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 http://www.frbsf.org/education/teacher-resources/open-operating-federal-reserve-response-911/video

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

 

Plusses and Minuses of Introductory Economics as Taught

         There are many interesting concepts that come forth in the study of basic economics. One of the most interesting things is the concept of the opportunity cost. It is easy to think of the accounting cost of an item. How much does that movie cost? Well, a ticket can be had for ten dollars. Nevertheless, the true cost of something is not just the dollar amount. The true cost is what you must give up in order to do something. Therefore, the opportunity cost is not just the ten dollars, but also the cost of the next best thing that you might be doing. Going to that movie is added to the cost of not studying for that exam (Krugman & Wells. p. 7). Most people have an implicit understanding of the concept, but it is not formally codified until the formal study of economics understands.

            A second interesting thing is the topic of fractional reserve banking. It is easy to take banking institutions for granted when thinking of the economy. They work within the economy, but they have an essential role in expanding the money supply. Banks have money, but to grow their own profits, they have to grow their balance sheets. Through lending, banks create money. For example, a bank starts with $100,000. It can then lend an amount up to the reserve ratio, 10% in this example. That means it lends $90,000 and keeps $10,000 on its books. The amazing thing is that it is not done. In our model, one bank stands in for the whole banking system. So that money that was lent is deposited back into it and they can lend it back out, and so on as long as its assets are 10% of its liabilities (Krugman & Wells. p. 418). In this manner, banks are not just mediators in the financial system, but they help create monetary policy. This can cause issues tough. In the aftermath of the most recent financial crisis, banks were given all sorts of money in hopes that they would then turn around and take advantage of the magic of fractional reserve banking. The problem was that banks were looking for creditworthy individuals, and potential borrowers were skittish. In that manner, the Federal Reserve did not get the sort of reaction it had been hoping for initially.

            A third interesting part of introductory economics is that it simplifies many complex issues with models. Looking at these models may make people think that there are easy explanations for complex issues when in fact every model is a simplification on the messy real world. For example, the intro econ view is that the labor market is like all efficient markets. There is a labor supply curve, and a labor demand curve, and there is an equilibrium price. There is also a wage floor, the minimum wage.  In introductory economics, the problem is the wage floor creates structural unemployment.

There is not enough spoken of the simplifications that have taken place to illustrate the concept.  All the math makes it sound as if it is all unquestionably true. The example here is the labor market.  The labor market supply and demand curve intersection graph assumes five big things that are not true. First is that all workers are the same. Second is that all jobs are the same. Third is that there is no such thing as search and the markets clear.  Fourth, they assume that there is no government to act as an agent of redistribution. Finally, they assume perfect information.

All these assumption cloud the reality of labor market(s). There are many labor markets, and for most, the equilibrium price is above the wage floor, so the wage floor only sets a standard. Those where the wage floor is above the clearing price, the jobs and the pay are horrible. A government should step in, as ours does to a limited extent, to make better the lives of those workers who work and those who are locked out of the labor market through structural unemployment. The problem is that a certain party has demonized those at the bottom of the wage scale, calling them takers and welfare queens. That means people want to work; there is a cultural and monetary advantage to working where there is not to just relying on benefits.

The econ 101 view is also a market with perfect information. The employer has an information asymmetry in that area, in that it knows more about the labor market than the potential employee does; this is helped in some form by sites like Glassdoor, but it is imperfect. There is also the power gradient in that the employer can take someone down to the clearing price, but in some labor markets, it is not possible to live at the clearing price for labor: thus the government-mandated wage floor.

The other option is to look at the labor markets that do clear. Here the example is migrant farm workers. They are paid less than the minimum and have no guarantee of employment. When Alabama cracked down on undocumented workers, farmers could not get people to harvest their fields because the national market price of farm labor was too low for people used to some labor protection. The jobs are that bad, and the government protection minimal. That’s why I think a minimum wage is good, because it helps pull those shadow wages up, and there is less poverty overall with transfers even with structural employment.

Overall, the question should be about the appropriate level of the minimum wage, and stricter enforcement of wage and labor laws, not less. Because there is such a thing as structural unemployment, but in reality it does not map as easily to a graph as you learn it in introductory economics.

Many more concepts spring up that are of interest and worthy of deep study. These are just the tip of the iceberg.

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

 

Money Supply and GDP

A decrease in the money supply will have the effect of raising interest rates. Once the interest rates are increased, then business investment will decrease. The decrease in business investment, all things else being equal, will decrease the GDP, as the investment component will decrease. The multi-step process is illustrated graphically below.

Figure 2 adapted from Krugman & Wells p. 473

            Figure 2 represents the money market. The X-axis shows the quantity of money, or “real money”. The Y-axis shows the real interest rate, designated with a lower case “I”. The vertical lines represent the money supply, as determined by the Federal Reserve through open market operations. This graph shows the decrease in the money supply (M-bar one to M-bar two). The equilibrium interest rate at the meeting of the money supply and the line representing the demand for money is higher on the y-axis than it was previous. This represents an increase in the interest rate.

            The next step in related processes between a decrease in the money supply and the lowering of the GDP is looking at the relationship between the interest rate and overall investment. These are inversely correlated so that when the interest rate increases, as in the first graph, investment is lowered. The best way to illustrate the relationship is through side-by side graphs that directly trace the rise in interest rates with a concurrent drop in investment, but technologic limitations prevent that from being shown clearly here.          

 

Figure 3 adapted from Krugman & Wells p. 281

            In Figure 3, the y-axis is the same as in Figure 2, with the interest rate change from Figure 2 carried over from the previous graph. The x-axis represents the total investment expenditure, or” I”. The pink line shows the inverse relationship between the interest rate and the investment. As the money supply decreased, the interest rate increased. As the interest rate increased, the point on the pink line moved from E₁ to E₂. The total investment thus decreased in value as the interest rate increased in consequence of the decreasing money supply.

            Figure 4 will show the ultimate result of the decrease in the money supply: lowered GDP.

Figure 4 adapted from Krugman & Wells. p. 344

Figure 4 is the graph of GDP against aggregate expenditure. The graph is only at equilibrium where the `colored lines meet the 45-degree line in black. This graph shows that equilibrium GDP will be lower wen changed by a decrease in the investment component. All things being equal, the sum of consumer expenditures, government expenditures, business investment, and net exports will decrease if one of those components is lowered. The previous figures have shown graphically how decreasing the money supply increases interest rates, which decreased investment spending. Here is the culmination of those processes. GDP at equilibrium is lower (y₂, representing the level of GDP at E₂ where the green line intersects the 45-degree line).  Thus, decreasing the money supply decreases the GDP.


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