Foreign exchange dealing can be traced back to the early stages of history, possibly beginning with the introduction of coinage by the ancient Egyptians, and the use of paper notes by the Babylonians. Certainly, by biblical times, the Middle East saw a rudimentary international monetary system when the Roman gold coin aureus gained worldwide acceptance followed by the silver denarius, both a common stock among the money changers of the period. In the Bible, Jesus becomes angry at the money changers. I hope His wrath was directed at the poor exchange rates and not the profession itself!
Into the Middle Ages, foreign exchange became a function of international banking with the growth in the use of bills of exchange by the merchant princes and international debt papers by the budding European powers in the course of their underwriting the period’s wars. By the end of the Renaissance, money and currency trading were the lifeblood of most civilized nations. In the eighteenth century, banker Mayer Rothschild said, “Give me control over a nation’s money and I care not who makes her laws.”
The gold standard was a fixed commodity standard: Participating countries fixed a physical weight of gold for the currency in circulation, making it directly redeemable in the form of the precious metal. In 1816, for example, the pound sterling was defined as 123.27 grains of gold, which was on its way to becoming the foremost reserve currency and was at the time the principal component of the international capital market. This led to the expression “as good as gold” when applied to Sterling—the Bank of England at the time gained stability and prestige as the premier monetary authority.
Of the major currencies, the U.S. Dollar adopted the gold standard late in 1879 and became the standard-bearer, replacing the British Pound when Britain and other European countries came off the system with the outbreak of World War I in 1914. Eventually, though, the worsening international Depression led even the dollar off the gold standard by 1933; this marked the period of collapse in international trade and financial flows before World War II.
As an investor, it is essential to acquire a basic knowledge of the Federal Reserve System (the Fed). The Federal Reserve was created by the U.S. Congress in 1913. Before that, the U.S. government lacked any formal organization for studying and implementing monetary policy. Markets were consequently often unstable and the public had little faith in the banking system. The Fed is an independent entity, but is subject to oversight from Congress. This means that decisions do not have to be ratified by the president or anyone else in the government, but Congress periodically reviews the Fed’s activities.
The Fed is headed by a government agency in Washington known as the Board of Governors of the Federal Reserve. The Board of Governors consists of seven presidential appointees, each of whom serve 14-year terms. All members must be confirmed by the Senate, and they can be reappointed. The board is led by a chairman and a vice-chairman, each appointed by the president and approved by the Senate for four-year terms. The current chair is Ben Bernanke, who was sworn in on February 1, 2006, and whose term as chairman expires in 2014.
There are 12 regional Federal Reserve Banks located in major cities around the country that operate under the supervision of the Board of Governors. Reserve Banks act as the operating arm of the central bank and do most of the work of the Fed. The banks generate their own income from four main sources:
The income generated from these activities is used to finance day-to-day operations, including information gathering and economic research. Any excess income is funneled back into the U.S. Treasury.
The system also includes the Federal Open Market Committee, better known as the FOMC. This is the policy-creating branch of the Federal Reserve. Traditionally, the chair of the board is also selected as the chair of the FOMC. The voting members of the FOMC are the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and presidents of four other Reserve Banks who serve on a one-year rotating basis. All Reserve Bank presidents participate in FOMC policy discussions whether or not they are voting members. The FOMC makes the important decisions on interest rates and other monetary policies. This is the reason they get most of the attention in the news media.
The primary responsibility of the Fed is “to promote sustainable growth, high levels of employment, stability of prices to help preserve the purchasing power of the dollar, and moderate long-term interest rates.”
In other words, the Fed’s job is to foster a sound banking system and a healthy economy. To accomplish its mission, the Fed serves as the banker’s bank, the government’s bank, the regulator of financial institutions, and as the nation’s money manager.
The Fed also issues all coin and paper currency. The U.S. Treasury actually produces the cash, but the Fed Bank then distributes it to financial institutions. It is also the Fed’s responsibility to check bills for wear and tear, taking damaged currency out of circulation.
The Federal Reserve Board (FRB) has regulation and supervision responsibilities over banks. This includes monitoring banks that are members of the system, international banking facilities in the United States, foreign activities of member banks, and the U.S. activities of foreign-owned banks. The Fed also helps to ensure that banks act in the public’s interest by helping in the development of federal laws governing consumer credit. Examples are the Truth in Lending Act, the Equal Credit Opportunity Act, the Home Mortgage Disclosure Act, and the Truth in Savings Act. In short, the Fed is like a police officer for banking activities within the United States and abroad.
The FRB also sets margin requirements for stock investors. This limits the amount of money you can borrow to purchase securities. Currently, the requirement is set at 50 percent, meaning that with $500 you have the opportunity to purchase up to $1,000 worth of securities.
Most people accept the Fed without question, even though very few understand even its most basic operations. Auto magnate Henry Ford once said, “If the public knew what the Federal Reserve did, there would be a revolution before the sun comes up tomorrow.”
Many of those who do know have concluded the economy would be better off without it. Let the market decide the ratio between spending and savings, they say. The Fed ultimately acts to redistribute wealth by increasing the money supply and lending it cheaply to banks, which, in turn, lend it back to the people who created the wealth in the first place. In essence, a bank may get money at 2 percent that some see as a 29 percent rate on their credit card. Critics say the Federal Reserve System is neither federal, a reserve, nor a system.