Sunday,
January 28,
2001

Global money mechanisms - part I

By Henry Lamb

If, indeed, it is money that makes the world go 'round, it is the least understood component in an extremely complex engine. Actually, money is only the fuel that makes the engine run. Few people understand either the fuel or the engine. At best, this article will cast only a sliver of light on the mechanisms through which the world's money flows.

It is important to begin to understand these strange and mysterious mechanisms, because increasingly, the control of the machinery is moving away from national governments, beyond the reach of individual citizens, and into the hands of a very few, very powerful people.

The world's money flow is controlled, essentially, by these institutions:

A thorough understanding of all these institutions is well beyond the scope of this article. It is important, however, as a first step toward understanding, to know something about the purpose, structure, and function of each. This is the first of a series of articles whose aim is to shed light on the creation, structure, and function of these institutions.

The U.S. Federal Reserve System:

The Federal Reserve System was born on December 23, 1913; it was conceived, however, in November, 1910. The three-year gestation period was fraught with political intrigue of the first order. Although Virginia's Democratic Representative Carter Glass, is recognized as the author of the Federal Reserve Act, which ultimately prevailed over the "Aldrich Plan," advanced by Republican Senator Nelson Aldrich, the central banking scheme contained in both plans was the product of Paul Warburg, whose family, along with the Rothschilds, controlled the Reichsbank in Germany.

Although Paul Warburg was only 34 when he arrived in America in 1902, he was able to craft the banking system desired by the bankers, maneuver the plan through Congress, and get President Wilson to sign it, even though Wilson, as a candidate, had vowed not to "accept any plan which concentrates control in the hands of banks." Warburg's incredible accomplishment had nothing to do with the virtue of the plan. It had everything to do with money, big money provided by big bankers. The political strategy and tactics are worth noting.

In 1908, President Theodore Roosevelt named Senator Nelson Aldrich (whose daughter married into the J.P. Morgan family) to head a new National Monetary Commission to recommend a permanent solution to the devastating bank panics that occurred in 1907. After spending nearly $300,000 touring Europe for two years, Aldrich, a Republican, took the Assistant Secretary of the Treasury, and four New York bankers to Jekyll Island for a so-called hunting excursion. Paul Warburg was in the party, and dominated the discussions which led to what was to become known as the Aldrich Plan.

Warburg arranged for a $5 million slush fund from his banker friends to create the "National Citizens League." Three university professors were selected to tour the country to "educate the country and break down prejudices." Things were going great until the Republicans lost control of the House in 1910. Carter Glass took control of the House Banking Committee, bitterly attacking the Aldrich Plan. Glass advanced his own Federal Reserve Act. No one bothered to tell the American people that the two measures were almost identical. The battle was between the Republicans, who were seen to favor the New York banking establishment, and the Democrats, who were seen to favor farmers and southerners. Both plans contained the essential ingredients of a central bank: the authority to issue notes, control the discount rate, and set the fractional reserve rate. The differences in the plans were around the edges.

Fearing that the Aldrich Plan had become tarnished by Democratic rhetoric, Paul Warburg jumped ship. The Presidential elections of 1912 looked like a shoo-in for Taft's second term, until Warburg decided to support Woodrow Wilson, an obscure Governor from New Jersey. Suddenly, former President Theodore Roosevelt announced he was running for President on the "Bull Moose" ticket. Roosevelt, a popular two-term Republican President, split the Republican vote and ushered Wilson into the White House. To be safe, Felix (Paul's brother) Warburg supported Taft, Paul Warburg supported Wilson, and another banker, Otto Kahn, supported Roosevelt. The bankers won. Paul Warburg was named to the first Federal Reserve Board by Woodrow Wilson.

The Federal Reserve Act created the Federal Reserve Board, consisting of seven members to be appointed by the President and confirmed by the U.S. Senate. Not more than one member could be appointed from each of the 12 Federal Reserve Districts and the appointees must represent a broad spectrum of business interests. The President also specified which appointees would serve as chairman and vice chairman for four-year terms. Members were originally appointed to 10-year terms, which were later extended to 14 year, staggered terms. It was thought such long terms would minimize political influence over the board.

A three-member committee of the original board selected the 12 Districts, named the cities, and set the date for operations to begin on November 2, 1914. The Federal Reserve System has been modified over the years, but still functions pretty much as it was originally designed.

The 12 Federal Reserve Banks are owned by their member banks within the District.

Originally, each District bank had to secure capitalization in the amount of $4 million from its member banks.

The board of directors of each Federal Reserve Bank consists of nine members, three of whom are appointed by the Federal Reserve Board (now called the Federal Reserve Board of Governors), and who have no affiliation with banking. The remaining six directors are elected by the member banks, half of whom cannot be bankers while half must be bankers.

What the Federal Reserve does

Among its primary functions is the implementation of monetary policy through what is called "open market operations," changing reserve rates, and setting the discount rate - the rate at which the Federal Reserve lends money to its member banks.

The open market operation is a method of influencing the availability of cash in the banking system. It was discovered almost by accident in the early 1920s when the Federal Reserve was not making enough income to cover its expenses. The Fed began buying government securities with its reserves, as a way to increase its income. It discovered the cash it used to purchase the securities was deposited in commercial banks, thereby increasing the cash available for loans made by the commercial banks. Conversely, when the Fed sold its government securities, it tended to reduce the cash available in commercial banks. This method of influencing the supply of money became so popular with the Fed, that in 1935 Congress created the Federal Open Market Committee within the Federal Reserve System (FOMC).

This group consists of the seven members of the Board of Governors (Federal Reserve Board), and five presidents of district banks, chosen by the board to serve one year terms. The President of the New York Federal Reserve is a permanent member. This group makes the key decisions on the supply of money available through "open market" purchases and sales of assets.

By also controlling the reserve rate, the Fed has an iron-clad hand on the availability of money in the system. The reserve rate is the percentage of deposits that financial institutions are required to keep on hand. By reducing the reserve rate, more money is available for loans; by increasing the rate, less money is available.

The discount rate is used to control commercial interest rates. It is the rate of interest paid to the Federal Reserve Bank by its member borrowers. When the Fed raises the discount rate, all interest rates must rise accordingly, making money more costly to borrow. By raising and lowering the cost of borrowing, the Fed strongly influences all economic activity that relies on borrowed money.

This function was one of the primary objectives of the Federal Reserve System when it was created. Before the Federal Reserve Act, banks loaned as much of their depositors' money as they chose, to individuals and businesses, and charged whatever interest they could get. Banks never had enough money on hand to satisfy their depositors, should all depositors want their money at the same time. The slightest hint that a bank didn't have sufficient funds to cover depositor demands, often resulted in a "run on the bank," which caused thousands of banks to crash. The Federal Reserve System was envisioned as a "bank of last resort," to supply short term loans to banks to meet depositor demands.

Despite the new Federal Reserve System, nearly 10,000 banks failed between 1930 and 1933.

The Federal Reserve is also the mechanism through which the U.S. Treasury Department gets new currency into the system. The U.S. Treasury engraves and prints bills and mints coins which are distributed through the Federal Reserve banks. About $500 billion is now in circulation, most of which is outside the United States.

To get currency from the U.S. Treasury, each Federal Reserve bank is required to pledge collateral at least equal to the amount of currency it issues. Collateral is most often in the form of U.S. government securities, gold certificates, special drawing rights (to be discussed in subsequent articles), and other "eligible paper" such as bills of exchange or promissory notes. In addition, the Federal Reserve pays about four-cents per bill for the cost of production.

Aside from these basic functions, the Federal Reserve System is also responsible for supervising the operations of banks within each district, and assuring compliance with equal opportunity lending, and other relevant legislation.

Since its creation, the Federal Reserve System has been the object of great criticism. Many contend that it is unconstitutional in that it takes away from Congress the power to "coin money and regulate the value thereof." Others claim that the depression of the 20s and 30s was the direct result of the Fed's manipulation of loans in order to foreclose on property held as collateral by the banks. Still others contend that the Fed is actually owned by a handful of wealthy bankers and big corporations whose purpose is to gather unspeakable wealth unto themselves.

The purpose of this report is neither to justify, nor condemn the Federal Reserve System. It is, instead, an effort to shed light on what is to many people, a vast, unknown black hole. It is apparent, that whether we like it or not, the Federal Reserve System is the engine through which money is converted to economic energy in America. The more we know about it, the better we should be prepared to protect ourselves, or to benefit from it. As this series of articles unfolds, we will see that the Fed is a vital part, but only one part, of a world-wide system through which the global economy flows.

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