Opinion Forum

End the Fed

November 14th, 2009

If you asked most people to name one of the most powerful, elusive, independent, and secretive arms of the federal government, they would probably reply with one of the nation’s law-enforcement or intelligence-gathering outfits, such as the FBI, CIA, NSA, or NRO. Very few people would suggest that the real answer might be the U.S. Federal Reserve. But when you look at the facts objectively, they make a startlingly compelling case. For instance, when a Freedom of Information request is made, the FBI must either answer it or explain why they can’t, but the Fed doesn’t even have to publish the M3 money supply, which tells us the amount of dollars floating around in our economy. The CIA, though secretive, must usually give some account to Congress of what they are doing with our money and why. The Fed however, can loan half a trillion dollars to foreign banks without so much as telling Congress first that they are going to do it.

There are many people who believe that a central bank is essential to the smooth running of a modern economy. However, I have personally become convinced that the truth is the exact opposite; that like most government planning efforts, any attempt to centrally control a nation’s currency and banking system is doomed to failure. In order to understand the problems with a central bank though, one must first understand two things: the purpose of the interest rate in a modern economy, and how the Federal Reserve is allowed to control it via their control of the currency and banking system.

Borrowing and lending are used in a modern economy to finance production by transferring money from the people who have saved it to the people who can use it to create more. At its most basic level, the interest rate is used to control this rate of borrowing and lending. When interest rates are low, borrowing is easy and there will be more of it; when they are high, borrowing is harder and there will be less. Thus, the interest rate is used to control the rate of growth in a modern economy, to keep production steadily increasing while also making sure that savings are never depleted too far. Ideally, if one were to plot this production increase, one would come up with a linear graph with a constant, positive slope. However, because humans are imperfect and nobody can know everything about the market all the time, what the graph actually looks like is more of a sine wave focusing on that ideal linear plot. The interest rate controls the amplitude of this sine wave by becoming higher at the peaks and lower at the troughs. When the economy is at the peak of the wave, it means that people borrowing too much and saving too little, and the banks must raise rates; when it is at a trough, it means that people are saving more than is necessary and rates can be lowered to increase lending and spur growth.

Now, here is the process by which the Fed controls our interest rate and our currency. Each bank in the country is required by law to set aside a certain fraction of its money in an account with the Fed in a practice known as fractional reserve banking. The interest rate, also known as the federal funds rate, is the rate at which the banks’ demand for reserves matches the Fed’s supply. When the Fed wishes to increase the federal funds rate, it does so by selling government securities, which are paid for by the banks when the Fed reduces the amount of money in the banks’ reserve accounts. This forces the banks to make up the difference in the reserve account, thus reducing the total money supply. When it wishes to lower interest rates, it does so by buying back these securities and putting the money into the banks’ reserve accounts, thus increasing the money supply. The federal funds rate thus sets the tone for the interest rates the banks will charge on their own loans: if the federal funds rate is 5% then the interest rate on the loan you took out for your house may be somewhere between 3% and 7%; if the federal funds rate is 20% then your interest rate may fall somewhere between 15% and 25%.

An economic bubble, such as the stock bubble of the 1990s or the housing bubble that just burst, is created when the Federal Reserve keeps interest rates artificially low in a time when banks should be raising the rates to curb lending and borrowing. This gives investors and borrowers false confidence in the state of the economy, which spurs more lending and borrowing, which increases the paper gains, until some outside event finally serves to knock over the house of cards and sets off the nasty corrective recession. The purpose of the Federal Reserve is to pop this bubble before it really gets going by raising rates, thus bringing the economy back to normal levels of production. Or in the words of William McChesney Martin, governor of the Fed from 1951-1970, the Fed’s job is “to take away the punch bowl just when the party is getting going.” The only problem with this is, people like punch. People like large economic gains. And there will always be people like Barney Frank and Chris Dodd, who will insist that nothing is wrong even as the bubble is rapidly taking a nosedive. Of course, the Fed could (and should) theoretically act to prevent crashes before they happen by preemptively raising rates. However, not only is it not always easy to determine whether a bubble is forming, but when was the last time you heard a report in the news about a disaster that never happened? Central banks are deliberately run in such a way as to keep them apart from the political fray because they do a better job when not controlled by political interests, but if the Fed consistently acted to prevent crises that, in the view of the politicians and the people were never going to happen in the first place, they would not be able to maintain that independence long.

The Federal Reserve was created in almost direct response to the bank panics of 1907. Its formation was supposed to stabilize the money supply and prevent severe financial crises from happening. We have now had the Federal Reserve in charge of our currency and our banks for nearly 100 years. I don’t know about you, but between the Great Depression of the 30s, the stagflation of the 70s, and our current economic mess, I don’t think the Fed has a very good track record. As for the panics the Federal Reserve was created in response to… well, let’s just say that there aren’t very many schools in the nation teaching children about the horrible conditions during the Great Depressions of 1857 or 1873. And at least if a bank failed in one of those panics, then the only people who were affected were the people who owned that bank or dealt with it. Does anyone care to contemplate what would happen to our nation today if the Federal Reserve failed? Or what would happen if the Fed, in order to avert one method of failure, courted another by inflating the money supply?

Well, if you’re not willing to contemplate it, then you’d better start. The current federal funds rate is at the historic low of 0%, which means that the Federal Reserve has been quite literally flooding the world with dollars in an attempt to combat the recession. But eventually the Fed will have to attempt to pull those dollars back in by raising inflation rates. The last time this happened was in the 70s and 80s, when low inflation rates increased our money supply by 13% and former Fed Chairman Paul Volcker was forced to pull that money back in by raising inflation rates to nearly 20%. And if that little fact scares you, then try this one on for size: now that the Fed has increased the money supply by 120%, how high do you think the federal funds rate will have to go to suck all of that back out of the system?

Before the advent of the Federal Reserve, banks managed their own reserve funds and coined their own money according to standards regulated by Congress in accordance with Article 1, Section 8 of the Constitution. While banks were free to create fiat currencies of their own based on their private specie reserves, these currencies were at least required to be redeemable in specie and any bank that stretched their “bankers privilege” too far would inevitably pay the price for it in the end. Did the nation experience occasional bank runs and financial panics during those years? Sure. But to my mind, the rules of those times had one inestimable advantage over ours: if banks were managing their own money and ended up doing a bad job of it, then at least when their houses of cards fell down those bankers would fall along with the rest of the system. Given a choice between a system where the people creating our currency are banking their lives and livelihoods (no pun intended) on doing a good job of it and a system where people are deliberately insulated from the consequences of their actions, I am inclined to pick the former.

Referenced work: Economics: Making Sense of the Modern Economy edited by Simon Cox

Articles written by Brianna Aubin
Tags: banks, Federal Reserve, inflation, interest rates, money supply, recession
Categories: Economics, History, Politics | Comments (13) | Home

13 Responses to “End the Fed”

Elizabeth Barrette | November 14th, 2009 at 10:49 am

I agree that the Fed is functioning poorly. I would like to see a lot more transparency and logic in the economic system. However, I am extremely disinclined to scrap the Fed in favor of returning to a former system *which we know also did not work well, which is why we replaced it*. I would prefer to create something new, based on all our current knowledge, in hopes of getting something that will work better than previous failed attempts (including the Fed). For example, I would like to entertain models of a sustainable economy, not one that requires *constant growth*, because contant growth in a finite environment (such as a nation or a planet) inevitably leads to crash after crash due to hitting the limits of the environment. Many of the problems we’re suffering now are limit-collision problems. In order to create a system that will be stable rather than spawning crashes, and one that will last instead of destroying resources faster than they are created, we really need to think outside the box.

John Antilety | November 14th, 2009 at 1:11 pm

Your theory presumes that the Fed is a government agency.

They are not. They’re a privately held company, that in turn owns the World Bank and IMF. They are far, FAR bigger than you cover in your post.

The people running the Fed could, quite literally, walk straight into the Vatican in broad daylight and put a bullet in the head of the Pope, and nobody, I mean nobody would be able to do a thing about it. They own everything.

Brianna | November 14th, 2009 at 2:27 pm

“Your theory presumes that the Fed is a government agency. They are not. They’re a privately held company, that in turn owns the World Bank and IMF. They are far, FAR bigger than you cover in your post.”

The Fed was created by the government and has officials appointed by the government. There is no way it could hold a monopoly on the national currency without government approval and support. It is a perfect example of the assertion that no true monopoly can occur in the economy without the help and tacit approval of the government. Incidentally, does this mean that you support my view and agree we should get rid of the darn thing?

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“For example, I would like to entertain models of a sustainable economy, not one that requires *constant growth*, ”

You are asking for a Hadrian’s Wall, and for permission to thwart the law of nature that says a living organism must either grow or die. If there is one thing human beings are incapable of, it is standing still. To live is to grow; to attempt to thwart this law is to die.

“contant growth in a finite environment (such as a nation or a planet) inevitably leads to crash after crash due to hitting the limits of the environment.”

And where do you think are the limits of the environment? Were they back in the Ice Age, before people learned to farm and domesticate animals? Were they in the stone age, before people figured out how to make metal tools? Were they before people learned how to use coal and oil and natural gas? Were they before the industrial revolution, before people learned to build factories and automatize? Were they the limits of Earth’s atmosphere, before we learned how to build rockets and send our works throughout the solar system? Were they before the computer and the internet, before people learned how to send information halfway around the world in the blink of an eye?

The limits of the environment are not confined to a certain set of resources that exist independently of humanity’s ability to recognize or utilize them, nor are they even confined to the material present on this planet. They are at the exact same place as the limits of human ingenuity and the human mind. I would expect you of all people, who possesses such an extraordinary mind, to realize that.

“Many of the problems we’re suffering now are limit-collision problems.”

The housing bubble was not a limitation problem; it was a “government wants to ramp up land price through artificial land restrictions and then give poor people affordable housing by fiat” problem. The health care problems are not limitation problems, they are “government wants to give health care to the poor and elderly by ramping up spending” problems. The problems in our education system are not limitation problems, they are “unions don’t want to get fired for doing a crappy job and governments want to use the schools to push progressive learning policies and political agendas” problems. The current flood of dollars in the system is not a limitation problem. It is a “the Fed thinks the best way to solve a recession is to print more money and hope nobody notices, buy bad assets rather than let them collapse as they should, spend money like a drunken sailor on shore leave, and sell the debt to China in the hope that they’ll let us get away with it” problem. God knows we have problems. But the recession we are in now has nothing to do with running up against the “natural limits” of the system and quite a bit more to do with government thinking it is some sort of cure-all to the nation’s ills.

“In order to create a system that will be stable rather than spawning crashes, and one that will last instead of destroying resources faster than they are created, ”

If we were destroying resources faster than they were being created, if we did that *by nature*, we’d be dead by now. Someone who tries to move forward by taking one step forward and two steps back never ends up traveling anywhere. As for spawning crashes, you are partially right in that respect; in a truly free market system, one of the major causes of recessions would be running up against the limits of our current system (the others would be overspeculation, natural disasters which destroyed resources, and inflation of currency by private banks). The way to cure these recessions however would not be to stall growth, but to find a way to expand the limits of the system.

“we really need to think outside the box.”

There is one box you can never think outside of. We call it “reality”. You will never be able to get rid of recessions; they are a natural part of the economic system. You can however, at least get rid of the humongous houses of cards built by people who have neither the desire nor the inclination nor even the ability to base their decisions on reality. In order to get rid of the truly vicious crashes (you can never completely rid yourself of mere recessions), we should get rid of the people who cause the crashes because they are unable and unwilling to do what is necessary before things become so bad that there has to be a crash.

Tom | November 14th, 2009 at 3:02 pm

Very interesting and informative, Brianna. I understand the problems you point to, but I don’t understand what you would replace the Fed with. We certainly couldn’t function in the international economy by returning to arrangements in existence before the Fed was created. In fact, if we threw out the Federal Reserve System and started all over again, we’d have to create something that would look a lot like it. Congress could amend the Federal Reserve Act to require the Fed to operate in different ways, given that it’s an institution within the government and functions at the will of the government. That’s why you see Bernanke testifying on the Hill so often. But the Fed is independent for a reason — can you imagine Congress getting involved in the routine business of the Fed?

Elizabeth, I’m afraid there’s a problem of reality in dreaming of the “sustainable economy” you referred to. Economies, and economic systems, can only grow or not grow. Not growing means collapse in fairly short order. There simply can be no such thing as a completely stable, non-volatile economy. In order to even think about such a model, you have to hold every variable you can think of constant, and there will still be variables you’ve missed. Unfortunately, the variables are all dynamic.

John, you’re way off the mark on all counts. The Federal Reserve System is, in fact, a creation of the government, through the Federal Reserve Act. Everything about the Fed can be changed by Congress (and the President), to include abolishing it. The Fed most certainly does not “own” the World Bank and the International Monetary Fund. The idea that the Fed owns everything and could get away with shooting the Pope is, if you’ll pardon my bluntness, one of the silliest conspiracy theories I’ve heard.

Tom | November 14th, 2009 at 3:08 pm

Well, Brianna, apparently we were writing comments at the same time, and you were quicker than me! You covered everything I said in much more detail, and quite nicely. I still have one question — once the Fed is gone, what will you replace it with?

Brianna | November 14th, 2009 at 6:14 pm

“We certainly couldn’t function in the international economy by returning to arrangements in existence before the Fed was created.”

I don’t see why. It was less than 100 years ago that we created the Fed, and only 40 since we ditched the gold standard altogether. Why is it impossible to go back to a commodity/representative standard (a representative currency is paper backed by some sort of commodity) with the number of dollars to a troy ounce of gold/silver regulated by Congress? I know people have said that there isn’t enough gold in the world to represent wealth anymore, but really, according to whom? The amount of money something costs isn’t assigned arbitrarily; it depends on that item’s value relative to other items and the amount of money in the market. If there was less money in the market, prices would just go down to reflect it. Wages would go down too, but as long as purchasing power remained equivalent, why would that be an issue? If you’re making $100 and it costs you $50 to live, what’s the difference between that and making 80$ when it costs you $40 to live? If private banks were allowed to issue notes based on their specie reserves, it would break the power of the Fed and the monopoly on our money. And if there were no monopoly on the money supply, then the collapse of one bank or even a set of banks would not bring down the system (it’d kinda suck, but then so does this recession). And as long as Congress set the standard of how many dollars one could issue per amount of gold/silver, it would keep the bankers from running off into the clouds with the money supply. You wouldn’t even have to use only gold/silver if you didn’t want to; the Weimar Republic backed the Rentenmark in real estate, and it would be perfectly possible to issue a currency backed in some other commodity. The main requirement would be that any piece of paper would have to be backed by some solid, tangible asset so that people couldn’t lie about the money supply.

The only power the Fed has that private banks don’t and can’t without government support is the power to make money out of thin air via printing press without backing it with anything. Banks like that because it allows them to make more loans whether they can afford to do it or not. Government likes that because it allows them to embark on massive spending whether they can afford to do it or not. The people just get screwed.

Teach Children to Save Money? | November 15th, 2009 at 1:46 am

Couldn’t agree more, the Fed is not doin’ so good. As a single parent that was *less* than good with money throughout my youth, teaching children about money is CRUCIAL, in my mind. I’m not going to blame parents, schools, etc, but quite simply, I clearly “didn’t get it”, and I am still paying for those mistakes a decade later! And quite frankly, I hate the position I got myself in, everytime I pay off my past debts… I could have used my time/money sooooo much better.

Brian Bagent | November 16th, 2009 at 4:31 am

Brianna, I am certain that you are aware of the central problem here: too many people fail to comprehend what money actually is or, more accurately, what money represents when there is an exchange of it for products and services between free, moral agents. Too many have failed to discard the feudal model of wealth, which would include everyone that believes that we can spend our way out of a recession.

“Throughout men’s history, money was always seized by looters of one brand or another, but whose method remained the same: to seize wealth by force and to keep the producers bound, demeaned, defamed, deprived of honor. That phrase about the evil of money …comes from a time when wealth was produced by the labor of slaves—slaves who repeated the motions once discovered by somebody’s mind and left unimproved for centuries. So long as production was ruled by force, and wealth was obtained by conquest, there was little to conquer. Yet through all the centuries of stagnation and starvation, men exalted the looters, as aristocrats of the sword, as aristocrats of birth, as aristocrats of the bureau, and despised the producers, as slaves, as traders, as shopkeepers—as industrialists.”

Brianna | November 16th, 2009 at 10:13 am

Brian – as far as that’s concerned, I can hardly blame them for failing to comprehend what money is, since I can just about flat-out guarantee you that nobody ever taught them (I used to actually think about it, and I never figured it out)

As for having banks print out private notes, I want to amend that slightly. It occurred to me after signing off that it would be pretty easy to pass out legit-looking forgeries in such a circumstance, and some reading I did the other day confirmed that. So instead, how about this: the Bureau of Engraving and Printing still gets to print bills, but instead of doing this solely for the Fed any bank would be allowed to purchase them on the basis of their specie reserves. Since the BEP doesn’t actually eat government money, but basically works on a for-profit scheme where they get paid about $0.05 for every note printed, I would have no objection to their sticking around to supply banks with notes.

Brian Bagent | November 16th, 2009 at 1:02 pm

Another good quote on money, from our 3rd President, Thomas Jefferson:

(Jefferson’s quote is in italics, my responses are in bold)

I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks ,
which is precisely what the federal reserve is
to control the issue of their currency,
which is precisely what the federal reserve does
first by inflation,
which they’ve done to the tune of about 120% in the last year
then by deflation,
which is what they will do via the insane interest rates we will see within the next 15 months
the banks and corporations that will grow up around the banks will deprive the people of all property
a little birdie told me that FANNIE MAE and FREDDIE MAC are now homeowners renting out to the very people that defaulted on their loans to begin with
until their children wake-up homeless on the continent their fathers conquered..’

Brianna | November 16th, 2009 at 2:19 pm

I am actually aware that Fannie and Freddie are going into the renting business. Though of course, since I became aware of it through the Glenn Beck program, that must mean that it can’t possibly be true, let alone be both true and bad for the country. Remember, Fannie and Freddie are just trying to help all those poor people whose homes are getting repossessed… the fact that their homes are getting repossessed because the government prodded banks into giving them sub-prime loans they couldn’t afford is completely unrelated to the current problem and shouldn’t deter people from sacrificing and helping the poor during this dire national emergency.

Brian Bagent | November 16th, 2009 at 5:51 pm

It is one thing for a teen or college student to fail to grasp what money is, even one with an IQ beyond 2 standard deviations. It is quite another for adults that have bought a house/car or worked at some productive endeavor. Another 5 or 10 years of life will teach you that.

Unfortunately, the idea of a central bank is so widely accepted as to be axiomatic, just as it was axiomatic 700 years ago for Europeans to believe that the earth was flat and was the center of the universe. Andrew Jackson came one vote short of being impeached over repealing the charter of the central bank of that time. It is a constant struggle to guard against them, one made more difficult by our nearly worthless public education system.

Brianna | November 16th, 2009 at 6:11 pm

Are you sure? Andrew Johnson came one vote short of impeachment, but I don’t recall ever hearing about Andrew Jackson getting impeached. I believe he was censured when he allowed the charter of the Second Bank to lapse, but I can’t find any reference to an impeachment.