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May 14, 2010

Why We Need the Federal Reserve



DISCLAIMER: Before anyone reads this article, I want to make it crystal clear that I am not defending the current actions of the Federal Reserve.  In fact, the Federal Reserve that I envision is drastically different than the one currently in place.  For those who comment about my article without reading it, I will copy and paste this disclaimer as a response.  I believe the Fed should be audited.  The purpose of this post is to make sure that if we do eliminate the Fed, we have a central monetary authority in place.
ABUSE OF POWER
The Federal Reserve has clearly abused its power.  The Troubled Asset Relief Fund could turn out to be one of the largest financial frauds in American history.  The New York Federal Reserve website stated that the TALF was designed to provide liquidity to our economy by purchasing poor performing illiquid securities and exchanging them for cash.
The New York Fed added that this was designed to improve the credit markets and give institutions the ability to lend.  As we have already determined, the liquidity created by TALF has been used to lend mostly to the federal government.  The economic progress that has been made in the last few quarters has definitively come from the private economy’s ability to operate with less credit.
Where the real abuse comes from is the Federal Reserve’s earnings. In 2009, the Fed earned a record profit.  While this article makes a brief argument that this was good for taxpayers, I believe the contrary.  By taking these troubled assets off private balance sheets, the Federal Reserve eliminated the ability of private entities to take those profits.  Simply put, had the Fed simply stabilized the system, the $50 billion in profits from 2009 would have been on private balance sheets.  How is depriving the private sector from those profits beneficial to the economy?
Some have argued that the Federal Reserve bought these assets at a premium.  If that’s the case, then the taxpayer is still in the hole by hundreds of billions of dollars.  Furthermore, since there was a bubble in this market, it can easily be concluded that the taxpayers will not get their investment back.  I believe that the Fed could have done less when it came to troubled assets and allowed the private financial system to reap profit and thus improve the credit markets.
KEEPING THE CORE OF THE FED
The core purpose of the Federal Reserve is to stabilize the money supply and prevent a run on the banks.  Without the Federal Reserve, bubbles and bursts would be just as bad as they are today.  What do I mean by that?  The Federal Reserve is failing to stabilize the money supply because it is caving to the demands of the marketplace.  It is easier to operate with low interest rates, therefore, Wall Street, the government, small businesses, and individuals would all want “easy money” for an extended period of time.  Do we really believe that interest rates will behave rationally if the Federal Reserve does not exist?
Many argue that the market itself can handle interest rates and to an extent this is true.  However, we need an entity around to monitor lending between banks.  If we do not, each time the economy begins to contract, banks will halt their lending thus making credit nearly impossible and deepening (maybe even creating) the next recession.  This is because there will be no institution in place to increase liquidity when needed.
As for the banking system, as we see from today’s video, the Federal Reserve must be ready at all times to provide liquidity and confidence to the banking system to prevent major bank runs and fund the smaller runs.  Without the Federal Reserve, it’s difficult to determine who or what will intervene in the banking system if the threat of a run occurs. 
HISTORY OF MONETARY FAILURE
Finally, the number one reason I support the maintaining of a central monetary authority is because we have eliminated the Federal Reserve before.  During the Andrew Jackson years, President Jackson took on the National Bank and in 1836 refused to renew its charter.  The Second National bank became a private bank and went bankrupt in 1841.  However, starting in 1836, the US had no centralized banking system.
Also, in 1836, Jackson dealt a blow to paper currency by passing the Specie Circular which allowed for land to be bought and sold only with gold or silver.  This caused paper currency to be devalued and inflation followed.  Inflation also grew as a result of local banks printing excessive amounts of money (through fractional lending).  Without a Federal entity to regulate the banking system, things were more out of control than with various asset backed securities in 2007-8.
When the bubble burst, a panic set in.  People ran on the banks, asset prices crashed, and ultimately America entered its first Great Depression.    With credit and prices collapsing, the situation quickly deteriorated:  (From author Edward Shepard, written in 1888)
“Commercial failures began in New York about April 1. By April 8 nearly one hundred failures had occurred in that city—five of foreign and exchange brokers, thirty of dry-goods jobbers, sixteen of commission houses, twenty-eight of real-estate speculators, eight of stock-brokers, and several others. Three days later the failures had reached one hundred and twenty-eight. Provisions, wages, rents, everything, as the New York Herald on that day announced, were coming down. Within a few days more the failures were too numerous to be specially noticed; and before the end of the month the rest of the country was in a like condition. The prostration in the newer cotton States was peculiarly complete. Their staple was now down to ten cents a pound; within a year it had been worth twenty. All other staples fell enormously in price.”
Without the presence of a federal monetary entity, the economy and the bubbles/bursts were worse not better.  I believe that the Federal Reserve needs to take the following steps to downsize and adequately monitor the monetary situation.
1)      Sell off all asset back securities.  The creation of an exchange (like the NYSE) could allow for quicker price discovery and transactions.
2)      Sell off all government treasuries aged 10 years or less.  The Fed should use 30 year bonds to dip into the interest rate market when necessary, but buying new government debt could encourage the fiscal side of the government to be even more irresponsible.  To my knowledge, the Fed does not own any short term debt, but I am making this recommendation to be safe.
3)      Leave Washington.  The Federal Reserve should have no headquarters.  It can operate effectively out of each of its regional locations.  Federal Reserve board meetings should occur in each location on a rotational basis.  This gives the Fed a local view of the economic situation and keeps them away from the influences of Washington DC.
4)      Eliminate Senate confirmations.  The Federal Reserve’s board of governors can elect its own membership as well as its chairman.  We do not need the Congress to meddle in its business.  If anything it can be overseen by a board of private regulators.
5)      Monitor reserve requirements.  Banks in the United States can lend $20 for every $1 deposited.  What is the current market ratio?  Are banks lending $12 to every $1 of deposits?  We know what the ceiling is but what is the economy lending at?  This can give us a great idea of how extended the banking system is and can help when dealing with a possible “run.”
6)      Stop worrying about jobs.  The Fed is getting involved in the jobs picture.  The only way the Fed can impact employment is to create more easy money for employers to borrow and hire people.  This, however, leads to more bubbles and further economic consequences.
The bottom line is that the Fed serves an important economic purpose when it is operating properly.  The current set-up of the Federal Reserve is allowing it to be too influenced into creating easy money.  By separating itself from government and focusing solely on banking and the money supply, the Fed should be able to promote stable economic activity.

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