committee, making sure that bank, closest to Wall Street, is the most significant of the reserve banks. The FOMC is chaired by the Chairman of the Federal Reserve Board of Governors (Ben Bernanke in 2012) who is also required as the Federal Reserve Chairman to report to the U.S. congress twice a year.

So, there are some checks and balances in this amalgam of government appointees and private enterprise, but congress cannot direct the chairman, nor can the president of the United States. Of course, the chairman is always cognizant of the fact that his entire institution only exists because of a charter by congress, so he is not inclined to just thumb his nose at congress.

Obviously, the most powerful committee members of the FOMC are the seven from the Board of Governors, for they also make decisions over other Fed matters that are outside of the purview of the FOMC. The Board of Governors is currently made up of academics and some former bankers, weighted more right now toward academics.

The system was designed with the intention of meeting the needs of both private citizens and private bankers and is considered unique among the central banks of the world because of its odd hybrid nature. It is also unique in that the U.S. entity that prints and coins the currency, the U.S. Treasury, is not a part of this central banking system at all and does not get to decide how much money to print. It prints bills and stamps coins on order of the Federal Reserve and gives this currency to the Federal Reserve at solely the cost of manufacturing the money.

But who REALLY owns the Federal Reserve?

There are two blind spots in the typical summary of the Federal Reserve System above. One is the idea that the private bankers who hold five positions on the FOMC are outnumbered by the seven government-appointed members on the FOMC (the Board of Governors). In policy, that is true, but, in fact, it is not: For a long time now the Federal Reserve's Board of Governors has run mysteriously short by two members. Two positions have gone unfilled for some time. So, the current reality is that the banks who have five voting representatives on the FOMC are an equal match to the Board of Governors. Secondly, the five people who do sit on the Board of Governors are not particularly consumer advocates.

A second reality is that ownership in the twelve regional Federal Reserve banks (amount of shares and, therefore, size of vote in decisions made by those reserve banks) is based on the size of reserves the member banks (owners) have invested. Since each member bank must invest 3% of capital into the Federal Reserve Bank it is a member of, larger banks obviously have many more shares of stock in their Federal Reserve Bank than smaller ones. Thus, Bank of America, J.P. Morgan Chase, and Wells Fargo own about 50% of all Federal Reserve Bank stock. In other words, the very banks that are central to all the foreclosure scandals in the U.S. control a good 50% of the vote at the reserve banks. That means they elect the president of their Federal Reserve Bank who will rotate through the only five voting positions on the FOMC that are held by Federal Reserve Bank presidents.

In essence, this means a collective of a few very large banks run the Federal Reserve System and does with the money supply whatever they choose. So long as Ben Bernanke (one of the votes of the current five sitting members of the Board of Governors) is on their side, they'll have a majority for every decision because they are assured of six votes out of ten on any decision for as long as the Board of Governors (the only people who might conceivably watch over the interests of Joe Citizen) runs with only five sitting members.

Federal Reserve monetary policy:

With the creation of the Federal Reserve System in 1914 came the first Federal Reserve note backed by gold -- the forefather of our modern dollar. This elastic currency is the legally declared "tender" of United States and is given to the twelve Federal Reserve banks to distribute through the national bank system in accordance with the needs of the public as seen fit by the Federal Reserve, never as directed by congress. The Federal Reserve has the authority from congress to act without even reporting the basis for its monetary policy decisions to congress, but it is partially audited annually by the Government Accountability Office (GAO).

The level of auditing is not as thorough as many members of congress would like it to be and was only made more specific during the Great Recession. The audit cannot look at or report any transactions decided on by the FOMC or any direct loans from the Fed to member banks, and it cannot look at any international transactions or at internal Fed communications related to either of these. Further, the Fed's monetary policies are not approved by anyone in government but just by those members sitting on the FOMC, nor are its policies open to audit.

Here are some ways the federal reserve changes money supply:

Does the Federal Reserve loan money to the US government?

The Treasury, which is government, issues securities based on the US government's funding shortfalls, but these cannot under law be purchased directly by the Federal Reserve. So, in that sense, no, the Fed does not loan directly to the government. The Fed, however, does transact the exchange of funds to buy those securities through its own accounts with member banks.

Ordinarily, the Treasury issues securities in the form of short-term Treasury bills ("T-bills,"), longer-term notes, and bonds, with bonds being the longest term. The bonds are auctioned to banks in the Federal Reserve System, and the Fed debits the reserve account that it holds for each those member banks by the cost of the bonds that each bank buys. So, the bank gets the bonds as assets, and its reserve accounts are debited to match. The money debited for the bonds is credited to the U.S. Treasury's account where it is used for payment of U.S. government expenses. This doesn't really create new money into the system because the bank loses from its reserve account what it gains in assets, except for the interest paid on those bonds.

That is how we've operated for decades. At a later date, the Treasury has to pay back with interest all the money it raised from securities. To do so, it sells even more bills, notes, or bonds to raise even more money. That sounds a bit like a Ponzi scheme that has to top out somewhere, and it has gone on for decades (because the government continually spends more than it takes in via tax and tariff revenue), except during the Clinton administration where it actually ran a surplus budget for a few years and began to pay down the national debt.  Credit rating agencies during the Great Recession have begun warning the U.S. government that, in their opinion, it has now arrived at the point where it can no longer keep paying its interest with ever larger issues of treasuries. Having seen the light on this scheme, the credit-rating agencies have said, "Start cutting back, or we'll start cutting your credit rating back."

How the Federal Reserve controls the money supply

The Federal Reserve in essence creates all original money by decreeing its existence (what is called "fiat money") and it has various ways to do this. ("Original" is an important word here, as you'll see down the page.) The most obvious way is that the Fed can order the treasury to print bills or mint coins, which enter the monetary system in any amount the Fed chooses. In fact, the Treasury never prints currency unless the Fed directs it to do so. When the U.S. Treasury prints physical money, it only charges the Fed the cost of printing and delivering the money.

The Treasury is not allowed by law to print money to pay its own (the government's own) debts directly, and the Fed, as mentioned, is not allowed to finance that debt directly by buying securities from the government, as that could amount to the same thing since the Fed can order the printing of money that it receives. The treasury also only issues treasury securities if it is short on revenue, so the Fed does not tell the treasury how many bonds, etc. to issue. It just handles the issue. Thus, the Fed can get new money into the system by ordering the printing of physical money, but money does not really enter through the normal purchase of bonds and other treasuries by member banks. Those are just transfers of funds from private sector to government.

The money that is printed is no longer backed by precious metals. Rather, it has perceived value because the government decrees the money to be the only legal tender for all debts in the US, meaning the only thing that has to be accepted for payment of all debts. If everyone in a nation is constrained by law to use something for the payment of all debts, everyone is naturally going to want more of that thing and, therefore, value it. The money's value is really only maintained by how well the Fed manages it. It can quickly become worthless if it is managed poorly. (For more on this see the article "A Moron's Guide to Money."

Only about 10% of the money that is created each year in the United States is coin or paper. The rest i intangible. It exists only on computer spreadsheets in bank accounts that all start at the Fed. It moves from there to bank to bank as numbers in documents that never do become tangible money. The government prints only as much in the form of currency as people want so they can have some jingle in their pockets. So, it is completely limited in how much it can expand the money supply when printing and minting by demand. There is no point in warehousing a lot of physical bills and coins that no one wants in their pockets or purses. A certain number, of course, is held in vaults to buffer the flow of currency as demand swells and shrinks.

The easiest way the Fed can create money is by simply adding it to the reserve balances of its member banks, but it cannot just add any amount wanted, or the money would quickly become more worthless than blank paper because it isn't even fit for writing on. So, the Fed continually monitors and regulates the "money" supply on its spreadsheets (both tangible and non-tangible), employing various checks and balances to try to assure the money retains its perceived value.

Since the loss of perceived value in money is known as inflation, the Fed (via the FOMC) religiously watches inflationary figures. The Fed's standard is often a policy-set inflationary target. It tries to put money into the system or pull it out in such manner as to maintain that inflationary target; thereby maintaining a certain perceived value in the money. The Federal Reserve is mandated by congress to align two goals (often called the Federal Reserve's "dual mandate") -- minimal inflation and maximal job growth -- that are by intention opposing goals.

This tension creates balance: Create too much money, and inflation rockets upward. Close the supply too tightly, and the economy stalls and jobs are lost because banks get tighter with their limited money supply and raise the cost of their loans for those who want any of it. So, balancing these objectives is supposed to keep the money in appropriate supply with the jobs that make the money ... so as not to create money faster than one is creating jobs or to lose jobs from tightening the supply too much.

Our Federal Reserve typically tries to keep inflation at a predictable 2% -- an arbitrarily chosen "minimal" number that the Fed feels comfortable with because the country seems to run fairly fluid and stable at that level. Zero inflation, they feel, sits right on the economic stalling point where jobs fall off, so they don't want that, as they risk seeing jobs decline before they can act, and that can be a very difficult unwinding of the economy to turn around.

(Obviously, the crash of 2008 proves it is quite possible for the economy to become completely unstable while maintaining that 2% inflation rate. The Fed was oblivious to the crash that was coming right up to the time it came. Ben Bernanke had a few nagging doubts a few months ahead, but did nothing to reverse Fed policies. Now, the Fed, with Uncle Ben still at the helm, is being trusted to fly us through a disaster that it completely failed to see coming.)

The US Federal Reserve's roll in the Great Recession

It is the Fed's job to manage the nation's monetary system and regulate the nation's banking system, though other regulatory agencies are involved, too. Clearly the Great Recession can be laid at the Fed's feet for mismanagement. If it were doing its job of watching and regulating, such a crisis would never have developed. It pushed for and orchestrated the deregulation that allowed for this mess to develop (particularly through the former Fed Chairman, Alan Greenspan). It completely failed to see the disaster coming and only reacted in hindsight. The Fed was created out of previous financial crises specifically to make sure monetary crises do not develop and to manager our recovery through them if they do. This global crisis was a failure of the Federal Reserve System, in which Congress places too much trust, to do its regulatory job.

It is no surprise then that the vast majority of Americans rate the Fed's job performance lower than they rate the IRS. Only 30% of Americans approve of the job the Federal Reserve has done, while 40% approve of the job the IRS has been doing. You have to do a pretty poor job in this country to be rated by taxpayers lower than the much-hated IRS.

[December 2017 Update: More than five years after the original writing of this article, the Federal Reserve's board of governors has tilted completely in favor of banker rule with three of its positions now unfilled, resulting in full majority power over the FOMC being held by the bankers' own Reserve Bank presidents.]

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