FX International Payments
By Frances Coppola
To provide context for these questions, it’s important to understand what the U.S. Federal Reserve System is: where it came from, how it works and – perhaps most importantly – its mandate. And that requires going beyond discussion of 2017 exchange rates and international trade to a brief, but fascinating, history of central banking in our early post-independence years.
The Fed is a relative newcomer among central banks. Most European countries have had central banks managing their economies and their exchange rates (directly or indirectly) for centuries. But the Fed is only just over 100 years old, founded in December 1913 when President Woodrow Wilson signed the Federal Reserve Act into law.1
However, it was not the U.S.’s first central bank. In the aftermath of the War of Independence, the young country desperately needed to stabilize its finances and create a viable union with a single currency. The first “Bank of the United States” was set up in 1792 with a 20-year charter. It was modelled on the Bank of England, which Alexander Hamilton – the principal architect of the U.S. bank – admired for its support of Britain’s growing empire. In addition to issuing currency notes and coins, the new bank managed the U.S. government’s finances and acted as deposit-taker and lender for private citizens.2
The first Bank of the United States was fiercely opposed, not least by Thomas Jefferson and Andrew Jackson, who thought it would give the banking industry too much power. They preferred a system of state banks to support America’s largely agrarian economy. When the Bank’s charter came up for renewal, its principal advocate, Alexander Hamilton, was no longer around to speak for it, having been killed in a duel in 1804. The first Bank of the United States’ charter expired in 1812 and was not renewed.3
At the same time, during the early 1800s, currency exchange rates were changing. Early in the century, both the U.S. and U.K., for example, were on the gold standard, and currency exchange was generally done in “specie” – gold coins or bullion used interchangeably as both were valued by their weight in gold. But as economics professor Lawrence Officer of the University of Illinois at Chicago explains in his book, Between the Dollar-Sterling Gold Points, “Sometime between the colonial period and the 1830s, probably around the turn of the century, merchants became more inclined to use bills of exchange rather than specie to make their payments abroad and by the 1830s had developed "a distinct preference for payment of their foreign obligations by means of bills" rather than by coin.”4 In an email interview, Officer likened bills of exchange to paper checks.
Exchange rates were determined based on the ratio of gold content between the two currencies. At the time, gold sovereigns (pounds) contained 113.0016 grains of gold and the U.S. gold dollar contained 23.2200; the exchange rate was 113.0016 divided by 23.2200, or $4.8665 dollar per pound. That exchange rate (£1 = $4.8665) was known as the “mint parity” exchange rate between the pound and the dollar.5 Actual observed exchange rates were typically slightly lower owing to the cost of shipping the gold (and, later, transporting the bill of exchange) across the Atlantic and the time lag between paying dollars for pounds and then receiving those pounds when presenting the bill, according to Measuring Worth, an educational website of which Officer is a primary author.6 Actual exchange rates varied between $4.14 and $4.63 from 1791 to 1810, based on the average of documented transactions for each year, according to Measuring Worth.
Meanwhile, the demise of the first Bank of the United States coincided with another expensive war against Britain. By 1814, the U.S. government was in financial trouble and the economy in a slump: the USD-GBP exchange rate rose to $4.90 in 1815 and $5.22 in 1816.7 Several financiers and politicians proposed a second Bank of the United States to stabilize the currency and help the government manage its debt. After two years of argument, a skeptical President Madison reluctantly agreed. The Bank opened for business in Philadelphia in January 1817.8
The new bank had wider powers and a more extensive reach than the first. Its early years saw a financial crisis and a depression, but from 1823 onwards the bank presided over a period of expansion and prosperity.9 Measuring Worth shows that USD-GBP exchange rates ranged between $4.50 and $4.98 from 1818 to 1836.
However, Jackson was as opposed to the second Bank of the United States as he had been to the first. When he was elected President for a second term in 1832, he set about dismantling it. He ordered that federal deposits should be placed in state banks instead of the Bank of the United States. The removal of federal deposits significantly reduced the bank’s size, limiting its ability to influence the U.S. dollar’s value and the availability of credit; the institution became increasingly anachronistic. In April 1834, the House of Representatives voted not to re-charter the bank. For the next 75 years, the U.S. had no central bank.10
The lack of a central bank which could stabilize the U.S. dollar and manage commercial banks made America prone to financial crises, or “panics” as they were then known. There were major panics in 1837, 1857, 1873 and 1893, and minor panics in many intervening years.11 Each major panic caused an economic recession; the 1893 panic caused a depression nearly as severe as that of the 1930s.12 While Measuring Worth’s data indicates dollar exchange rates were devalued during each of these times, the worst devaluation by far occurred in the 1860s, when the Lincoln Administration funded the Union cause in the Civil War by issuing “greenbacks,” which were dollar bills not backed by specie.13 For seven of the 10 years the USD-GBP exchange rate was above $6, and it soared to $9.97 in 1864.
By the end of the 19th century, there was growing unrest at the inability of the U.S. government to control either the currency or the availability of credit. The U.S. was a member of the international gold standard, but lacking a central bank that could intervene in the gold market as European central banks did, U.S. money supply rose and fell with the international gold price. When gold was scarce, so was the dollar, both internationally and nationally. The depression of the early 1890s caused small business failures and high unemployment.14 In 1896, William Jennings Bryan gave a fiery speech in which he demanded that the U.S. government take back control of its money supply by unilaterally adopting a silver standard.15
The panic of 1907 was the last straw. The failure of the Knickerbocker Trust triggered widespread runs on banks and trusts. But there was no central bank to provide liquidity to distressed finance houses. The financier J.P. Morgan arranged emergency loans to keep markets functioning, and eventually the big banks that made up the New York Clearing House agreed to provide funding similar to that a central bank would have provided.16 Despite their efforts, though, the Panic disrupted international business and trade, causing a widespread economic slump.17
In 1908, Congress set up the National Monetary Commission to provide a systematic analysis of currency and banking reform, with a view to preventing further panics. The Commission recommended the foundation of a new central bank that would have functions felt equally by “wage earners, farmers, manufacturers, and all others engaged in productive industry.”18
Mindful of the experiences of the past, those who designed the new central bank did not try to replicate the “Bank of the United States.” The 1913 Federal Reserve Act provided for the establishment of 12 Federal Reserve Cities, each with its own Federal Reserve Bank and each overseeing a Federal Reserve District that may or may not align to a state boundary.19 These are in turn overseen by a Federal Reserve Board of seven Governors appointed by the President.20 The 12 Federal Reserve Banks and their Board collectively make up the Federal Reserve System, colloquially known as “the Fed.”
The Federal Reserve Banks have distinctive roles and competences. For example, the St. Louis Federal Reserve Bank maintains the Fed’s statistical database, known as FRED, and the New York Federal Reserve Bank runs the Fed’s Real Time Gross Settlement (RTGS) system, Fedwire.
The Federal Reserve Act gives the Fed a specific mandate to “maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”21 This is known as the “dual mandate,” because it assigns equal importance to employment and price stability.22 For this reason, jobs reports are as important to the Fed’s monetary policy decision makers as inflation reports.
The Federal Open Market Committee (FOMC) is responsible for making monetary policy decisions affecting interest rates and the dollar’s exchange rate. The FOMC is made up of the seven Federal Reserve Governors, plus five of the Reserve Bank heads.23 Because of its unique position at the heart of the U.S. financial system, the New York Federal Reserve Bank has a permanent vote on the FOMC: the remaining four positions are elected by the other 11 banks.24 The New York Federal Reserve Bank is responsible for executing “open market operations” (buying and selling of securities and currencies) to implement FOMC decisions regarding interest rates and manage exchange rates.25
Since the Fed’s founding, USD-GBP exchange rates touched above $5 only once: in in the depths of the Great Depression it hit $5.04 in 1934. Following World War II, the exchange rate dipped permanently below $4 in 1949; permanently below $3 the following year; and below $2 in 1982 (except for a brief period in 2007);26 and traded at about $1.30 as of this writing in mid-July 2017. Despite the increasing value and relative stability of the dollar, the Fed hasn’t explicitly managed exchange rates since switching to inflation targeting in 1992.
Establishing the Fed ended frequent financial panics in the U.S. and helped stabilize the dollar’s exchange rate. Since the Fed’s creation, there have been only two major financial crises, in 1929-33 and 2007-8, though they have been much larger and longer-lasting than 19th century panics. There also has been unprecedented expansion of the U.S. economy, supported by active Fed monetary policy. As businesses have developed the confidence to use the U.S. dollar in international trade, the U.S. dollar has become the world’s premier reserve and settlement currency.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “The Fed – FAQs,” Federal Reserve; https://www.federalreserve.gov/faqs/about_12594.htm
2. “The First Bank of the United States: A Chapter in the History of Central Banking,” Federal Reserve Bank of Philadelphia; https://www.philadelphiafed.org/-/media/publications/economic-education/first-bank.pdf
4. Between the Dollar-Sterling Gold Points, (page 108), Lawrence Officer, Cambridge University Press; http://www.cambridge.org/catalogue/catalogue.asp?isbn=0521038219
5. “What is the Mint Parity Theory of Rate of Exchange?,” PreserveArticles.com; http://www.preservearticles.com/2012012721720/what-is-mint-parity-theory-of-rate-of-exchange.html
6. Dollar-Pound Exchange Rate from 1791,” Measuring Worth; https://www.measuringworth.com/datasets/exchangepound/result.php
8. “The Second Bank of the United States: A Chapter in the History of Central Banking,” Federal Reserve Bank of Philadelphia; https://www.philadelphiafed.org/-/media/publications/economic-education/second-bank.pdf
11. “Banking Panics of the Gilded Age,” Federal Reserve History; https://www.federalreservehistory.org/essays/banking_panics_of_the_gilded_age
12. “Financial Panics of the 19th Century,” ThoughtCo; https://www.thoughtco.com/financial-panics-of-the-19th-century-1774020
13. “The Greenback Question,” United States History; http://www.u-s-history.com/pages/h171.html
14. “Before the Fed,” Federal Reserve History; https://www.federalreservehistory.org/essays/before_the_fed
15. “Cross of Gold speech,” William Jennings Bryan; http://historymatters.gmu.edu/d/5354/
16. The Panic of 1907, Federal Reserve History; https://www.federalreservehistory.org/essays/panic_of_1907
17. “Economic effects of runs on early “shadow banks”: Trust Companies and the impact of the panic of 1907,” Frydman, Hilt & Zhou; http://www.nber.org/papers/w18264.pdf
18. “Report of the National Monetary Commission,” Federal Reserve History; 19. https://www.federalreservehistory.org/-/media/files/national_monetary_commission_report_1912.pdf?la=en
19. “Federal Reserve Act, Section 2: Federal Reserve Districts,” Federal Reserve; https://www.federalreserve.gov/aboutthefed/section2.htm
20. “Federal Reserve Act, Section 10: Board of Governors of the Federal Reserve System,” Federal Reserve; https://www.federalreserve.gov/aboutthefed/section10.htm
21. “Federal Reserve Act, Section 2A: Monetary Policy Objectives,” Federal Reserve; https://www.federalreserve.gov/aboutthefed/section2a.htm
22. “The Federal Reserve’s Dual Mandate,” Federal Reserve Bank of Chicago; https://www.chicagofed.org/research/dual-mandate/dual-mandate
23. “Federal Reserve Act, Section 12A: Federal Open Market Committee,” Federal Reserve; https://www.federalreserve.gov/aboutthefed/section12a.htm
25. “What We Do,”Federal Reserve Bank of New York; https://www.newyorkfed.org/aboutthefed/whatwedo.html
26. “Dollar-Pound Exchange Rate from 1791,” Measuring Worth; https://www.measuringworth.com/datasets/exchangepound/result.php