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Tuesday, September 30, 2014

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The First and Second Banks of the United States: The Historical Basis for a Decentralized Fed

Those considering the future of the Federal Reserve would do well to revisit the past. In Philadelphia's historic Old City, a short walk from the Philadelphia Fed, you will find the vestiges of two earlier attempts at a central bank.

Following the Revolutionary War, the newly formed nation of the United States sought a way to re-establish commerce, repay war debt, restore the value of currency, and lower inflation. One of our Founding Fathers — Alexander Hamilton, the first Secretary of the Treasury — devised a plan to accomplish these goals. His idea? Create a national bank that would issue paper money, provide a safe place for public funds, offer banking facilities for commercial transactions, and act as the government's fiscal agent.

First BankMany people opposed the idea. They believed that a national bank was unconstitutional and would place too much power in the hands of the federal government. Despite the opposition, Hamilton prevailed, and Congress created the Bank of the United States (often called the First Bank), granting it a 20-year charter. Although not a central bank in the modern sense, the First Bank was the nation's first attempt at central banking. It opened in 1791 and closed in 1811, when Congress failed to renew its charter.

However, by early 1815, much like at the end of the Revolutionary War, the U.S. found itself heavily in debt after fighting the War of 1812 and struggling with soaring prices and devalued money from rising inflation. Furthermore, with no national bank, the government had difficulty borrowing money and making payments. Many people felt that the solution to the country's problems lay in establishing another national bank. After much debate and opposition, Congress established the second Bank of the United States (the Second Bank), which, like its predecessor, had a 20-year charter. Opening in 1816, the Second Bank closed in 1836, when Congress failed to override President Andrew Jackson's veto of the reauthorization of the Second Bank.

Like the First Bank, the Second Bank was the victim of a distrust of centralized power. More important, both banks became entangled in politics and failed to find the balance and independence necessary to serve our vast and diverse country.*

Second BankIt was almost 80 years before the nation was ready to try again.

By 1913, many Americans accepted the fact that the nation needed a central bank as a means of stabilizing the currency and the financial system. The country had been rocked with financial panics on a regular basis since the Civil War. The Panic of 1907 led Congress to establish a commission to consider ways to mitigate such financial crises.

There were two competing views. The bankers, mainly from New York, and some politicians in Washington favored a strong central bank with the power to issue currency and support the efficient functioning of the payment system. This institution was to be governed by the bankers themselves. The Wall Street crowd at the time thought that this institution should be located in New York.

However, many Americans were suspicious of having such a strong central entity. In addition, many citizens did not want to vest a lot of power in an institution controlled so heavily by the "special interests" in New York — at the time referred to as the "money trusts" — or in politically charged Washington. Moreover, the country was geographically diverse, and the economic needs of its different parts varied.

When President Woodrow Wilson signed the Federal Reserve Act into law in 1913, it included an ingenious compromise — a decentralized central banking system. This unique structure helped overcome political and public opposition that stemmed from fears that this new central bank would be dominated either by political interests in Washington or by financial interests in New York.

Over the years, the conduct of monetary policy has changed, and most of the authority for setting policy is now vested in the Federal Open Market Committee (FOMC), which is made up of the seven members of the Board of Governors and the presidents of the 12 Reserve Banks. This change was detailed in the Banking Act of 1935, which amended the Federal Reserve Act and created the FOMC as we know it today.

Nearly a century ago, there were valid reasons for creating an independent and decentralized central bank, with a network of regional Reserve Banks, rather than one based solely in the nation's political or financial capital. Those reasons remain valid today.

  • * For more information, see History of Central Banking, Federal Reserve Bank of Philadelphia, 2009, and The First Bank of the United States: A Chapter in the History of Central Banking, Federal Reserve Bank of Philadelphia, 2009.

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