Banking Act of 1935 Centralizes U.S. Monetary Control Summary

  • Last updated on November 10, 2022

By centralizing monetary control, the Banking Act of 1935 assured American businesspeople of a more stable and predictable economic environment and allowed them to conduct longer-range planning.

Summary of Event

The Banking Act of 1935 reorganized control of the U.S. monetary system, centralizing power in the hands of the Board of Governors of the Federal Reserve System Federal Reserve system Federal Reserve Board Board of Governors of the Federal Reserve System and the Federal Open Market Committee Federal Open Market Committee (FOMC). Prior to the act, each of the twelve Federal Reserve banks that had been established by the Federal Reserve Act of 1913 had greater freedom to pursue policies of their own choosing. This lack of central control had the potential to create chaotic business conditions. Businesspeople could not be sure what credit policies the Federal Reserve banks would implement. As a result, entrepreneurs could not predict confidently whether their customers would face an economic upturn and easy credit in upcoming months or instead be discouraged from purchasing because of an economic downturn that might be allowed or encouraged by the local Federal Reserve bank. Furthermore, a business could unexpectedly find itself at a competitive disadvantage in relation to a rival in another city if Federal Reserve banks differed in their monetary policies. These types of uncertainties made business planning and forecasting difficult. [kw]Banking Act of 1935 Centralizes U.S. Monetary Control (Aug. 23, 1935) [kw]Act of 1935 Centralizes U.S. Monetary Control, Banking (Aug. 23, 1935) [kw]U.S. Monetary Control, Banking Act of 1935 Centralizes (Aug. 23, 1935) [kw]Monetary Control, Banking Act of 1935 Centralizes U.S. (Aug. 23, 1935) Banking Act (1935) Banking;legislation Monetary control, centralization [g]United States;Aug. 23, 1935: Banking Act of 1935 Centralizes U.S. Monetary Control[08960] [c]Laws, acts, and legal history;Aug. 23, 1935: Banking Act of 1935 Centralizes U.S. Monetary Control[08960] [c]Banking and finance;Aug. 23, 1935: Banking Act of 1935 Centralizes U.S. Monetary Control[08960] Eccles, Marriner Glass, Carter Strong, Benjamin

The Federal Reserve Act of 1913 Federal Reserve Act (1913) represented a desire to put knowledge of the economy and its monetary system to work. Its passage marked the first systematic attempt to influence the U.S. economy through monetary policy (governmental control of the national money supply and credit conditions). A committee of experts with specialized knowledge not commonly held by politicians would guide monetary policy. Concern about how to balance potential control of the monetary system for political purposes against domination of it by private banking interests led to a splitting of power between private bankers and the presidentially appointed Federal Reserve Board.

The Federal Reserve Board could indirectly change interest rates charged by banks or change the amount of money available to lend, by recommending to the twelve Federal Reserve banks that they change the interest rate on loans they made to banks or by recommending purchases or sales of government bonds and bills. The Federal Reserve Board made few recommendations of either type during its first twenty years. Instead, the chief executive officers, or governors, of the twelve Federal Reserve banks took independent control of monetary policy through the Governors Conference. That group made its own policy choices, then offered them to the Federal Reserve Board for ratification. The Federal Reserve Act of 1913 did not provide for this conference; its unauthorized action was indicative of private banks’ reluctance to yield to central control.

In addition, the individual Federal Reserve banks were free to ignore recommendations of the Federal Reserve Board. The Federal Reserve Bank of New York Federal Reserve Bank of New York in particular acted independently. Its governor, Benjamin Strong, also acted as a powerful leader among the officials who set monetary policy for the system as a whole. Strong’s death in 1928 left the system without commanding leadership. Following the 1929 stock market crash, the New York Reserve Bank favored buying government bonds from banks to provide purchasing power to the economy. It acted on this policy, but Strong’s successor was unable to persuade the rest of the Federal Reserve system to follow along. The Depression might have been far less severe if he had.

Between the stock market crash and the banking holiday declared by President Franklin D. Roosevelt in 1933, the Federal Reserve banks operated essentially independently, according to the beliefs of their own boards of directors. The Federal Reserve Board was weak and divided in opinion. The Open Market Investment Committee Open Market Investment Committee (an authorized body that replaced the Governors Conference in 1923), with one member from each Federal Reserve bank, was similarly powerless. Each bank’s representative came to meetings with directions from the bank’s board of directors, and those banks rarely were unified in their goals. The decentralized control in the period from 1929 to 1933 led to monetary policy that has been described as inept and as possibly worsening the Depression.

The Banking Act of 1933 Banking Act (1933) set up the Federal Open Market Committee, a successor to the Open Market Investment Committee, to determine appropriate bond sales or purchases for the Federal Reserve system. The FOMC also had one member from each Federal Reserve bank. It instituted all policy actions, and the Federal Reserve Board had only the power to approve or disapprove. Federal Reserve banks remained free not to participate in any open market operations recommended by the FOMC.

System officials blamed inadequate powers, rather than misuse of powers, for their inability to stop the Depression’s economic contraction and to prevent bank panics and failures. Furthermore, many system officials were willing to tolerate the bank failures, seeing them as proper punishment for poor management or excessive earlier speculation in financial markets. The failures were concentrated among smaller banks and those that were not members of the Federal Reserve system, so they were of relatively little interest to the larger banks with the most influence in the system. The larger banks, in fact, saw the failures as a way of shaking their small competitors out of the market.

In response to the behavior of the Federal Reserve system in the 1920’s and early 1930’s, Marriner Eccles, a banker and Treasury Department official, devised a plan to correct what he saw as flaws in the monetary control system. He and many others believed that better use of monetary policy could be a powerful tool to end the Depression. Some argued that improper use of monetary policy had exaggerated the economic downturn and that, therefore, less rather than more central control was indicated. Eccles, however, wanted to implement the powers of the Federal Reserve system more broadly and to establish conscious centralized control of the monetary system.

Eccles’s proposals formed the basis for Title II of the Banking Act of 1935, which stirred strong debate in Congress. Senator Carter Glass, who had helped develop the Federal Reserve Act of 1913 and had coauthored the Glass-Steagall Act of 1932, Glass-Steagall Act (1932)[Glass Steagall Act (1932)] particularly opposed changing the nature of the system. It was argued that a stronger Federal Reserve Board would become an arm of the political administration rather than provide independent judgment. These debates led to a rewording of the act to reduce control by the executive branch.

The act reorganized the central bodies of the Federal Reserve system. The Federal Reserve Board was renamed the Board of Governors of the Federal Reserve System, and the U.S. secretary of the treasury and comptroller of the currency were dropped from membership. Each of the board’s seven members was to be appointed by the president, but the members’ fourteen-year terms would overlap, so that no single presidential administration could appoint a majority. The FOMC was reconstituted to include all members of the Board of Governors and five presidents of Federal Reserve banks. Those five positions would be filled by the twelve Reserve bank presidents on a rotating basis. They were to give independent policy recommendations rather than being guided by their banks’ boards of directors as in the past. Most important, each Federal Reserve bank was required to follow the policies recommended by the FOMC and not operate on its own.

The Board of Governors also gained the power to set reserve requirements, or the percentage of deposits that private banks in the system had to keep available to meet demands for withdrawals. The act left election of Federal Reserve bank presidents and vice presidents up to the banks’ boards of directors but made those choices subject to approval by the Board of Governors. These main provisions of the Banking Act of 1935 took power from the individual Federal Reserve banks and centralized it within the Board of Governors and FOMC. Eccles, who had been made chair of the Federal Reserve Board late in November, 1934, was chosen to chair the new Board of Governors that replaced it.

Significance

The most important impact of the Banking Act of 1935 was its message: In the future, there would be a centralized guiding hand behind U.S. monetary policy. Along with other New Deal reforms such as the establishment of the Federal Deposit Insurance Corporation (which the Banking Act of 1935 amended), the act helped to persuade the American business community that there would not be another Great Depression. Businesspeople could predict a more stable American economy in which the government promoted a steady course of growth, with neither excessive unemployment nor the opposite problem, high rates of inflation.

Businesspeople became relatively certain of being able to obtain bank credit for promising projects. Previously, they sometimes had faced bank loan officers who were unwilling to lend because they were uncertain about future national financial conditions and the availability of funds to their banks. Centralized and planned monetary control greatly reduced these uncertainties.

Although individual banks would still fail, depositors and borrowers could rely on the Federal Reserve system to prevent large-scale bank failures. Banks themselves could count on a steadier, more predictable monetary policy environment in which to conduct business. Centralization of power made it possible and profitable for businesses and especially financial speculators to monitor the FOMC and try to guess its policy decisions, which were kept secret for several weeks to avoid any disruptive effects on financial markets. A new job function of “Fed watcher” thus was created.

Formal centralization of control did not end debates concerning independence of the Federal Reserve system. Individual bankers still wanted influence within the system, and the Treasury Department was unwilling to relinquish control of the system completely. The Board of Governors agreed at first to cooperate with the Treasury Department by buying government bonds, as a means of keeping bond prices high to aid the financing of government operations. In 1936, the Board of Governors also exercised its new power to raise the required reserve rate. This acted to reduce the amount of money available to the financial system, more than offsetting the effects of bond purchases. The combined policy contributed to a minor recession in 1936 and 1937. Congress then proposed very specific guidelines for establishing monetary policy, leaving little room for discretion on the part of Federal Reserve system officials. The proposal was not made law, but system officials heeded the implicit warning to coordinate plans with other government agencies.

The Board of Governors and FOMC chose not to exercise their powers to any great degree during the 1930’s, generally letting recovery from the Depression run its course. During World War II, the Federal Reserve banks agreed to cooperate with the Treasury Department’s borrowing, buying Treasury bonds to maintain their price and keep interest rates low. As the war neared its end, however, the Treasury’s desire to keep interest rates low conflicted with the FOMC’s wish to restrain the growth of the money supply as a means of preventing inflation.

The Employment Act of 1946 stated that the government had a responsibility to use all of its tools in a coordinated fashion to maximize employment, production, and purchasing power. Implicitly, the act recognized that neither fiscal policy (use of government powers to tax and spend) nor monetary policy alone was powerful enough to control the U.S. economy. The FOMC continued to buy Treasury bond issues, but Federal Reserve system officials argued more strongly against the constraint that this cooperation imposed on their decisions. In March, 1951, an agreement was reached under which the FOMC was no longer responsible for supporting the price of Treasury bonds. That left the system without a clear and specific policy objective. The public had begun to believe in the power of monetary policy, so Federal Reserve system officials wanted to state clearly how that policy would be used.

An appropriate growth rate of the money supply was chosen as one objective. The FOMC would provide enough money to finance business expansion without causing inflation. The second objective was to vary credit conditions countercyclically, reducing credit availability during business expansions and allowing easier credit during contractions, as a means of offsetting business cycles. The Board of Governors and the FOMC began to exercise their powers of central control in a manner basically independent of political or private business interests. Banking Act (1935) Banking;legislation Monetary control, centralization

Further Reading
  • citation-type="booksimple"

    xlink:type="simple">Board of Governors of the Federal Reserve System. The Federal Reserve System: Purposes and Functions. Washington, D.C.: Author, 2002. An official exposition for the general public. Periodically updated.
  • citation-type="booksimple"

    xlink:type="simple">Broaddus, Alfred. A Primer on the Fed. Richmond, Va.: Federal Reserve Bank of Richmond, 1988. Booklet provides useful background on the Federal Reserve system, summarizing its structure and operation. Devotes a long section to describing actions of the system in the 1970’s and early 1980’s and also offers case studies.
  • citation-type="booksimple"

    xlink:type="simple">Clifford, Albert Jerome. The Independence of the Federal Reserve System. Philadelphia: University of Pennsylvania Press, 1965. Discusses the structural arrangement of the Federal Reserve system, including changes up to 1960. Valuable for insights into debates concerning which public or private agencies should control the U.S. monetary system.
  • citation-type="booksimple"

    xlink:type="simple">De Saint-Phalle, Thibaut. The Federal Reserve: An Intentional Mystery. New York: Praeger, 1985. Examines the philosophy behind the U.S. system of bank regulations, including those related to overseas bank holding companies and international lending. Includes index.
  • citation-type="booksimple"

    xlink:type="simple">Friedman, Milton, and Anna J. Schwartz. A Monetary History of the United States, 1867-1960. Princeton, N.J.: Princeton University Press, 1963. Authoritative study of the operation of the U.S. monetary system by two highly respected economists. Provides a narrative discussion of the use of monetary policy, illustrated with detailed statistics. Argues for the power of monetary policy, devoting more than one hundred pages to explaining how correct use of such policy could have prevented the Great Depression or at least minimized its effects.
  • citation-type="booksimple"

    xlink:type="simple">Hafer, R. W. The Federal Reserve System: An Encyclopedia. Westport, Conn.: Greenwood Press, 2005. Provides a comprehensive explanation of the structure, processes, and policies of the Federal Reserve system and describes key events in the system’s history.
  • citation-type="booksimple"

    xlink:type="simple">Moore, Carl H. The Federal Reserve System: A History of the First Seventy-Five Years. Jefferson, N.C.: McFarland, 1990. Highlights major events in the history of the Federal Reserve system and provides an overview of the issues the system has faced. Accessible to the general reader.
  • citation-type="booksimple"

    xlink:type="simple">Patman, Wright. The Federal Reserve System: A Study Prepared for the Use of the Joint Economic Committee, Congress of the United States. Washington, D.C.: Government Printing Office, 1976. Chapter 9, “The Banking Act of 1935,” gives a concise history of the political maneuvering behind passage of the act and rationales for its passage. Other chapters outline the history of the Federal Reserve system. Includes appendixes containing letters and speeches concerning aspects of the U.S. banking system.
  • citation-type="booksimple"

    xlink:type="simple">Wells, Donald R. The Federal Reserve System: A History. Jefferson, N.C.: McFarland, 2004. Describes American banking practices before formation of the Federal Reserve and then presents a full history of the Federal Reserve system, including information on the system’s relationship to each presidential administration and how the system has evolved over the years.

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