Free To Choose: a personal Statement

The Anatomy of Crisis
75
emergency printing press, as it were. This was the way embodied
in the Federal Reserve Act. It was supposed to prevent even the
temporary disruptions produced by the restriction of payments.
The twelve regional banks established by the act, operating under
the supervision of a Federal Reserve Board in Washington, were
given the power to serve as "lenders of last resort" to the com-
mercial banks. They could make such loans either in the form
of currency—Federal Reserve Notes, which they had the power
to print—or in the form of deposit credits on their books, which
they had the power to create—the magic of the bookkeeper's pen.
They were to serve as bankers' banks, as the U.S. counterpart of
the Bank of England and other central banks.
Initially, it was expected that the Federal Reserve Banks would
operate mostly by direct loans to banks, on the security of the
banks' own assets, in particular, the promissory notes correspond-
ing to loans by banks to businesses. In many such loans, the
banks "discounted" the notes—that is, paid out less than the face
amount, the discount representing the interest charged by the
banks. The Federal Reserve in turn "rediscounted" the promis-
sory notes, thereby charging the banks interest on the loans.
As time passed, "open market operations"—the purchase or
sale of government bonds—rather than rediscounts became the
main way in which the System added to or subtracted from the
amount of money. When a Federal Reserve Bank buys a govern-
ment bond, it pays for it either with Federal Reserve Notes that
it has in its vaults or that it has freshly printed or, more typically,
by adding on its books to the deposits of a commercial bank.
The commercial bank may itself be the seller of the bond or it
may be the bank in which the seller of the bond keeps his deposit
account. The extra currency and deposits serve as reserves for the
commercial banks, enabling them as a whole to expand their de-
posits by a multiple of the additional reserves, which is why cur-
rency plus deposits at Federal Reserve Banks are designated
"high-powered money" or the "monetary base." When a Federal
Reserve Bank sells a bond, the process is reversed. Reserves of
commercial banks decline and they are led to contract. Until fairly
recently the power of the Federal Reserve Banks to create cur-
rency and deposits was limited by the amount of gold held by the

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76
FREE TO CHOOSE: A Personal Statement
System. That limit has now been removed so that today there is no
effective limit except the discretion of the people in charge of the
System.
After the Federal Reserve System failed in the early
1930s
to
do what it had been set up to do, an effective method of preventing
a panic was finally adopted in
1934.
The Federal Deposit In-
surance Corporation was established to guarantee deposits against
loss up to a maximum. The insurance gives depositors confidence
that their deposits are safe. It thereby prevents the failure or finan-
cial difficulties of an unsound bank from creating runs on other
banks. The people in the crowded theater are confident that it is
really fireproof. Since
1934
there have been bank failures and
some runs on individual banks. There have been no banking panics
of the old style.
Guaranteeing deposits in order to prevent a panic had frequently
been used earlier by the banks themselves in a more partial and
less effective way. Time and again, when an individual bank was
in financial trouble or was threatened by a run because of rumors
of trouble, other banks banded together voluntarily to subscribe
to a fund guaranteeing the deposits of the bank in trouble. That
device prevented many putative panics and cut others short. It
failed on other occasions either because a satisfactory agreement
could not be reached or because confidence was not promptly re-
stored. We shall examine a particularly dramatic and important
case of such a failure later in this chapter.
THE EARLY YEARS OF THE RESERVE SYSTEM
The Federal Reserve System started to operate in late
1914,
a few
months after the outbreak of war in Europe. That war changed
drastically the role and importance of the Federal Reserve System.
When the System was established, Britain was the center of the
financial world. The world was said to be on a gold standard but
it could equally well have been said to be on a sterling standard.
The Federal Reserve System was envisioned primarily as a means
of avoiding banking panics and facilitating commerce; secondarily,
as the government's banker. It was, taken for granted that it would
operate within a world gold standard, reacting to external events
but not shaping them.

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