Few institutions generate more mystery and controversy than the Federal Reserve – or the “Fed” for short. It has already become a topic in the current presidential campaign. Some see the Fed as absolutely necessary to the function and protection of the financial system. They credit the Fed’s strong actions in 2008 and 2009 as preventing another Great Depression.
But there are also strong views critical of the Fed. The Fed is accused of creating inflation and debasing the dollar’s value, prompting speculative investment bubbles and working for the interests of the wealthy. It’s also said that rather than promoting stable growth, the Fed actually causes more volatility in the economy.
So which is the Fed: friend or foe of the economy? Let me answer some questions about the Fed and then let you decide.
What is the Federal Reserve?
The Fed is the central bank of the United States, established in 1913. It backstops the financial system and serves as a lender of last resort for banks and other lenders. The Fed is privately funded by member banks. Its charter is controlled by Congress and its directors (Board of Governors) are appointed by the President and confirmed by the Senate.
Why Was the Fed Created?
The U.S. economy in the 19th and early 20th centuries endured several economic panics (termed recessions today), where depositors rushed to banks to withdraw their money. The problem with these “bank runs” was that banks didn’t keep all deposits in their vaults. In normal times, depositors wouldn’t demand their money at the same time. This meant banks had spare funds to loan and earn interest. So when economic conditions caused depositors to become scared and want their money, bank runs could force banks to close and cripple the financial system.
The Fed was created to provide funds to banks to prevent their closure during bank runs. Furthermore, with depositors knowing they could retrieve their money even during bad economic times, the expectation was that bank runs would be prevented altogether.
What Powers Does the Fed Have?
The Fed has three key powers. First, the Fed controls the percentage of deposits that must be kept in bank vaults. Second, the Fed controls two interest rates banks pay to borrow from the Fed or other banks.
It’s the Fed’s third power that is astonishing to many. The Fed can create and destroy money! The Fed creates money by buying investments from banks using new cash. The Fed destroys money by doing the reverse.
During the Great Recession the Fed aggressively used the second two powers, lowering its two key interest rates from over 5 percent to almost 0 percent and tripling the money supply.
Does the Fed Do More Harm than Good?
This is the key question dividing supporters and critics of the Fed. Fed backers say the institution is essential to maintaining stability and confidence in the financial system. They point to the lack of bank runs in recent recessions. Backers say the Great Recession demonstrated the power of the Fed to move rapidly to curtail the free-fall of the economy and prevent lending markets from collapsing. They contend that without the Fed, the country would have experienced a second Great Depression. Furthermore, due to the incentives created by the Fed for banks to keep much of the newly created money in bank vaults, supporters say the Fed achieved these goals without sparking higher inflation.
There are two major criticisms of the Fed. With no links to a monetary base like gold or silver, it is possible for the Fed to create so much money that higher inflation is the result.
There’s also the concern that with the Fed alternately stepping on the “money gas” to speed the economy and then on the “money brake” to slow the economy and prevent inflation, the Fed may unwittingly create more instability.
What are the Alternatives to the Fed?
Some want to dismantle the Fed and return to a pre-Fed economy where money was tied to a real asset (like gold), and banks and their depositors had to handle their own risks of bad investments and bank runs. Private insurance – funded by banks – could be used as a backstop for banks in financial trouble.
Others want to keep the Fed but end discretionary investing by banks. Banks would be restricted to being middlemen between depositors and mutual funds – among those being low-risk funds – with depositors having full knowledge of how their funds are invested. The Fed’s main job would be to increase the money supply in line with growth in the economy.
The Fed, its powers, and its role in the economy – particularly in trying to smooth its ups and downs – are very, very important topics. They deserve a full debate and discussion.
However, step one in this process is to understand what the Fed is, what it does and what are the options. Then we can collectively decide how we want the Fed to operate.
Dr. Mike Walden is a William Neal Reynolds Distinguished Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of North Carolina State University’s College of Agriculture and Life Sciences.