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Social Education 70(2), pg 62–68 ©2006 National Council for the Social Studies The Fed’s Year of Transition

Mark C. Schug Scott Niederjohn

Many Americans regard the chair- He served for more than 18 years. He time, there were serious concerns about man of the System as was originally appointed to the office how well a job Greenspan would do holding one of the nation’s most powerful as chairman on August 11, 1987 by following Volcker’s success in fighting jobs, second only to the president’s. The President Reagan. Greenspan was . Today, it is Greenspan many influence of the Fed chairman stretches reappointed to the board to serve a consider the difficult act to follow. He beyond the borders of the full 14-year term that began February has earned widespread confidence for and effects and market 1, 1992; he was appointed chairman by his ability to handle monetary policy. conditions of nations throughout the Presidents Reagan, Bush, Clinton, and He faced several challenges while in world. Yet, to many Americans—peo- Bush, and served the second-longest office: ple not known for their high levels of term in the history of the Fed. (Only economic literacy—the workings of the William McChesney served longer.) • Ten weeks into his term, the stock Federal Reserve System and the duties Table 1 shows a list of past chairmen. market crashed—the Dow Jones of the chairman are a mystery.1 The pur- Greenspan succeeded Paul A. Average dropped 508 points on pose of this article is to: Volcker as Fed chairman in 1987. At the October 19, 1987. Having learned

• Examine the historical develop- ment of the Federal Reserve Table 1. Past Chairmen of the Board of Governors2 System; Chairmen Date of term Charles S. Hamlin Aug. 10, 1914-Aug. 9, 1916 • Provide background on Ben William P.G. Harding Aug. 10, 1916-Aug. 9, 1922 Bernanke, the new Fed chairman; Daniel R. Crissinger May 1, 1923-Sept. 15, 1927 • Explain the basic tools of mon- Roy A. Young Oct. 4, 1927-Aug. 31, 1930 etary policy used by the Fed; Sept. 16, 1930-May 10, 1933 Eugene R. Black May 19, 1933-Aug. 15, 1934 • Examine the causes of the Great Marriner S. Eccles* Nov. 15, 1934-Jan. 31, 1948 Depression, a topic of special interest to Bernanke; and, Thomas B. McCabe April 15, 1948-March 31, 1951 William McChesney Martin, Jr April 2, 1951-Jan. 31, 1970 • Provide some key resources for Arthur F. Burns Feb. 1, 1970-Jan. 31, 1978 social studies teachers who wish G. William Miller March 8, 1978-Aug. 6, 1979 to teach about the Fed and mon- Paul A. Volcker Aug. 6, 1979-Aug. 11, 1987 etary policy in their classrooms. ** Aug. 11, 1987-Jan. 31, 2006 The Fed’s Year of Transition Ben S. Bernanke Jan. 31, 2006-present Alan Greenspan retired as chairman of * Served as Chairman Pro Tempore from February 3, 1948, to April 15, 1948. the Board of Governors of the Federal ** Served as Chairman Pro Tempore from March 3, 1996, to June 20, 1996. Reserve System on January 31, 2006.

S o c i a l E d u c a t i o n 62 lessons from the actions taken testifies by the Fed in 1929, Greenspan before the Senate Banking took steps to keep liquidity in the Committee on Capitol system to prevent this crash from Hill, Nov. 15, 2005, during spreading beyond the financial a confirmation hearing on markets. his nomination to be the next Federal Reserve Board Chairman. • In the late 1990s, Greenspan faced the financial collapse in Asia. He (AP Photo/Dennis Cook) was able to soften the impact of this crisis on the U.S. economy.

• He presided over the boom in technology stocks during the 1990s and warned that the rapid growth may have been unwar- ranted. On December 5, 1996, he used the term “irrational exuber- ance” to express his concern that the bubble would burst.

• Greenspan may be best remem- bered for monitoring the economy in the 1990s (He presided over the longest economic expan- sion in U.S. history: March embarked on a new and, at the time, confirmed by the Senate. A governor’s 1991–February 2000), and for his controversial direction for managing the term is 14 years. The terms are staggered handling of the economy after the banking system. The structure of the with one term expiring every two years. terrorist attacks on September 11, Fed was uniquely designed to reflect The idea of the terms is twofold. First, 2001. both the national and regional interests the staggered terms provide for continu- of the nation. ity in making policy decisions. Second, Why Social Studies Teachers Should the length of the term is deliberately Care about the Fed Board of Governors intended to insulate the governors The same day that Alan Greenspan National monetary concerns are the from the day-to-day political concerns stepped down, January 31, 2006, Ben S. purview of the Board of Governors regarding monetary policy. The idea is Bernanke was confirmed by the Senate located in Washington, D.C. The Board that the Board of Governors has enough as the new Fed chairman. Bernanke was of Governors guides the Fed’s policy independence to regulate the nation’s sworn in on February 1. Why should actions. The board has regulatory pow- supply without undue political we care about the Fed and who leads ers over certain state-chartered banks pressure. it? Perhaps a little background on the as well as bank holding companies. It Federal Reserve will clarify. The Fed handles the nation’s checkbook and acts Twelve Regional Banks is the nation’s central bank. It is the pri- as the nation’s fiscal agent. It oversees the The regional monetary interests of the mary institution influencing our nation’s activities of the regional banks, approv- nation are reflected by the reserve banks. . The Fed was established ing appointments of their presidents and The Federal Reserve System is divided as a result of some painful monetary three members of the reserve banks’ into 12 districts. Each district is served experiences—a series of financial pan- board of directors. Probably the most by a regional reserve bank and most have ics. In 1893, a financial panic drove the important responsibility of the Board one or more branches. These banks are nation into a deep depression. Again in of Governors is participating on the designed to have some independence 1907, a severe panic forced several banks Federal Open Market Committee. This from the Board of Governors. The into failure. While the 1907 panic did committee directs the nation’s monetary presidents are chosen by each bank’s not trigger a depression, it highlighted policy. board of directors. The board itself is serious flaws in the banking system. The Board of Governors consists of made up of members typically drawn With the passage of the Federal seven members, referred to as governors, from the region’s banking and business Reserve Act in 1913, the United States who are appointed by the president and community.

M a r c h 2 0 0 6 63 The regional banks make impor- Bernanke was a professor of eco- tant contributions to policy discus- As George arrives and nomics at . sions, providing regional banking per- opens the bank’s iron spective to national economic issues. 4. Is Bernanke regarded as a For example, a major restructuring is gates, the bank lobby is scholar? Yes. Bernanke has taking place among U.S. domestic auto- inundated with citizens published many articles on a makers Ford and General Motors. The demanding to withdraw wide variety of economic issues, of Chicago, with all of their funds…Uncle including monetary policy and help from its branch in Detroit, takes ; he is also the special interest in the auto industry. The Billy proclaims, “This is author of several scholarly books Federal Reserve Bank of Chicago is also a pickle, George. This is and two textbooks. He has held located in a major agricultural center. a pickle.” a Guggenheim Fellowship and a This Chicago Fed pays special attention Sloan Fellowship, and he was a to how monetary policy might influence Fellow of the Econometric Society the agricultural markets. and of the American Academy of Arts and Sciences. Bernanke How Is the Chairman Appointed? served as the director of the Ben Bernanke was appointed Fed Monetary Program of chairman through a process similar to the National Bureau of Economic other high level federal appointments. Research (NBER) and as a mem- The (FRA) of ber of the NBER’s Business Cycle 1913 established the Federal Reserve Dating Committee. System. The FRA explains who is eli- gible to serve on the Board of Governors, 5. Does Bernanke have any who may serve as chairman, and it sets background as a leader in k-12 the term limits. The FRA states that to Bernanke was sworn-in on June 21, education? Yes. Bernanke served become chairman a person must be a 2005 as chairman of the president’s two terms as a member of the member of the board. This might sug- Council of Economic Advisers. Montgomery Township Board of gest that only current governors can Education in New Jersey. serve as chairman but, as explained by 2. What position did he hold Andrew Foerster of the Federal Reserve before being appointed as chair- The Business of Banking— Bank of Richmond, a candidate can be man of the president’s Council It’s a Not so Wonderful Life simultaneously appointed governor of Economic Advisers? Prior To understand the importance of the and chairman.3 The president has the to his appointment to the council, role of the Fed and its new chairman, responsibility of nominating governors Bernanke served as a member of it is important to understand the basics to the Federal Reserve. Then the process the Board of Governors of the of the nation’s banking system. Most moves to the Senate where the nomi- Federal Reserve System. He was everyone is familiar with the scene in nee testifies before the Committee on appointed on August 5, 2002, and the movie “It’s A Wonderful Life,” star- Banking, Housing, and Urban Affairs. resigned on June 21, 2005. ring James Stewart, where the worried From there, the nomination moves to the townspeople of Bedford Falls race to floor of the Senate for a vote. The chair- 3. What are Bernanke’s academic the community’s Building and Loan man is appointed to a four-year term. He credentials for the Fed job? bank. The scene begins by showing or she can serve several four-year terms, Nominees for the chairman of the townspeople congregating outside of as did Alan Greenspan. Fed in the past have come from the bank’s gates that were closed by Now, just who is Bernanke? What banking, government, academia, George Bailey’s Uncle Billy in a panic. are his qualifications to hold one of the and from within the Fed. Bernanke As George arrives and opens the bank’s most powerful positions in Washington is an academic. He has an impres- iron gates, the bank lobby is inundated and, for that matter, in the world? Here sive educational background. He with citizens demanding to withdraw all is a short list of “Most Frequently Asked received a bachelor’s in economics of their funds. While Uncle Billy pro- Questions about Ben Bernanke”:4 in 1975 from claims, “This is a pickle, George. This (summa cum laude) and a doctor- is a pickle.” George attempts to explain 1. What was Ben Bernanke’s most ate in economics in 1979 from to the mob that their money is tied up recent appointment before the Massachusetts Institute of in their neighbor’s homes, as an invest- becoming chairman of the Fed? Technology. From 1985 to 2002, ment, and the bank has very little cash

S o c i a l E d u c a t i o n 64 around 10 percent of checking deposits, which banks must hold in reserves to provide liquidity and satisfy requests for withdrawals. You will see in the next section that this required reserve ratio has an affect on the country’s supply of money. Because of the fractional reserve system utilized by banks, it is often said that banks “create money.” While this may conjure up images of a banker run- ning a printing press in the bank base- ment, this is not what we are referring to. To understand how banks “create money,” one must first understand how an defines money. consider money to be anything that is generally accepted as payment for goods and services. Therefore, money clearly includes cash and currency. However, James Stewart, left, Thomas Mitchell, right, and Donna Reed appear in the 1946 movie “It’s a Wonderful Life.” In this scene, Stewart, who plays George Bailey, is trying given this definition, money also to mediate a crisis ignited when anxious townspeople descended on the communi- includes checking accounts—as checks ty’s Building and Loan in a “,” demanding to withdraw their money. (AP Photo) can be written on these accounts and used to pay for items that people pur- chase. left to give out. An episode like this is to acquire the $30,000 needed for a Consider the following scenario. referred to as a “bank run” as customers 20-percent down payment. This leaves Sally Saver goes to First National Bank literally run to their banks to withdraw her requiring $120,000 to purchase the and deposits $1,000 that she received their deposits. home. Without a bank from which to as a gift from her grandparents. She now This famous movie scene depicts acquire these funds, this teacher might has a checking account with $1,000 from the fundamental lesson that banks do start asking members of her family, her which she can write checks. What will not have all of their customers’ depos- friends, and her neighbors and pos- First National Bank do with this newly its on hand. Even a solvent bank does sibly co-workers for loans. While it is deposited money? Well, if there is a 10 not keep enough cash on hand to satisfy possible she might come up with all percent reserve requirement, they will withdrawals from all of its customers. of the money needed to buy the home, put $100 in their vault and lend out the The majority of customer deposits are each of these loans would almost cer- rest to people who want loans. Say Mike not kept in the vault, but instead are tainly be negotiated with their own Inventor walks into First National Bank lent out to be used for productive pur- terms and conditions. The costs of looking to borrow $900 to develop his poses. acquiring money in this manner are next great invention. If the bank decides The role of a bank, often called very high. that his project is worthwhile, they might financial intermediation, is vital to the As an alternative, we have banks give him the $900 he requests. If Mike efficient workings of a market economy. that utilize a fractional reserve system, puts the $900 in his checking account, Banks provide the critical service of meaning that only a fraction of bank he can now write checks for this amount. bringing together folks with extra money deposits are actually kept in the bank There is now $1,900 of money available (the lenders) with those who need to satisfy withdrawals. The rest of the ($1,000 in Sally’s checking account and money (the borrowers). This allows money is lent out to individuals, firms, $900 in Mike’s) to be spent. In other people to buy homes, entrepreneurs municipalities, the federal government words, $900 in new money has been to start new businesses, students to go or others to be used for productive “created.” This process will continue to college or the local school district purposes. The money that banks keep over and over again as the bank lends to build a new state-of-the-art school. on-hand to satisfy withdrawals is called out $810 of Mike’s deposit while putting Consider the prospects of a young reserves, and is either held in the bank’s $90 in reserves and thus “creating” more teacher trying to buy a $150,000 home vault or in an account at the district’s money. Our fractional reserve banking in a world without banks. Perhaps, by Federal Reserve Bank. The Fed man- system leads to this multiplier effect on diligently saving her money, she is able dates a required reserve ratio, typically money.

M a r c h 2 0 0 6 65 Tools of Monetary Policy A 1977 amendment to the Federal Resources Reserve Act gave the Fed responsibility for pursuing a number of goals for the Teacher Resources from the Fed nation’s economy. Essentially, this act The Federal Reserve System provides teachers with many resources for instruc- states that the Fed should promote high tion. These include conferences for teachers, the annual Fed Challenge competi- employment, stable prices, and sustain- tion for high-school students and a variety of print and electronic materials. able economic growth. The Fed cannot The regional Federal Reserve Banks offer many of these services and often guarantee that everyone has a job or that include tours for teachers and high school students. inflation remains under control; this is Your first stop might be to visit Federal Reserve Education or FRED by determined by the decisions of millions clicking www.federalreserveeducation.org. This website has several great features. of firms and households interacting in It introduces teachers to the Fed Challenge, an academic competition that the economy. However, the Fed can help provides high school students (grades 9–12) with an insider’s view of how create an environment where these goals the Fed makes monetary policy. Learn more by going to www.bos.frb.org/educa- are more likely to be achieved. How tion/fedchallenge. does the Fed do this? The answer is through monetary policy—the setting of FRED features resources on personal finance. This includes content on: the nation’s money supply. The Fed does • Consumer banking this primarily through three tools: • Consumer protection • Economics Open Market Operations • Home ownership The most important, and frequently • Interest rates used, tool of monetary policy is open • Loans and credit market operations. Eight times per year, the Federal Open Market Committee FRED also features a section called Fed 101. Here you will find explanations meets to set interest rates. These meet- regarding the history and structure of the Fed as well as information on mon- ings receive significant attention from etary policy, banking supervision, and financial services. Finally, FRED provides many, including the media, with post- a wide range of other resources including: meeting reports typically stating that the Fed “lowered interest rates,” “raised • Publications and videos interest rates,” or “didn’t change interest • Online learning rates.” Open market operations are the • Regional bank websites tool the Fed uses to make these interest • Resources and research rate changes. • Other economic education websites including the National Council While media reports on these Fed on Economic Education. meetings make it sound as if the Fed can simply change interest rates as it desires, The website of the Federal Reserve Bank of is an example of there is a bit more to it in practice. The the type of resources provided by the regional Fed banks. Go to www.frbsf.org. Fed uses open market operations to Click on Educational Resources. Here you will find several resources including control the rate—the inter- a newsletter titled Econ Ed and the Fed. This winter, it offered a lesson on The est rate that banks charge each other to Federal Reserve (the Fed), transparency, the Federal Open Market Committee, borrow overnight in the Federal Funds and monetary policy. Click on Open & Operating to learn about a video describ- Market. While this may sound compli- ing the response of the Fed following September 11. You might also wish to cated, it really isn’t. As we mentioned click on Dr. Econ, which presents answers in response to questions you enter. previously, banks are subject to a reserve There are several other resources here including: requirement mandated by the Fed. In the earlier example, we assumed that • Fed Chairman Game banks were required to keep 10 percent • Great Economists Treasure Hunt of their checking deposits in reserve. • Crossword Puzzle Sometimes banks are either short of their required reserves or have at the end of the day. When this happens, those banks with extra funds can lend them to banks that are short in

S o c i a l E d u c a t i o n 66 have on banks and their costs of doing business.

Discount Policy The final tool of monetary policy that the Fed can wield is called discount policy. Discount policy means chang- ing the discount rate—or the rate mem- ber banks must pay to borrow money from the Fed. By lowering this discount rate, the Fed can encourage borrowing or they can raise the discount rate and discourage borrowing. In either case, the money supply is affected. While the discount rate is typically changed in conjunction with the , discount loans are rare. One reason for this is that the discount rate is kept higher than the federal funds rate—so banks have no incentive to borrow in the discount market. Discount loans Depositors gather outside the closed doors of the American Union Bank in New are most often used to bail out failing York City, Aug. 5, 1931. It is one of the smaller city banks that experienced a depre- banks or to help banks that operate in ciation of its assets and was closed by order of the state superintendent of banks. agricultural markets where the majority (AP Photo) of their lending takes place during one part of the year. the Federal Funds Market—where the cally done when the Fed fears inflation. Ben Bernanke, the Fed, and the borrower pays the federal funds rate. They are hoping to slow spending on The Fed influences this interest goods and services by raising the costs Ben Bernanke is a student of Great rate by buying and selling government of borrowing money. Depression history himself. In his book, bonds. When the Fed wants to lower Essays on the Great Depression, he interest rates, and encourage firms and Reserve Requirements referred to the Great Depression as the individuals to borrow, they buy govern- As we have discussed, the Fed sets a “Holy Grail of macroeconomics.” In the ment bonds from securities dealers. In percentage of checking deposits that preface of this book, he wrote: “I guess return for these bonds, the Fed credits banks must hold in reserves. In April I am a Great Depression buff, the way these dealers’ bank accounts at the Fed. of 1992, the Fed lowered this required some people are Civil War buffs. I don’t This puts more money into the bank- reserve ratio from 12 percent to 10 per- know why there aren’t more Depression ing system and places downward pres- cent. That was the last time this tool of buffs. The Depression was an incred- sure on the federal funds rate (increases monetary policy was used. When the ibly dramatic episode—an era of stock the supply of money). Other interest reserve requirement is lowered, banks market crashes, bread lines, bank runs, rates in the economy then follow (like are required to keep less money in and wild currency speculation, with the interest rates on car loans or homes) reserves, and more money is created in storm clouds of war gathering ominously and borrowing becomes cheaper. This the lending process. In other words, less in the background all the while.”5 is typically done when the Fed is wor- money sits in bank vaults and more is Between 1929 and 1933, the output ried about the economy slipping into in the hands of the public to use to pur- produced in the United States plum- recession. The hope is that lower inter- chase goods and services. Conversely, meted by almost 30 percent. Further, est rates will encourage borrowing and if the reserve requirement were raised, the unemployment rate surged to more keep the economy strong. On the other banks would have to keep more money than 25 percent and more than 9,700 hand, the Fed can raise the federal funds in reserves and less money would be American banks failed. The number rate by selling government bonds. By created in the lending process. Reserve of bank panics during this period was doing so, they take money from banks requirements are infrequently changed unprecedented, and spurred President (lower the supply of money) and conse- by the Fed, primarily because of the Roosevelt to make his famous statement, quently raise interest rates. This is typi- impact that changes in this tool would “The only thing we have to fear is fear

M a r c h 2 0 0 6 67 itself.” The reasons for the onset of the consequences of bank management or did it. We’re very sorry. But thanks to Great Depression, causing unparalleled bad banking practices, or as inevitable you, we won’t do it again.”7 The Fed’s economic misery in the United States reactions to prior speculative excesses, response to more recent financial cri- and around the world, has been widely or as a consequence but hardly a cause sis, like the October 1987 stock market debated. of the financial and crash and the attacks of September 11th, The Fed remained remarkably in process.”6 Further, Friedman and suggest they have learned their lesson passive during the onset of the Great Schwartz note that bank failures were from the Great Depression and won’t Depression. The Fed refused to perform concentrated among smaller banks let such an event happen again. its function as a lender of last resort (one while the Fed was controlled by big city of the major reasons for forming the Fed bankers that “deplored the existence” of Notes in 1913) for failing banks. The Board of the smaller banks. 1. National Council on Economic Education, “What American Teens and Adults Know about Economics” Governors did not fully understand the In addition, the Federal Reserve (Poll prepared by Harris Interactive, New York, negative impact that bank failures would System raised interest rates in 1931, 2005). 2. From the website of the Board of Governors of the have on the money supply and the econ- which discouraged business borrowing Federal Reserve System, federalreserve.gov/bios/ omy in general. and and caused the money supply to shrink boardmembership.htm#chairmen. Anna Jacobson Schwartz discussed this further. With so much less money to go 3. Andrew Foerster, “Choosing the Next Chairman of the Federal Reserve,” Region Focus of the Federal in their influential book, A Monetary around, businesses could not get the Reserve of Richmond (Fall 2005). History of the United States, 1867– loans they needed and were forced to 4. More information on Ben Bernanke is available on 1960, reporting that the Fed, “tended stop investing. the White House website at www.whitehouse.gov/ cea/bbernankebio.html. to regard bank failures as regrettable What does Bernanke make of all 5. Ben S. Bernanke, Essays on the Great Depression this? He fully acknowledges the failings (Princeton, N.J.: Princeton University Press, 2000). Mark C. Schug is professor of curriculum of the Federal Reserve System during the 6. Milton Friedman and Anna Jacobson Schwartz, A and instruction and director of the Center for Great Depression. In fact, at a 2002 con- Monetary History of the United States, 1867–1960 Economic Education at the University of Wis- ference in honor of Milton Friedman’s (Princeton, N.J.: Princeton University Press, consin-Milwaukee. M. Scott Niederjohn 90th birthday, Bernanke, then a Fed 1963). is an assistant professor of economics and direc- 7. Greg Ip, “Long Study of Great Depression Has tor of the Center for Economic Education at governor, told Friedman, “Regarding Shaped Bernanke’s Views,” The Journal Lakeland College in Sheboygan, Wisconsin. the Great Depression. You’re right, we (December 7, 2005).

Teacher-Produced Resources and Lesson Plans on “Contexts and Legacies of the Lewis and Clark Expedition”

The Minot State University History Department presents materials from an NEH-sponsored summer 2005 institute

Themes include: Grades & Formats: Exploration and Environment Lessons for Grades 4-12 Jefferson and Nation-Building WebQuest American West, Past and Present DBQ Native Cultures and Legacies Primary Source Study

For your FREE copy, go to: http://history.misu.nodak.edu

S o c i a l E d u c a t i o n 68