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At a European Central Bank Colloquium in Honor of Tommaso Padoa-Schioppa, The
European Central Bank, Frankfurt, Germany
April 27, 2005
The Evolution of Central Banking in the United States
This conference honors the many contributions of Tommaso Padoa-Schioppa. As a staff
member at the Banca d'Italia starting nearly four decades ago and as a member of the
Executive Board of the European Central Bank (ECB) since 1998, Tommaso has been
deeply involved in what central banks do and how they are organized.
Tommaso has stated: "In shaping monetary policy operations, the role of the financial
environment is not less important than the charter."1 That observation was made in the
context of the way open market operations ought to be conducted, but I would like to
interpret it more broadly in my remarks today. In particular, I will address the question of
whether a central bank's operations depend in an important way on the architecture of the
financial system and the economy it serves. The charter imposes a certain framework, but
events may require changes to procedures and, on rare occasions, changes to the charter.
To explore this topic, I would like to discuss the evolution of central banking in the United
States, with particular reference to currency, relations between the regions and the center,
mandates, and communication. Along the way, I will compare our experience with that of
the ECB. I will, of course, be speaking for myself and not my colleagues at the Federal
Reserve. To start, let me address the title of this session: "A Single Currency and a Team of
Thirteen Central Banks." How did the United States develop a single currency, and what are
the parallels that we can draw with the euro?
A Single Currency
Although the notes of the First and Second Banks of the United States achieved relatively
wide circulation, not until the 1860s, during our Civil War, did a national paper currency
become established. The first step was an issuance of Treasury currency, commonly known
as "greenbacks" because of the color of the ink used to print the notes. Shortly thereafter,
the Congress authorized the establishment of national banks, which issued notes that were
backed by holdings of government bonds. National bank notes of different banks were
similar in design and widely accepted in transactions, but the system had some flaws--the
main one being that there was no means of quickly adjusting the supply of national bank
notes to changing circumstances. In other words, we had established a national currency
system but not a central bank to manage it.
This beginning contrasts with the way the euro was established as a single currency out of
many European currencies. Rather than having no central bank, what was to become the
euro area had, in fact, twelve national central banks, each managing its own currency. Those
currencies were brought into line with one another, first through the exchange rate
mechanism and later by the permanent fixing of exchange rates. The ECB then was created
as a central bank to manage the euro even before a euro paper currency came into existence.
Federal Reserve notes began to circulate in 1914. The System's treatment of these notes
serves as an example of Tommaso's observation that central bank operations respond to
financial events. Initially, notes issued by one Reserve Bank could not be reissued into
circulation by another Reserve Bank. A person could travel from Boston to New York with
notes from the Federal Reserve Bank of Boston in his pocket, spend the notes in New York,
and have them accepted. But when the notes made their way to the Federal Reserve Bank of
New York, that Bank returned the notes to Boston for re-issue. With regard to currency,
then, the Federal Reserve System's charter established twelve banks issuing similar, but not
identical, currency. Over time, however, financial practice made this distinction unimportant,
and the treatment was later discontinued. Today, currency is treated fungibly by the Reserve
Banks, regardless of which Bank issued the note. The notes still carry identifiers that let us
track the Reserve Bank to which the notes were originally assigned, and they are still
allocated as liabilities to individual Reserve Banks. But there is no practical distinction
between the notes of the Reserve Banks.
My understanding is that euro banknotes circulate in a similar fashion within the euro area
and that any national central bank can re-issue fit euro banknotes regardless of the original
issuer. Although the country that originated the production order is indicated by the letter
prefix to the euro banknotes' serial number, even that designation is becoming less important
as the Eurosystem moves to a pooled system of printing banknotes. Even though the
Eurosystem contains the central banks of sovereign nations, the unified treatment of euro
banknotes recognizes the unifying force of a single currency.
Clearly, then, as one considers currency, the history of the Federal Reserve supports and
reflects the truth of Tommaso's statement. As our economy evolved from regional to
national, our currency moved more completely in that direction. I would argue that the euro
reflects a different perspective, with the currency playing a catalytic role in the development
of a continental economy as well as reflecting developments in that regard.
Regions and the Center
In 1913, the very idea of a central bank was contentious in the United States. The result of
the Federal Reserve Act was a compromise, with regional Reserve Banks owned by their
member commercial banks and a Board in Washington to provide oversight. Although the
integration of U.S. financial markets was considerable by the time the Federal Reserve Act
was passed, remaining segmentation made it possible to have different prices for Reserve
Bank credit in different regions during the System's early years. To be sure, these differences
were not huge--basic discount rates differed by as much as 1-1/2 percentage points, with
differences of 50 to 100 basis points persisting for long periods. In Tommaso's terms,
monetary policy operations--that is, discount policy--reflected both the regional nature of
the System's charter and the partial segmentation of the financial environment.
Further integration of the money market over time shifted the focus of policy from twelve
regional discount policies to a single national policy. In addition, concern about operational
efficiencies and about the level of borrowing led to a move from discount rates to open
market operations as the policy instrument of choice. This shift may also have been aided by
the expansion of the government bond market during and after World War I. The use of
open market operations accelerated the desire for coordination of policy at the national
level, so that one Reserve Bank was not draining liquidity at the same time that another was
adding liquidity. Again, the financial environment contributed to developments in policy
implementation.
The balance of policy power shifted from the regions to the center, when the Banking Act of
1935 established the Federal Open Market Committee in its modern form, with the Board
having the majority of votes. From the perspective of monetary policy, it was at that point
that the Federal Reserve System became a single central bank rather than a confederation of
regional central banks. Thus, as Tommaso might suggest, charter changes also played an
important role in the structure of policy.
In the Eurosystem, the balance between the center and the regions is still evolving. The
composition of the Governing Council, the Eurosystem's equivalent to the FOMC, and the
administrative roles of the Governing Council and the Executive Board reflect the relative
strength of the national central banks. This difference in the relative power of the center,
however, should not have great significance for the conduct of monetary policy. As in the
Federal Reserve System, each Eurosystem policymaker is expected to act in the interest of
the entire currency area.
In the United States, once policy implementation boiled down to managing the consolidated
balance sheet of the Federal Reserve Banks, it made sense to concentrate open market
operations in New York, where most major banks and dealers had offices. New York bought
and sold on the FOMC's orders, but the resulting portfolio was allocated to each Reserve
Bank based on its capital. In the Eurosystem, open market operations are conducted in a
unified but decentralized manner. Each national central bank collects bids from financial
entities in its country and relays those to the ECB where they are ranked and allocated
accordingly.
I would argue that these slight variations in the implementation of monetary policy reflect
the financial circumstances under which each institution operates, with a unified money
market in the United States and more-fragmented (but consolidating) money markets in the
eurozone.
Internal Dynamics
Although the 1935 legislation that created the Federal Open Market Committee of today
shifted monetary policy power from the regions to the center, important questions remained
about the internal workings of the FOMC itself. With only five of the twelve Reserve Bank
Presidents on the Committee at any one time, how were these seats to be allocated?2
The FOMC finally settled on a rotation system that was a compromise between strict
equality and relative importance of each District in the financial system. New York was
given a permanent seat. Cleveland and Chicago were grouped together, and the remaining
Reserve Banks were put into groups of three. Thus, Presidents of Reserve Banks other than
New York would be FOMC members every other year or every third year. That rotation
structure has remained unchanged since 1942.
The FOMC operates through formal votes on policy questions, yet in recent years dissents in
the recorded votes have been remarkably rare. Through discussion and with the leadership
of the Chairman, the Committee often crafts a policy action that all members can agree on.
Yet, if one looked only at the final vote, one would miss the lively and wide-ranging debate
that goes on within the meetings themselves. We try to give the flavor of this debate in the
minutes released three weeks after each meeting, and we do release detailed transcripts with
a lag of five years.
My understanding is that the ECB's Governing Council operates by consensus, although a
procedure is in place for a majority vote to determine the course of monetary policy. So far,
the ECB has maintained the principle of one member, one vote, with the six Executive
Board members and the twelve national central bank presidents voting equally regardless of
the economic size of the country that they represent. The ECB has had to wrestle with how
to adjust voting as the euro area expands over the next decade or so. The European Council
has accepted a proposal from the ECB to cap the number of voting national central bank
presidents at fifteen and to begin rotational voting once the number of countries in the euro
area exceeds fifteen. The voting rotation would look a bit like that initially established by the
Federal Reserve, with the frequency of voting by individual members depending in part on
the economic and financial size of their regions. The big difference, however, is that the
national central bank presidents would have fifteen votes versus the six votes of the
Executive Board members, whereas Federal Reserve Board members have a seven-to-five
voting advantage over regional Fed Presidents.
Clearly the system that we follow, with strong regional representation but a majority in the
center, reflects the judgment made in 1935 regarding the primacy of political appointees
with a national mandate. I would argue, although those closer to the scene might correct me,
that the ECB's approach to its regional representation reflects an evolving compromise that
attempts to balance the ongoing legitimacy of national monetary authorities with the need
for a practical solution to the challenges posed by the increasing number of nations within
the eurozone.
Mandates and Approaches to Monetary Policy
The original Federal Reserve Act contained almost no explicit macroeconomic goals for the
System to follow. The gold standard was thought to be sufficient to produce price stability,
and the central bank's lending to meet the needs of trade ("real bills") was seen as fostering
financial stability and the smooth functioning of the economy. Nonetheless, fairly early in its
history, the Federal Reserve interpreted its mandate to be the promotion of monetary and
credit conditions that would foster sustainable growth and a stable value of the dollar. After
the Great Depression and World War II, the federal government took a more-active role in
managing the macroeconomy. The Employment Act of 1946 committed the federal
government to use its resources to foster maximum employment. This act provided some
broad guidance for the Federal Reserve but not explicit goals for monetary policy.
Against the backdrop of poorer economic performance in the 1970s, the Congress gave the
Federal Reserve explicit goals in a 1977 amendment to the Federal Reserve Act. These goals
were stated in terms of maintaining long-run growth of monetary and credit aggregates that
would promote "maximum employment, stable prices, and moderate long-term interest
rates." Thus, the mandate really contained three goals, but the last one has been widely
interpreted as those long-term interest rates consistent with the first two goals, giving the
Federal Reserve a "dual mandate" of maximum employment and stable prices.
Many times in recent decades, the Federal Reserve has stressed its long-run goal of stable
prices, linking it with the other half of our mandate by noting that in the long run the two do
not conflict. However, at times the Federal Reserve has used the flexibility that our dual
mandate provides to consider the variability of real output in policymaking.
For the ECB, the Maastricht treaty mandated that price stability would be the primary
objective. The treaty also established that the ECB should support the general economic
policies of the European Community, aiming at growth and employment but only insofar as
price stability is not endangered. This focus on price stability helped establish credibility for
the new central bank and has helped anchor inflation expectations among the public. A case
can be made that the primacy of the inflation goal also reflected the Bundesbank's distaste
for inflation in light of the German hyperinflation of the 1920s and that this legacy was
bequeathed to the new European Central Bank. Still, policymakers need to be free to act
when severe supply shocks occur. The ECB has wisely interpreted its mandate as
maintaining price stability "over the medium term," giving it flexibility to deal with
temporary shocks.
Obviously, in both the United States and Europe, external conditions and experiences have
guided the development of the mandate, as Tommaso would have suggested and common
sense dictated.
Communication and Transparency
As the conduct of monetary policy has changed over time, it has become increasingly
important that the central bank communicate in an effective and transparent manner. The
Federal Reserve's communications efforts are a work in progress, with several significant
advances being implemented over the past few years. In March 2002, the FOMC began to
release the vote of its members immediately after its meetings. In December 2004, the
FOMC accelerated the release of its minutes from an average of six weeks after the
meetings to just three weeks after the meetings. As part of its communication efforts, the
Federal Reserve, since the late 1970s, has been providing forecasts of inflation and real
economic activity twice a year, as several other central banks have elected to do more
recently. Until recently, these forecasts had a horizon that could be as short as one year. This
past January, the semiannual FOMC forecasts reported in the Monetary Policy Report were
extended to include the following calendar year.
ECB communication practices differ in some notable aspects from those of the Federal
Reserve, with the differences partly reflecting the ECB's unusual situation as a multinational
central bank. The ECB does not release minutes or transcripts and does not provide
information on Governing Council votes. Rather than detailing the differing views of
individual members, who might feel pressure to represent their national interests if their
votes were made public, the ECB focuses on explaining the analysis behind the Governing
Council's consensus. In particular, the ECB follows its monetary policy meetings with a
news conference in which the president reads a statement reflecting the Council's
deliberations and then answers questions.
Changes to ECB communication policy in recent years also have reflected the ECB's
multinational status. In December 2000, when the ECB started releasing twice-yearly
forecasts of gross domestic product and inflation, it chose to release its staff forecasts, in
contrast to the practice of the Federal Reserve, which releases the range and central
tendencies of projections of the individual FOMC members.
I would argue that the Federal Reserve's ongoing process of transparency may also reflect
the highly developed state of our financial markets and a growing recognition that, against
that financial backdrop, shaping the expectations of market participants can on occasion be
an important adjunct to monetary policy. I would be curious to learn the degree to which the
ECB's approaches to communications reflect the financial circumstances as well as the
multinational nature of the institution.
Conclusion
In conclusion, I would like to stress the importance of Tommaso's observation about policy
that I quoted at the outset. Monetary policy arrangements do, and should, adjust over time to
changes in the economic and financial environment. This brief review of the history of the
Federal Reserve shows this adjustment process at work over our ninety-year history. The
charter lays out a structure for policy implementation that is appropriate for the financial
system of the day. The financial system then changes and policy implementation must adapt.
Eventually, changes in the financial system can trigger changes in the charter that give
policy implementation a new context. While there is no single best way to arrange monetary
policy and central bank functions within a multiregional system, I am struck by the broad
similarities between the Federal Reserve and the Eurosystem as each grapples with a large,
complex, and ever-changing macroeconomy. In some ways, your experience has collapsed
into several years changes that evolved over decades for the Federal Reserve. But both
experiences, and the ongoing changes in the economic environment in which we operate,
suggest that the art of central banking is certainly likely to undergo further changes.
Bibliography
Board of Governors of the Federal Reserve System (1994). The Federal Reserve System:
Purposes and Functions. Washington: Federal Reserve Board.
Board of Governors of the Federal Reserve System (1943). Banking and Monetary Statistics
1941-1970. Washington: Federal Reserve Board.
Board of Governors of the Federal Reserve System (1976). Banking and Monetary Statistics
1914-1941. Washington: Federal Reserve Board.
Board of Governors of the Federal Reserve System (1941). Banking Studies. Washington:
Federal Reserve Board, pp. 65-83.
European Central Bank (2004). The European Central Bank: History, Role and Functions
(1533 KB PDF). Frankfurt, Germany.
European Central Bank (2004). The Implementation of Monetary Policy in the Euro Area
(1195 KB PDF). Frankfurt, Germany.
European Central Bank (2004). The Monetary Policy of the ECB (1661 KB PDF).
Frankfurt, Germany.
European Central Bank (2002). "The Liquidity Management of the ECB," (1358 KB PDF)
ECB Monthly Bulletin (May), pp. 41-53.
Kennedy, Ellen (1991). The Bundesbank--Germany's Central Bank in the International
Monetary System. New York: Council on Foreign Relations.
Meltzer, Allan H (2003). A History of the Federal Reserve, Volume I, 1913-1951. Chicago:
University of Chicago Press.
Padoa-Schioppa, Tommaso (2004). The Euro and Its Central Bank. Cambridge: Mass.: MIT
Press.
"Textual Changes in the Federal Reserve Act and Related Laws" (2002). Compiled in the
Law Library of the Board of Governors of the Federal Reserve System, October 31.
Footnotes
1. Padoa-Schioppa (2004), pg. 86. Return to text
2. At any given time, the FOMC consists of only twelve members--the seven members of the
Board of Governors and five of the twelve Reserve Bank Presidents on a somewhat
complicated rotating basis. By custom, however, all twelve Reserve Bank Presidents attend
the meetings of the Committee. The extra seven presidents are not considered nonvoting
members of the FOMC; they are just not on the Committee at that time. Since there are no
nonvoting members of the FOMC, the term "voting member of the FOMC" is redundant. A
more accurate term is "non-voting participant." To complicate matters further, some of the
extra seven Reserve Bank Presidents are designated as alternate members of the FOMC,
depending on the rotation group arrangement. Return to text
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