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Tom Firey: The magic of money and the Fed dilemma

July 30, 2013|By TOM FIREY

The second most powerful person in the world, according to an old Washington cliché, is the chairman of the Federal Reserve’s Board of Governors.

Earlier this month, Ben Bernanke, the current chair, spent two days in a de facto exit interview with a Senate committee; he is expected to leave the job this winter. Despite his position’s awesome reputation, few Americans know what the Federal Reserve does. So, as Bernanke starts his farewell tour, let’s gain an (admittedly simplified) understanding of how “the Fed” works, recognize some of its successes and failures, and learn why it has some staunch critics.

Congress created the Federal Reserve System in 1913 with the chief goal of improving banks’ stability. Back then, banking was very different than it is today: banks were mainly regulated by the states, and regulators tightly controlled banks’ size (a bank often served just one town) and number (a town would have few banks — and maybe just one). 

That sounds romantic: the small-town banker serving his neighbors. But the system was terrible for bank customers. A town’s banks often acted as a cartel, coordinating with each other to offer low interest on deposits, charge high rates on loans and limit services. This was the age of marble bank facades, gilded lobbies and cushy “banker’s hours.” And that’s what policymakers wanted: Fancy banks made a town look prosperous, rich bankers were good political allies and trapped customers were easy targets for taxation.

But the system created a problem that politicians couldn’t ignore. Because banks were small and localized, they were unstable. A local economic shock — say a bad harvest or a struggling employer — could start a financial panic, draining banks’ reserves and leaving many depositors without access to their money. Federal lawmakers could have overruled the states and allowed banks to expand across large geographic areas, improving their stability — but federal politicians didn’t want to upset the cozy system built by their statehouse friends. Instead, Congress created the Federal Reserve to lend money to stressed banks, which hopefully would let the banks stay open while the local economy righted itself.

Over time, the Fed’s role expanded beyond protecting banks to protecting the economy itself and the value of money. It does this by manipulating the money supply — what’s known as “monetary policy.” To understand how this works, imagine a town with just two residents, Jones and Smith, and only Jones has money. If Jones deposits his money, the bank can loan some of it to Smith. That way, Jones and Smith have access to money and the town seems to have more money than before. However, all the “new” dollars make each dollar a little less valuable.

The Fed alters the money supply by manipulating interest rates. The chief way it does this is through “open-market operations” — buying and selling government bonds and other assets. During a recession, the Fed buys assets, handing out money that flows into banks and lowers interest rates. During an economic boom that might lead to a bust, the Fed sells assets and pulls dollars out of the economy — taking “away the punch bowl before the party gets going,” in the words of Fed Chair William McChesney Martin.

In the recent bad economy, politicians and the media have given much attention to “fiscal policy” — changing government spending and tax rates in order to steer the economy. But the last half-century of research by economists across the political spectrum has shown that fiscal policy has a weak effect on a struggling national economy; only monetary policy seems powerful enough to fight recessions. So then why does the Fed have staunch critics, some of whom want to “end the Fed”?

The reason is that historically the Fed has made some bad mistakes. Concerned about the “party” of the Roaring ’20s, the Fed shrank the money supply, which was the chief cause of the Great Depression. In an attempt to spur the sluggish 1970s economy, the Fed created too many dollars, lowering their value and sparking inflation. Some critics argue the Fed also kept interest rates too low during the recent housing boom, contributing to its bust.

The best argument in favor of having the Federal Reserve is that it can conduct monetary policy. That’s also the biggest concern about the Fed.

As Bernanke departs, his supporters will laud the many unconventional ways he found to expand the money supply in the last few years — the so-called “quantitative easings.” His critics, meanwhile, will note that the economy remains lousy despite the Fed’s money-pumping, and worry that all those dollars will cause problems in the future.

Thomas A. Firey is senior fellow for the Maryland Public Policy Institute and a native of Washington County.

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