How The Federal Reserve Works (And Who Really Owns It) - YouTube

The Federal Reserve: the cornerstone of the American economy.

For just over a century the Fed has overseen the financial system of the US, but its track

record has been far from perfect. Worse yet, it has such a unique and convoluted

structure that it’s very difficult for people to really understand it, which is why unsurprisingly

the Fed has been subject to various conspiracy theories, from being owned by the Rothschilds

to being operated by lizard people. Today, we’re going back to the dawn of American

finance to see how the Fed was created, how it works and who really owns it.

This video is brought to you by Skillshare, where you can find a ton of different classes

including my own series of videos on how the stock market works.

You can watch them for free by registering with the link in the description.

America during the late 19th century was a nation in turmoil and not just in the literal

sense. The Civil War was no doubt devastating, but

even during the peace that followed America was plagued by frequent and deep economic

depressions. The underlying cause was simple: America just

lacked a proper financial system and more importantly, it didn’t have a central bank

to save the day when things turned bad. Now, keep in mind, central banking wasn’t

a new concept. The Dutch were the first to come up with a

central bank in 1609 and it was instrumental in transforming the Netherlands from a swampy

backwater into a global economic empire. Following the example of the Dutch, the English

created the Bank of England in 1694, which of course became the backbone of the British

Empire. But it’s exactly this association with the

British that made the Founding Fathers reluctant to use the same model in the United States.

There were two attempts at establishing a central bank even despite public opposition:

Alexander Hamilton himself led the first movement in 1791.

But in both cases the systems lasted under 20 years and did little to stabilize the situation.

And by all accounts the situation was very very bad.

Back then even a single local bank failing could result in nationwide panics.

People knew that no one could save their bank if it went bust, so as soon as rumors of insolvency

started spreading, everyone frantically started withdrawing whatever they had, bankrupting

otherwise healthy and solvent banks simply out of fear.

Such bank runs happened with frightening regularity and the depressions that followed were long

and painful. Of course, American bankers realized very

well just how bad their industry was doing. Paul Warburg, one of the great American bankers

of his day, said in 1907 that the American banking system then was at about the same

point as 15th century Italy or Babylon in 2,000 BC.

Just a few months after Warburg made that statement, the country suffered the Panic

of 1907 and it was particularly severe. To start things off, in 1906 a devastating

earthquake destroyed 80% of San Francisco. With reconstruction efforts underway, capital

was very tight and because all the money back then was in paper form it was much more difficult

to reallocate it across the country. One banker tried to abuse that by manipulating

the stock price of the United Copper company back on Wall Street.

He hoped to see his shares rise exponentially in value, but instead they crashed, dragging

down the entire stock market with them. That banker was involved in 10 different banks

across the East Coast and one after another these banks failed as people assumed they

were insolvent and withdrew all their money. Pretty soon even banks that had nothing to

do with that guy were going under, and so the fearful bankers of America turned to the

only man with the power to save them: J. P. Morgan.

Back then, John Morgan was the king of Wall Street, and even today the bank he created

is the largest one in America. He wasn’t the wealthiest man at the time,

that title belonged to John Rockefeller, but Morgan was certainly the man everyone turned

to when things got bad. In October 1907 Morgan summoned the great

bankers of the day to his office at 23 Wall Street.

With the collective capital of America’s big banks, Morgan arranged for the rescue

of the healthy banks that were nevertheless near bankruptcy due to irrational fears.

Virtually the same thing would happen a century later in 2008 when the government bailed out

the banks, but this time it was happening entirely thanks to private individuals like

John Morgan. Once the panic was contained, it became clear

to everyone that a central bank was necessary and Congress immediately passed legislation

to create one. However, that was pretty much the only thing

everyone agreed on: the actual details of how it would work sparked long and fierce

debates that halted any progress. The agricultural South, for example, was afraid

that a powerful central bank would give Washington and Wall Street too much power over them.

The bankers meanwhile wanted to make sure that the central bank would not be manipulated

by political interests: they wanted it to be as independent as possible from Washington.

The sheer number of competing parties made creating a central bank extremely difficult

and negotiations would in fact take over 5 years to finalize.

What’s interesting though, is that these negotiations weren’t happening on Capitol

Hill. Instead, they were held 600 miles south of

Washington on Jekyll Island in Georgia. That resort was home to an exclusive club

of over a hundred of the wealthiest men at the time, including John Morgan.

Of course, only a select few would help draft the actual plan for the central bank and it

wouldn’t be until 1913 that legislation would actually come to pass.

The newly created Federal Reserve was truly a miracle of compromise.

To accommodate all the various interests of the diverse United States, the Fed became

a central bank unlike any other in the world. To begin with, it wasn’t even a single bank,

instead it was a network of twelve regional banks each governed by local bankers and businessmen.

Some of these banks were in obvious places, like New York and Chicago, but many of the

other locations came down to politics. The Senator from Missouri, for example, was

a key vote needed to pass legislation, which why today Missouri is the only state to have

two federal reserve banks within its borders. To appease Washington, these twelve regional

banks would have a single governing body, comprised of seven people appointed by the

president and confirmed by the Senate. To limit the president’s power, he can only

appoint one governor every two years with a 14-year term.

But the really unique part of the Fed’s structure, and you can thank John Morgan for

that, is the fact that each regional bank is actually structured as a private corporation

that has its own stock. Here’s how it works: every nationally-chartered

bank in America is required by law to keep 6% of its capital in its regional reserve

bank. In exchange, that private bank receives an

equivalent amount of shares in the regional reserve bank.

These shares, however, are quite different from the shares of public companies.

Their price is fixed at $100 per share and they cannot be sold or traded.

They carry voting rights to about two-thirds of the Board of Directors for that regional

reserve bank, but as we know the real power is in the Board of Governors appointed by

the President. What these shares do have, however, is a fixed

6% dividend per year. It’s worth noting that this dividend doesn’t

entitle the banks to any the Fed’s profits. Instead, everything the Fed earns above that

6% payout goes directly into the Treasury. And keep in mind, the Fed is very profitable:

in 2017 it sent $80 billion to the Treasury, while only paying out $14 billion to the regular

banks that hold its stock. So who are the shareholders of the Federal

Reserve? Well, basically every big bank in America.

The full list is 150 pages long, but pretty much every name you know appears on it.

But here’s the beautiful thing: most of America’s big banks are public corporations.

In other words, if you want to benefit and make money off of the unique structure of

the Federal Reserve you can do that by purchasing stock in American banks.

Since ownership in the Fed depends on capital, the bigger the bank, the bigger its ownership

stake. Therefore, it would be wisest to start from

the top of the list. And speaking of the stock market, in case

you somehow missed it last month I released a 20-minute animated series of videos on how

the stock market works on Skillshare. I cover topics like how dividends get paid

out or how ETFs work and if you want to watch the full class you can register for a 2-month

free trial of Skillshare using the link in the description.

Once you’ve registered, search for “investing 101” or follow the link I’ve left in the

comments below. If you don’t know, Skillshare is the best

online learning platform out there. It has thousands of different classes on a

wide variety of topics, including business and the stock market.

By the way, I want to thank all 2,000 of you who already watched my class: you’ve helped

make it the most popular stock market class on Skillshare and I’m thankful for that.

In fact I’m already working on a second series of videos that goes deeper into how

companies work, including valuations, buybacks, multi-class stocks and a whole bunch of other

fascinating topics. I’ll let you know when that course goes

live, but until then make sure you’ve checked out Skillshare and my one course on it.

Anyway, thanks for watching. If you’re new to Business Causal make sure

to subscribe and also consider liking this video if you enjoyed it.

As always, a big shoutout to my patrons on Patreon for supporting me and for being awesome.

You’ll hear from me again in about two weeks and until then, stay smart.