Transcript Slide 1

Panics and the Fed
A crowd gathers on Wall Street during the bank panic in October 1907.
Overview
• Banking basics
• More than you want to
know about the Panic of
1907
• The Federal Reserve Act of
1913
• How the Fed works
Money Basics
• What is Money?
• Anything generally accepted in payment for goods and
services.
– Medium of Exchange
– Store of Value
– Unit of Account
– Fiat system
Measuring Money- 2010
Banking Basics
• Banks are not “money warehouses.”
• Banks “pool” money that might otherwise be idle.
• Then they lend money from the pool to customers who are
likely to repay it.
– Individual customers can buy goods and services with the
money they borrow.
– Business customers can use loans to expand their
operations.
• In this way, the money banks lend produces additional goods
and services.
• Banks can also earn a profit: 3-6-3 rule
The Money Creation Process
• I walk into Bank A and deposit $1,000 cash into my
checking account.
• What does Bank A do?
• They put $100 in reserves and make a $900 loan.
• What does the person that takes out the $900 loan do with
the money?
• Deposit in Bank B. Bank B puts $90 into reserves and
makes an $810 loan.
• $1,000 cash has turned into: $1,000 + $900 + $810 =
$2,710 and it keeps going.
The Money Multiplier
• Money Multiplier = 1/reserve requirement = 1/0.10 = 10
• $1,000 deposit creates $10,000 in “money”
• At least that’s the theory
– No excess reserves
– No cash
The Money Multiplier
First Bank of the United States
• The First Bank of the United
States was approved by
Congress in 1791.
• Alexander Hamilton,
President Washington’s
Secretary of the Treasury
was the architect.
• Hamilton modeled it after
the Bank of England.
• At the time, there were also
state chartered banks.
First Bank of the United States
• The First Bank of the United
States was a quasi-public
institution:
– Private bank = making
loans by issuing notes.
– Public bank = the federal
government provided
20% of the $10 million
that was used to
establish it.
First Bank of the United States
• The First Bank also handled
the federal government’s
finances.
• Much like the Fed today, the
First Bank of the United
States served as the federal
government’s fiscal agent,
holding its deposits and
paying its bills.
• The federal government
borrowed from the First
Bank of the United States.
First Bank of the United States
• The anti-Federalists, feared
that the First Bank would
become a monopoly.
• They challenged its
constitutionality.
• The charter of the First Bank
of the United States was
allowed to expire in 1811.
Second Bank of the United States
• The War of 1812 severely
curtailed international
trade.
• This restricted federal tax
revenues.
• The war also caused the
federal government to take
on more debt, and the
government relied heavily
on state banks to obtain
loans.
• As a result, state banks
expanded their printing of
banknotes, which
contributed to a severe
increase in inflation.
Second Bank of the United States
• Congress chartered the
Second Bank of the United
States in 1816.
• It was substantially larger
than the First Bank, with an
initial capitalization of $35
million (with, again, 20
percent coming from the
federal government and 80
percent coming from
private investors).
Second Bank of the United States
• The Second Bank also acted
as the fiscal agent of the
federal government.
• It had branch banks in every
state.
• It acted as a “banker’s
bank” and occasionally lent
money to state chartered
banks to preserve their
liquidity.
Second Bank of the United States
• Nicholas Biddle was
appointed as the Bank’s
president in 1823.
• Biddle led efforts to control
the nation’s money supply.
• He reduced the amount of
notes issued by the state
chartered banks.
Second Bank of the United States
• He also denounced the
• Andrew Jackson was
Second Bank as
elected to the presidency in
unconstitutional.
1828.
• In his view, the Second Bank • After his reelection in 1832,
Jackson removed federal
was an:
deposits from the Second
– Anti-democratic
Bank.
institution
• It closed in 1836.
– Anti-frontier institution
– Anti-state’s rights
institution
Second Bank of the United States
After the Second Bank of
the United States went out
of business, in 1836, the
U.S. was without any sort of
central bank.
“The bank, Mr. Van Buren, is
trying to kill me, but I will
kill it.”
U.S. Financial System
• New York was the nation’s
financial center.
• Interest rates fluctuated
with the country's annual
agricultural cycle.
– Farmers borrowed
money in the spring and
paid back loans in the
fall.
– Purchasers of
agricultural products
borrowed money in the
fall to purchase harvests.
• Foreign investors placed
funds in New York banks to
take advantage of the
seasonal higher rates.
Fears of Panics
• A financial panic could start with the failure of a single large
industrial firm with money on deposit in a major New York
bank.
– By pulling out its money, one company could endanger the
New York bank’s health.
– To come up with enough reserves in the face of such a
failure, the bank might try to sell their holdings of stocks
and bonds causing the prices of stocks and bonds to fall.
• Then the problem worsened, as banks realized they had to
sell still more stocks and bonds to replenish reserves.
U.S. Financial System
• The result would be a fullblown panic among the
banks trying to raise cash.
• The banking system would
collapse like a house of
cards.
Panic of 1907
• F.A. Heinze, owner of a
Montana copper mine
arrived in New York with
$25 million in cash and
stocks he obtained in an
out-of-court legal
settlement with a rival
mining company.
• He soon made a lot of
friends - - aggressively
purchasing interests in
several New York banks.
Panic of 1907
• Heinze tried to “corner” the
stock of United Copper
Company.
• In less than 24 hours, he
dropped $50 million.
• On October 14, the stock of
United Copper soared to
$62 a share.
• On October 16, it closed at
$15 a share.
• Heinze failed in his attempt
to corner the company’s
shares.
It Gets Worse
• Heinze resigned as
president of Mercantile
National Bank.
• Mercantile National’s
depositors panic and begin
withdraw their money.
• Heinze’s Butte (Montana)
Savings Bank fails.
• The brokerage firm of Otto
Heinze &: Co., which is
owned by the brother of
F.A. Heinze also fails.
And Worse
• On October 18, nine banks
form an emergency pool of
funds to aid Mercantile
National.
• But depositors at
Knickerbocker Trust
Company begin to withdraw
their money.
• Depositors were worried
because Knickerbocker’s
president, Charles T. Barney,
was an associate of (wait for
it)… F.A. Heinze.
J.P. Morgan to the Rescue
• J. Pierpont Morgan had the
capacity to control the
outcome of the situation.
• Even at age 70, he was still
the dominant figure in
American finance.
• He was neither elected nor
appointed to the task.
• He simply decided to take
action.
J.P. Morgan to the Rescue
• He started by designating a
committee of bankers to
audit the books of
Knickerbocker Trust.
• Morgan decided not to bail
out Knickerbocker Trust.
• He blamed it’s problems on
bad management.
• Morgan did decide to help
Trust Company of America
J.P. Morgan to the Rescue
• Treasury Secretary
Cortelyou met with Morgan
in New York.
• Cortelyou announced that
$25 million of U.S.
government funds would be
deposited in New York City’s
banks to meet any further
emergencies that might
arise.
Rockefeller to the Rescue
• John D. Rockefeller, nearly
70 years old, pledged to
deposit $10 million of his
own money in New York’s
financial institutions.
J.P. Morgan to the Rescue
• Under heavy pressure from
J.P. Morgan, New York
bankers contributed to a
$25 million rescue pool for
cash-strapped stockbrokers,
who have been unable to
borrow and were “facing
ruin.”
J.P. Morgan to the Rescue
• In response to New York’s
Mayor, a Morgan-led
syndicate bailed out the City
by agreeing to place $30
million worth of its revenue
bonds with investors.
• Morgan also pressured trust
company presidents into
putting up funds to support
the Trust Company of
America and Lincoln TrustCompany.
• Morgan and his associates
also devised a plan to save
the brokerage firm of
Moore & Schley from
failure.
Calls for Reform
• The Panic of 1907 proved
to be a defining moment in
U. S. financial history.
• It demonstrated the
problems of an
uncoordinated fractionalreserve banking system.
• It prompted widespread
calls for reform.
The Panic of 1907
Why a Federal Reserve System?
• Central Bank of the
United States
• Created in 1913 by
Congress (Federal
Reserve Act)
• Response to nations’
recurring bank panics
34
The Federal Reserve System
35
Fed Goals
• Safe, flexible and stable
financial and monetary
system.
• Dual Mandate:
– Stable Prices
– Maximum Employment
36
Structure of the Federal Reserve
37
12 Federal Reserve Banks
1
2
3
Boston
New York
Philadelphia
4
5
6
7
8
9
Cleveland
Richmond
Atlanta
Chicago
St. Louis
Minneapolis
10 Kansas City
11 Dallas
12 San Francisco
1
9
2
3
7
12
4
10
8
11
11
5
6
38
Board of Governors
• Located in Washington DC.
• Responsible for setting and implementing the
nation’s monetary policy.
• Consists of 7 members appointed by the
president and confirmed by the Senate.
• Each member serves one 14-year nonrenewable term with one member appointed
every two years and one member is appointed
as the chair for a 4-year renewable term.
• Board membership is relatively stable since a
new president can be sure of appointing or
reappointing only two members in a presidential
term.
• Board structure was designed to insulate
monetary authorities from short-term political
pressure by elected officials.
39
Federal Open Market Committee
• Consists of the 7 board governors plus 5
presidents of the Reserve Banks (one is
always NY Fed president and the rest
rotate– next slide)
• Sets monetary policy
• Meets 8 times per year
• Conducts open market operations
– Purchases and sales of U.S.
government securities by the FED
– Most important tool of monetary
policy
– Conducted by NY Fed Bank
40
The Reserve Banks
• Conduct research on their local
economy
• Supervise banks in their region
• Earn revenue through bank services
(clear checks, issue new currency,
withdraw damaged currency)
• Economic education programs for
teachers
41
The Fed’s (Normal)Tools of Monetary Policy
• Open Market Operations –
buy and sell government
bonds to set federal funds
rate.
• Discount Loans – loans from
the Fed to banks.
• Reserve Requirements –
amount of reserves banks
must hold.
42
How do Open Market Operations Work?
• The Fed uses Open Market
Operations to exert control
over the Federal Funds
Rate.
• The Federal Funds Rate is
the interest rate paid in the
Federal Funds Market.
• The Federal Funds Market is
the market for overnight
loans, between banks,
within the Federal Reserve
System.
Lowering the Federal Funds Rate
• Why would they do this?
– Economy is weak and they want to increase business and
consumer borrowing/spending.
• How do they do this?
– Instruct New York Fed Bank to buy treasury bonds from
banks.
– The Fed pays these banks by crediting their reserve
accounts.
– This increase in the supply of reserves (money) lowers the
price of money (Federal Funds Rate).
– Other interest rates in the economy then typically follow.
Fed Independence
• Normally considered quite independent:
– Serve long terms
– Financially independent from Congress
– Challenged today
Questions
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