Ending the Fed: Arguments for and Against - Essay Example

Ending the Fed: Arguments for and Against Executive Summary The Federal Reserve should be abolished because it is immoral, unconstitutional, impractical, promotes bad economics, and undermines liberty. Its destructive nature makes it a tool of tyrannical government -Ron Paul, End The Fed (2009, p. 141) Ron Paul is not alone in his vitriol about the Federal Reserve (the “Fed”). This institution has been hated by many since its birth in 1913. It is an open question whether the Fed should exist at all and what would happen after its demise. The Fed emerged out of crisis and manages crisis with monetary policy. The Fed was created in 1913 to prevent the panics of the late 1800s and early 1900s. The principal way that the Fed manages the economy and financial crises is to manipulate the money supply. The Fed does its work by adjusting three things: the reserve requirement, the discount/federal funds rates, and open market operations. There are a number of positive outcomes that can result if the Fed was abolished. One positive outcome is the end of the yo-yo monetary policies that leads the country to move from recessionary to inflationary periods. A second positive outcome is greater competition and safer investment among financial institutions. There are negative outcomes to ending the Federal Reserve. The principal negative outcome is that the business cycle will run unchecked. Financial crises will tear the nation apart even more than already do. The recommendation of this paper is to keep the Fed and prevent laissez faire politics from wrecking the nation in dire economic times. Historical Background The United States has wrestled with the idea of centralized banking since its birth. After suffering through serious financial crises in the 1880s and early 1900s, the United States settled on the Federal Reserve system. The country embraced central banks twice before creating the Fed. The country created the First Bank of the United States in 1791 and then let the charter lapse in 1811. Congress created the Second Bank of the United States in 1816 and then let that charter lapse in 1828 (The Federal Reserve, 2010). Both banks failed because they were seen as answering to big city money interests and not the ordinary agrarian citizen. (The Federal Reserve, 2010). Today the Fed is also associated by some with big financial conglomerates. The United States created the Fed after enduring a series of financial crises. Several banking panics rocked the country in the late 1800s and early 1900s. The United States took action after the panic of 1907. In that year, the nation faced a dire banking crisis caused by speculation. Private industry, led by J.P. Morgan, had to step in to save the economy. The government created an independent government body, the Fed, in 1913 to prevent a recurrence of the panics. Never again was the health of the American economy going to be left to chance or the largesse of industrial giants. (The Federal Reserve, 2010). Function of the Federal Reserve The Fed prevents or ameliorates financial crises by manipulating the money supply. In recessions, increasing the money supply is key. Banks have more money to lend to financially strapped businesses and individuals. During inflationary periods, decreasing the money supply is necessary. Prices will stop going up when people have fewer dollars to spend. The Fed uses three tools to control the money supply: the reserve requirement, the discount/federal funds rate, and open market operations (Slavin, 2010, p. 344). The first weapon in the Fed’s arsenal is the power to change the reserve requirement. Reserves are the sums banks have to hold on to and can’t lend out. The money supply increases when the reserve requirement decreases – banks can put more money into circulation as loans. The opposite happens when the reserve requirement is increased. The Fed has an immediate impact on lending when it changes the reserve requirements (Slavin, 2010, p. 333). Another way that the Fed controls the money supply is by engaging in open market operations. The Fed buys and sells government securities, including U.S. Treasury bills, notes and bonds, and securities already marketed by the Treasury (Slavin, 2010, p. 339). The Fed increases the money supply by buying securities and letting public dollars enter the stream of commerce and decreases the money supply by doing the opposite (Slavin, 2010, p. 340). The Fed decreases the interest rate on the securities by bidding up the price of securities. The interest rate goes down when the interest paid out remains the same (per the equation interest rate = interest paid/price). The Fed achieves the opposite effect by bidding down the price. (Slavin, 2010, p. 339). Open market operations are the most versatile way that the Fed can impact the money supply. Finally, the Fed influences the money supply by adjusting the discount rate and federal funds rate. The discount rate is the interest rate banks pay the Fed for borrowing money from it. The federal funds rate is the rate that banks charge each other for borrowing from each other. A higher rate makes it more expensive for banks to borrow money. Banks will take out less money and then lend out less to their customers. The lower the discount or federal funds rate, the cheaper it is for banks to take out money and the more they will lend to their customers (Slavin, 2010, p. 342-343). The Fed exercises considerable power with the discount and federal funds rates. Ending the Fed: Positive Outcomes Enemies of the Fed state that ending the Fed will generate many positive results. Ron Paul, for example, states that ending the Fed will stop the business cycle, end inflation, decrease the size of government and end total war (Paul, 2009, p.7, 63, 205). There are two compelling positive outcomes among the mix. One positive outcome is that the Fed will no longer be able to engage in stop and go monetary policy leading the country in and out of recessionary and inflationary periods. The second positive outcome is that financial institutions will have to compete in a safe way and will not be able to depend on bailouts to save them from highly risky investing. Fed monetary policy has delayed effects on the economy that can fling the country side to side between recessionary and inflationary periods. In recessions, the Fed expands the money supply to banks and decreases interest rates to increase credit. At first, however, banks hesitate to increase loans because their potential customers have become credit risks in the recession. For example, small businesses needing loans to make payroll may not have enough sales to make the loan payments. The Fed has to lowers rates significantly before banks finally start lending again (Slavin, 2008, 347). By the time banks start lending freely again, however, the money supply may have expanded so much that the nation goes into an inflationary period. The Fed then responds by contracting the money supply. The banks again tighten up. The country then approaches recessionary times again. The Fed increases the money supply and starts the cycle all over again. (Slavin, 2008, 362). The recessionary/inflationary period of the 1970s and early 1980s is an example of the yo-yo effects the Fed can have on the economy. Monetary growth in the 1960s led to double digit inflation in the 1970s. The Fed constricted the money supply in 1973, leading to a severe recession. The Fed increased the money supply in 1975 and then reversed course in 1979 when the prime rate of interest soared to 20%. The money supply constriction led to a 6 month recession in 1980, prompting the Fed to reverse course again. Again inflation went up and again the Fed constricted the money supply. The country again went into a recession, this time in 1981. When the Fed increased the money supply in response, the prime interest rate again increased to 20%. The iterations of monetary expansion and contraction and the effects on the economy are dizzying. It is a wonder that the country ever righted its course. (Slavin, 2008, 362-363). Ending the Fed will end the back and forth in the economy that it causes. The business cycle will continue with its peaks and troughs. The country does not have to fear runaway recessions or inflationary periods, however. If the Treasury could be given the power to maintain constant monetary supply growth of about 3%, recessions and inflationary periods can be smoothed out. This is the theory put forward by the monetarist school of thought championed by economist Milton Friedman. The Fed infrastructure is not necessary to have a stable economy. (Slavin, 2008, 362). Another good consequence of ending the Fed will be greater accountability and competition among financial institutions. The Fed exists to protect banks from going under and devastating the economy. Their mission has creeped over time to include protecting financial institutions in general from going under (Ritholz, 2009, 67). This came as a response to the banking panics of the 1880s and early 1900s. Banks overleveraged themselves and engaged in speculative investing. Busts in those investments caused the public to worry about their deposits and they raided the banks for their money back. Many banks failed in the process (The Federal Reserve, 2010). The recent financial crisis is a grandchild of those panics. Many large banks leveraged themselves in incredibly risky sub prime mortgages. The nation and subsequently the world panicked when the mortgages failed and the collection of securities based on those mortgages lost their value (Ritholz, 2009, 180). In came the Fed. Instead of letting the behemoths fail, the Fed and the Treasury teamed up to bail out the financial institutions that had engaged in the risky sub prime mortgage security deals. The Fed bailouts tell companies that engaging in risky behavior is ok – the government will come to the rescue. The whole world suffers as a result. Ending the Fed will lead to fewer calamities caused by greedy conglomerates. Financial institutions will rethink risky investments when they know that the consequence of those investments failing will be bankruptcy and not a bailout. Consumers will have greater confidence in their deposits when they have an opportunity to shop around for banks that employ sane financial practices. Some firms will fail, but that will only leave responsible firms in the wake. No longer will taxpayers be held at the mercy of giant companies that threaten financial ruin if they are not bailed out. Ron Paul stated the case for competition best: In a capitalist economy, the prospect of failure imposes discipline and consumer service. It is an essential aspect of the competitive marketplace, whereas a promise against failure only entrenches inefficiency and incompetency. (Paul, 2009, 27). Ending the Fed will promote competition and better investment practices among financial institutions. The entire world will benefit. Ending the Fed: Negative Outcomes There are negative outcomes to ending the Federal Reserve. The overarching negative impact is that the business cycle will operate unfettered. Recessions and inflationary periods might go on for longer periods of time. They might even fester into national calamities, like the Great Depression, the period of “stagflation” in the 1970s and the current economic crisis. It has been hard enough for the Fed to right the nation’s course with monetary policy. The nation will truly be adrift without central banking. A lesson from history reminding us of what would happen without the Fed is the Fed’s act of omission during the banking panic of the Great Depression. People raided the banks during the Great Depression and contracted the money supply by hoarding their cash. Ben Bernanke summarized the situation: As depositor fears about the health of banks grew, runs on banks became increasingly common. A series of banking panics spread across the country, often affecting all the banks in a major city or even an entire region of the country. Between December 1930 and March 1933, when President Roosevelt declared a "banking holiday" that shut down the entire U.S. banking system, about half of U.S. banks either closed or merged with other banks. Surviving banks, rather than expanding their deposits and loans to replace those of the banks lost to panics, retrenched sharply. (Bernanke, 2004). The Fed did not step in to save these banks. Fed leadership subscribed to a "liquidationist" thesis (Bernanke, 2004). Weak banks had to be dissolved in order to make room for more vibrant banks. The Fed ignored the small banks that comprised the majority of the failing banks. (Bernanke, 2004). The Fed’s laissez faire approach to the banking crisis only exacerbated the monetary contraction that was fueling the Depression. Catastrophe happened without Fed action. The same would occur if the Fed did not exist. Another lesson from history lies in the financial meltdown that happened when the Fed and the Treasury Department refused to save Lehman Brothers in 2008. Lehman Brothers was the fourth largest global financial-services firm. They did everything from investment banking, equity and fixed-income sales, research and trading, investment management, private equity, and private banking (Sourcewatch, 2010). Lehman Brothers was heavily invested in sub prime mortgages and took a great loss when these mortgages failed. They desperately needed help. The Fed and the Treasury Department refused to help Lehman Brothers. Lehman Brothers declared bankruptcy – the largest in United States history. The financial services sector seized up immediately . Merrill Lynch sold itself to Bank of America for a pittance to avoid Lehman Brothers’ fate. The American International Group (AIG) went to the government for a major bailout. Wall Street suffered the worst stock price drop since the 2001 World Trade Center attacks. These financial consequences were not exclusively the result of Lehman Brothers declaring bankruptcy but Lehman Brothers’ fall did exacerbate the financial crisis that was unfolding in the world (New York Times, 2009). Recessions and inflationary periods will become worse without the Fed. The Fed is not perfect but it does ameliorate financial crises when they take affirmative steps to deal with a situation. Recommendation: Keep the Fed Monetary policy is a blunt tool and Fed bailouts provide cover for risky investing. It is unthinkable not to have the Fed, however. Laissez faire economics does not work. Financial devastation perpetuates itself without sound monetary policy. The nation will be worse off without the Fed than with it. Conclusion The Fed is a lightning rod for debate about the economy. The Fed was created to prevent the panics that shook the nation before 1913. It manages the economy and crises by controlling the money supply. There are several positive outcomes to ending the Fed. Two are getting rid of the Fed’s yo-yo effect on the economy and increasing competition and safe investing among companies. There is a more compelling negative effect of getting rid of the Fed. Financial crises will run unchecked. The country needs the Fed to protect us from the extremes of the business cycle. References Bernanke, B. (2004). Money, gold, and the Great Depression. Retrieved from http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm. The Federal Reserve (2010). History of the federal reserve. Retrieved from http://www.federalreserveeducation.org/fed101/history/ The New York Times (2009, September 12). ‘An epidemic of capital destruction.’ Retrieved from www.nytimes.com Paul, R. (2009). End the Fed. New York: Grand Central Publishing. Ritholz, B. (2009). Bailout nation. Hoboken: John Wiley & Sons, Inc. Slavin, S. (2008). Macroeconomics. (8th Ed.). New York: McGraw-Hill Irwin. Sourcewatch (2010). Lehman Brothers. Retrieved from http://www.sourcewatch.org/index.php?title=Lehman_Brothers Read More