An independent central bank in a democratic country: the Federal Reserve experience

Federal Reserve Bank of New York - Quarterly Review, Spring, 1994 by William J. McDonough

I am honored this evening to address this distinguished group of central bankers, economists, representatives of international institutions, and others interested in the process of reform in Eastern Europe and the Newly independent States. In sponsoring this conference on the role of central banks in the region, the University of Chicago Law School, and especially Professors Kenneth Dam and Geoffrey Miller, deserve our deepest thanks.

One very timely issue confronting policymakers in Eastern Europe and the Newly independent States is the proper scope for central bank independence. As the organizers of this conference have rightly noted, central banks that are both powerful and autonomous, yet at the same time responsive to the needs and wishes of their people, are fundamental to the economic development and political stability of all countries.

Integral to economic development and political stability is a commitment to the liberty, dignity, and independence of people. These are ideals all our countries share today. But liberty and independence, while precious, assume different form as they take root in countries throughout the world. How much liberty and independence do we give to our people? How much is responsibility for governing our people to be centralized? How much is sovereignty to be divided? In the United States, these are questions that our ancestors sought to answer and that we continue to air and debate in public.

This evening, I would like to share with you some of my views as to how these issues took hold in the United States in the development of the Federal Reserve System and why I believe central bank independence is so very important in a democracy. Independence has, perhaps, a special meaning in the context of the United States' experience with central banking. We as a nation were born primarily of individuals who set an independent course for themselves by leaving their own countries to seek a better life in the New World. Our country owes its growth, its prosperity, and its prominence to these individuals. How to preserve the individual liberty they sought and won has become an enduring theme in the history of the United States.

This history reflects the dynamic tension set forth in our Constitution of checks and balances to ensure that the powers of government do not alienate the rights of people. The responsibilities of government versus the rights of individuals, the centralization of power in the federal government versus its dispersal to the states, the mistrust of government versus faith in individuals are notions that are as alive in the Federal Reserve System today as they were when our republic was being shaped more than two centuries ago.

Compared with a number of other countries' experience with central banking, which goes back centuries, the Federal Reserve, at some eighty-years-old, is a relative youth. Not widely known is that there were two earlier central banks in the United States prior to the creation of the Federal Reserve System in 1913. The first was chartered in 1791, the second in 1816. Each bank remained in operation for twenty years. A look at this bit of history is useful to understanding our central banking system today.

The First Bank of the United States emerged in the aftermath of the revolutionary war. The Continental Congress, lacking the power to tax and needing means to finance an army, was dependent on the individual states to meet its requests for funds as well as on the largesse of Great Britain's enemies at the time. France was particularly important to the United States in this period. A remark by Alexander Hamilton in 1780 about Benjamin Franklin, then our minister in Paris, tells it all. "Franklin," Hamilton is supposed to have said, "having drawn lightning from the clouds, was expected to draw money from the coffers of the King of France with the same ease and whenever it was required."

Ten years later, as Secretary of the Treasury, Hamilton was able to persuade President Washington and Congress to charter such an institution. The advantages of a national bank were clear, Hamilton argued. First, it would augment the active or productive capital of a country; ... as it is a well-established fact, that banks in good credit, can circulate a far greater sum than the actual quantum of their capital in gold and silver." Second, a national bank would allow the central government "greater facility ... in obtaining pecuniary aids, especially in sudden emergencies." And third, it would facilitate the payment of taxes.

The charter for the First Bank of the United States was signed in February 1791. The first central bank was, as the Federal Reserve System is today, a mix of public and private interests. While serving as the government's bank, the First Bank, unlike the Federal Reserve, was also allowed to conduct commercial business. It was capitalized at $10 million, of which one-fifth was subscribed by the government and the balance by private shareholders. Its demand notes were made receivable in all payments to the government, although at the time the only media of exchange the Constitution considered legal tender were gold and silver or specie. The First Bank was managed by twenty-five directors chosen by the shareholders, who also selected one director as president. When its charter lapsed in 1811, it was not renewed.