Panics and the Fed

1. Panics and the Fed A crowd gathers on Wall Street during the bank panic in October 1907.

2. Overview • Banking basics • More than you want to know about the Panic of 1907 • The Federal Reserve Act of 1913 • How the Fed works

3. 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

4. Measuring Money- 2010

5. 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

6. 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.

7. 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

8. The Money Multiplier

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

14. 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).

15. 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.

16. 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.

17. Second Bank of the United States • Andrew Jackson was elected to the presidency in 1828. • In his view, the Second Bank was an: • Anti-democratic institution • Anti-frontier institution • Anti-state’s rights institution • He also denounced the Second Bank as unconstitutional. • After his reelection in 1832, Jackson removed federal deposits from the Second Bank. • It closed in 1836.

18. 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.”

19. 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.

20. 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.

21. U.S. Financial System • The result would be a full-blown panic among the banks trying to raise cash. • The banking system would collapse like a house of cards.

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

27. 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

28. 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.

29. 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.

30. 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.”

31. 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 Trust-Company. • Morgan and his associates also devised a plan to save the brokerage firm of Moore & Schley from failure.

32. 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 fractional-reserve banking system. • It prompted widespread calls for reform.

33. The Panic of 1907

34. 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

35. The Federal Reserve System

36. Fed Goals • Safe, flexible and stable financial and monetary system. • Dual Mandate: • Stable Prices • Maximum Employment

37. Structure of the Federal Reserve

38. 12 Federal Reserve Banks 1 Boston 2 New York 3 Philadelphia 1 9 4 Cleveland 2 5 Richmond 3 7 12 4 6 Atlanta 10 8 7 Chicago 5 8 St. Louis 6 11 11 9 Minneapolis 10 Kansas City 11 Dallas 12 San Francisco

39. 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 non-renewable 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.

40. 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

41. 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

42. 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.

43. 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.

44. 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.

45. Fed Independence • Normally considered quite independent: • Serve long terms • Financially independent from Congress • Challenged today

46. Questions

47. http://www.youtube.com/watch?v=PTUY16CkS-k&feature=player_embeddedhttp://www.youtube.com/watch?v=PTUY16CkS-k&feature=player_embedded