The American economy is a complex balance of services, financial, manufacturing, agricultural, and banking industries. For this reason, the U.S. is a global economy, relying upon foreign investments and trade to create and retain wealth. Over the years, America has evolved from farming-based, to industrial, to a services-based economy. As a result, the banking system from its inception has weathered the many growing pains associated with a new government and currency, instituting regulations and a centralized bank to examine the economy, and implement policies intended to offset factors negatively affecting the general financial health of the country.
Now, as the United States moves towards a globally interdependent marketplace, the stakes are much higher than they were when Congress established the Federal Reserve in the early 1900’s. A country’s debt can now become the world’s debt, and the role of the U.S. federal banking system is now considerably more under pressure and scrutiny than ever before. As we have been seeing with the current liquidity crisis in the U.S., and how it has affected U.K. and Asian markets, strong, comprehensive policy-making is now crucial to sustaining long-term economic viability.
Even despite the growing need for quick, precise actions by the Federal Reserve System, the decision-making regarding the economy often meets with controversy. The recent bail out plan, passed by Congress in October, met with skepticism and is still being questioned as to its effectiveness. As we have seen in the news, the Federal Reserve has taken a strong stance and defends its rationale for its response to the growing crisis.
For these reasons, the Federal Reserve System, while an American institution, is indirectly a global policy-maker, and therefore, its influence is both far-reaching and necessary. This paper will examine the Federal Reserve Banking System in the United States; how the current liquidity crisis we now face is tied into the global economy, begun by easing regulations, and worsened by inadequate risk controls; and how the response of the Federal Reserve will ultimately determine the outcome.
History and Background to the Federal Reserve Banking System and Monetary Policy
Throughout American history, the banking system endured many financial crises, with almost every scenario ending in bank failures and causing deep recession. It became clear that with the capitalist system, the proclivity towards a series of peaks and troughs, the “business cycle,” existed. From the onset of the American government, however, a centralized bank system was opposed. As the Federal Reserve website recounts, as early as 1791, the First Bank of the United States was established by Congress, but did not succeed due to the apprehension of a singular bank entity (www.federalreserveeducation.org). However, in the ensuing years, high inflation and depressions became prevalent—most notably, the Depression of 1893 began due to a banking panic, followed by market speculation in 1907, that also resulted in a banking panic (www.federalreserveeducation.org). In response to the need for bank regulation, in 1913 the Federal Reserve System was instituted, “to promote an…safer banking system” (Mishkin 285). As Frederic Mishkin further explains, a central bank would control the money supply and credit (284). The rationale was that a centralized bank implementing the monetary policy Mishkin referred to above, would help to minimize the impact of a potential downward trend and curb the effects of speculation. According to the Federal Reserve website, there are twelve Federal Banks spread throughout major U.S. cities, with a Board of Governors, consisting of seven members, presiding over the system (www.federalreserve.gov/pubs/frseries/frseri). Further, the Federal Open Market Committee, comprised of the Board of Governors plus five additional members, is the group responsible for...