And in the face of ignorance and resistance, I wrote financial systems into existence.—Lin-Manuel Miranda as Alexander Hamilton
Although the financial framework of the United States retains aspects of the foundation laid centuries ago, what we knew even several presidential administrations ago about banking, currency, and financial regulation has evolved at dizzying speed. In the midst of a turbulent economy, we must understand the complex inner workings and intricate interplay between two institutions—the U.S. Department of the Treasury and the Federal Reserve System—that affect our standing as a world economy and our position as citizens. So, let’s begin by looking back in order to anticipate a path forward.
Congress established the Department of the Treasury (Treasury) in 1789. It was created to serve as a permanent institution for the management of government finances. Although Treasury is responsible for managing the nation’s finances, it does not have the authority to set fiscal policy. That is done by the legislative and executive branches. Treasury is responsible for analyzing and reporting on current and prospective economic developments in the global economy and advising the president on appropriate economic policies.
Revolutionary America. Treasury’s history is rooted in the turmoil of the American Revolution and concern over how the revolutionary government would finance the war. The Continental Congress had no power to levy and collect taxes or secure foreign funding. To administer the government’s finances, Congress created the Office of the Treasurer in 1775, followed by the Treasury Office of Accounts in 1776. With the Declaration of Independence, the government was able to secure loans from abroad. The Colonial Treasury Office managed the fledgling nation’s finances until September 1789, when the First Congress established the Department of the Treasury.
The new nation. Alexander Hamilton was sworn in as the first secretary of the Treasury on September 11, 1789. Hamilton’s first act was to revitalize public credit by repaying a $75 million war debt. Hamilton then pushed through the creation of a national bank, which acted as the government’s fiscal agent. The quasi-public national bank loaned government money and extended credit to American businesses and industries. Passage of the 20-year charter of the first Bank of the United States was so controversial that it fractured the First Congress into separate factions.
Treasury reform. Since its founding, Treasury’s financial policies have been remodeled several times, specifically with the dismantling of the national bank system. President Andrew Jackson effectively killed the national bank system when he let the charter of the second Bank of the United States expire in 1836. Presidential adherents of Jacksonian financial policy continued to block the development of a new banking system, arguing instead for the creation of an independent treasury, removing all government funds from private financial institutions.
In 1846, President James K. Polk brought the independent treasury system to life with the passage of the Constitutional Treasury Bill. The Bill established the Independent Treasury for the exclusive management of the nation’s finances, devoid of any entanglement with private and state banks. The federal government was now its own banker.
Civil War and Treasury reform. In the midst of the Civil War, the Independent Treasury was proven inadequate to meet the federal government’s fiscal needs. The government desperately needed to generate cash to finance the war. It had no choice but to borrow from private and state banks. To prevent a recurrence of the same financial hardships of war debt financing, the National Bank Acts of 1863 and 1864 authorized the creation of a national banking system and uniform national currency, violating the spirit of an independent treasury.
The Federal Reserve Act of 1913 established a new authority to set monetary policy, overseen by Congress and designed to function free from political influence by the executive branch. The Federal Reserve System (Fed) is the central bank of the United States. Its goal is to furnish an elastic currency, oversee a more stable monetary system, and effectively supervise U.S. banking institutions. Today, the Fed consists of three policymaking branches, each responsible for setting monetary policy: the Federal Reserve Board of Governors (Board), the Federal Reserve Banks (Reserve Banks), and the Federal Open Market Committee (FOMC, established separately in 1933). There are 12 Reserve Banks and 24 Branches split into regional districts. Each Reserve Bank is represented by its own president, who also serves in rotation as voting members of the FOMC.
The Great Depression and Banking Acts of 1933 and 1935. The 1929 stock market crash and Great Depression demonstrated the original authority assigned to the Fed was insufficient to effectuate monetary policy and maintain a stable economy. The Banking Acts of 1933 and 1935 restructured the Fed. The 1933 Act increased the Fed’s independence by removing the secretary of the Treasury and comptroller of the Currency from Board membership. The Banking Act of 1935 consolidated responsibility within the Board for setting the reserve requirements and discount rate. Of greatest importance was the creation in 1933 of a new branch within the Fed, the FOMC, to conduct open-market operations.
Treasury-Federal Reserve Accord, 1951. At the height of World War II, the Fed concluded winning the war was the nation’s most important financial goal and agreed to support the war effort by abdicating its authority to set interest rates to Treasury. Treasury kept interest rates low, allowing the government to run up substantial debt at a lower cost.
After the war, the Fed and Treasury were divided over how to revive the postwar economy. Treasury retained control over interest rate policy, keeping interest rates low to make repayment of war debt cheaper for the government. The Fed focused on reviving the overall economy by reducing inflation and preventing U.S. currency from becoming worthless; however, the Fed could not make any adjustments without Treasury’s permission.
Tensions between the Fed and Treasury invited congressional intervention in 1950, culminating in the Treasury-Federal Reserve Accord on March 4, 1951. The Accord affirmed separation between the two entities over monetary policy, restoring the Fed’s authority to set interest rates without Treasury interference. The Accord also recognized that the separation of government debt management operations from monetary policy was necessary for the long-term success of the U.S. economy.
Reform Act of 1977. The Federal Reserve Reform Act of 1977 shaped the Fed’s current monetary policy by amending the policy goals of the original Reserve Act. The Fed was directed to pursue new policy goals, known as the dual mandate, to promote maximum employment, stabilize prices, and moderate long-term interest rates.
Dodd-Frank Act of 2010. In response to the 2007–2009 financial meltdown, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010 to enhance consumer protection and reform Wall Street by increasing the Fed’s regulatory supervision of shadow banking systems, targeting all financial services, intermediaries, and individual businesses based on their significance to the overall financial system.
Treasury’s mission is to maintain a strong and stable economy, promote economic growth, and create job opportunities. The secretary of the Treasury is a member of the president’s cabinet. The secretary is primarily responsible for drafting economic policy and recommending that policy to the president. Treasury works with other federal institutions, including the Fed, to fulfill policy objectives.
Treasury is organized into two major components, Departmental Offices and Operating Bureaus. The Offices are responsible for formulating fiscal policy and management of Treasury, while the Bureaus carry out specific operations. The basic functions of Treasury include managing government finances, collecting taxes, producing coins and currency, supervision of financial institutions and investigation, and enforcement of finance laws.
Fiscal policy. The nation’s fiscal policy is set by both the executive and legislative branches of the federal government, not Treasury. Fiscal policy is any legislative action taken by the federal government to influence the direction of the economy by altering taxing and spending policies in response to economic conditions. Depending on the intent, fiscal policy can be classified in one of two ways: expansionary or contractionary.
There are two key fiscal policy tools that Treasury exercises to influence the economy in the short and long term: taxation and government spending. Adjusting taxation and government spending can influence the broader economy by increasing or decreasing the amount of expendable income and employment.
Taxation. The rate of income taxes on households and businesses is the primary method to influence the economy. To expand the economy, policy makers decrease the income tax rate; to contract the economy, they increase the income tax rate.
Spending. Government spending can stimulate or cool economic activity. To expand the economy, policy makers increase the amount of spending on government-funded projects, creating new jobs and income; to contract the economy, they lower the amount of spending.
Expansionary fiscal policy (either decreasing taxes or increasing government spending) is primarily utilized to prevent a recession or help the economy recover from a recession. Expansionary fiscal policy was designed to stimulate the economy by generating extra income and reducing unemployment. Contractionary fiscal policy (raising income taxes or decreasing government spending) is primarily used to combat inflation when economic growth becomes unsustainable.
The economy naturally and inevitably fluctuates between good and bad. When the economy veers too far off course in either direction, the government intervenes to try to right the economy.
The Fed’s general function is to stabilize the U.S. economy and financial systems. Its monetary policy refers to actions undertaken to influence the cost and availability of money and credit in the economy. The Fed implements monetary policy in accordance with Congress’ dual mandate to promote a healthy economy by maintaining stable prices, maximum employment, and moderate long-term interest rates. This is primarily achieved by influencing interest rates and overall financial conditions using a variety of tools.
Policy-making bodies. The Board of Governors of the Fed (Board) consists of seven members who are appointed by the president and confirmed by the Senate. The Board exercises supervisory controls over financial institutions and is responsible for setting the reserve requirements and discount rate.
The FOMC is the body responsible for setting national monetary policy. The FOMC sets interest rates and the federal funds rate (the interest rate financial institutions charge each other to lend excess reserves overnight). The FOMC conducts open market operations to manage the health of the economy and determine whether to make adjustments (to reserves) to maintain the target federal funds rate. Open market operations entail buying and selling government securities on the open market in order to expand or contract money in the banking system and influence interest rates. The FOMC also influences monetary policy by publicly announcing the likely course of the economy, which affects the decisions households and businesses make about future large-scale spending, thereby affecting long-term interest rates, stock prices, and employment in the United States.
To implement monetary policy, the Fed has traditionally used three core instruments: open market operations (discussed above) and setting reserve requirements and discount rates. Reserve requirements are a percentage of deposits financial institutions must maintain in reserve. The discount rate is the interest rate financial institutions pay on short-term loans from a Reserve Bank at rates above the federal funds rate. Changing reserve requirements can alter the amount of reserve funds available to lend. In 2008 and 2014, two supplementary tools were added, for use only when the traditional tools are ineffective: interest on reserve balances rate and overnight reverse repurchase agreement offering rate. The interest on reserve balances rate imposes interest on excess reserves, including required reserves held at Reserve Banks. The overnight reverse repurchase agreement offering rate is an arrangement for financial institutions to purchase securities from the Fed overnight using excess reserves, which the Fed repurchases the next day with interest. Both are used to discourage financial institutions from loaning excess reserves at a rate below the federal funds rate.
In March 2020, the Fed reaffirmed its promise to do whatever it takes to prevent the U.S. economy from collapsing under the weight of the pandemic.
Alexander Hamilton’s financial system may barely be recognizable in the operations and authority of the Federal Reserve Bank. Likewise, the Department of the Treasury bears little resemblance to a Jacksonian independent treasury. However, the role of a central bank remains a key component of American economic policy because of its ability, in the words of former Fed Chair Janet Yellen, “to take risks and avoid harm to the economy” (quoted in Christopher Leonard, How Jay Powell’s Coronavirus Response Is Changing the Fed Forever, Time (June 11, 2020)). For more than 100 years, Treasury and the Fed have adhered to principles of influence and direct intervention during times of economic crisis on behalf of both households and businesses to backstop the U.S. economy. While complex policy and intricate processes within each institution continue to evolve, in times of economic turbulence, the Fed’s protectionist approach has consistently managed extreme fluctuations and brought stability and security.
