Saturday, December 20, 2014

In Defense of the Federal Reserve

There are ultra-conservative politicians who do not like the Federal Reserve System. The most notable of these is the former House member from Texas, Ron Paul, who also ran for president several times. He hated the Federal Reserve so much he wrote a book called “End the Fed”. Reading his book reveals a reactionary mindset that was shaped by his youth in the Great Depression. It is less about his perceived evils of the Federal Reserve and more about what he thinks is the panacea for whatever economic ill is at hand: the gold standard. It is important to look at people who want to change the status quo and to look at what they want in their stead. Ron Paul and his ilk want to go back to a system that was abandoned by Lincoln when the north needed money in the Civil War and then by all of the European Powers in the Great Depression (Krugman & Wells. p. 417).  We abandoned the gold standard because it failed.
            We have the current system because with a gold standard, the monetary system treats money as a commodity in itself. Paul wants to hold onto it and hoard it – at least twice in his book, he speaks lovingly of various hoards he has had. The problem is that with commodity money, you need to spend it to trade it for goods and services. With commodity money there is an opportunity cost to exchange because there is a fixed amount of it in circulation. There are also mines that grow the supply of money, but as long as the global economy is growing at a rate greater than the supply of you commodity money, the money itself will increase in value and there will be a disincentive to spend it. The whole basis of the Populist movement in the late nineteenth century and William Jennings Bryan’s “Cross of Gold” speech was the commodity nature of the money at the time. Therefore, with the political winds shifting, the panic of 1907 was enough to show the authorities that the current monetary regime was not working. The Federal Reserve was put in place and it was nominally still back by gold at a fixed rate in 1913. That worked until the crash of 1929 and the ensuing depression showed that even gold-backed currency needed to float some times. It is telling that the earlier the major economies left gold backing in the Depression, the sooner they started to recover. The post-war Bretton Woods system was an even weaker gold standard, with the U.S. maintaining convertibility of the dollar in foreign currency and fold at fixed rates. The nation could do this because after the war the U. S. was the largest creditor nation and had huge stockpiles of gold. Nixon closed the gold window and allowed currencies to float because the reserves were dwindling and to keep the previous price ratios was expensive.
            The reason to go through all of that is that far right politicians are idiots and either do not know their history or bought into their ideology first and then looked for post hoc explanations. The strength of the nation is individually, in the strength of its institutions. The Federal Reserve System is not perfect. It has made transitions to transparency, but they still only hold press conferences after every other meeting.  The Federal Reserve Act shields the Federal Reserve from political oversight because the central bank is supposed to be neutral and rules based. Far right politicians who hate government by their nature are not happy with an institution that is self-funded and has proved over time that it can keep the economy running smoothly. It has worked so well that economist call the time from the war to the oil supply shocks and the resulting stagflation “The Great Moderation”. Moreover, that was just its day-to-day operations.
            The video “Open & Operating: The Federal Reserve Responds to September 11” shows that the central bank , while important in everyday life, is even more important in emergency. Early in the film, the narrator describes the Fed’s role as keeping people’s faith in the financial system (3:30). Through the Bank’s actions, they did just that. The day of the attack, they made sure ATMs had plenty of cash on hand, pushing over four hundred million dollars’ worth of currency to banks (6:12). They also provided liquidity to check writers, making sure that all the checks cleared, and providing almost forty times the normal liquidity in float, the time between a check being cashed and it being cleared (6:40). However, the Bank was not just focusing on the stability of the local economy in New York and Washington, where the people were directly affected. The events of 9/11 spread shockwaves throughout the nation, as everyone was uncertain of what would happen next. In that time, the Fed lent over 46 billion dollars to banks that needed money at the discount window (11:00), and in the week that followed, it injected hundreds of billions of dollars into the banking system by purchasing bonds from banks (12:30). When the FMOC met that week, it lowered the target federal funds rate half a percentage point, a large amount at that time (14:12). All of these actions helped maintain the financial system’s stability, and though there was a downturn because of the attacks, it was not as deep or long as it might have been without the quick actions of the Fed and its long institutional knowledge. Those who think the nation would be as prosperous or agile without the Fed are foolish, perhaps naive at best. 

Federal Reserve Bank of San Francisco. (2014) Open & Operating: The Federal Reserve Responds to September 11.  Retrieved at

Krugman, P. & Wells, R. (2013). Macroeconomics. New York, NY : Worth Publishers