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F. Ward McCarthy Jr.


The banking industry is regulated by an elaborate
institutional structure that exercises extensive authority over virtually every aspect of banking activity.
The sheer size and complexity of the system is overwhelming and has been a source of confusion in the
administration of the supervision and regulation, of
banks. For this very reason, the Task Group on
Regulation of Financial Services, chaired by Vice
President George Bush, has studied the federal regulatory structure in order to reorganize and improve it.
The agency reorganization proposed by the Task
Group, however, merely rearranges authority under
the existing agency structure and does not reduce the
number of bank regulators.
A first step toward resolution of the reorganization
dilemma is to gain a better understanding of the
origin and development of the institutions that comprise the current regulatory framework. Students of
bank regulation offer two familiar explanations for
government control of banking. Public regulation of
banking is typically rationalized on the idealistic
grounds that it enhances economic stability by fostering honest and sound practices. An alternative view
disputes the existence of the correspondence between
regulation and the public interest and regards public
regulation as a means of protecting the banking industry from competition. While each of these perspectives contributes to our understanding of government regulation of banking, neither provides an adequate explanation of the genesis and development of
the institutional structure of the regulatory frameThe views expressed in this article are those of the
author and do not necessarily reflect the opinions of the
Federal Reserve Bank of Richmond or the Board of
Governors of the Federal Reserve System.

work. In order to understand this evolution, it is
necessary to recognize that government regulation of
the banking industry has enhanced the revenue generating capabilities of government authorities. The
institutional structure of bank regulation has served
as an instrument of public finance.
This article traces the major developments in the
evolution of the bank regulatory structure in this
country in order to gain some insight into the process
that generated the current regulatory framework.
Two major themes are developed: (1) government
intervention in banking was motivated by considerations of-public finance and (2) there has been a pronounced reluctance of government agents to divest
themselves of regulatory authority once they have
gained it.
The article begins with an examination of the
colonial period when government control of banking
was initiated and the principle of government intervention was established. Section II explains the postcolonial development of charter regulation under state
legislative control and notes the attempt to establish
federal regulatory authority through the central bank
functions of the First and Second Banks of the
United States. Section III discusses the erosion of
state legislative control of bank entry and the implementation of free banking over the second quarter of
the century. The reestablishment of dual federal and
state regulatory control under the National Bank Act,
and the extension of federal regulatory authority
through the creation of the Federal Reserve System
are examined in sections IV and V, respectively.
Section VI presents a brief review of the reform
measures of the 1930s that established the Federal
Deposit Insurance Corporation and extended the authority of the Federal Reserve System. Concluding
remarks are offered in section VII.




The prevailing public policy regarding banking
during the colonial period1 was to substitute government control for market competition. Colonial governments promoted government financial interests
and obstructed the development of private banking
organizations. Due to this government intervention,
public enterprises dominated the colonial banking era
and private banks seldom survived.
The precedent for government control of banking
in the colonies was established in 1690 when the
Commonwealth of Massachusetts became the first
American government to circulate an inconvertible
paper currency. The notes were issued in anticipation
of taxes to replenish a treasury that had been depleted
by an unsuccessful military expedition. Over the
next several years the colony accommodated treasury
deficits by expanding note issues, delaying or extending redemption periods and replacing redeemed issues
with more tax anticipation notes. This inflationary
finance contributed to a general depreciation of paper
currencies, a disappearance of precious metals from
circulation, and a decreased public willingness to pay
taxes. Nonetheless, these first issues of paper currency established the pattern for early monetary and
banking developments. By 1712 six other colonies
had followed the example of Massachusetts and were
utilizing public banks as an expeditious method of
public finance.2
Colonial governments guarded the right to circulate paper currency as a privileged monopoly and, in
so doing, impeded private banking institutions.3 If

Banking and other financial functions were provided
on a limited basis in the American colonies. Barter and
book credit were used extensively and many mercantile
needs were met by British merchants. Commercial banks,
which played an important role in the economic development of the United States, did not appear until after independence. In their absence, private merchants and banks
of issue were the primary sources of domestic banking
Colonial banks were not at all commercial in character.
Several histories of colonial banking refer to them simply
as “batches of paper money.” See, for example: Davis R.
Dewey, Financial History of the United States [7], John
Jay Knox, A History of Banking in the United States
[23], Horace White, Money and Banking [55].

New Hampshire, Rhode Island, Connecticut, New York,
New Jersey, and South Carolina were all issuing paper
Pennsylvania, Maryland, Delaware, Virginia
and Georgia fell into line by 1760.

Prior to 1690, all banking projects appear to have been
private. The establishment of the public bank in Massachusetts in 1690 coincided with a temporary end to
attempts to issue notes by private banks. Unfortunately,
there is very little documentation of this period in bank-


the purpose of this policy can be deduced from its
effects, then the motivation clearly was to enhance
the ability of colonial governments to raise revenue.
In the absence of market discipline, colonial governments were free to exploit their self-imposed monopoly power and to reap the financial benefits of
regulation by circulating a variety of currencies
through their banks.4
Even when regulatory action was rationalized as
being in the public interest, the government often
was a beneficiary of the intervention. For example,
in 1714 the Commonwealth of Massachusetts rejected
a private proposal for a land-collateralized private
note issue as contrary to the public interest.5 T h e
Massachusetts General Court’s objection to the proposal centered on two issues: (1) the inadequacy of
real estate as security for note issue, and (2) the inequity of granting the privileges and profit opportunities of note issue to private individuals. The
colony promptly revealed its true intentions, however,
when it agreed to accommodate the private demands
for currency by issuing its own treasury bills backed
by real estate. Although this note issue was intended
to diminish support for the private bank, it actually
did the reverse. For this -application of a double
standard “increased the zeal and raised a strong resentment” 6 in those who supported the development
of private banks.
ing history and it is impossible to reconstruct the policy
behavior of the government at that time. However, in
1711 the Commonwealth did preempt private interests by
issuing a loan to merchants in need of funds to finance
supplies for a private project. For details see Dewey [7]
and A. D. Eliason, The Rise of Commercial Banking
Institutions in the United States [9], pp. 10-13.

One banking historian provided the following unflattering description of public banks.
. . . they were monotonously alike in character, in
origin, and in results. Ingenuity in devising variations of the main principle appears to have been
exhausted. There were interest-bearing notes, some
of which were legal tender, while others were not;
there were non-interest-bearing notes, some of which
were legal tender for future obligations but not for
past debts; some were legal tender for all purposes,
and others not legal tender between private persons,
but receivable for all public payments. In some instances funds arising from certain sources of taxation
were pledged for the redemption of the notes, in
others not. In some cases they were payable on
demand; in others, at some future time. Sometimes
they were issued by committees, and sometimes by a
specially designated official.
Dewey [7], p. 24.

The plan was entitled “A Projection for Erecting a
Bank of Credit in Boston, New England, Founded on
Land Security.” The preamble recited that the decline in
trade necessitated a greater circulation of a medium of

Hutchinson, History of Massachusetts from 1628 to
1774, as quoted in White [55], p. 390.


Eventually the conflict between private and public
bank interests was decided by crown authorities who
had ultimate jurisdiction over such matters because
the colonies were part of the realm of England and
subject to English law. British authorities were initially sympathetic to private banks and countermanded colonial government policies that conflicted
with English law. In 1735, the Lords of Trade 7 i n
London overruled Massachusetts legislation that explicitly prohibited the circulation of notes by a private
partnership. The Lords recognized that private
credit issues were permissible under common law as
long as the notes were not made legal tender. This
ruling effectively removed the major constraint on
private banking.
The view that the business of banking could be
conducted independently of government influence
prevailed, however, for only a short period. In 1741,
Parliament extended the principal provisions of the
so-called “Bubble Act” of 1720 to the colonies.8 The
purpose of the original act was to strengthen the
British government’s control over unincorporated
joint-stock companies.
The occasion for the extension of this legislation to
the colonies was the establishment of a private land
bank in Massachusetts, a revival of the abortive 1714
proposal. Opposing the new land bank were those
who distrusted private ownership of the bank and
feared that it would lead to an increase in the volume
of bills of credit circulating in the colony. 9 Chief
among the opponents was the governor of the colony
who published a proclamation warning that the land
bank notes were fraudulent and harmful to trade.
Since the governor and his supporters lacked the
legal authority to restrain the land bank, they petitioned Parliament to do so. In passing the extension
to the Bubble Act, Parliament referred explicitly to
the land bank as one of the offenders which was to be
suppressed. In so doing, Parliament reversed the
earlier position taken by Whitehall in upholding the

In 1696, Parliament created the Board of the Lords of
Trade and Plantations to oversee the colonies, make them
more useful to England and suppress industries detrimental to England’s interests.

The act is entitled “For restraining and preventing
several unwarrantable schemes and undertakings in His
Majesty’s colonies and plantations in America.” The act
states that all clauses of the Bubble Act “did do and shall
extend to and are and shall be in force and carried into
execution” in America.
Q The colony of Massachusetts was an aggressive note
issuer and, with the exception of 1732 and 1739, issued
bills every year between 1702 and 1741 inclusive. There
was also a large inflow from Rhode Island, often referred
to as the most reprobate of the colonies for its lack of
monetary restraint.

legality of private banks and paper money issues in
the colonies, and firmly established the requirement
of government sanction as a major principle of bank
regulation in this country.

The experience of the colonial era influenced both
the post-colonial regulatory framework and the commercial banking industry that developed within this
framework. To avoid repetition of the colonial experience with inflationary paper currency issues, the
Constitution prohibited the individual states from
issuing paper money. This restriction prevented the
reappearance of public banks and created the potential
for private enterprise banking.
This potential, however, was not realized because
the individual state governments had the incentive to
utilize banking as an instrument of public finance just
as the colonial governments had done. State governments were able to circumvent restrictions on direct
monetary authority by chartering banks as corporations with the power to issue debt obligations.1 0
Government control of banking was perpetuated because state-chartered banks could legally circulate the
paper currency that the states themselves could not.
As a result, commercial banking in America began
with incorporation and the specific governmental
sanction of charter regulation.
Under charter regulation, which characterized the
first fifty years of commercial banking, the establishment of a new bank required a charter that was
granted only by a special legislative act.11 This enabled the legislatures to control the number of banks
in operation and set the range of the permissible and
obligatory activities for banking institutions. Charter

The constitutionality of state banks was upheld in
Briscoe v. Bank of Kentucky, 36 U.S. (11 Pet.) 257 (1837).
The Supreme Court ruled that state banks could issue
notes, even when stock in the state bank was held by the

With the two notable exceptions of the First and
Second Banks of the United States, each of which was
chartered by Congress, charter regulation was essentially
a system under the control of the individual states. However, Congress also sanctioned the Bank of Pennsylvania
in 1780 which was established to furnish supplies for the
Continental armies and ceased operations in 1784. In
1781, Congress approved a charter for the Bank of North
America although there was doubt concerning Congressional legal authority to grant a corporate charter since
the power to incorporate was universally accepted as an
implied and exclusive right of the individual state legislatures. Consequently, the bank also obtained charters
from the states of Delaware, Massachusetts, New York
and Pennsylvania.



regulation, then, presented state governments with a
potential source of revenue because a charter conferred a valuable corporate privilege on terms specified by the state. States were able to exact favorable
financial arrangements in the form of bonuses and
low-interest loans in exchange for granting banks the
opportunity to earn monopoly profits.
In order to enhance the stature of governmentsanctioned banks, charters were often couched in
language designed to encourage public acceptance of
chartered institutions. Of far greater significance to
the value of a charter, however, was the conviction
that a charter also conferred a monopoly privilege.
The earliest chartered banks were understood to be
monopolies even when monopoly power was not explicitly granted. Of course, this interpretation of
charter rights was encouraged by those possessing
charters, but also was reinforced by a commonly held
misconception regarding competition. New institutions, chartered or unchartered, were thought to
represent an inherent threat to the stability of all
banking interests. In short, competition was viewed
as an evil. This misconception prevailed for several
years even after experience proved it to be indefensible.
For example, there were no provisions in the original charter of the Bank of North America granting
exclusive rights to banking in Pennsylvania.12 Nonetheless, the bank maintained its monopoly for ten
years after its establishment in 1781 because of fears
that banking could not survive under a competitive
framework. The fear of competition stemmed from
the erroneous assumption that the specie requirements of an additional bank would prevent the possibility of profitable bank operations.
A new bank produces no new deposits of specie.
There is not a dollar more money added to the
A new bank divides the deposits of
specie and of course diminishes the advantages of
For it is manifest that two banks with
small capitals will do less than one bank with both
capitals. Besides the ordinary banking risks, each
institution is in danger from the others.1 3

Even after events demonstrated that bank entry
and competition did not have the feared effects, opposition to competitive banking remained among both
those who wished to maintain monopoly power and
those who wished to restrain it. Established banking

institutions continued to resist new entry in order to
maintain their monopoly privileges and profits. These
monopoly privileges, in turn, induced a popular resentment of banks, the privileged status of which was
seen as smacking of aristocracy, as constituting a
threat to the existence of individual freedom, and as
being in need of restraint. In short, contemporary
popular opinion equated corporate power with monopoly power. For this reason, an increase in the
number of bank charters was interpreted as an “expansion of privilege rather than a division of it,“1 4
and a restriction on the number of corporations was
viewed as the effective method of limiting monopoly
power. Ironically, the opponents of banking formed a
coalition with established banking interests in pursuit
of the common goal of restricting bank entry.
Although the states succeeded in limiting the number of banks by controlling entry, charters were not
indispensable in the early years of charter regulation.
In fact, some banks operated for years without receiving legislative sanction. This practice, however,
was curtailed around 1800 with the appearance of
so-called “restraining acts.” These laws attempted
to restrict banking to chartered banks and made it
illegal for anyone unauthorized by law to become a
member or a proprietor of any banking institution.
As a consequence of the restraining laws, the common
law right to borrow was distinguished from the right
to borrow by issuing obligations intended to circulate
as money; the business of banking was legally reserved to corporations chartered by the state.15 This
legal restraint on entry permitted the state legislatures to solidify their control of banking and protected the monopoly power of chartered institutions
from encroachment by private non-sanctioned interests.
Once the restraints on unincorporated banking
were in effect, the competition for new bank charters
intensified. As the demand for banking services grew
with economic expansion, more entrepreneurs attempted to enter the banking industry. State legislators, who controlled the rights to a valuable franchise, were solicited both by existing charter-holders
who lobbied to protect their privileges and by wouldbe bankers who lobbied for new charters. Thus, in


For an excellent discussion of this controversy see
Anna J. Schwartz, “The Beginning of Competitive Banking in Philadelphia, 1782-1809” [38], pp. 417-432.

From “On Banks” an article written anonymously in
the Gazette of the United States, March 10, 1792, as
quoted in Schwartz [38].


Bray Hammond, Banks and Politics in America [19],
p. 67.

These restraining acts also gave birth to the unregulated financial sector because they did not prohibit other
incorporated and unincorporated businesses outside the
field of banking, such as canal companies and water companies, from going into debt by issuing notes. These
notes often were accepted as money.


the early part of the 19th century, banking was an
integral part of the political system.
Since they were bargaining from a position of
strength, state legislatures were able to insist on a
variety of favorable financial arrangements in exchange for the profit opportunities conferred by
charters. The allure of profits was also strong enough
to motivate aspiring charter holders to provide a
variety of pecuniary inducements to individual legislators. Charges of corruption were widespread and
were proven in some cases.1 6 Although monopoly
banking privileges were diluted as state-chartered
banks grew more numerous, the benefits of any resulting competition were severely limited. Indeed,
many chartered banks were handicapped from the
start because they were forced to fulfill unsound commitments as the price of obtaining a charter.
The federal government did not have the constitutional authority to regulate banks by statute, but
exerted a strong regulatory influence through the
First (1791-1811) and Second (1816-1836) Banks
of the United States which were chartered by Congress.1 7 The First Bank of the United States was

One historian described the chartering process in New
York :
The evidence . . . afforded a most disgusting
picture of the members of the legislature and
indeed of the degradation of human nature itself.
The attempt to corrupt, and in fact, corruption itself,
was not confined to any one party. It extended to
individuals of all parties.
Jabez Hammond, History of Political Parties in New
York. Albany, 1843, I, p. 337 as quoted in Hammond,
“Free Banks and Corporations: The New York Free
Banking Act of 1838” [18], p. 190.

There are no clauses in the Constitution pertaining to
banking, per se. The monetary clauses of the Constitution are:
Article 1, section 8 which gives Congress the power
“To regulate Commerce with foreign Nations, and
among the several States, and with the Indian
Tribes; To establish an uniform Rule of Naturalization, and uniform Laws on the subject of Bankruptcies throughout the United States; To coin Money,
regulate the Value thereof, and of foreign Coin, and
fix the Standard of Weights and Measures. . . .”
Article 1, section 10 which restrains state activities to
the extent that
“No State shall enter into any Treaty, Alliance, or
Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any
Thing but gold and silver Coin a Tender in Payment
of Debts; pass any Bill of Attainder, ex post facto
Law, or Law impairing the Obligation of Contracts,
or grant any Title of Nobility.”
Article 1, section 8, clause 18 which concluded the
specific grants of power by granting Congress the
“To make all Loans which shall be necessary and
proper for carrying into Execution the foregoing
Process, and all other processes vested by this Constitution in the Government of the United States or
any Department or Officer thereof.”

established to serve as a fiscal agent for the Treasury,
to furnish credit to the federal government, and to
issue a uniform national paper currency. Although it
was federally chartered, it was mostly privately
owned and was intended to compete with other private commercial banks. The First Bank was not
established as a central bank. That is, it was not
intended to serve as a central depository, clearinghouse and lender of last resort for a banking system.
Indeed, there was no integrated banking system as
such. For when the First Bank was chartered in
1791, each of the four banks in existence comprised
an isolated banking system of its own and did not
need any of the functions provided by a central bank.
Furthermore, while Congress’s right to charter any
bank was hotly disputed, its right to charter a central
bank was not even considered a possibility under
contemporary interpretations of the Constitution. A
central bank was a genus that had not been clearly
differentiated from other banks by 1791.
Much to the chagrin of the state governments,
however, the First Bank emerged as a central bank
and the general regulator of money and state chartered banking institutions.18 Because of its size, fiscal
agency functions, large reserve holdings and interstate branches, the First Bank was able to constrain
the activities of the state banks by presenting the
notes of state banks for redemption in specie. In so
doing, the First Bank imposed restraints on the note
issues of state banks and, consequently, the public
finance potential of state chartering authority. This
role was later adopted and expanded by the Second
Bank of the United States which attempted to assert
itself in central bank activities.19 Even though central
bank authority was not prescribed by statute, the
bank “performed these functions deliberately and
avowedly-with a consciousness of quasigovernmental responsibility and of the need to subordinate profit
and private interest to that responsibility.“2 0

Richard H. Timberlake, Jr. The Origins
Banking in the United States [43], p. 10.




The Second Bank of the United States did not always
impose restraint on state bank note issues. Initially the
bank’s policy was expansive in order to appease state
banks and encourage them to redeem their notes in
specie. The Second Bank agreed to exchange its own
notes for a large sum of state bank notes, to hold these
state bank notes in its vault and to accommodate state
currency needs during financial crises. It was not until
the latter part of the decade that the Second Bank began
to redeem state bank notes on a large scale. See Murray
N. Rothbard. The Panic of 1819: Reactions and Policies

Hammond, Banks and Politics [17], p. 324. See also
Timberlake, The Origins of Central Banking [43], chaps.
3 and 4. for a discussion of the role of the Second Bank
of the United States.



Early attempts by the states to check the authority
of the Second Bank by taxation were curtailed by the
Supreme Court in the McCulloch v. Maryland case
of 1819. The Court was petitioned to rule in a suit
brought against the Second Bank by the state of
Maryland for failure to pay a tax that the state
imposed on all banks not chartered by the Maryland
legislature. Similar taxes had been imposed or were
being considered by a number of other states opposed
to the Second Bank. The case was of immediate
importance because the taxes were a threat to the
existence of the Bank, but the more important issue
was the extent and strength of federal powers. In
upholding the Second Bank as a legitimate exercise
of the implied “necessary and proper” powers delegated to the federal government by the Constitution,
the Court ruled the Maryland tax to be an unconstitutional “power to destroy” federal government authority:
If the states may tax one instrument employed by
the [federal] government in the execution of its
powers, they may tax any and every other . . .
means employed by the [federal] government, to an
excess that would defeat all the ends of [federal]

This Supreme Court ruling helped to extend the
life of the Second Bank until its charter expired in
1836. However, partly because it was generally
believed that the Bank had extended its powers without license at the expense of state governments, bills
for renewal of the Bank’s charter were first vetoed by
President Jackson and then delayed indefinitely. This
effectively curtailed federal central banking activities
until the organization of the Federal Reserve System
in 1913, and returned the control of bank regulation
to the individual states.

Public dissatisfaction with both the corruption and
instability of the banking system under charter regulation led to the development of several experimental
regulatory systems.21 Two of the most important of
these systems were free banking and the safety fund
system, both of which apparently had their American
origin in New York state.
In 1825, a New York legislative committee report
recommended reform of the chartering system. The

Prohibition was not uncommon. Arkansas, California,
Iowa, Oregon and Texas all prohibited banking for various periods.


reform was intended to eliminate the parceling of
monopoly banking privileges so that “whatever advantages are to be derived from banking operations
all citizens would be free to enjoy alike.“2 2 The
following year, a similar committee report decried
the charter system as “odious to the free spirit of our
civil institutions” and detrimental to sound banking
because the “[c]onfidence, induced by the supposed
sanctity of a charter, enables the unworthy and dishonest managers of [a bank’s] concerns to flood the
country with a circulation”23 that would not exist
otherwise. This committee recommended the removal
of legislative control of entry and an increase in
competition to improve public welfare and the performance of the banking system. Within a year plans
for a banking system with easier entry and increased
competition were proposed. However, the state legislature was able to resist, at least temporarily, the
political pressure to divest itself of its chartering authority.
Instead, the state satiated public demands for reform when it enacted the Safety Fund Act which
introduced the idea of guaranteeing creditors against
loss due to bank failure. Under the safety fund
system, the state maintained its ability to utilize the
banking system as an instrument of public finance
because the legislature maintained control over the
issue and terms of bank charters. In addition, each
bank was required to contribute a portion of its
capital to a fund which was to be used to liquidate
the liabilities, capital stock excluded, of failed banks
participating in the system. The contributions to this
fund were controversial for two reasons. First,
bankers objected to being subjected to the additional
costs of safety fund membership because they already
contributed to the state legislature in return for the
grant of a charter. Second, critics of the system
noted that the flat rate contribution to the fund meant
that low risk banks subsidized bankers with high risk
preferences. The uniform contribution did not reflect
the relative riskiness of the individual contributors
as would a fee that varied directly with risk. In
addition, by eliminating the risk assumed by the
public, the uniform contribution also reduced public
incentive to monitor and discipline individual bank
behavior. This aspect of the plan was soundly criticized by opponents who anticipated the recent prob22

New York State Senate Journal, 1825, as quoted in
Robert E Chadduck, The Safety Fund Banking System
in New York 1829-1866 [4]; p. 371.

Report of the committee on banks and insurance companies on petitions. Albany, 1826. As quoted in Chadduck [4], p. 372.


lems associated with the flat rate premium of FDIC
deposit insurance24 by some one hundred and fifty
The gravest objection to the system, is the creation of the Bank fund, by the half per cent, annual
contribution of the banks. This is represented by
the “Union Committee,” as being one of those
defects “endangering the soundness of the currenbanks responsible for others, over which they have
no control; as offering a “premium in favor of
misconduct, at the expense of those which are
wisely and cautiously maxiaged; . . ."2 5

In addition to introducing an insurance principle
to bank regulation, the Safety Fund Act did initiate
the transfer of the authority of direct state control of
banking from special legislative statute to delegated
authority. The law provided for three bank commissioners. One was appointed by the state governor
and the other two were appointed by the banks. These
commissioners were empowered to examine the condition of banks and apply for injunctions against
those which were judged to violate safety fund law
provisions. The supervisory powers furnished in this
legislation formed the basis of current bank supervision.
In 1838 New York removed the requirement of
specific legislative sanction for bank entry when it
passed free banking legislation.26 In permitting
banking to be open to an indefinite and unlimited
number of banks, this free banking act was both
revolutionary and controversial. It departed from the
legal convention of granting incorporation through
special enactment and delegated the powers to charter
an unlimited number of corporations to an administrative authority. 27 In the spirit of laissez faire, it
restored the common law right to engage in the business of banking and disassociated banking from the
status of privileged monopoly that had characterized
banking from early colonial times.
Free banking, however, did not completely eliminate either legal restrictions on entry or portfolio

For a discussion of the current controversy see Eugenie D. Short and Gerald P. O’Driscoll, Jr., “Deregulation and Deposit Insurance” [39], pp. 11-23.

An anonymous pamphleteer, as quoted in Fritz Redlich,
The Molding of American Banking, Men and Ideas [31],
vol. 1, p. 93.

Michigan passed the first free bank act in 1837.

As early as 1811 small manufacturing firms were permitted to incorporate without special legislative sanction.
Toward the latter part of the period of charter regulation,
legislation was passed to charter a specified number of
banks, but there were no laws permitting general incorporation of banks until free banking.

restrictions designed -to aid states in raising revenue.
Under free banking, prospective bankers were entitled to a charter only if they met minimum legal
capital requirements. Banks chartered under free
banking laws were entitled to issue their own notes
but were required to deposit designated state government bonds as security for all notes issued. This
security requirement helped to supply a market for
government bonds and compensated the states for
the loss of the financial assistance that was routinely
required from banks under state charter regulation.
In addition to these restrictions, free banks were required to redeem all circulating notes on demand in
specie, and were entitled to earn interest on the
securities as long as they remained solvent. If a free
bank failed to redeem its notes, the state closed the
bank and reimbursed the noteholders with the proceeds of a sale of the bank’s assets.
The success of free banking as a reform movement
is a point of considerable debate. The traditional
appraisal of free banking, which is used as support
for government regulation, is that it was dismal. The
system has been judged harshly because of its heterogeneous currency and because it witnessed many bank
failures, failures which caused note holders to suffer
losses which were substantial in some cases. To
critics of free banking, the period is characterized by
the behavior of the so-called wildcat banks which
gained infamy due to their purported success in exploiting the potential for fraud in the free banking
system. The Governor of Indiana expressed his concern with wildcat banks in an 1853 address:
The speculator comes to Indianapolis with a
bundle of bank notes in one hand and the stock in
the other; in twenty-four hours he is on the way to
some distant point of the Union to circulate what
he denominates a legal currency authorized by the
Legislature of Indiana. He has nominally located
his bank in some remote part of the State, difficult
of access, where he knows no banking facilities are
required, and intends that his notes shall go into
the hands of persons who will have no means of
demanding their redemption.2 8

However, episodic evidence of the exploits of wildcat banks leaves a stronger impression of the difficulties associated with free banking than a more
complete view of the experience would justify. Evidence of satisfactory performance can be found in
the statements of contemporaries who were intimately connected to the banking of the era. For
example, the state auditor of Indiana appraised the
results of free banking much more favorably than

As quoted in Knox [23], p. 318.




one might have expected in light of the governor’s
speech three years earlier.
The experiment of free banking in Indiana, disastrous as it has been in some particulars, has
demonstrated most conclusively the safety and
wisdom of the system. The original bill was crude
and imperfect, admitting of such construction as
held out to irresponsible men inducement and
facilities for embarking largely in the, business of
banking, without the ability to sustain themselves
in a period of revulsion. That revulsion came . . .
and yet the loss to which the bill-holder was necessarily subjected, in many cases, did not exceed five
per cent, and in no case exceeded twenty per cent
of the amount in his hands.2 9

Recent study of the free banking era provides more
conclusive evidence that the experience under free
banking varied considerably and that the kind of misconduct conventionally attributed to wildcat banking
was atypical.30 Many banks were profitable and, of
the banks that did fail, many redeemed their notes at
par. Many of the difficulties of the period occurred
in the first few years of free banking and seem to
have been associated with the organizational difficulties of instituting the system. For example, the
free banking system in New York was a disaster initially, but after some of its defects were corrected it
became the model for other free banking states.
Moreover, the regulations imposed on free banks
may themselves have been a source of instability. For
example, the requirement that government bonds be
deposited as security for bank notes increased bank
exposure to term structure risk and forced the retirement of bank notes as bond prices fell. Recent
evidence suggests that regulated free bank portfolios
were more important determinants of bank failure
than misconduct or mismanagement.
Despite its alleged failures, the free banking movement gained widespread acceptance. By 1860, more
than half of the thirty-two states, including some of
the most populous, possessed some form of free banking. Moreover, in 1863, some of the features of free
banking were initiated on a national level with the
passage of the National Bank Act and the establishment of the National Banking System.


The idea for a national system of banks evolved
over a long period of time. In the McCulloch v.
Maryland case of 1819, the Supreme Court established the constitutional foundations of a national
banking system. A decentralized system was advocated as early as 1834 by banking reformers who
were opposed to the financial power of a central bank
and favored “abolishing all monopoly, and for substituting in the place of a National Bank a National
System of Banking.“3 1 Long before the National
Bank Act, it was recognized that a system of national
banks could be organized to provide the national
currency desired by some bank reformers. Moreover,
it was also understood that the circulation of a national currency backed by federal government securities could help to create a market for government
bonds and satisfy the funding needs of the federal
government even in the absence of a central bank like
the Bank of the United States. For example, Millard
Fillmore, the Comptroller of the Currency in New
York, who advocated the extension of free banking
throughout the country, noted that should
Congress authorize such notes as were secured by
stocks of the United States, to be received for
public dues to the National treasury, this would
give such notes a universal credit, co-extensive
with the United States, and leave nothing further
to be desired in the shape of a national paper currency. This would avoid all objection to a national
bank, by obviating all necessity for one for the
purpose of furnishing a national currency. T h e
National Government might be made amply sec u r e .32

However, neither a national currency nor a national banking system was feasible given the prevailing political climate and the acceleration of the
free banking movement during the antebellum period.
It was only because the Civil War put great financial
pressure on the federal government to exploit the
revenue generating potential of a national currency
that a national banking system was established.
The first federally sponsored proposal for a system
of national banks appeared in the Annual Report of
the Secretary of the Treasury in 1861. In this
Report, Secretary Chase outlined a plan for a national


As quoted in Hugh Rockoff, The Free Banking Era:
A Re-Examination [34], p. 22.


The remainder of this section is based on the following: Rockoff [34]: Arthur J. Rolnick and Warren E.
Webber, “New-Evidence on the Free Banking Era [35],
and “The Causes of Free Bank Failures; A Detailed
Examination” [36].



“Essays on the Currency on Which is Proposed the
Enactment by Congress of a General Bank Law” Boston,
1834, quoted in Leonard C. Helderman, National and
State Banks [20].


Buffalo Historical Society Publications, X, pp. 282-283,
quoted in Helderman [20].


system based on the principles of New York’s free
banking law. He advocated a free banking framework “because it has the advantage of recommendation from experience. It is not an untried theory. In
the State of New York and in . . . other States it has
been subjected . . . to the test of experiment, and has
been found practicable and usefu1.“33 Of course,
Chase’s plan differed from the New York plan or
any state free banking system because it substituted
federal control of a national currency backed by
United States securities for the heterogeneous banknote issues of the individual banks.
As was the case with previous instances of government intervention, a national banking system was
rationalized as being in the public interest. For example, Chase hailed the proposed national currency
as potentially “the safest currency which this country
has ever enjoyed.“3 4 As was the case with previous
instances of government intervention, however, the
government also was intended to be a beneficiary of
the control scheme. Chase argued that national banks
would provide the “further advantage of a large demand for government securities . . . [and] increased
facilities for obtaining the loans required by the
war.“ 35 Indeed, Chase clearly viewed the banking
system as a potential source of financial assistance for
the beleaguered United States Treasury. In the
absence of a central bank, a national currency backed
by federal government securities was the most convenient means of tapping this source:
To enable the government to obtain the necessary
means for prosecuting the war to a successful issue,
without unnecessary cost, is a problem which must
engage the most careful attention of the legislature.
The Secretary has given to this problem the best
consideration in his power, and now begs leave to
submit to Congress the result of his reflections.
The circulation of the banks of the United States
constitutes a loan without interest from the people
to the banks, costing them nothing except the expense of issue and redemption and the interest on
the specie kept on hand for the latter purpose; and
it deserves consideration whether sound policy does
not require that the advantages of this loan be
transferred, in part. at least., from the banks, representing only the interests of the stockholders, to
the government., representing the aggregate interests of the whole people.36

There was considerable opposition to a national
system. The first two attempts to enact legislation
authorizing a national currency and a national banking system were defeated in spite of recommendations
of the Secretary of the Treasury and the President.
In 1863, however, Congress established the National
Banking System by enacting the National Currency
Act, now known as the National Bank Act.37 T h e
original bill passed the Senate by only two votes and,
given the antifederal persuasion of the southern
states, the bill would not have been enacted had the
South been represented in Congress.
The act marked the beginning of the dual banking
system, the division of regulatory authority between
state and federal governments. The law provided the
federal government with the authority to charter and
supervise national banks and to regulate the national
currency by establishing the Office of the Comptroller of the Currency within the Treasury Department. Since the national banking system was modeled
after free banking, a group of five or more persons
was permitted to form a national bank by satisfying
the minimum statutory capital requirement and filing
articles of association with the Comptroller. Each
national bank also was required to deposit United
States bonds with the Comptroller and in exchange
received national bank notes equal to 90 percent
of the lesser of the par or market value of the deposited bonds. The act also imposed a number of
restrictions on bank activity that were rationalized
as enhancing bank soundness and financial stability
including : (1) a requirement to maintain reserves
against both deposit and note liabilities,38 (2) restrictions on the scope of operations primarily to accepting
deposits and making short-term, self-liquidating loans
to business,39 and (3) a requirement to provide periodic reports of condition to the Comptroller.

The original national banking law was approved on
February 25, 1863 and was entitled “An act to provide a
national currency, secured by a pledge of United States
stocks, and to provide for the circulation and redemption
thereof.” This law was repealed and a revised version
was enacted July 3, 1864. On June 10, 1874 Congress
declared that the act “shall hereafter be known as the
National Bank Act.”


Report of the Secretary of the Treasury on the State of
the Finances for the Year Ending June 30, 1861 [32],
p. 19.

Ibid., p. 19.




Ibid., p. 17.

For an excellent discussion of the rationales and functions of reserve requirements, see Marvin Goodfriend and
Monica Hargraves, “A Historical Assessment of the
Rationales and Functions of Reserve Requirements” [16].

This concept of the proper functions of banking, widespread in the 19th century, is frequently referred to as the
“banking principle” and was derived from the “real bills”
doctrine. The “banking principle” and other 19th century
banking theories are discussed in Loyd W. Mints, A
History of Banking Theory [25].



Two factors hindered the growth of the National
Banking System initially. First, most bankers preferred to continue to conduct business under state
charters which typically had fewer restrictions and
offered more attractive profit opportunities than national charters. In addition, the Comptroller exercised arbitrary discretion in granting charters, discretion that discouraged entry. In considering charter
applications the Comptroller made subjective appraisals both of the economic potential of the community
and the extent of potential competition and also required the endorsement of a prominent citizen or,
sometimes, even a member of Congress.4 0 This
policy was neither consistent with the Congressional
design for an expanding national banking system nor
was it specifically granted by an allegedly free-bank
Strong measures, however, were soon taken to
coerce greater participation in the national banking
system. In 1865 Congress imposed a ten percent tax
on any bank paying out state bank notes after July 1,
1866. In his speech proposing the bill41 on February 27, 1865, Senator John Sherman left no room for
doubt that the tax was intended to eliminate state
banking by prohibiting profitable issue of state bank
A still more important feature of this bill is the
section to compel the withdrawal of State bank
notes . . . national banks were intended to supersede
the State banks. Both cannot exist together . . . the
power of taxation cannot be more widely exercised
. . .4 2

Resistance to the national banking legislation remained strong. A Maine bank challenged the tax
and the constitutionality was tested in the Veazie
Bank v. Fenno case which was considered by the
Supreme Court in 1869. The bank contended that
the tax was a direct tax that had not been apportioned
among the states as required by the Constitution.
Furthermore, it argued that the tax exceeded Congressional authority because it impaired a franchise
granted by the state. The Court, however, absolved
Congress of any wrongdoing, confirmed the validity

Ross M. Robertson, The Comptroller and Bank Supervision [33], pp. 57-69.

An act to amend an act entitled “An act to provide
internal revenue to support the Government, to pay
interest on the public debt, and for other purposes,”
approved June 13, 1864.

of the tax and disposed of any lingering notion of
states’ rights regarding currency issues. The reasons
for the decision, which virtually assured the expansion of the national system first proposed by former
Secretary of the Treasury Chase, were summarized
in the statement of the by-then Chief Justice of the
Supreme Court Chase :
. . . the judicial cannot prescribe to the legislative

departments of the Government limitations upon
the exercise of its acknowledged powers.
power to tax may be exercised oppressively . . .
[and not] be pronounced contrary to the Constitution [by the Judiciary] . . . [Furthermore] [i]t
cannot be doubted that under the Constitution
[Congress is given] the power to provide a circulation of coin . . . [and] bills of credit, . . . Having
thus, in the exercise of undisputed Constitutional
powers, undertaken to provide a currency for the
whole country, it cannot be questioned that Congress may, constitutionally, secure the benefit of it
to the people by appropriate legislation.4 4

In rejecting the majority opinion, the dissenting
justices argued that the decision had no historical or
legal precedent. State banking organizations had
been accepted members of the financial community
since the early years of the nation and their constitutionality had been upheld by the Supreme Court
twenty-two years earlier in the Briscoe v. Bank of
Kentucky case. In the view of the dissenting justices,
the tax was “an unprecedented amputation of state
authority.“ 4 5
Through its power to tax, Congress persuaded a
large number of state banks and new entrants to
apply for a national charter. Ambitions, however,
for a banking system comprised solely of nationally
chartered banks were never realized because the tax
on state bank notes did not effectively restrain state
banks. By the time the tax on state bank notes was
imposed, deposits were supplanting currency as the
primary medium of exchange, and commercial banking was emerging as a profitable deposit banking
business immune to the Congressional tax on state
bank notes. As the innovation of deposit banking
spread, state banking underwent a resurgence. The
less restrictive state charters again were potentially
more profitable than national charters, just as they
had been before the tax on state bank notes. With
much more limited corporate powers, national banks
were never able to attain the supremacy envisioned
by the creators of the National Bank Act.


As quoted in Walter Wyatt, “Constitutionality of
Legislation Providing for a Unified Commercial Banking
System” [57], p. 244.


75 U.S. (8 Wall) 533.



Wyatt [57], pp. 245-246.


Gerald T. Dunne, Monetary Decisions of the Supreme
Court [8], p. 50.



The period between 1875 and 1913 was marked
by a series of attempts to remedy perceived inadequacies in the banking system. The retirement of
bond-backed national bank notes and greater utilization of private clearinghouse arrangements were central to the reform movement. Congress was slow to
respond to this reform agitation that endorsed a decrease in federal regulatory authority, but eventually
responded by enacting legislation roughly based on
clearinghouse principles. In so doing, however, Congress expanded and solidified the federal government’s control over the banking industry and enhanced the revenue-generating capabilities of the
federal regulatory framework with the formation of
the Federal Reserve System in 1913.
The primary motivation for reform was the vulnerability of the financial system to liquidity crises
and panics. Contemporary observers focused on two
essential causes of this instability: (1) the pyramiding of reserves and (2) the alleged inelasticity of
the money supply. 4 6
Pyramiding occurred because banks operated on a
fractional reserve system that permitted them to hold
part of their required reserves as deposits with other
banks. So-called country banks maintained reserve
deposits at designated reserve city banks, and the
latter held deposits at central reserve city banks.
Reserve city and central reserve city banks held
only a fractional reserve against the reserve deposits
they held for other banks and thus were able to use
some of the reserve deposits of depositing banks to
meet their own required reserves. As a consequence,
the actual cash reserve was a smaller fraction of
aggregate deposits than the numerical reserve ratios
stipulated by statute for individual institutions. Moreover, reserves tended to be highly concentrated in the
large money center banks that had a significant correspondent business. While a fractional reserve
banking system is vulnerable to bank runs in the
absence of a lender of last resort, this pyramiding of
reserves sometimes exacerbated the problem. Any
systematic drain on the reserves of a sizable group

of banks caused a liquidity problem for the large city
correspondents as the banks experiencing the drain
would have to draw down their reserve deposits at
the city banks. A sustained large drain could cause
problems of crisis proportions. This reserve system
obviously affected the deposit-to-currency convertibility and, consequently, the total amount of money
The alleged inelasticity of national bank notes was
viewed as a separate defect of the system. This was
so because the size of the note issue was determined
by the level of government debt and, therefore, was
fairly rigidly fixed within short periods of time.4 7
National bank notes did not satisfy the popular notion
of an elastic currency because they did not vary with
cyclical and seasonal fluctuations in business activity.
For this reason, reformers considered a currency
based on national bank notes to be a serious flaw in
the financial system.
In order to remedy these perceived defects, reformers recommended both a move away from a bondsecured currency and the development of a market
mechanism to serve a lender of last resort function.
Two of the most important reform measures based
on these ideas were the “Baltimore Plan” of the 1894
American Bankers Association convention and Theodore Gilman’s “Graded Banking System.“48 T h e
Baltimore Plan focused on currency reform as the
remedy to financial instability and proposed revisions
of the National Bank Act including amendments
(1) to repeal the requirement that federal government bonds be deposited as security for bank notes,
(2) to provide for a new national currency backed
by bank assets, and (3) to provide for the relief of
liquidity crises with the circulation of an emergency
currency issued under heavy taxation in order to
encourage retirement after the emergency.
Like the Baltimore Plan, the “Graded Banking
System” stressed the ‘ability of banks to generate
reserves to meet short-term increases in the demand
for currency as the key to the stability of the banking
system. This proposal called for the organization of
clearinghouse associations to perform the lender of
last resort function. Clearinghouses developed in
this country in order to facilitate interbank transactions, and eventually operated in all of the reserve




Friedman and Schwartz note that this view of inelasticity was due partly to a failure to recognize fully the
significance of deposits as money, and partly “[to] a
particular manifestation of the ubiquitous ‘real bills’ doctrine.” Milton Friedman and Anna Jacobson Schwartz,
A Monetary History of the United States 1867-1960 [13],
p. 169.

In order to increase its note circulation, a national bank
required time to (1) purchase the government bonds that
serve as security, (2) transfer the bonds to the United
States Treasurer, (3) notify the Comptroller to forward
the notes and (4) transport the notes.


Theodore Gilman, A Graded Banking System [14].



cities of the national bank system and in other financial centers. Clearinghouses, though privately owned
by the member banks they served, nevertheless functioned like a central bank in at least two ways : first,
by requiring member banks to hold a cash reserve
against deposit liabilities, and second, by creating new
reserves for member institutions in emergencies.
Also, the clearinghouses innovated new arrangements
to help their members cope with panics. For example,
clearinghouses attempted to alleviate the problem of
reserve drain, without the costly procedure of maintaining 100 percent reserves, by utilizing emergency
currencies to stretch the reserve base of member
banks in order to relieve liquidity crises.49 T h e s e
clearinghouse innovations have been recognized as
the market’s response to the need for central bank
functions and “the specifically American solution to a
problem with which central banks in other great
commercial nations were faced.“5 0
The principles embodied in clearinghouse arrangements and currency reform represented a potentially
effective means of rectifying the unstable characteristics of the banking system and, for this reason, were
central to a number of reform proposals considered
by Congress. Such proposals, however, were opposed
in some quarters because they diluted the federal
government’s control over the banking system, threatened the financial power that the bond-backed currency provided to the federal government, and sanctioned private competition in the issue of currency. 5 1
Congress was reluctant to adopt any reform that
diluted federal regulatory authority.
In fact, no substantial reform legislation emerged
from Congress for several years. After the financial
panic of 1907, a panic marked by a widespread run
on banks and an inability of those institutions to
convert deposits into cash upon demand, the AldrichVreeland Act was enacted in an attempt to establish a
mechanism to relieve liquidity crises and to prevent
bank failures in a way similar to that practiced by
clearinghouses. The Aldrich-Vreeland Act was the
first legislation to provide for a currency backed by
short-term assets and “also marked the first tendency

R. H. Timberlake, Jr., “The Central Banking Role of
Clearing-House Associations” [42], p. 4.


Redlich [31], part II, p. 158.


The utility of clearinghouse issues was recognized by
many of its harshest critics.
The major criticism of
clearinghouse operations is that they were illegal because
the federal government exercised an exclusive authority
to issue money. For a discussion of this point! see Timberlake, “The Central Banking Role of Clearing-House
Associations” [42], pp. 14-24.


for legislation to [encourage] . . . centralization and
cooperation among banks.“52 The act, however, did
not bring about any major reduction in federal control of banking. First, it was only a temporary measure. Second, it established the Secretary of the
Treasury as the regulator of the emergency currency
of the National Currency Associations. More significantly for basic reform, however, it did establish the
National Monetary Commission to study the currency
and banking situation and report its findings to Congress.
After the National Monetary Commission completed its deliberations on domestic and foreign banking practices, it submitted a summary of the perceived
defects of the banking system and remedies for these
defects. The Commission’s reform proposal, known
as the Aldrich Plan, called for the establishment of a
National Reserve Association to be comprised of a
central executive office and fifteen branches, each of
which was to be divided into local associations. The
organizational, structure of the National Reserve Association was modeled after the clearinghouse system
and it was intended to function as a clearinghouse.
Senator Aldrich was quite explicit on this matter :
The organization proposed is not a bank, but a
cooperative union of all the banks of the country
for definite purposes and with very limited and
clearly defined functions. It is, in effect, an extension, an evolution of the clearing-house plan modified to meet the needs and requirements of an
entire people.5 3

Membership in the National Reserve Association
was to be voluntary and the entire paid-in capital
stock was to be owned by the members. National
banks were to be able to join without any qualifications, while state banks and trust companies needed
only to conform to specified reserve and capital requirements to become members. Under the Aldrich
Plan, the government had little control over banking
because the Commission adhered to the principle that
practitioners were the best qualified to manage clearinghouse operations. The Commission also sought
to remove the incentive for members to manipulate
the organization for profit by placing a ceiling on the
dividends that the stockholders could receive. The
National Reserve Association was intended to be
responsive to the public interest and insulated from
conflict of interest.

Robert Craig West, Banking Reform and the Federal
Reserve 1863-1923 [52], p. 51.

As quoted in West, Banking Reform [52], p. 73.


The great central banking potential that clearinghouse operations offered was never realized because
federal authorities would not relinquish regulatory
authority. The control of the National Reserve
Association became the focal point of the contemporary dialogue on reform. The Aldrich proposal was
criticized for promoting monopolistic tendencies because the procedure for selecting directors gave
greater influence to banks with a larger number of
shares in the National Reserve Association. Critics
also noted the virtual absence of government control
over the Reserve Associations. The sharpest critics
dismissed the National Reserve Association as a
poorly disguised scheme for a central bank.5 4
Congress, however, was not content to remedy
these perceived defects. It was simply opposed to the
privately controlled structure of the National Reserve
Association and determined to replace it with a
government-controlled institution, although there was
disagreement concerning the degree of centralization
of that authority. Ultimately, Congress established
the Federal Reserve System. That System was intended to serve the same clearinghouse functions as
the National Reserve Association and consequently,
had an organization that was quite similar to that of
the National Reserve Association except, of course,
that the Federal Reserve was under closer control of
the federal government.55 The capstone of the system, the Federal Reserve Board, was located in
Washington and, with the exception of its ex officio
members (the Secretary of the Treasury and the
Comptroller), all of its members were Presidential
appointees.5 6

See Timberlake, Origins of Central Banking [43], p.
192. It was very important that any reform measure
avoid the appearances of a central bank. A central bank
was offensive to both those who feared large bank domination of the financial system and those who feared
political control. In the words of a contemporary:
No, there is no way possible to keep a central bank
free from Wall St., without [it,] it couldn’t be a success, again you can’t keep it out of the hands of
Monopolists and politics, . . .
M. Lauretson, president of the First State Bank of Tyler,
Minnesota as quoted in Eugene N. White, The Regulation and Reform of the American Banking System, 19001929 [54], p. 93.

The striking similarity between the Aldrich Plan and
the Federal Reserve Act is documented in Paul M.
Warburg, The Federal Reserve System, Its Origins and
Growth [48], pp. 178-406.

The idea of the Board has been attributed to political
expediency. (For details, see West [52], chaps. 5 and 6.)
President Wilson is often credited with this suggestion.
However, the idea probably originated with Professor J.
Laurence Laughlin who recommended a central board in
his reform proposal called “Plan D.” See J. Laurence
Laughlin, The Federal Reserve Act: Its Origins and
Problems [24].

While proponents of the Federal Reserve Act
criticized the Aldrich Plan for proposing a central
bank, they declined to recognize the central bank
features of the Federal Reserve System.57 The central authority was depicted as a benign coordinating
agency that would function as a public utility or
perhaps even a “supreme court of American finance.”
The assumption underlying this view obviously was
diametrically opposed to the laissez faire principle
that the National Monetary Commission adopted
when it recommended the Aldrich Plan. The proponents of the Federal Reserve Act also declined to
recognize the potential for political conflict embodied
in the central organization and occasionally invoked a
“people-control-it-through-the-government” 58 doctrine to dismiss this notion. Federal government
control of the Federal Reserve was considered to be a
strong feature because it placed “great power in the
hands of the people.“5 9 Carter Glass was one of the
more eloquent adherents to this principle.
No financial interest can prevent. or control [the
Board]. It is an altruistic institution, a part of the
Government. itself, representing the American
people, with powers such as no man would dare
misuse . . . strictly a board of control . . . doing
justice to the banks, but fairly and courageously
representing the interests of the people . . . the
task of political control [of the Board] is the expression of a groundless conjecture.6 0

The major point of departure for adversaries of the
proposed Federal Reserve System was the central
organization which made the system a central bank.
The “public control doctrine” simply was not acceptable to those who embraced the practical view that
“control through a Government bureau, by political
appointees, is not synonymous with control by the

Carter Glass denied that the Fed was a central bank
after it had been in operation for almost a decade.
“What are these regional banks?
There is no mystery about them . . . they are banks
of banks. They do not loan, can not loan, a dollar
to any individual in the United States . . . but only
to stockholding banks . . .
At the head of these 12 regional banks we put a
supervisory board. It is not a central bank.”
Carter Glass. “Truth About the Federal Reserve System.” Speech in the Senate of the United States, January 16-17, 1922 [15], p. 8.

Timberlake, Origins of Central Banking [43], p. 194.


H. H. Seldomridge, 60th Congress, 1st session, as
quoted in Timberlake, Origins of Central Banking [43],
p. 194.

Carter Glass, as quoted in Timberlake, Origins of
Central Banking [43], pp. 193-194.



people and for the people.“61 This view also had its
spokesman in Congress.
This bill creates a “central bank.” This plan is
much more centralized, autocratic, and tyrannical
than the Aldrich plan. It is true that we are to
have 12 regional banks; but these are but the
agents of the grand central board, which absolutely
controls them. The power is not, with them; they
are not in any material matter given the right of
independent, action; they must obey orders from

Washington. 62

The Federal Reserve Act did not repeal the National Bank Act or abolish the Office of the Comptroller of the Currency, but rather superimposed a
second regulatory system on the existing National
Banking System and created a second regulatory
agency. In so doing, federal authorities strengthened
their control over national banks by requiring the
latter to become members in the Federal Reserve
System, even though bankers had little representation in the System’s central decision-making process.
Also, by vesting new regulatory authority in this
second regulatory agency, Congress created a new
avenue to bring state-chartered banks under the
scope of federal control, preempted profitable operations of private clearinghouses and permitted the
federal government to maintain exclusive control
over the issue of paper currency.
In enacting the Federal Reserve Act, Congress
diluted the authority of the Comptroller and camouflaged the link between the Treasury and bank regulation. There was a conscious decision not to sever
this link completely, however. Indeed Congress declined to abolish the Office of the Comptroller of the
Currency or to put it under the control of the Federal
Reserve System despite sentiment to extinguish
“remnants of an undemocratic, antiquated and dangerous"63 system.
In addition, Congress established the Federal Reserve to function as an instrument of public finance.
Because the Fed was granted the authority to
purchase and rediscount assets in exchange for its
own non-interest-bearing liabilities, Fed operations
were potentially quite profitable. Section 7 of the
Federal Reserve Act required that “all net earnings
[of the Federal Reserve Banks] shall be paid to
the United States as a franchise tax.” While the

Frank Mondell, 60th Congress, 1st session, as quoted in
Timberlake, Origins of Central Banking [43], p. 195.

Horace M. Towner, 63rd Congress, 2nd session, as
quoted in West, Banking Reform [52], p. 119.


Paul M. Warburg, “Political Pressure and the Future
of the Federal Reserve System” [49], p. 72.


Act provided for the retirement of national bank
notes, it attempted to ensure the continuation of a
strong market for government bonds by authorizing
every Federal Reserve bank to “buy . . . bonds and
notes of the United States . . . with a maturity
. . . not exceeding six months, issued in anticipation
of the collection of taxes.” Section 4 also authorized
the issue of Federal Reserve bank notes “under the
same conditions and provisions of law as relate to
the issue of circulating notes of national banks
secured by bonds of the United States bearing the
circulating privilege, except that the issue of such
notes shall not be limited to the capital stock” of each
Federal Reserve Bank. Finally, Congress spelled out
the relationship of the new Federal Reserve System
to the U.S. Treasury Department as follows:
Nothing in this Act contained shall be construed as
taking away any powers heretofore vested by law
in the Secretary of the Treasury which relate to the
supervision, management, and control of the Treasury Department and bureaus under such department, and wherever any power vested by this Act
in the Federal Reserve Board or the Federal Reserve Agent appears to conflict with the powers of
the Secretary of the Treasury, such powers shall
be exercised subject to the supervision and control
of the Secretary of the Treasury.6 4

Almost from the start, the Comptroller of the Currency and the Fed were in conflict. The controversy
revolved around bank supervisory and examination
functions and the authority of the Fed to have access
to the information gathered by the Comptroller in
examination reports.65 The Fed believed that access
to information on bank financial conditions was necessary to the proper discharge of its responsibilities.
The Comptroller, however, was reluctant to share
confidential information with the Fed, and for a
period of time only sent abstracts of examination
reports to the Fed. The Comptroller’s position
seemed to be based on the notion that access to
confidential financial information on the banking
system was not vital to the successful operation of
the new central bank. This attitude was reflected in a

Federal Reserve Act,. section 10. The legislative history of this passage gives little insight into its intent
because it was not debated in Congress. The provision
appeared during the Senate discussion of the bill on one
of the several new prints of the bill intended to incorporate ‘minor changes. No one directly claimed authorship, although the Senate Committee chairman implied
that it was suggested by the Treasury. Regardless of its
intent, it contributed to the jurisdictional friction between
the two federal agencies. For a discussion of this passage
in the law, see A. D. Welton, “The Reserve Act in Its
Implicit Meaning” [51], p. 57.

Robertson [33], p. 107.


report written by a committee that was commissioned
by the Comptroller to study the jurisdictional issue:
In requesting access to the complete reports of
examination, the Federal Reserve banks appear to
be operating upon the assumption that the credit
extended by them is an extra hazardous risk and
of an abnormal character justifying them in demanding information not exacted by other banking
institutions and in no way relating to the solvency
of the bank. This point of view is not warranted
by past banking experience and if the extending of
accommodations is to be restrictive and surrounded
with burdensome exactions, the success of the system is in jeopardy.6 6

In any event, the Comptroller declined to cooperate
with the Fed or explain what purpose this confidential information served to the Treasury Department.
The friction between the two federal agencies
eventually put the Comptroller’s office in jeopardy.
By 1921, Congress had introduced a number of bills
to abolish the Comptroller’s Office and resolutions to
investigate the agency’s behavior. Opponents of the
Comptroller argued that it would be more democratic
if the autocratic powers exercised by the Comptroller
were vested in a board.67 It was argued that the
Federal Reserve Act had made the Comptroller redundant and that its continued existence would
constitute an unnecessary source of “costly delays,
duplication of work, inefficiency and unbearable irritation.“ 68 These accusations, predictably, were denied
by the Comptroller. Nothing of significance came of
any of these bills or resolutions, in part because the
relations between the two agencies did improve after
1923. Without the embarrassment of open hostilities
between the two federal agencies, Congressional incentive to rectify the overlapping authority disappeared.

The advent of the reformed and dually executed
federal regulatory framework coincided with fundamental changes in the financial environment in the
United States. The outbreak of European hostilities
in 1914 presented unusual demands for funds and
stimulated activity in the financial services industries.
After the United States entered the war, the inte66

Quoted in Robertson [33], p. 108.


Congressional Record, 65 Congress, 3rd session, 1919.


Warburg, “Political Pressure” [49], p. 72.

gration of commercial and investment banking activities was encouraged by the federal government which
enlisted broad commercial bank support in underwriting and distributing Liberty Bonds to help finance the government’s enormous demand for funds.
Participation in this distribution provided many commercial banks with the expertise necessary for expanded securities operations and helped to educate a
general public that became more willing to invest
funds in the capital markets during the ensuing era
of prosperity.
Consequently, even after the war, commercial bank
involvement in all aspects of the securities markets
continued to increase. The general prosperity enabled many nonfinancial corporations to reduce indebtedness to banks or to utilize the accommodative
securities markets as a substitute for bank loans to
finance business.69 Commercial borrowing at banks
declined, threatening the profitability of traditional
loan activities and leaving the banking industry with
surplus funds. Many banks relied on the longer term
capital markets to offset the reduction in loan revenue. Since state banks were not constrained by
federal regulations, they directly accelerated their
activity in the investment banking business; national
banks were forced to rely more on trust company or
securities affiliates. By the mid 1920s, investment
banking and security services had become so popular
with the public that many banks found it necessary
to provide investment services in order to remain
Both branch banking and securities activities of
national banks were the focus of reform proposals
prior to the depression. While the national banking
system was growing relative to state-chartered banking in terms of numbers,70 the proportion of total
deposits attributable to national banks was declining
due to the attrition of many of the larger national
banks. These defections reflected an effort to gain
access to the most favorable regulatory framework.
For example, many national banks were able to increase their branching capabilities71 by converting to
state charters or merging with a state bank and
retaining state-charter status. National banks seek69

Lauchlin B. Currie, “The Decline of the Commercial
Loan” [5], and William N. Peach, The Security Affiliates
of National Banks [27], chaps. 2 and 4.

Raymond P. Kent, “Dual Banking Between the Two
World Wars” in Banking and Monetary Studies [22],
p. 45.

The National Bank Act did not forbid branching by
national banks. However, the Comptroller interpreted
the law to preclude branching. See Robertson [33], pp.



ing more direct participation in the securities business
had the same incentives to operate under state regulation. As a consequence, the Comptroller was especially concerned that national bank powers be broadened in order to curtail national bank defections.7 2
The so-called McFadden Act, which was passed in
1927, included provisions intended to equalize competition between national and state banks. The law
reduced inequities in branching regulations and
granted explicit authority to national banks to buy
and sell marketable securities.
Shortly thereafter, commercial bank involvement in
securities activities accelerated as commercial banks
became aggressive innovators in the investment banking industry. By the end of the 1920s, “commercial
banks and their security affiliates occupied a position
in the field of long-term financing equal to that of
private investment bankers, both from the standpoint
of investment banking machinery and from the standpoint of the volume of securities underwritten and
distributed by the two groups of institutions.“7 3
Following the stock market crash of 1929 and the
subsequent collapse of the banking system, however,
concern for more rigid control over banking activities,
especially investment practices, resurfaced. In 1930,
Congressional committees studied the causes of the
1929 collapse, which many believed to be the root
cause of the economic and financial distress. Bank
investment practices, especially the extent to which
bank credit had been funneled into the stock market,
became the focus of investigation and criticism. Indeed, to many who witnessed the developments of the
late 1920s, the sequence of events seemed to provide
formidable evidence of commercial bank culpability :
No sooner had the McFadden Act taken effect,
then the great bull market had gotten underway!
During the period from 1928 through 1930, commercial banks had substantially increased their
share of the new bond issues and had begun to
make inroads in the equities market.7 4

In addition, the Congressional investigations exposed instances of conflict of interest, speculative
abuse and personal enrichment by officials at some
of the larger commercial banks. These revelations
helped to reinforce a general impression of bank
culpability and put the banking community on the
defensive. Although the scope and pervasiveness of

these abuses are still subject to debate, the dramatic
nature of the Congressional hearings had a strong
influence on public sentiment, and thereby contributed to both the lack of public confidence in the
banking system and to the popular belief that stronger
bank regulation was necessary.
Dispassionate study, however, suggests that the
banking system was as much a victim as a cause of
the financial instability because the central bank that
was intended to serve the lender of last resort function failed to serve this purpose.76 In the absence of
an organized private lender of last resort mechanism,
previously provided by private clearinghouses, the
banking system had no means of self-correcting its
reserve deficiencies and stemming a financial crisis.
As a consequence, conditions in the banking system
deteriorated until the “bank holidays” broke the momentum of the panic.
The severity of the banking emergency led to the
adoption of several reforms intended to prevent the
recurrence of events that were perceived to have contributed to the collapse of the banking system. The
reforms, however, reflected quite different attitudes
regarding the deficiencies of the private and public
sectors. Because the banking community bore the
greatest share of the blame for the financial crisis,
many of the legislated reforms restricted the scope
of bank activities. On the other hand, the failure of
the federal regulatory structure either to prevent or
to alleviate the financial crisis brought an entirely
different legislative response. Congressional reform
expanded and strengthened the federal regulatory
system. Rather than enhance the banking system’s
ability to deal with financial crises independently,
Congress increased federal regulatory control over
banking. The two most important reforms introduced
deposit insurance on a national level and altered the
organization and power of the Federal Reserve
Deposit insurance, however, was a very controversial reform measure. Since the New York Safety
Fund System had been established both to satisfy the
public demand for reform and to permit the New
York legislature to maintain its chartering authority,
there had been several experiments with deposit guarantees. All had failed during times of crisis. The
unpopularity of deposit insurance with bankers had
been responsible for many conversions from state to


See for example the Annual Report, Comptroller of the
Currency, 1924.



Peach [27], p. 20.


Edwin J. Perkins, “The Divorcement of Commercial
and Investment Banking: A History” [29], p. 500.


See, for example: Friedman and Schwartz [13], chaps.
7 and 8 and Clark Warburton, Depression, Inflation and
Monetary Policy: Selected Papers, 1945-1953 [50], chaps.


national charters in states with deposit guarantee
systems.7 6 Bankers objected to deposit insurance
on a number of grounds, but the strongest objection
was that it subsidized risky management by “imposing a heavy expense and a heavy burden on the
sound institution for the benefit of the weaker institution.” As had been the case one hundred years
earlier in New York state, deposit insurance represented a means of restoring public confidence in both
the banking system and the regulatory framework
without sacrificing any regulatory authority. Consequently, Congress established deposit insurance under
the administration of the Federal Deposit Insurance
Corporation (FDIC).
In some respects, the establishment of the FDIC
was analogous to the creation of the Federal Reserve
System. First, there was no clear separation between
the Treasury and the FDIC. The Comptroller was
appointed as one of the three members of the board
of directors of the FDIC that elects the FDIC chairman. Second, the creation of the FDIC did not
significantly alter or reduce the power of the Comptroller or the Federal Reserve. The FDIC simply
was superimposed on the existing framework. Third,
the FDIC inherited the existing federal regulatory
jurisdiction because all banks under federal regulation-national banks and state-chartered members of
the Federal Reserve-were required to have their
deposits insured by the FDIC. Moreover, the FDIC
paved the way for the extension of federal regulatory
authority by permitting state-chartered banks to be
admitted to insurance coverage subject to FDIC
supervision. The FDIC succeeded in extending
federal regulatory control over state-chartered banks
to a much greater extent than either the National
Banking System or the Federal Reserve System because of the importance of deposit insurance to public
In addition to establishing the FDIC, the reform
legislation of the 1930s altered the organization and
operations of the Federal Reserve System. The
Federal Reserve Board-renamed the Board of Goverrors of the Federal Reserve System-and the Open
Market Committee were reconstituted to reduce the
influence of the individual Federal Reserve banks and
increase the centralization of control of the system.
While both the Secretary of the Treasury and the

After the panic of 1907, Kansas, Mississippi, Nebraska,
North and South Dakota, Oklahoma; Texas and Washington passed laws establishing bank, deposit guarantee

Susan Estabrook Kennedy, The Banking Crises of 1933
[21], p. 216.

Comptroller were removed as ex officio members of
the Board and the franchise tax on the Federal Reserve earnings was abolished, the reform did not
eliminate the importance of the Federal Reserve System to the Treasury financing program. To the
contrary, this reform legislation broadened the authority of the Federal Reserve to, purchase federal
government securities as a fundamental tool of Federal Reserve operations. This broadened authority
has helped to maintain the market for government
debt that the federal government first attempted to
ensure when it passed the National Bank Act. In
addition, a variety of Fed-Treasury pecuniary transfers have continued since the banking legislation of
the 1930s and have increased dramatically in recent
years.7 8
* * *
Statutory changes in the federal regulatory framework since 1935 have been basically of a technical
nature, although there has been some strengthening
and extension of the authority of the federal regulatory agencies. In addition, there have been several
proposals for reorganizing and simplifying the regulatory structure. These efforts, however, have not
resulted in substantial reorganization but rather have
led to attempts to increase inter-agency coordination
by establishing committees composed of members of
the various agencies. For example, the Federal Financial Institutions Examination Council (FFIEC),
which is comprised of the heads of the FDIC, Federal
Reserve and the Comptroller as well as other federal
regulators, was formed in order to reduce the inefficiencies and redundancies of the system and improve
cooperation. It is possible, however, that the FFIEC
may itself become an independent agency.

Public regulation of banking was established during
the colonial period to enable colonial governments to
finance public expenditures. The institutional structure of regulation that has evolved since that time
also has served as an instrument of public finance.
Charter regulation permitted state governments to
circumvent Constitutional restrictions on state monetary authority. State legislatures were able to exact
favorable financial arrangements in exchange for the
charter privilege of issuing currency. However, the
elimination of direct state legislative control of entry

See Goodfriend and Hargraves [16] on this point,
especially pp. 13-16.



under free banking did not eliminate the public finance function of government regulation. Free banking strengthened the market for state government
debt by requiring bank notes to be secured with
government bonds. This framework was eventually
established on the federal level with the enactment of
the National Bank Act which provided for a national
currency collateralized by federal government bonds.
The establishment of the Federal Reserve System
and the Federal Deposit Insurance Corporation enabled the federal government to satisfy public demand
for banking reform and maintain the public finance
function of federal regulation.

The structure of bank regulation in the United
States has evolved over the better part of three centuries. Since a primary motive for regulation has
been an expansion of the financial power of various
government authorities, the structure of regulation
has been designed to serve this purpose. In addition,
the structure of bank regulation has become more
complex at each stage of its evolution because of the
reluctance of government agents to divest themselves
of regulatory authority. Any consolidation of the
federal regulatory structure would represent a significant reversal in a secular trend that has continued
since the colonial period.

Com1. Burns, Helen M.
munity and New Deal Banking Reforms 1933-1935.
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13. Friedman, Milton, and Schwartz, Anna Jacobson.
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2. Cagan, Phillip.
“The First Fifty Years of the
National Banking System-An Historical Appraisal.” In Banking and Monetary Studies. E d i t e d b y
Deane Carson. Homewood, Ill.: Richard D. Irwin,

A Graded Banking System.
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3. Carosso, Vincent P. Investment Banking in America: A History. C a m b r i d g e : H a r v a r d U n i v e r s i t y
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(August 1931).

6. D a v i s , J o s e p h S t a n c l i f f e . E s s a y s i n t h e E a r l i e r
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“Federal Reserve Act of 1913.” In F i r s t A n n u a l
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12. Federal Reserve Committee on Branch, Group, and
Chain Banking. “The Dual Banking System in the
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System. Washington: Federal Reserve Board, n.d.


15. Glass, Carter. “Truth About the Federal Reserve
Speech in the Senate of the United
States, January 16-17, 1922.
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Federal Reserve Bank of Richmond (March/April
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“Free Banks and Corporations: The
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19. Hedges, Joseph Edward. Commercial Banking and
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Hopkins Press, 1938.
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of 1933. Lexington, Ky.: University Press of Kentucky, 1973.
22. Kent, Raymond P. “Dual Banking Between the
In Banking and Monetary
Two World Wars.”
Studies. Edited by Deane Carson. Homewood, Ill.:
Richard D. Irwin, 1963.
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United States. N e w Y o r k : B r a d f o r d R h o d e s a n d
Company, 1900.
24. L a u g h l i n , J . L a u r e n c e . The Federal Reserve Act:
Its Origins and Problems. New York: The Macmillan Company, 1933.
25. Mints, Loyd W. A H i s t o r y o f B a n k i n g T h e o r y .
Chicago: University of Chicago Press, 1975.
26. O r i g i n a l A c t s P e r t a i n i n g t o N a t i o n a l B a n k s i n
Chronological Order, vol. 1. Washington: U. S.
Comptroller of the Currency, n.d. (Processed.)


27. Peach, William N.
The Security Affiliates of
National Banks. Baltimore: Johns Hopkins Press,


28. Peltzman, Sam. “Toward a More General Theory
of Economic Regulation.”
Journal of Law and
Economics 19 (August 1976).

44. U. S. Comptroller of the Currency. Annual Report,
December 1, 1924 Washington : Government Printing Office, 1924.

29. Perkins, Edwin J. “The Divorcement of Commercial and Investment Banking: A History.” T h e
Banking Law Journal 68 (June 1971).

45. U. S. C o n g r e s s . H o u s e . A m e n d m e n t s t o F e d e r a l
Reserve Act. H.R. Report 1026 to Accompany S.
5236, 65th Cong., 3rd sess., 1919.

30. Posner, Richard A. “Theories of Economic Regul a t i o n . ” Bell Journal of Economics 5 ( A u t u m n


31. Redlich, Fritz. The Molding of American B a n k i n g ,
Men and Ideas. 2 v o l s . N e w Y o r k : J o h n s o n R e print Co., 1968.
32. Report of the Secretary of the Treasury on the
State of the Finances for the Year Ending June 30,
1861. Washington : Government Printing Office,
33. Robertson, Ross M. T h e C o m p t r o l l e r a n d B a n k
Supervision. Washington: U. S. Comptroller of
the Currency, 1968.


Changes in the Banking and Currency
System of the U n i t e d S t a t e s . H . R . R e p o r t 6 9 t o
Accompany H.R. 7837, 63rd Cong., 1st sess., 1913.

47. U. S. National Monetary Commission. “Report of
the National Monetary Commission,” “Suggested
Plan for Monetary Legislation,” and “Suggested
Plan for Monetary Legislation-Revised Edition.”
In Publications of the National Monetary Commission, vol. I. Washington: U. S. Government Printing Office, 1912.
48. Warburg, Paul M. The Federal Reserve System,
Its Origins and Growth, vol. 1. New York: The
Macmillan Company, 1930.

34. Rockoff, Hugh. T h e F r e e B a n k i n g E r a : A R e Examination. New York: Arno Press, 1975.
35. Rolnick, Arthur J., and Webber, Warren E. “New
Evidence on the Free Banking Era.” A m e r i c a n
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The Origins of Central Banking in the
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Press, 1978.

“Political Pressure and the Future of
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the Federal Reserve System.”
Reserve System-Its Purposes and Work.
American Academy of Political and Social Science
Annals 99 (January 1922).

50. Warburton, Clark. Depression, Inflation and M o n e tary Policy: Selected Papers, 1945-1953. B a l t i more: Johns Hopkins Press, 1966.

“The Causes of Free Bank Failures:
A Detailed’ Examination.” Federal Reserve Bank
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37. Rothbard, Murray N. The Panic of 1819: Reactions and Policies. New York and London: Columbia University Press, 1962.
38. Schwartz, Anna J. “The Beginning of Competitive
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“Deregulation and Deposit Insurance.” Economic
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National Banking System. Prepared for the National Monetary Commission, 1910; reprint ed.,
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52. West, Robert Craig. Banking Reform and the Federal Reserve 1863-1923. Ithaca : Cornell University
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(MimeoReserve Bank of Kansas City, n.d.

5 4 . W h i t e , E u g e n e N . The Regulation and Reform of
the American Banking System, 1900-1929.
Princeton : Princeton University Press, 1983.
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New York: The Ronald Press Company, 1923.

42. Timber-lake, Richard H., Jr. “The Central Banking
Role of Clearing-House Associations,” n.d. (Mimeographed.)

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Timothy Q. Cook


quarters that the Fed would “ease” policy. The
revisions lifted M1 to the midpoint of its range and
altered expectations that such a policy move was
imminent. 3 , 4


Early each year the Federal Reserve uses the past
year’s data to revise the seasonal factors used to
seasonally adjust the money stock. As shown in
Table I, the 1984 revisions in the seasonal factors
caused unusually large revisions in the seasonally
adjusted 1983 monthly M1 growth rates for the
second year in a row.1 , 2 In addition, the revisions
shifted some of the growth in M1 in 1983 from the
first to the second half of the year. Table I also
shows that, with one exception, the effect of the 1984
revisions on the 1983 monthly growth rates was in
the opposite direction from the effect of the 1983
revisions on the 1982 monthly growth rates.
The revisions in the 1983 seasonally adjusted M1
growth rates were of unusual interest because they
influenced expectations regarding Federal Reserve
behavior and the economy. In July 1983 the Fed had
reset (or “rebased”) the 1983 target range for M1
to run from the second quarter to the fourth quarter
of the year. Originally the weak growth of M1 in
late 1983 had caused it to fall to the lower end of the
range, which contributed to expectations in some

The measure of the money stock discussed in this paper
is the narrowly-defined M1, which includes currency,
demand deposits, other checkable deposits, and nonbank
travelers checks. There were also revisions in the broader
measures of the money stock, M2 and M3. The formal
position of the Federal Reserve in 1983 was that it was
placing greater weight on M2 and M3 than on M1 for
policy purposes. The focus on M1 in this article is not
meant to imply anything about the weight placed on M1
versus the other monetary aggregates for policy purposes
in 1983. Rather it reflects three other factors: (1) the
revision in the level of M1 was by far the greatest relative
to its target range and generated the most public interest;
(2) the possible seasonal adjustment problems with M1
were a major concern in policy discussions at the Federal
Reserve Bank of Richmond in the latter months of 1983;
and (3) this paper evolved from those discussions.

All growth rates referred to in the paper are on an
annualized basis.



The range for M1 from the second quarter to the fourth
quarter was 5 to 9 percent. The money stock revisions
raised the growth rate of M1 over this period from 5.5
Most of the revision in the monthly
to 7.2 percent.
growth rates of M1 was due to revisions in the seasonal factors. However, a portion (20 percent) was due
to benchmark revisions in the unadjusted data.
*For example, “The money supply’s faster growth reduces any incentive for the Fed to ease credit conditions,
several analysts said” (“Interest Rates Rise as Analysts
Worry that Fed Won’t Be Loosening Reins Soon,” Wall
Street Journal, February 4, 1984, p. 45).

Table I




The seasonal factor revisions also influenced expectations concerning the near-term future course of
the economy. Many economists place a high weight
on changes in the growth rate of the money stock as a
determinant of short-run economic activity. The M1
growth rate originally dropped from 14.1 percent
over the six months ending May 1983 to 3.4 percent
over the six months ending January 1984, causing
fears of a recession in the first half of 1984.5 T h e
money stock revisions reduced the deceleration in M1
from 12.7 percent in the six months ending May 1983
to 5.9 percent in the six months ending January
1984. According to press reports at the time, this
lessened expectations of a deceleration in economic
activity in 1984.6
Most importantly, the 1983 revisions are of interest
because the underlying forces that caused them illustrate two major problems faced by monetary policymakers trying to use seasonally adjusted money stock
data as a guide to policy: (1) changes in government regulations and policies can cause abrupt
changes in the effect of a seasonal event (such as a
holiday or a tax date) on the demand for money, and
(2) the current year’s seasonal factors may at times
be inappropriately influenced by past movements in
the money stock not related to seasonal events. The
purpose of this article is to discuss the goal and
possible pitfalls of using seasonally adjusted data as a
guide to policy and to illustrate these pitfalls by
examining two factors that contributed to the 1983

It is widely believed that the monetary authority
should focus on seasonally adjusted money stock data

See, Milton Friedman, “A Recession Warning,” Newsweek, January 16, 1984, p. 68. Also, “More Analysts
Doubt Concensus Prediction of Brisk 1984 Growth,”
Wall Street Journal, January 19, 1984, p. 1.

in order to reduce seasonal variations in interest
rates.7 In discussing this goal, it is useful to focus on
two behavioral relationships : the public’s demand
for money and the Federal Reserve’s policy reaction
function. The public’s demand for money varies inversely with interest rates and positively with the
volume of monetary transactions and has a random
element that reflects movement in money demand not
explainable by interest rates or transactions. The
Federal Reserve reaction function links movements
in various policy targets-such as the money stock
or national income-to the Federal Reserve’s policy
instrument. 8 For instance, when the money stock is
growing at a greater-than-desired rate, the Federal
Reserve might move its policy instrument in order to
put upward pressure on the Federal funds rate and
other short-term rates, which, in turn, would decrease
the demand for money and bring the money stock
back to its desired path.
In terms of the goal of eliminating seasonal movements in interest rates, an ideal seasonal adjustment
procedure would have two features. First, it would
construct seasonal factors that eliminate movements
in the money stock due to the effect of seasonal events
(i.e., events that recur at around the same time every
year) on the demand for money. The major seasonal
events that bring an increase in transactions are holidays (especially Christmas) and tax dates (especially
April). The logic here is straightforward. The effect
of these seasonal events on the demand for money is
temporary. Hence, if the Federal Reserve initially
reacts to them by moving its policy instrument in
order to put upward pressure on the funds rate and
other short-term rates, it will subsequently react by
reversing this action. For instance, there is a huge
seasonal increase in the demand for money in April
to pay Federal income taxes. If the Federal Reserve
reacted to this strength by moving its policy instrument in order to put upward pressure on short-term
interest rates, this movement in rates would simply
have to be reversed in May after the seasonal movement in the demand for money subsided.


For example, “[Several analysts said] that the revised
figures also should make Reagan Administration officials
somewhat happier. Some administrative officials have
voiced concern that the Fed was being too restrictive in
its credit policy and that the money supply’s slow growth
since last July might produce a new recession sometime
this year [1984]” (“Interest Rates Rise.” Wall Street
Journal, February 7, 1984, p. 45). Of course, the money
supply decelerated sharply even with the revisions.
Hence, concern regarding the likelihood of a recession
persisted in some quarters. For example, see the comments by Anna Schwartz in “Bonds Continue to Fall on
Expectations Fed’s Tight Credit Grip May Last a
While,” Wall Street Journal, February 8, 1984, p. 47.


See [l, pp. 37-39], [4, pp. 292-96] and [9, p. 1] for
discussions of the goals and effects of seasonally adjusting the money stock.

The question of what is the Federal Reserve’s policy
instrument is purposefully left vague here for two reasons. which are discussed in Wallich [13]. First, over
the years the policy instrument has changed (at different
times it has been the Federal funds rate, the level of
nonborrowed reserves, the level of borrowed reserves,
etc.). Second, observers occasionally differ as to what
term best describes the Federal Reserve’s policy instrument at any point in time.



The second feature of an ideal seasonal adjustment
procedure would be to avoid eliminating movement
in the money stock not due to the effect of seasonal
events on the demand for money. In particular, an
ideal seasonal adjustment procedure would prevent
the seasonal factors from being influenced by movement in the money stock of an apparent seasonal nature that is not due to seasonal events.9 Such movements could occur if (1) the random term in the
money demand equation by chance temporarily has a
seasonal pattern, or (2) the Federal Reserve reaction
function by chance temporarily introduces seasonality
into the Federal funds rate which in turn causes seasonality in the demand for money. The logic here is
that seasonality in the money stock due to these forces
will not be of a recurring nature. Hence, if the seasonal factors are changed to reflect these temporary
forces, in subsequent years the Federal Reserve may
react inappropriately to observed seasonally adjusted
money. To see why, consider the following example.
Suppose for some reason it happens that for two or
three years in a row the Federal Reserve moves its
policy instrument in a manner that puts downward
pressure on the Federal funds rate and other shortterm rates in the second half of the year, and as a
result money grows more rapidly in the second half
of the year than the first. If seasonal factors are
constructed that eliminate this movement, then in
subsequent years (i.e., after this intra-yearly pattern
of short-term rates is no longer present) seasonally
adjusted money growth will actually be inappropriately low in the second half of the year. In this case
the Federal Reserve might react inappropriately to
the perceived weakness in the money supply.
In practice, identifying whether movement in the
money stock is in fact due to seasonal events can be
very difficult. Although one can identify seasonal
events fairly easily, their effect on the demand for
money can change over time, sometimes abruptly.
Government action as well as technological change
can alter the seasonal demand for money related to
any specific event. Consider, for example, the April
tax date when the seasonal demand for money is
positively related to the amount of nonwithheld Federal income taxes that have to be paid. Government
action could increase the tax date effect on M1 by
raising taxes, decrease its effect on M1 by increasing

withholding of taxes at other times during the year,
or change the timing of the effect by changing the tax
date. Similarly, technological change could influence
the seasonal movement in money by increasing the
ease of substitution between M1 and other assets or
by contributing to the development of new assets not
included in M1 with transactions capabilities, such as
money market funds.
The question remains: How well does the actual
seasonal adjustment procedure incorporate the two
features of an ideal seasonal adjustment procedure
discussed above, and under what circumstances does
the actual procedure depart from this ideal procedure? Prior to 1982, the money stock was seasonally adjusted using the X-11 seasonal adjustment
program developed at the Bureau of the Census of
the U.S. Commerce Department. Since then, the
money stock has been seasonally adjusted with a variant of the X-11 procedure called X-11-ARIMA.
The X-11 program is essentially a ratio-to-moving
For a
average seasonal adjustment procedure.1 0
monthly series the basic steps of this procedure are
(1) a 12-month centered moving average of the
original series is constructed; (2) this centered
average is then divided into the original series to get
ratios (called seasonal-irregular ratios) for each
month in the series ; and (3) a moving average of
these ratios is computed separately for each month
(i.e., a separate average of the ratios for January, the
ratios for February, etc.). This average is an estimate of the seasonal factor for each month. The use
of a moving average of the ratios allows for a seasonal pattern that changes gradually over time.
The version of X-11 used to adjust the money
stock data derives seasonal adjustment factors for
each individual month in the series primarily from a
weighted 7-term moving average of the ratios in the
corresponding calendar months of surrounding years.
For example, the adjustment factor for January 1980
is derived primarily from a weighted average of the
January ratios for the years 1977-1983 inclusive.
Where a month is in one of the terminal years of the
series, the span of the moving average is reduced
since data for a full centered 7-term moving average
are not available.


Also, the ideal seasonal adjustment procedure would
not allow one-time events, such as the 1980 credit controls, to be transmitted to the estimates of the seasonal
factors. See [3, pp. 880-81] for a discussion of the effect
of the credit controls on the money stock and the action
taken to prevent it from distorting the seasonal factor


This is a highly simplified description. For a detailed
description of the procedure see Shiskin [11]. Lawler
[S] contains a step-by-step summary of the X-11 seasonal adjustment of the money stock. Two more recent
articles describing the X-11 and X-11-ARIMA procedures
are Cleveland and Pierce [3] and Hein and Ott [5].
Cleveland and Pierce also give an excellent discussion of
the work done by the staff of the Board of Governors on
methods to improve the seasonal adjustment procedures.


The X-11-ARIMA modification of the X-11 procedure differs only in that it uses an ARIMA (autoregressive-integrated-moving-average) model to generate forecasts of future values of the money stock.1 1
The forecasted values are then used to project the
money stock series into the future, thereby enabling
the same weights to be applied to this extended
series as are applied to years when all the actual
necessary data are available.
There are at least two major sets of circumstances
under which this seasonal adjustment procedure departs from the requirements of the ideal procedure
discussed above. First, seasonal factors will not fully
adjust in one year to an abrupt change in the effect
of a seasonal event on the demand for money. Of
course, the seasonal factors will not reflect the change
at all if it occurs in the current year. Second, the
seasonal adjustment procedure can not effectively
distinguish between movement in money due to seasonal events and movement of an apparent seasonal
nature due to other factors. Hence, the possibility
exists that the seasonal factors will at times be inappropriately affected by movements in money not
due to seasonal events.1 2 , 1 3
These two problems represent opposite extremes
for the X-11 seasonal adjustment procedure. The
procedure could deal more effectively with abrupt
changes in the effect of seasonal events on the demand
for money by shortening the number of years used
to calculate a given year’s seasonal factors. However,
doing so would increase the risk that the seasonal
factors would be influenced by movement in the

This and other proposed modifications to the X-11
seasonal adjustment procedure are discussed in [9, Section 3].

It should be emphasized that this discussion does not
imply that there is some easy way to deal with these
problems. Following the recommendation of the Committee of Experts on Seasonal Adjustment Techniques
[8], a continuing research program on seasonal adjustment methods has been established at the Board of
The Board’s staff has studied numerous
possible improvements in the seasonal adjustment process. one of which was the ARIMA modification to the
basic X-11 model. (See [3].) Another recommendation
of the Committee of Experts was to study “model-based”
approaches to seasonal adjustment of the money stock
which would in part relate the seasonal factors directly
to seasonal events. The staff of the Board of Governors
responded to this recommendation by developing an
experimental model-based approach to construction of the
seasonal factors [10]. There is some evidence that this
procedure is better able to identify seasonal movement in
money strictly due to seasonal events than is X-11. (See
footnote 21 later in this article.)

money stock due to policy or random events. Conversely, the risk of the seasonal factors being influenced by policy or random events could be reduced by
lengthening the number of years used to calculate a
given year’s seasonal factors. But this would make
the seasonal factors less responsive to abrupt changes
in the influence of seasonal events on the demand for
In the remainder of this article it will be argued
that the initial seasonally adjusted money stock data
in 1983 were distorted by both of these problems.
Section III will discuss an abrupt change in the effect
of seasonal events on the demand for money caused
by a change in government regulations. Section IV
will discuss the possible impact on the original 1983
seasonal factors of past movements in money not due
to seasonal events.


In December 1982, the money market deposit account (MMDA) was authorized by the Depository
Institutions Deregulation Committee (DIDC). The
principal features of the account were that it was not
subject to an interest rate ceiling, it required an
initial deposit and maintenance balance of at least
$2500, and depository institutions could not promise
to pay any fixed or indexed rate for a period greater
than a month. Also, MMDAs were allowed only
three transactions by check per month. For this
reason the expectation was that they would be treated
by investors as “savings” rather than “transactions”
accounts and they were not included in M1.14 This
was similar to the decision that had been made in
1980 with respect to money market fund (MMF)
shares, which were not included in M1 because most
MMFs limit minimum check size to $500 [12]. The
expectation regarding the use of MMDAs for transactions purposes has proved correct: the turnover
rate of MMDAs has been about three times per year,
which is actually a little below that of regular savings
deposits. Table II combines MMDAs with MMF
shares to get a total measure of non-M1 accounts with
some transaction capabilities. The table shows that


A third problem, not discussed in this paper. is that
there can be one-time events whose distortions are transmitted to the estimates of the seasonal factors (see footnote 9).


A second account, the “Super-NOW,” introduced in
January 1983, was allowed unlimited transactions and
included in M1.



Table II



Turnover rates ore for consumer deposits.

** This estimate of the turnover rate on consumer demand deposits is from [12, p. 100].

by April 1983 the amount of these accounts outstanding was considerably greater than either transactions
accounts included in M1 or regular savings accounts.
Despite their low turnover rate, MMDAs (and
MMF shares) can be used just like regular savings
deposits to cover large seasonal needs, such as tax
payments in April and Christmas-related expenditures. Unlike regular savings deposits, however,
these accounts can be used directly for seasonal transactions purposes, and this can reduce the seasonal
use of M1 that normally occurs at the April tax date
and at Christmas. The reasoning is as follows.
Regular savings deposits have to be moved into transactions accounts before they can be used to cover
seasonal transactions needs. Ordinarily, these funds
are moved into demand deposits, which are included
in M1. Consequently, unadjusted M1 rises before
the April tax date and before Christmas and then
subsequently falls. In contrast to savings deposits,
MMDA and MMF accounts can be used at tax time
and Christmas time without being moved into M1.
To the extent this is done, it reduces the buildup and
subsequent contraction of M1 deposits. Consequently, the greater the use of non-M1 transaction
accounts to cover seasonal transaction needs, the
smaller will be the amplitude of the cycle in unadjusted M1 for any given seasonal event. The possible
effects of MMDAs and MMFs on the seasonal demand for M1 around the April tax date and Christmas in 1983 are considered below.
The April Experience
Because transactions related to the April tax date
are concentrated over a very short period of time, it
is possible--at least for 1983-to use weekly MMDA

and MMF data to illustrate the effect of the use of
MMDAs and MMFs on the normal seasonal buildup
in M1. The Treasury normally takes the week of the
tax date (April 15) and the following two weeks to
fully process and collect tax payments. Table III
shows that changes in MMDAs and MMF shares
the week including April 15 and the following two
weeks were very low relative to the surrounding
weeks. Since these three weeks coincide with the
period in which transactions balances normally decline as the Treasury collects tax payments, it is
reasonable to attribute the weakness in MMDAs and
MMFs at this time to their use for tax payments.
Table III also shows a hypothetical path for
MMDAs and MMF shares that would have occurred
in the absence of the tax date. The path is based on
the assumption that were it not for tax payments,
weekly changes in MMDAs and MMF shares would
have been at least equal to the smallest weekly change
for the two weeks on either side of the three-week
tax period. The total difference of $8.8 billion between the hypothetical and actual paths of MMDAs
and MMF shares is a very rough estimate of the
extent to which these accounts were used for tax
purposes.1 5 The total amount of nonwithheld indi15

This estimate does not imply that nothing else was
affecting the weekly flows of MMDAs and MMF shares
over the period shown in Table III, only that the weakness of each asset in the weeks from April 20 through
May 4 relative to the surrounding weeks can be attribA number of specific points
uted to tax payments.
related to this general comment are: (1) The weakness
in MMF shares and the strength in MMDAs over the
whole period shown in Table III reflects the movement
of funds out of MMFs into MMDAs during this period.
The estimate in the text abstracts from this movement by
comparing the growth of each asset in the tax payment
period to its own growth in the surrounding weeks. (2)


Table III

($ billions)
MMF Shares (general purpose and broker/dealer)



March 23







- 1.0

March 30


- 1.6

April 6


- 1.3

April 13


April 20



- 1.6

- 3.1

- 1.6


April 27







May 4




- 1.7



May 11


- 1.0

May 18



May 25


- 0.2


Hypothetical path equals the smallest change for two weeks on either side of the three tax payment weeks.

vidual income tax payments in April and May of
1983 was $33.1 billion. Hence, this estimate implies
that about one-fourth of these payments were made
with MMDAs and MMF shares.
This $8.8 billion figure can be used to get a rough
estimate of the effect of MMDAs and MMFs on the
M1 growth rate in April. A dollar of funds that is
moved into demand deposits to pay taxes stays there
about one-half of a month.16 On the basis of this
Tax refunds may have been boosting MMDAs throughout this period,-but there is no reason to believe they
were boosting MMDAs in the tax payment weeks any
less than in the surrounding weeks. (3) There may have
been some buildup in MMDAs in early April for tax
payment purposes. However, the use of a post-tax date
week to get the hypothetical MMDA path should prevent
this possibility from affecting the path. (4) The monthly
flow of funds into IRAs in 1983 reached its peak in April.
Growth in IRAs at commercial banks! thrift institutions,
and MMFs was $4.8 billion in April compared to an
average 1983 monthly increase of $2.0 billion. Some part
of these funds probably came out of MMDAs and MMF
shares at around the tax date. If so, the procedure used
in the text may bias upward the estimated effect of these
accounts on M1 growth. However, the increased IRA
payments in April are small compared to the payments
for nonwithheld taxes, so the bias should be small.

This estimate is based on the ratio of the strictly seasonal movement in M1 in April-calculated as the difference between the unadjusted and seasonally adjusted
changes-to total nonwithheld individual income taxes in
April and early May, which ranged from 46 to 51 percent
in the years from 1976 through 1980. (The ratios in the
years after 1980 are excluded because they were probably
affected by the growth of MMFs.) While this estimate
might seem high, it is evident from the weekly unadjusted
data that the buildup in M1 starts well before the 15th
and the contraction in M1 takes till the end of the month.

estimate, MMDAs and MMFs together lowered the
monthly average level of M1 in April by $4.4 billion.
If the assumption is made that the M1 seasonal
factors had already fully captured the effect of the
MMF shares outstanding in April 1982 ($161.8
billion-or 33.0 percent of the April 1983 combined
level of MMDAs and MMF shares), then the introduction of MMDAs lowered the seasonally adusted
level of M1 in April 1983 by $2.9 billion and reduced
the seasonally adjusted growth rate by 7.0 percentage
A second major period of seasonal need for transactions funds occurs in the months preceding Christmas. Typically the monthly average level of unadjusted M1 begins to rise in September, peaks in
December and then falls through February. 17 B e cause of this pattern, the seasonal factors reduce the
growth rate of M1 in the period from September
through December and increase it in January and
Unlike the April tax date, when transactions are
The slowness of the contraction in M1 following the tax
date occurs because it takes the Treasury 2 to 3 weeks to
(The daily
process and collect all the tax payments.
pattern of Treasury tax collections is available from the
Daily Statement of the U. S. Treasury).

For more detail on the behavior of unadjusted M1
around Christmas see Broaddus and Cook [2].



concentrated at one date, Christmas-related expenditures are distributed over a period of months, making
it difficult to illustrate the use of these accounts at
Christmas by looking at weekly data. Also, as noted
above, MMDAs are limited to three transactions by
check per month and most MMFs limit minimum
check size to $500. The April tax payment is ideally
suited to these accounts since it involves only one
large payment. In contrast, Christmas expenditures
involve numerous smaller transactions, not all of
which can be handled directly by these accounts because of the limitations on transactions. However,
one can also use these accounts at Christmas indirectly by making numerous small expenditures
with a credit card before Christmas and one large
transaction in January with an MMDA or MMF
account. To the extent that this was done, the use
of MMFs and MMDAs to finance Christmas-related
expenditures was spread out over an even longer
period going well into January.
Tables IV and V present evidence that MMDAs
and MMFs were used around Christmas for transactions purposes both directly and indirectly in conjunction with credit cards. Table IV shows that
redemptions of MMDAs and MMF shares were high
in both December and January. The high level of
redemptions in January suggests that credit cards
were in fact used in conjunction with MMDAs and

MMFs to circumvent the restrictions on the use of
those accounts for transactions purposes. If this was
the case, then revolving (i.e., credit card) installment
credit (on a seasonally adjusted basis) should have
grown relatively rapidly in the months prior to
Christmas and then relatively weakly after Christmas
as people wrote checks against their MMDA and
MMF accounts. As shown in Table V, revolving
installment credit grew at a much faster rate than
non-revolving installment credit in the months prior
to Christmas and at a much slower rate in January.
From December to January the differential between
the growth rate of revolving installment credit and
other installment credit fell by 17 percentage points.18
Additional evidence on the possible effect of

A couple of caveats should be made about the interpretation of the differential between the growth rates of
revolving and non-revolving installment credit.
the monthly growth rates of revolving and non-revolving
installment credit are volatile. There are other instances
when this differential has fallen by as much as 17 percentage points, although not over the December-January
period. Hence, the swing in this differential should only
be viewed as consistent with-not proof of--the position
that credit cards were used in conjunction with MMDAs
around Christmas. Second, the growth rates referred to
are seasonally adjusted rates. If the seasonal pattern of
revolving installment credit has changed around Christmas, then the revolving credit seasonal factors will
change over time to reflect this. In future years the
sharp drop in the differential between the growth rates
of revolving and other installment credit from December
to January will be eliminated. The situation is analogous
to the impact of MMDAs on the M1 seasonal factors.

Table IV

($ billions)

MMFs (excluding institutions-only)


(monthly avg.)



(average of end
of current and
previous months)



























































MMDA data are from April 17, 1984 Federal Reserve Statistical Release G.6, “Debits and Deposit Turnover at Commercial
Banks.” MMF data ore from various issues of Donoghue’s Money Fund Report of Holliston, MA 01746.
Note: Turnover rate equals monthly redemptions multiplied by 12 and divided by amount outstanding.



Table V

(seasonally adjusted)
Revolving Installment Credit
Change in
($ millions)


Other Installment Credit



Change in
($ millions)


(in percentage















































Federal Reserve Statistical Release G.19.

MMDAs and MMFs on M1 during the 1983-84
Christmas period comes from a comparison of the
buildup and subsequent contraction in unadjusted M1
in 1983-84 to previous years. Table VI shows that
in the five years before 1983-84 the growth rate of

unadjusted M1, net of trend, in the four months
preceding Christmas averaged 12.5 percent. However, in 1983 the growth rate, net of trend, was only
10.9 percent. It is impossible to prove that this weakness in the pre-Christmas buildup of M1 was neces-

Table VI

(annualized unadjusted growth rates)

August to



August to

December to

August to
(col. 2 - col. 1)





December to
(col. 3 - col. 1)


































- 19.0












- 18.6























sarily due to MMDAs and MMFs. However, in
conjunction with the redemption and revolving credit
data this interpretation is certainly plausible.1 9
THE CASE OF 1981-82

As noted in Section II, the current seasonal adjustment procedure can not effectively distinguish between movement in the money stock related to seasonal events and movement of an apparent seasonal
nature resulting from other forces. An apparent
seasonal pattern in money not related to seasonal
events might occur for a number of reasons. One
possibility would be that, for whatever reason, the
Federal Reserve moved its policy instrument in a
manner that caused the Federal funds rate and other
short-term rates to move in a similar pattern over
more than one year. This would tend to impart a
seasonal influence on money (via the demand for
money) which would influence the calculation of the
seasonal factors. It appears likely that this phenomenon occurred over the 1981-82 period.
Chart 1 graphs the intra-yearly pattern of the
Federal funds rate in 1981 and 1982. In both years
the funds rate was at or close to its yearly high at
around midyear and then fell sharply to its yearly
low at year-end. In 1981 the funds rate fell from
19.04 percent in July to 12.37 percent in December,
while in 1982 the funds rate fell from 14.15 percent
in June to 8.95 percent in December.
In order to get a measure of the effect of movement
in the funds rate on the intra-yearly pattern of the

demand for money, it is necessary to use the interest
rate coefficients of a money demand equation. Chart
2 shows the intra-yearly pattern in money demand in
1981 and 1982 predicted by the movement in the
funds rate in those years and the interest rate coefficients of the San Francisco Federal Reserve Bank’s
money demand equation [6].20 The values in the
chart are shown as deviations in billions of dollars
from the average predicted level for each year and
are solely dependent on interest rate movements (the
procedure used to get these values is described in a
note to the chart). A high value in a given month
means that the current and lagged funds rate was
causing the demand for money to be high in that
month relative to the average level for the year. The
latter five months of 1982 are extremely high relative
to the rest of 1982. This pattern is also evident, but
to a lesser degree, in 1981.
The relative strength of the series shown in Chart 2
in the latter months of 1981 and 1982 suggests that
Federal Reserve policy may have introduced seasonality into the money stock in the 1981-82 period.
Of course, this “policy-related” seasonality would

Actually, the interest rate used in the San Francisco
money demand equation is the six-month commercial
paper rate, not the Federal funds rate. However, the two
rates are very closely correlated over the 1981-82 period,
as evidenced by a simple correlation coefficient of .94.
Consequently, applying the San Francisco interest rate
coefficients to the Federal funds rate gives a close
approximation of the interest rate effect on the demand
for money predicted by that equation.

Chart 1
1981 AND 1982


A second factor that may have affected the pattern of
M1 around Christmas is the increased share of other
checkable deposits (OCDs) in M1. The argument would
be that OCDs have a greater “savings” component than
the rest of M1 (see [7]) and that therefore their inclusion
in M1 should decrease the amplitude of the cycle in unadjusted M1 around Christmas. The seasonal behavior of
OCDs is hard to assess because they have only been
sizable since 1980-i.e., over four Christmas periods. Of
these, the seasonal pattern of OCDs around Christmas
was distorted by the introduction of nationwide NOW
accounts in January 1981 and super-NOW accounts in
January 1983. Furthermore, throughout the period there
is a strong upward trend in OCDs. In the 1983-84 cycle
the seasonal increase in OCDs does appear to have been
weaker than the seasonal increase in the rest of M1.
However, as shown in Table VI, the seasonal increase in
M1 prior to Christmas in the three years before 1983-84
averaged 12.1 percentage points, which was considerably
above the 1983-84 buildup. This suggests that another
factor was at work in 1983-84.



Chart 2

OF M1 IN 1981 AND 1982
(Differences between predicted value for
month and average predicted value for year,)

Note: The estimates in this chart were calculated
as follows:

rates to growth rates calculated using seasonal factors
from the period before 1981 and 1982. This was
done using the original seasonal factors for 1980.
Over the five months ending in December 1983, M1
computed with the 1980 seasonal factors grew at an
annual rate of 4.8 percent; this is 2.2 percentage
points greater than the growth rate of M1 calculated
with the original 1983 seasonal factors.21
This estimate of the effect of policy-related seasonality in 1981 and 1982 on the original seasonally
adjusted M1 growth rate over the last five months of
1983 rests on the assumption that nothing else in
1981 and 1982 was changing the seasonal pattern of
M1 in a way that would increase growth over that
period relative to the first seven months of the year.
Ultimately, perhaps the best test of whether policyrelated seasonality in 1981 and 1982 distorted the
original seasonally adjusted M1 data in 1983 is
whether the seasonal factors eventually revert to their
pre-1981 levels. The 1984 seasonal factor revisions,
which provide some evidence on this point, are discussed below.

1. Values for the interest rate effect (IE)
on money demand were calculated for
each month using the interest rate coefficients of the San Francisco Federal
Reserve Bank’s money demand equation
(estimated with data from August 1976
through December 1981):

2. The predicted level of M1 each month
was calculated by the equation
In (M1) = b + IE
where b is a constant set at a value (6.495)
so that the average predicted level of M1 in
the 1981-82 period would equal its actual
average level. The effect of this simplification is to abstract from the impact on
money demand of the other variablespersonal income and changes in bank loansin the San Francisco equation.

be a problem in interpreting the seasonally adjusted
1983 M1 data only if it influenced the calculation of
the 1983 seasonal factors. However, given the nature
of the X-11 seasonal adjustment procedure, it is reasonable to expect. that the 1983 seasonal factors
would, in fact, be affected by the increase in money
demand resulting from the sharp decline in the funds
rate in the latter months of 1981 and 1982.
A way to get a crude estimate of the possible effect
of policy-related seasonality in 1981 and 1982 on the
original seasonally adjusted growth rates of the
money stock in 1983 is to compare these growth


Table VII summarizes the effect of the 1984 revisions in the seasonal factors on the 1983 M1 growth
rates for the periods discussed in this article. The
revisions lowered the April growth rate by 4.6 percentage points and raised the May growth rate by a
comparable amount. The revisions raised the growth
rate of M1 in the four months preceding Christmas
by 1.7 percentage points and lowered the growth
rate by 2.5 percentage points in the two months
following Christmas. The revisions raised the growth
rate of M1 by 2.0 percentage points over the last five
months of the year. Also, as shown earlier in Table
I, all but one of the revisions in the seasonally

An interesting question is whether the experimental
model-based seasonal factors (see footnote 12) are less
likely to be affected by policy-related seasonality than the
X-11-ARIMA seasonal factors. The model-based seasonal factors have been published only since 1982. However, based on the 1982-83 experience, there is some evidence that they are superior in this regard. The early 1983
X-11-ARIMA seasonal factor revisions lowered the 1982
M1 growth rate from July to December by 1.9 percentage
points, and then the early 1984 revisions raised the 1983
M1 growth rate over those months by 2.0 percentage
points. In contrast, the early 1983 experimental modelbased seasonal factors lowered the 1982 M1 growth rate
from July through December by only 1.1 percentage
points, and then the early 1984 revisions left the 1983 M1
growth rate over those months virtually unchanged.



Table VII



Growth Rate
Growth Rate benchmark)



- 2.7


+ 4.6




- 5.8



+ 1.7



- 2.5



+ 2.0

August to December
December to
February 1984
July to December

source: Federal Reserve Statistical Release H.6 (February 10,

adjusted monthly growth rates were in the opposite
direction of the early 1983 revisions of the 1982
growth rates.
Because of the very nature of the X-11-ARIMA
seasonal adjustment procedure, it is impossible to
positively identify what underlying development or
developments caused the seasonal factors to change.
However, the revisions are consistent with the hypotheses that (1) the introduction of MMDAs caused
a change in the pattern of the demand for M1 around
seasonal events and (2) the original 1983 seasonal
factors were inappropriately influenced by policyrelated seasonality in money demand in 1981 and
1982. (Although both developments relate in part
to the last four or five months of the year and the
upward revision in the, seasonally adjusted growth
rate over this period may reflect one but not both of
them.) The latter argument is also consistent with
the fact that the revisions largely reversed the impact
on the growth of M1 in the latter five months of the
year caused by the early 1983 revisions.


The goal of focusing on seasonally adjusted money
stock data for policy purposes is to reduce seasonal
fluctuations in interest rates resulting from the impact
of seasonal events on the demand for money. Given

the nature of the current seasonal adjustment procedure, there are at least two major types of circumstances that could hinder this objective. First, there
can be abrupt changes in the impact of seasonal events
on the demand for money that are not fully captured
initially by the seasonal adjustment procedure. Second, the seasonal adjustment factors may be affected
inappropriately by movement in money not due to
seasonal events.
It appears likely that the original 1983 seasonally
adjusted money stock data were influenced by both
these circumstances. The introduction of MMDAs
probably decreased the use of M1 balances at times
of major seasonal transactions needs, such as the
April tax date and Christmas. And the policy-related
seasonality in the money stock in 1981-82 probably
affected the original 1983 seasonal factors. While
the nature of the X-11 seasonal adjustment procedure
makes it impossible to say for sure what underlying
developments caused the large revisions in the 1983
M1 seasonal factors, the revisions were consistent
with the view that these two problems did affect the
original seasonally adjusted M1 data.
The discussion in this article points out a potential
hazard of resetting the money supply target at midyear, as was done in 1983. The seasonal factors are
calculated on a 12-month basis and seasonal factor
problems frequently only become apparent as the year
progresses. If annual targets are set, these problems
simply wash out over the year. However, if the
target is reset at midyear from a new base, the
seasonal adjustment errors in the first half of the
year are in effect built into the base of the new target.
As a final comment, there are two reasons to be
optimistic that the problems in focusing on seasonally
adjusted money stock data in coming years will not
be as great as in 1983. First, it can be argued that
difficulties in seasonally adjusting the money stock
are most often associated with changes in governThe period from
ment regulations and policies.
1978 through 1983 included an extraordinary number
of such changes, including some discussed in this
paper (such as MMDAs) and others not discussed
(the introduction of money market certificates in
1978, the October 1979 change in monetary policy
operating strategy, the early 1981 introduction of
nationwide NOW accounts, the 1980 credit controls).
Many, if not most, of these developments were related
to the deregulation of interest rates at depository
institutions, which is a process that has largely been
completed. Hence, this source of disruption to the
seasonal pattern of M1 should be greatly diminished.
Second, the problems discussed in this paper relate


specifically to the current seasonal adjustment procedure (i.e., X-11-ARIMA). In accordance with
the recommendations of the Committee of Experts on
Seasonal Adjustment Techniques [9], a continuing
research program on seasonal adjustment methods
has been established at the Board of Governors [3].
There is reason to hope that the work being done by

the Board’s staff will lead to a seasonal adjustment
procedure that is better able to isolate the effect of
seasonal events on the demand for money. In particular, model-based procedures that, at least in part,
relate the construction of the seasonal factors directly
to specific seasonal events may be fruitful in accomplishing this end.

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