Essay on "Federal Reserve and How to Improve"

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[EXCERPT] . . . .

Federal Reserve and How to Improve It

The Federal Reserve was created in 1913 and acts essentially as a central bank. However, its good in economics is controversial. As Ron Paul (2009) notes, for example, "Part of the public relations game played by the chairman of the Fed is designed to suggest that the Fed is an essential part of our system, one we cannot do without" (p. 10). On the other hand, proponents of the Federal Reserve assert that the Fed serves a necessary role in the stabilization of the economy. This paper will examine the good that the Federal Reserve does and provide suggestions on how it might be bettered.

What Good is the Fed?

According to Federal Reserve chairman Ben Bernanke, the Fed is a tool by which the "government can always generate higher spending and hence positive inflation" (Paul, 2009, p. 7). Initially created to deal with the several Bank Panics in the late 18th and early 19th centuries by rescuing banks over-extended on credit, the Federal Reserve has grown to taken on several more roles. The Federal Reserve mission statement defines its purpose and good in "four general areas," that include "influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates; regulating banking institutions…; containing systemic risk…; and providing financial services" to governments and banks throughout the world (Mission, 2009). While these purposes are broadly delineated, the overall picture of the powers of the Fed can be summarily drawn by comparing it to a kind of central bank for the whole world -- a bank to which is essentially granted the power to oversee the American economy as well as the power to loan and create money for institutions in need.

While these may seem like good and noble purposes to some, they are questioned and attacked by others. The attacks do not necessarily stem from the fact that the Federal Reserve pursues such aims, but rather from a dissatisfaction with the way the Fed manages itself. As Paul (2009) states, "People know that this institution has an important job to do in managing the nation's money supply," (p. 10). The problem, critics like Paul identify, is that the extraordinary power granted to the Fed is not one by which inflation may be regulated but, quite the contrary, one by which "the business of generating inflation" is conducted (Paul, p. 12). The Federal Reserve, by its very nature, effects "artificial increase in the supply of money and credit," and thus causes inflation. What is hailed as a good by those who see lines of bottomless credit as essential to the American economy, is viewed as an evil who see such lines as destructive to the American economy.

From such a perspective, the Federal Reserve can be seen as both hero and villain. Depending upon one's orientation, it is either an economic savior or an economic bane. In either case, it has allowed "the largest banks" to "privatize profits and socialize losses," which is a business antithetical to the free market system, in which profits and losses are part of the game (Paul, p. 13). Regardless of one's opinion or perception of the Fed, the fact remains that it wields a significant power in terms of economic policy. Therefore, it ought to be regarded with some concern.

Improving the Fed

As George P. Shultz (2009) states, the most important way to improve the Fed and its management of economic policy is to think "long-term" (p. 3). This means that "future consequences" should supersede more "immediate" ones when it comes to dealing with economic downturns, bailouts, and depressions, especially in the current situation of recent years in which the U.S. Treasury Secretary has promised to work with the Fed in a $10 trillion stimulus package (Shultz, p. 10). In order to address the situation properly, on must "be concerned about the potential for inflation generated by these huge changes in the money supply and the imbalance in the federal budget" (Shultz, p. 10). With tax rates expected to soar, "identifying potential undesirable consequences" is one way the Federal Reserve might better its own position (Shultz, p. 11).

As Donald L. Kohn (2009) observes, the Federal Reserve fulfills its mission of promoting maximum sustainable employment and stable prices by establishing new and increasing lines of credit (p. 52). By making more credit available, the Fed believes it is "promoting employment and stable prices," but is this really the case? An analysis of critics' views might help to reveal what if anything the Federal Reserve can do to better reach its stated objective.

Ron Paul frames the approach to bettering the Fed by noting that "rarely do people ask what the fundamental source of instability [in our economic system] really is" (p. 13). He cites the 2006 study of economist Jesus Huerta de Soto, which "places the blame on the very institution of fractional-reserve banking" (p. 13). What Paul (and de Soto) assert is that the abolishment of fractional-reserve banking might be the best thing the Federal Reserve could do to better itself.

Fractional-reserve banking allows deposited money "currently in use as cash [to] be loaned out for speculative projects and then redeposited," and so long as there is not a run on the bank, the practice in theory functions stably (Paul, p. 13). If such a run affected not only a single bank but the entire system of banks nationwide, an economic collapse is inevitable. It is essentially a pyramid scheme, the likes of which Ponzi in the 1920s attempted to put into action. The institutionalization of this sort of banking that mixes the "traditional" role of "warehousing" with the riskier role of investing, allows for essentially the creation of "new money," which exists on the books but not in reality (Paul, p. 13). The best thing the Fed could do to operate on a more legitimate level is to eliminate the illusory practice of this pyramid style of banking. For as Paul states, "even with a government-guaranteed system of fractional reserves, the system is always vulnerable to collapse at the right moments" (Paul, p. 14).

Although bail outs have become commonplace, they too have a detrimental effect on the economy because they lower the value of the dollar through the creation of new money. Proponents of bailouts see them as the way to the stabilizing of the economy and regulation of inflation, but critics see them as responsible for the collapse of the economy and the cause of inflation.

As Michael Halloran (2009) notes, there is a "need for an improved regulatory regime to reduce the likelihood of crises and thereby the need for intervention by the Federal Reserve" (p. 151). The answer, however, is already supplied by Paul when he states that the dissolution of fractional reserve banking would help stabilize the economic system by curbing the pyramid-style Ponzi schemes currently at the root of our economic crises. If the Federal Reserve is set up to monitor monetary policy, starting with the system of fractional reserve banking would be a good place to start.

Still, problems remain, such as the fact that the Federal Reserve "can now buy just about anything it wants and write it down as an asset" (Paul, p. 34). This explains why the Federal Reserve purchases debt. The monetization of debt is just another way for money to be created out of thin air, further reducing the value of money already in circulation. As a result, the ability to "foresee" consequences, as George Schultz stated was important for the bettering of the Fed, becomes nearly impossible. False booms and real busts become inevitable as the problem of credit is amplified by the flooding of the market with new and ready cash.… READ MORE

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