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The N.Y. Fed posted a short piece today about the history of banking and the Fed’s role. Now, there are a few roles the Fed plays in the economy. But it’s important to understand that the Fed exists primarily to serve as a stabilizing force for the U.S. banking system.

The U.S. has always been based on a free market capitalist economic approach. Before the Fed, the banking capitalists didn’t just rule the monetary roost, they often times corrupted it. Before the Fed we had what was essentially rogue banking. Banks would issue loans and settle payments among themselves, but when a crisis broke out it turned into an "every man for himself" economy. Banks didn’t trust the solvency of other banks, payments were impossible to settle, the system froze up. The 1800s saw repeated scenarios like 2008 due to this fragmented arrangement (in fact, there were six depressions in the 1800s). To create some stability in the system we created the Federal Reserve System.

Now, the Fed gets most of its press for its intervention in the economy via monetary policy. So we hear a lot about quantitative easing and manipulating interest rates. This is important policy and certainly has a huge impact on the economy, but what we hear a lot less about is the brilliance behind the design of the interbank payment system. The N.Y. Fed briefly touched on this:

Seven minutes and forty seconds into the film, after the Miller Supply Company has received a check from Mr. Adams for business supplies, and after an employee has endorsed the check, the film turns to the topic of check clearing, where the Federal Reserve makes an appearance:

But instead of collecting the money direct from the Elmville National Bank, the company does it through its own bank where the check is arriving right now. This bank can collect $150 once it places its own endorsement on the check, as it is doing here. But, instead of collecting the money directly, it uses a more convenient method. Like many other banks, it sends its checks to the Federal Reserve Bank for collection. The Federal Reserve Bank is set up to handle thousands of checks from hundreds of banks in a single day. All these banks save themselves a great deal of trouble by collecting on checks through the reserve bank. The Federal Reserve Bank collects the money direct from the banks on which the checks are drawn and returns the checks to these banks.

While the narrator is describing the role of the Federal Reserve in check clearing, the film depicts checks being sorted by hand into a horizontal wooden structure, check amounts being tabulated with an adding machine,and checks being put into envelopes and sorted again in canvas bins.

To better understand this, it’s useful to understand the forms of money in our economy. Banks issue what Monetary Realism refers to as "inside money." It is created inside the private sector. This is the dominant form of money in our economy. The U.S. economy is almost entirely electronic these days. And this electronic money is almost entirely bank deposits. Deposits are the result of the loan creation process. And those deposits allow us all to transact, invest, etc.

When the Federal Reserve was created, a second form of money became more prominent. MR calls this "outside money." It is money created outside the private sector. This includes cash, coins and bank reserves. Private banks do not create these forms of money. But they’re important in helping banks operate.

Banks in the U.S. are part of the Federal Reserve System. So they maintain deposit accounts with regional Fed banks. These deposit accounts are held in bank reserves or outside money. You and I cannot access this money and it’s held on deposit specifically for two purposes -- to meet reserve requirements and help settle interbank payments. Ultimately, a banking system is all about being able to settle payments. And in a capitalist market like the one we have where the money supply has been privatized to an oligopoly of private entities, it’s crucial that payments be settled in an orderly fashion. This is one of the dominant and probably the most important roles of the Fed. The interbank system where deposits are held on "reserve" is where these payments settle. It’s kind of like having a nationalized banking system, but still maintaining private competitive banking.

It’s rather brilliant when you understand the design of it because it allows the money supply to be elastic and based almost entirely on a market based demand structure, but has elements of a nationalized banking system that help create oversight and order in a market that would otherwise be fragmented. Unfortunately, it’s all the other stuff the Fed does that gets all the negative press and takes the spotlight off this rather ingenious system design.

Addendum: It’s often noted that this system of private banking is not in keeping with public purpose. This is true to some degree. After all, private banks exist for private purpose to increase profits for their owners. So there is an interesting conflict in the existence of the Fed. The Fed is ultimately an act of Congress and so is designed to serve public purpose. But the Fed is subservient to the banks because it is private banking, which it oversees and operates within. I am not here to be judge and jury of that design structure, but merely to help you better understand what we have today.

Source: Understanding The Fed's Primary Purpose