How the Federal Reserve Got to Be - Article Example

Name of Student Name of Supervisor Date About Federal Reserve How the Federal Reserve got to be? Monetary policy is the most flexible economic policy tool of government, and possibly its most potent one as well. The experience of the 1920s and 1930s revealed a deep mistrust of monetary policy, and perhaps to a greater extent, of central bankers. Governments yearned for some form of stability, after decades of large fluctuations in the price level and in other major macroeconomic aggregates. Martin Mayer describes it in his book and says “Despite general dissatisfaction with the Feds performance in the last years of the 1920s boom and the first years of the depression, the restive Democratic Congress could not imagine another device to do the money job. A very eminent group of University of Chicago economists (headed by Frank Knight, Henry Simons, Aaron Director, Sen. Paul Douglas, and Albert Hart) had submitted a detailed scheme to nationalize the Federal Reserve Banks and convert all commercial banks to institutions that could accept demand deposits only subject to a 100 percent reserve requirement, as the only safe way to organize government deposit insui-ance.24 They got a respectful hearing from Agriculture Secretary Henry Wallace, who urged the scheme on Roosevelt, but neither the president nor the Congress wanted to upset this applecart when so many people were selling apples (p. 77) While fiscal policy would dominate the scene as the principal tool of policy, three concurrent forces lead to a shift back to the view that the central bank must occupy a central place in the implementation of economic policy. First, exchange rate stability is an illusion and must of necessity come in conflict with domestic objectives that diverge across countries. Second, the growth of trade and of capital mobility leads to international imbalances that are exacerbated by artificial attempts to maintain exchange rate regimes ill suited to such an environment. Third, fiscal policy is slow to act and is increasingly an inept instrument for attaining particular economic objectives. This is especially true in a world of high-frequency data. The impression is sometimes given that what has changed, in the 1990s especially, is the greater recognition of the importance of price stability. Nothing could be further from the truth. Economists and policy makers long ago felt that monetary policy was about delivering low and stable inflation rates. “It may be assumed that the whole of the economic world is agreed upon the desirability of securing some degree of stability in the general level of prices. Martin Mayer describes this situation and says, “Among the oddities of the 1990s has been the rise of a school of thought holding that there is no systemic risk n finance—that the markets will rebalance quickly if only governments will permit the foxes of economic growth to eat the lame ducks of unwisely sunk costs. Central banks, in this theory have fostered a culture of ‘pseudo-systemic risk” to puff up their own importance. Writing in 1995, when the emerging markets were booming, Anna Schwarz and colleagues wrote that, “investors will shun entities where they perceive uncompensated risk and flock to entities with more inviting returns”. Emerging stock markets are an example Two yea later, the collapse of these market & coupled with the collapse of the currencies of the countries where they were situated, plunged much of Asia and some of South America into the worst depression since the 1930s. (p.103) There were two principal players in the highly significant Federal Reserve-Treasury Accord of 1951, as best chronicled by Martin Mayer in The Fed. On the Treasury side of this key event assuring post–World War II Fed independence, there was William McChesney Martin, Assistant Secretary, who would subsequently become Fed Chairman. Martin had significantly advanced negotiations leading up to the Accord. Previously, the Fed had been forced to peg interest rates at low levels to help finance World War II. Martin's boss, Treasury Secretary John Snyder, a small-town Missouri banker, had at the behest of his poker-playing buddy, President Truman, demanded that the Fed continue after World War II to peg interest rates in order to “stabilize” the Treasury securities market. The other major player in the Accord was Marriner Eccles, who had been appointed Fed Chairman by President Roosevelt in 1934. Subsequently, in April 1948, President Truman, in a move that shocked virtually everyone, announced that Eccles would not be reappointed as Fed Chairman. However, Truman asked Eccles to continue to stay on and serve out his 14-year term as Fed Governor. Truman appointed Thomas McCabe to succeed Eccles as Fed Chairman. In an unprecedented move aimed at twisting their arms, President Truman invited Fed Chairman McCabe and the other members of the FOMC, including Fed Governor Marriner Eccles, to the White House on January 31, 1951. In this highly unusual meeting at the White House, Truman sought to force the Fed to continue to peg interest rates on Treasury securities at low and unchanged levels. He reiterated that both the Treasury and the Fed should do everything possible to maintain confidence in the Government securities market. According to an internal memo by Fed Governor Rudolph Evans, who attended the White House meeting, Fed officials stood their ground arguing that the pegging of interest rates should be ended so that the Fed could be freed to more effectively fight emerging inflation pressures. New challenges faced by contemporary central bankers include deregulation, securitization, and globalization. In the securitization process, for example, banks may pool loans, mortgages, or credit card receivables to create securitized financial instruments (such as mortgage-backed securities) that are ultimately removed from bank balance sheets and sold into the capital markets to mutual funds, among others. The upshot is that the bulk of total credit is today supplied to individuals, businesses, and the government by way of the capital markets, while a declining share is supplied by commercial banks, the Fed's traditional point of contact. The opposite was true in the mid-1970s when commercial banks accounted for the lion's share of the supply of total credit, with a much smaller share accounted for by the capital markets. Today, the major non bank lenders and investors in the capital markets include not only mutual funds, but also hedge funds, pension funds, insurance companies, and finance companies. Of course, there are also big players in the form of Government Sponsored Enterprises (GSEs) such as Fannie Mae and Freddie Mac. To complicate matters further, deregulation and financial innovation have made the velocity of money less predictable during the past two decades, thereby diminishing the significance of policy targets for monetary aggregate growth. To drive this point home, Martin Mayer, in his excellent new book The Fed, states that “securitization, derivatives, worldwide markets and the vastly increased liquidity of once non marketable assets (represented in the household world by home equity loans and easy access to margin values of stock market investments) have made the idea of the 'quantity' of money a historical curiosity, like belief in a flat Earth.” The “new reality” is that in order to determine whether financial conditions are favorable for sustainable growth, modern-day central bankers must put more emphasis on market psychology, stock price movements, bond yields, credit-risk spreads, and other indicators of the terms on which borrowers can raise funds in the capital markets and less emphasis on traditional bank credit or monetary aggregate measures. Most importantly, Fed officials must be sufficiently market savvy to deal with a situation in which a major outbreak of negative investor psychology threatens to trigger a crumbling in consumer and business confidence and a resulting slump in spending that will have a severely depressing effect on real (inflation-adjusted) GDP growth. Gross Domestic Product, or GDP, which is our broadest measure of economic output, is defined as the dollar value of all goods and services domestically produced. Martin Mayer interprets it: “From the central banking point of view, this is the ultimate disaster. The central bank is responsible for the money supply. Most of the money supply is in bank accounts. When a bank fails, the checks written against those bank accounts become worthless. To maintain the money supply, which is its primary business, in the central bank must therefore search about for ways to maintain the value of the deposits in the failing bank. The easy way is to buy some of the assets (or take them as collateral against a loan) at a price higher than the market price, hit this can work only if large supplies of cash are available to the purchaser. It is not a question of “Too big to fail,” a slogan that has spilled carloads of ink in the United State& In a fragile banking system, the accounts in any bank known outside its immediate neighborhood will have to be rescued”. (p.105) It is important to emphasize that congressional legislation dictates, as already noted, that the Fed is charged with maintaining stable prices of goods and services and maximum employment (sustainable growth), not with controlling stock prices. Thus, there is no law that says that the Fed should try to control stock prices; realistically, it could not do so with any precision even if it wanted to. Furthermore, critics say it would be, as a matter of principle, inappropriate for the Fed to try to substitute its judgment for the collective judgment of the large numbers of buyers and sellers in the market. Nevertheless, the Fed must at least be aware of stock price movements to the extent that they operate through the wealth effect to influence spending. In his semi-annual congressional testimony on July 18, 2001, Fed Chairman Greenspan observed that monetary policy, which focuses on the economy, will examine and evaluate financial factors only to the extent that they impact the economy. But this has been particularly the case recently as the wealth effect has had a significant influence on spending. Moreover, it is in the nature of asset price bubbles that investor, consumer, and business psychology overshoots both on the optimistic side when the asset price bubble is in its final highly speculative stages, and on the deeply pessimistic side after the bubble bursts, as it inevitably will. In The Fed, author Martin Mayer observed that the Fed has no choice but to be concerned with the behavior of asset prices. Mr. Mayer stated that It is not only a matter of 'wealth effects' that promote excess consumption and thus create pressures on either the domestic price level or the trade deficit. In conditions of modern finance, cheap money from an escalating equities market can promote over-investment and an eventual collapse in economic activity from the failure of previous investments to generate an adequate return. Martin Mayer describes says in this regard that” Greenspan’s luck was that the possessors of that extra cash bought securities instead of goods and services. Instead of a consumer price inflation, the United States got an asset price inflation— $1 more conventionally described as a stock market boom. And Greenspan’s belief in the prescience of markets turned out to be justified: while the exponential rise in stock prices cannot be explained without some reference to herd behavior, the truth is that much of the rise hi the stock market would later be validated by an increase in capitals share of gross domestic product, by the gigantic investment opportunity created by technological progress in the areas of telecommunications and computing, and by the easing of inflationary pressures as the federal budget moved toward balance (p.220) The major question facing Fed watchers is whether the Federal Reserve and its control over monetary policy is the best way to monitor the nation's economy. Alan himself has never wavered from his view that a true gold standard constructed along the lines already discussed would eliminate the need for what he does. Most economists today regard that as an irresponsible, even reckless, position. Is Alan right or wrong? Should all government programs and institutions be sunsetted—either continued or killed by the Congress after a set period, according to the needs of the time—as Alan suggested to an astonished Senator Paul Sarbanes during one of his confirmation hearings? That subject would make for a fascinating debate, for a different kind of book. A more mundane question is whether the Fed, in the post Greenspan era, will maintain the same clout that it had under Alan, or whether it will enter an era of faded glory. The Fed's job is to promote growth, fight inflation, and increase employment—somewhat contradictory objectives—through the use of its proprietary tools. “It's hard to hit three targets with one bullet, and easy to hit the wrong one, ” said author Martin Mayer, a scholar at the Brookings Institution. Years ago the Fed fulfilled its mandate behind closed doors, and it took six months or longer for news of its policy decisions to filter out to the public. In many ways, this is the same debate our founding fathers conducted during the early days of the Republic. Thomas Jefferson and his fellow Virginians distrusted the money men from New York and wanted to conduct the operations of government, such as they were, on a pay-as-you-go basis from tariffs and other nuisance taxes. Alexander Hamilton and the Federalists wanted to establish a central bank with the ability to raise money and finance operations through the capital markets. In the end, the Hamiltonians won, and we have been living with a central bank and extended banking system, in one form or another, for most of the past two centuries. What it comes down to is that for better or worse, the Federal Reserve is not going to go away. It would take an economic collapse of cataclysmic proportions to dramatically change the way the United States conducts business. A more or less united Europe has established its own central bank, as has Japan, the globe's other major economy despite its decade-long period of intermittent recession. Ideology aside, barring a global depression that would destroy much of the wealth of the developed world, central banks will continue to rule the marketplace, and the Federal Reserve will remain the most powerful central bank of all for the foreseeable future. For that reason more than any other, it is critical that someone of Alan's stature and intellect remain at the helm of the nation's most important financial institution. In our credit-soaked economy there can be no Keynesian liquidity trap: the buyer’s strike is against long-term instruments. A three- month Treasury bill or 90-day commercial note gives you back loll cents on the dollar very soon, and if you’ve lost half cent in total return because rates rose 2 percentage points the day after you bought the paper (and that’s all you do lose), you’re not suffering from it, An age of derivatives instruments makes it possible for people with a longer-term need for money to borrow in the short-term market, hedging their risk by swapping or by selling bond futures at a commodities exchange so that higher interest rates when the short-term loan must he renewed produce trading profits from the hedge large enough to absorb the interest costs on the rollover of the short-term loan. What seems plausible at this point—one wishes inure people were studying these problems—is that these influences and attitudes and tactics still work through a banking system. Nevertheless, the argument about whether the Fed “should target asset values is now over: the Fed has no choice. It is not only a matter of wealth effects that promote excess consumption and thus create pressures on either the domestic price level or the trade deficit. In conditions of modern finance, cheap money from escalating equities market can promote overinvestment and an eventual collapse in economic activity from the failure of previous investments to generate an adequate (or any) return. The effect of financial innovation has been to make the entire economy more like the housing market. &e the Internet stocks in April 2000. (p. 315) The economics literature has shown considerable interest in the question of how best to design a “contract” for a central banker; it is becoming clearer that such a view shifts too much responsibility onto too few individuals. Delivering good monetary policy, gaining credibility, and gaining a strong reputation require competence and due diligence toward differences of opinion among a small group entrusted with the task of implementing monetary policy. Therefore, the focus ought to be on policy-making boards of central banks since, whether de facto or de jure, this is how monetary policy is effectively carried out, and has been for decades. Works Cited Mayer, Martin. The Fed: The Inside Story of How the World's Most Powerful Financial Institution Drives the Markets. (New York: The Free Press, 2001). Read More