The Federal Reserve: the cornerstone of the American economy.
For just over a century the Fed has overseen the financial system of the US, but its track
record has been far from perfect. Worse yet, it has such a unique and convoluted
structure that it’s very difficult for people to really understand it, which is why unsurprisingly
the Fed has been subject to various conspiracy theories, from being owned by the Rothschilds
to being operated by lizard people. Today, we’re going back to the dawn of American
finance to see how the Fed was created, how it works and who really owns it.
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America during the late 19th century was a nation in turmoil and not just in the literal
sense. The Civil War was no doubt devastating, but
even during the peace that followed America was plagued by frequent and deep economic
depressions. The underlying cause was simple: America just
lacked a proper financial system and more importantly, it didn’t have a central bank
to save the day when things turned bad. Now, keep in mind, central banking wasn’t
a new concept. The Dutch were the first to come up with a
central bank in 1609 and it was instrumental in transforming the Netherlands from a swampy
backwater into a global economic empire. Following the example of the Dutch, the English
created the Bank of England in 1694, which of course became the backbone of the British
Empire. But it’s exactly this association with the
British that made the Founding Fathers reluctant to use the same model in the United States.
There were two attempts at establishing a central bank even despite public opposition:
Alexander Hamilton himself led the first movement in 1791.
But in both cases the systems lasted under 20 years and did little to stabilize the situation.
And by all accounts the situation was very very bad.
Back then even a single local bank failing could result in nationwide panics.
People knew that no one could save their bank if it went bust, so as soon as rumors of insolvency
started spreading, everyone frantically started withdrawing whatever they had, bankrupting
otherwise healthy and solvent banks simply out of fear.
Such bank runs happened with frightening regularity and the depressions that followed were long
and painful. Of course, American bankers realized very
well just how bad their industry was doing. Paul Warburg, one of the great American bankers
of his day, said in 1907 that the American banking system then was at about the same
point as 15th century Italy or Babylon in 2,000 BC.
Just a few months after Warburg made that statement, the country suffered the Panic
of 1907 and it was particularly severe. To start things off, in 1906 a devastating
earthquake destroyed 80% of San Francisco. With reconstruction efforts underway, capital
was very tight and because all the money back then was in paper form it was much more difficult
to reallocate it across the country. One banker tried to abuse that by manipulating
the stock price of the United Copper company back on Wall Street.
He hoped to see his shares rise exponentially in value, but instead they crashed, dragging
down the entire stock market with them. That banker was involved in 10 different banks
across the East Coast and one after another these banks failed as people assumed they
were insolvent and withdrew all their money. Pretty soon even banks that had nothing to
do with that guy were going under, and so the fearful bankers of America turned to the
only man with the power to save them: J. P. Morgan.
Back then, John Morgan was the king of Wall Street, and even today the bank he created
is the largest one in America. He wasn’t the wealthiest man at the time,
that title belonged to John Rockefeller, but Morgan was certainly the man everyone turned
to when things got bad. In October 1907 Morgan summoned the great
bankers of the day to his office at 23 Wall Street.
With the collective capital of America’s big banks, Morgan arranged for the rescue
of the healthy banks that were nevertheless near bankruptcy due to irrational fears.
Virtually the same thing would happen a century later in 2008 when the government bailed out
the banks, but this time it was happening entirely thanks to private individuals like
John Morgan. Once the panic was contained, it became clear
to everyone that a central bank was necessary and Congress immediately passed legislation
to create one. However, that was pretty much the only thing
everyone agreed on: the actual details of how it would work sparked long and fierce
debates that halted any progress. The agricultural South, for example, was afraid
that a powerful central bank would give Washington and Wall Street too much power over them.
The bankers meanwhile wanted to make sure that the central bank would not be manipulated
by political interests: they wanted it to be as independent as possible from Washington.
The sheer number of competing parties made creating a central bank extremely difficult
and negotiations would in fact take over 5 years to finalize.
What’s interesting though, is that these negotiations weren’t happening on Capitol
Hill. Instead, they were held 600 miles south of
Washington on Jekyll Island in Georgia. That resort was home to an exclusive club
of over a hundred of the wealthiest men at the time, including John Morgan.
Of course, only a select few would help draft the actual plan for the central bank and it
wouldn’t be until 1913 that legislation would actually come to pass.
The newly created Federal Reserve was truly a miracle of compromise.
To accommodate all the various interests of the diverse United States, the Fed became
a central bank unlike any other in the world. To begin with, it wasn’t even a single bank,
instead it was a network of twelve regional banks each governed by local bankers and businessmen.
Some of these banks were in obvious places, like New York and Chicago, but many of the
other locations came down to politics. The Senator from Missouri, for example, was
a key vote needed to pass legislation, which why today Missouri is the only state to have
two federal reserve banks within its borders. To appease Washington, these twelve regional
banks would have a single governing body, comprised of seven people appointed by the
president and confirmed by the Senate. To limit the president’s power, he can only
appoint one governor every two years with a 14-year term.
But the really unique part of the Fed’s structure, and you can thank John Morgan for
that, is the fact that each regional bank is actually structured as a private corporation
that has its own stock. Here’s how it works: every nationally-chartered
bank in America is required by law to keep 6% of its capital in its regional reserve
bank. In exchange, that private bank receives an
equivalent amount of shares in the regional reserve bank.
These shares, however, are quite different from the shares of public companies.
Their price is fixed at $100 per share and they cannot be sold or traded.
They carry voting rights to about two-thirds of the Board of Directors for that regional
reserve bank, but as we know the real power is in the Board of Governors appointed by
the President. What these shares do have, however, is a fixed
6% dividend per year. It’s worth noting that this dividend doesn’t
entitle the banks to any the Fed’s profits. Instead, everything the Fed earns above that
6% payout goes directly into the Treasury. And keep in mind, the Fed is very profitable:
in 2017 it sent $80 billion to the Treasury, while only paying out $14 billion to the regular
banks that hold its stock. So who are the shareholders of the Federal
Reserve? Well, basically every big bank in America.
The full list is 150 pages long, but pretty much every name you know appears on it.
But here’s the beautiful thing: most of America’s big banks are public corporations.
In other words, if you want to benefit and make money off of the unique structure of
the Federal Reserve you can do that by purchasing stock in American banks.
Since ownership in the Fed depends on capital, the bigger the bank, the bigger its ownership
stake. Therefore, it would be wisest to start from
the top of the list. And speaking of the stock market, in case
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