Monetary Policy Financial Institutions and the Economy - Essay Example

Monetary Policy Financial Institutions and the Economy Since the country’s founding, the United States Federal Government has struggled with the role and control of a central bank. The controversy surrounding the purpose of a central bank links to theoretical and practical economics and politics. Views concerning the control of a central bank vary from total autonomy to strict guidelines from Congress. In order to determine policy recommendations, the following is discussed: 1. Definitions of terms 2. The history and current role of the Federal Reserve system 3. The money supply and affecting factors 4. The cost of money and its affects on the economy 5. Assessment of the current economic conditions and recent decisions leading to them 6. Recommendations for current conditions 7. Explanation and projections The Federal Reserve receives too much credit when things go well; and too much blame when they do not. Definitions of Terms According to Saunders and Cornett (2007), a simple model of financial markets splits the participants into two groups: primary and secondary markets. Primary markets consist of those entities seeking capital, entrepreneurs, who do not have ample retained earnings to afford self finance. Generally, these entrepreneurs find an underwriting investment bank; a financial institution which assesses the value of the business and sets a stock or bond price, then sells the paper to raise capital. Investors buy the stock or fund the bonds. The primary market is entrepreneurs offering financial instruments to raise new capital to investors through investment banks or other financial institutions. These instruments are called Initial Public Offerings (IPO). The secondary market trades existing financial instruments through an exchange. Usually, these securities, investment instruments, have a financial history on which to be evaluated before an exchange accepts the securities for sale (Saunders and Cornett, 2007). Financial markets are further divided as money markets and capital markets. Money markets deal in securities with a maturity date within one year. Capital markets mature in longer time frames. (Saunders and Cornett, 2007) Bonds are debts with a maturity date, the investor loaned the business money. A stock has no maturity date; the investor owns a portion of the business. Financial institutions move money from those with excess to those with shortage through financial instruments. Supply, investors, and demand, entrepreneurs, dictate the terms and conditions of the trades facilitated by the financial institution. Commercial banks, savings banks, formerly savings and loans, thrift institutions, securities traders and investment bankers, finance companies, mutual funds, insurance companies and pension funds all serve as financial institutions, but with differing regulations (Saunders and Cornett, 2007). The History and Current Role of the Federal Reserve System Mayer (2001) defines a central bank as a bank of issue, meaning it creates currency to represent wealth. Many American patriots like Tom Payne and Tom Jefferson thought only state chartered private banks should issue bank notes because governments that can pay bills by printing money generally did so. Money is a commodity, just like bread, eggs and butter. If the supply of money increases without value to back it up, inflation occurs and all prices rise (56). A central bank is a lender of last resort. When all banks clear their transactions through a central bank, the central bank smoothes volatility problems through loans. All banks remain solvent by leaving reserves at the central bank, and then the bank lends money to create more reserves. (57) The central bank regulates financial institutions. (79) In 1791, Alexander Hamilton convinced President George Washington to implement a central bank over the protests of Jefferson and Madison. By 1811, Madison became President and did not renew the charter. The end of the Civil War brought in a new central bank which, too, lasted about 20 years. World War I, 1913, brought the Federal Reserve Act to form a compromised central bank with 12 regional banks. This compromise did not regulate disputes among the banks or with Washington, D.C. (Wells, 2004). As long as the gold standard was in place, the 12 banks could not print more money than was reserved. Friedman states (1994, p.250) “The 1974 removal of the prohibition against private ownership of gold in the United States was, somewhat paradoxically, a tribute to the end of gold’s monetary role”. The U.S., and by extension, most of the rest of the world, became a fiat economy, one in which bank notes act as unsecured loans to the government. Now, the Federal Reserve Bank wields enormous influence over the United States economy yet has no real oversight by Congress and the Chairman’s term is greater than the President’s. Alan Greenspan, former Chairman of the Fed, did not believe any central bank should be removed from the electoral process (Mayer, 80). In 1894, Friedrich Engels predicted the end of market collapses since the world had shrunk with the inventions of steamships, telegraphs, railroads and the Suez Canal. With excess capital spread throughout the world, local over-speculation should diminish to irrelevance. (Mayer, 1) The Federal Reserve now regulates financial institutions, banks and the money supply. The world of computers, day trading and financial markets available around the clock, around the world, Engels might wrongly predict the end of market collapses again. The Money Supply and Affecting Factors The Federal Reserve definition of M1 (see appendix) includes cash not in the Fed plus demand deposits such as checking accounts. The Fed prints money to control the supply of currency. Since demand deposits are included, the velocity of trades may affect the amount kept in checking accounts. Thrift and investment affect M1 as well, moving cash from consumerism to investment. For example: according to Mayer (p. 220) in 1991 the money supply rose 12.6%, at that time, a record. But, transactions were not occurring, that is people were not buying consumer goods. Finally, investors bought stock in technology and communications causing a stock market rise, asset inflation instead of consumer inflation. The ensuing “wealth” dividend sparked the consumer side of the market. The Savings and Loan crisis in the late 1980s and early 1990s created that recession. Black (2005, p. 9) indicates the S&L industry in 1990s was insolvent by about $150 billion due to rampant fraud and over-speculative investment strategies. The Federal Savings and Loan Insurance Corporation (FSLIC) had about $6 billion in funds, insolvent itself. The S&L managers were able to reap big rewards for speculation, the downside was covered by FSLIC insurance, in other words, the customers would not sue for fraud because they suffered no damages, and nobody in government wanted this known. So banks, with Federal Deposit Insurance Corporation (FDIC) well funded, were encouraged to buy S&Ls; or the stronger ones became Savings Banks. The money pumped into the economy did not expand the money supply, it simply exchanged assets. The money supply is affected by the actual supply of currency, consumer transactions, consumer price inflation and the competition between consumer demand and investment demand or thrift. The other factor is crisis. Fixing the economy usually involves exchanging or revaluing assets rather than increased production until the wealth equilibrium is re-established. The Cost of Money and Its Affects on the Economy The cost of money is generally viewed as interest rates although it can also be a return on investment in the case of capital markets. Interest rates represent three components: risk of lending, inflation estimates and profit. Risk versus reward controls the availability of funds. When interest rates are high relative to inflation, there is greater reward for the risk; therefore, more money is available to lend. When alternatives, such as the money markets, provide the same profit at less risk, less money is available for loans. Roche (2011) explains the myth of the multiplier. Banks are not reserve constrained; therefore, more money does not mean more loans. The Fed can print all the money it wants and without an increase in lending, the monetary base will remain insignificant. Currently, loan volumes are decreasing faster than the Fed is supplying money. From the borrower’s perspective, if money becomes too great a percentage of potential profit, the risk of business is not worth the reduced reward. So, the demand for money decreases. In stagnant economies, recessions and depressions, the risk in starting a business is very high. So, the cost of money must be very low; and investors still be willing to lend or capitalize. At some low interest rate, money goes to the mattress, as is the case now. Assessment of the Current Economic Conditions and Recent Decisions Leading to Them Bond markets, stock markets, foreign exchange markets, futures, commodities, everything is commoditized and bundled for sale as shares. Real estate in REITs, bonds and/or stocks in mutual funds create small investments with great spread of risk. The insurance industry has its own markets in risk known as reinsurers (Saunders & Cornett, 2007). Mayer (2001, p. 102) states when there is no systemic risk in investing, the market will only respond quickly if investors are liquid and profitable, that is solvent. Most Fed Chairmen have maintained some margin requirement for stock purchases. A margin requirement is the percent of stock purchase price that is the buyer’s own money. In the Greenspan years, derivatives, such as options, swaps and futures use leverage to control stock and were largely unregulated (Mayer, 79). That triggered the mortgage market to offer over leveraged loans and the ensuing mortgage crisis. M1 has increased from $1.55 trillion in February of 2009 to $1.844 trillion in January of 2011. This figure represents a 15.6% increase in M1 since October, 2010. At the same time, M2 only increased from $8.336 trillion to $8.840 trillion, an increase of 4.1% on average. An increase in the leading liquidity number did not generate sales in consumer goods, nor did it generate investment, the DOW is flat. So, the money must be reducing consumer debt. Interestingly, the March 7, 2011 Federal Reserve statistics show debt has not changed significantly in five years; however, the type of debt has with short term revolving debt decreasing and log-term non-revolving increasing debt increasing. This indicates households are trying to reduce monthly payments and lock in long-term rates. This indicates a continuing liquidity problem. And, since the increase has not stimulated economic activity, it probably indicates a solvency problem for many. The current U.S. unemployment rate is 8.9% as of February 2011 according to the Federal Reserve Statistics. This statistic can be very deceptive. The statistic is based on the number of people seeking employment divided by those employed added to those seeking employment. The military personnel is not included, but other government employees are. Under-employment is counted as full employment, for example, real estate brokers who have not made sales in this poor housing market. The inflation rate is 1.6%; and the interest rate for banks is 0.25%. Recommendations for Current Conditions Politics and economics can create polar disagreement between learned practitioners. Friedman is for free economies and let markets determine outcome. Blinder is for benevolent dictatorial control by the Fed, which will level the money supply properly (Wells, 193). Ultimately, free markets will arrive at a dynamic equilibrium; however, in many ways, the Fed contributed this problem. Two major changes need to occur. Employment must increase, and a more equitable allocation of payroll must occur. The CEOs, as in the time of the S&L crisis, need to accept some of the operational risks rather than designing stock options which eliminate risk. Employees pay structure must increase as a percentage of profits, as Henry Ford created his own consumers. The free market determines CEO pay, but the market demands more equitable distribution of the profit from labor. The recommendation to the Board would be, not an increase in minimum wage, but a minimum percentage split of profits to the labor force. The executive pay was limited to $1 million per year for tax deductibility. In order to circumvent this edict, companies gave executives stock options which guaranteed higher income regardless of outcome. Labor has been squeezed as a result. If the edict stands, and, in addition, labor must share one-third of the profit as bonuses in order for executives to receive bonuses, consumers will have more money, executives will still get bonuses and capital will still receive return on investment. Explanation and Projections When wages trail productivity, other things remaining unchanged, there must be a rise in unemployment (Batra, 146) Wages have lagged behind productivity for years. Technology and work force education has continuously increased the production of labor. If companies are required to pay a productivity bonus to employees, total labor earnings will be equal to or greater than productivity. Unemployment should drop, and consumers will have more spendable cash. Companies could sell more, reducing inventories and increasing profits. Executives will earn more on a greater profit base. Investors will receive a greater return on investments. The country will receive a greater tax income. Monetary policy will not solve this problem. This condition is not liquidity driven, it is solvency and ethically driven. References Batra, Ravi. (2005) Greenspan’s fraud: How two decades of his policies have undermined the global economy. New York: Palgrave Macmillan. Black, William K. (2005). The best way to rob a bank is to own one: How corporate executives and politicians looted the S&L industry. Austin, Texas: University of Texas Press. Federal Reserve Statistical Release. (2011, March 3) Money Stock Measures. Web. Friedman, Milton. (1994) Money mischief: Episodes in monetary history. New York, USA: Harcourt Brace & Company. Mayer, Martin. (2001) The Fed: The inside story of how the world’s most powerful financial institution drives the markets. New York: The Free Press. Roche, Cullen. (2011) The myth of the exploding U.S. money supply. Pragmatic Capitalism-Blog. Retrieved March 7, 2011, from Seeking Alpha Web site: http://seekingalpha.com/article/256913-on-the-myth-of-exploding-u-s-money-supply Saunders, Anthony and Cornett, Marcia Millon. (2007) Financial markets and institutions: An introduction to the risk management approach. New York: The McGraw-Hill Companies, Inc. Wells, Donald R. (2004) The Federal Reserve System: A history. Jefferson, North Carolina: McFarland & Company, Inc. http://www.tradingeconomics.com/Economics/Unemployment-Rate.aspx?Symbol=USD Appendix “1. M1 consists of: (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler's checks of nonbank issuers; (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits (OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union share draft accounts, and demand deposits at thrift institutions. Seasonally adjusted M1 is constructed by summing currency, traveler's checks, demand deposits, and OCDs, each seasonally adjusted separately.” (Federal Reserve Site, 2011) “M2 consists of M1 plus: (1) savings deposits (including money market deposit accounts); (2) small-denomination time deposits (time deposits in amounts of less than $100,000), less individual retirement account (IRA) and Keogh balances at depository institutions; (3) balances in retail money market mutual funds, less IRA and Keogh balances at money market mutual funds. Seasonally adjusted M2 is constructed by summing savings deposits, small-denomination time deposits, and retail money funds, each seasonally adjusted separately, and adding this result to seasonally adjusted M1.” (Federal reserve Site, 2011) Read More