The Federal Reserve is not evil

[ZeaLitY]

I'm sick of Ron Paul and his supporters' advocacy for the dissolution of the Federal Reserve and the return to the gold standard. Either of those moves would destroy the United States economy.

Do you know what banking without federal support was like after the second bank of the United States was closed down? How does virtually half of all banks failing sound? Would you gamble 50/50 that your deposits might get outright stolen and disappear in a string of bank failures?

The United States had regular crises until the one around 1907 became so ridiculously bad that the American public assented to building a central bank. Does this mean one building in New York City has total power? No. Our Federal Reserve System is distinctly American. It's composed of twelve member regions directors include three plainclothes figures in local industry to represent popular interests. Only the New York City Fed has a constant vote in all matters of policy conducted in D.C. meetings because of the importance of New York as a financial center. The rest of the country is well represented. In other countries, there's only one bank and perhaps one alternate headquarters in another major country. Hell, in other countries, there are only a handful of banks, while the US has thousands.

The Federal Reserve and its economists have had to learn about the science of economics like everyone else. It's impossible to apply retroactive accusations of malice against the Fed for "intentionally worsening the Great Depression" because the classical theory was still popular at that time and deficit spending during recessions hadn't come to prominence. Oh, and the S&L crisis? Congress. As the S&L crisis deepened, they engaged in regulatory forbearance – effectively allowing S&L managers to go even further into debt with wild gambles and loans.

It is easy to leverage conspiracy-flavored criticisms of the Fed because it’s 1) independent of Congress and 2) independent of Congress's appropriations and budgets. Oh no, they can create money! How can they earn interest on securities; that's evil! Give me a break. The Fed returns what it does not require to the United States treasury. "Oh, but how do you know?" Because if you're qualified to be a member of the Federal Reserve, you're qualified to make a hell of a lot more money in the private sector with your talents and knowledge. That's why members usually don't serve their full fourteen year terms. Furthermore, having an independent central bank is a good thing. There is evidence of a political cycle where incumbents engage in deficient spending to heat up the economy and make it look good before midterm or future elections, only to deal with the consequences after they pass. An independent central bank means that regardless of whatever idiot is in power, monetary policy will still follow a scientific course. And if it ever comes to that, Congress can still assume more control of the Federal Reserve through new legislation.

But now let's go to the mortgage crisis. Yes, the usual suspects deserve blame. Countrywide's CEO is a profiteering scumbag. The bankers who engaged in predatory lending, knowing full well that they could turn around and securitize their mortgages and leave someone else holding the bag, are beneath human. Alan Greenspan, who took the Federal Funds rate to 1% and advocated variable-rate mortgages has his own lion's share of responsibility. But does anyone consider the vast number of irresponsible people who jump at the chance to live in the red? Do you know people who have expensive cars they obviously cannot afford and will be paying off for the next twenty years? Do you know conspicuous, cretin consumers? No one blames the masses of idiots who don't bother reading the fine print, don't bother understanding how interest rates work, and don't bother thinking past the immediate gratification of "owning" a bigger house. Critics blame the greed of CEOs, but spare materialism which leads people to enter into these dangerous transactions willfully—those who cannot wait to lease a Mercedes and double-mortgage a two-storey home. Like other wild habits, this is a crisis of deficient self-responsibility.

If there is a true culprit, it is education. First is ethical education which extant corporate America desperately needs. Business school teaches one how to succeed, but not how to fail; officers on sinking ships take what they can and bail. Despite the outrage over Enron and WorldCom, internal control failures and fraud is actually up from the era of those incidents. But secondly, and more importantly, the American public (specifically students in secondary schools) need to be educated about our financial system. I graduated my public high school with flying colors in many subjects, and I achieved As in Economics I and II in college shortly after. But nowhere in my curriculum was an emphasis on Wall Street, monetary policy, banking, finance, and the Federal Reserve. Do you know what the principal tools of the Fed are? Do you know what the Federal Funds rate means? Do you know what goes on in a meeting of the Federal Open Market Committee? And do you know how the money supply is tightened and contracted, or why this takes place? If my example – sculpted by an otherwise excellent education – is true, then neither do many of the American public know. Yet, like Adam Smith's invisible hand, the actions of the Federal Reserve and the proceedings of Wall Street directly influence, and in the case of those affected by this recent crisis, dominate lives.

Think about it – right now, thousands of college students have been whipped up to hate the Federal Reserve with little knowledge about how it works other than the assumption that it is supposed to bail the economy out whenever things go to hell. And the Federal Reserve has performed exactly that duty. On Black Monday, 1987, the stock market crashed for reasons unknown and the financial system threatened to melt down entirely. But the Fed performed its lender of last resort function, ensuring beleaguered firms that it was ready to provide liquidity. The crisis was averted. The same goes for September 11. The planes brought down the Twin Towers, but they only temporarily dented the American economy. Inflation in the 70s? Blame OPEC and supply shocks. The S&L crisis? Blame Congress's tolerance despite a mounting inability to insure the victims through the FDIC. The dot-com bubble? Blame the separation of tech stocks from their fundamentals as fueled by gung-ho investing. The current woes not related to the mortgage meltdown? Blame Republican deficit spending in a time of economic growth. The Fed failed in the Great Depression and it failed in the early 1980s, but it was still learning how to best influence monetary policy as it rode the cusp of economic understanding and science.

The Federal Reserve is not evil. It signaled the end of a cycle of bank failures, and though it has failed a couple times, it has contrarily cleaned up the mess left by volatile markets and inept government many times more. If you want suspects, chase immoral corporate leaders, unscrupulous loan officers, overconfident investors, and uneducated citizens. The Fed's small role in paving the way for banks to borrow more reserves to finance bad loans does not suddenly invalidate its entire existence or history of preventing American crises. Though he has other shortcomings (pro-life and prayer in schools come to mind), Ron Paul’s libertarianism depends on the assumption that humanity is good; that corporations will regulate themselves; that people will take care of each other. Humanity is obviously not there yet. But more than his other policies, his stances on economics, if implanted, would instantly collapse the United States economy. It is attractive to still think in spite of this that he has idealistic aims, but if you want proof that he’s genuinely crazy, look no further than his plan to go back on the gold standard. Look that one up. Quod erat demonstrandum.

[Radical_Dreamer]

A buddy of mine summarized Ron Paul quite well: "He's the candidate I wish I was voting against." It would be nice if there was a slightly liberal sane Ron Paul for the Democrats to put up against the real one.

[FaustWolf]

Ooh, econo-talk!

For the sake of my own practice, I'll have a go at these:

Do you know what the principal tools of the Fed are?
The discount rate; reserve requirements for member banks; and open market operations -- the purchase and sale of government securities. I'm told that the third method is used most often, as the other two are too heavy-handed.

Do you know what the Federal Funds rate means?
When a bank runs too low on its reserves (thus failing to meet the reserve requirement stipulated by the Fed), said bank must borrow extra reserves from another bank on a short-term basis. The interest rate on this "overnight" loan is the Federal Funds rate. *Fun fact: the Federal Funds rate is what banks charge each other for borrowing; the discount rate is the interest rate the Fed charges banks for borrowing from it. Go figure.

Do you know what goes on in a meeting of the Federal Open Market Committee?
This is the heart of monetary policy. I'm unfamiliar with all the FOMC's operations, but I believe the most prominent task is setting targets for the purchase and sale of government securities. When the public purchases securities from the Fed, the amount of money in people's hands decreases (you're handing your money over and getting a bond or other security in return); when the public sells securities to the Fed, the amount of money in people's hands increases (you're handing over your bond in exchange for money). Thus, the FOMC is what essentially controls the economy's money supply, which in turn affects various interest rates such as the Federal Funds rate.

And do you know how the money supply is tightened and contracted, or why this takes place?
The mechanics take place in the FOMC. As for why: the Fed might want to stimulate private investment spending by increasing the money supply (expansionary monetary policy). In very simple terms, when there's a greater supply of money, the "price" of money -- the interest rate -- falls, and various investment opportunities will become more attractive to businesses. For example, if the economy's prevailing interest rates are extraordinarily high, a business could make lotsa cash by simply dumping its money in a savings account or interest-bearing securities. But if interest rates fall, businesses might get comparatively more bang for their buck by building new production facilities and reaping profits that way. This description isn't entirely accurate I'm sure, but it's how I think of things so I can draw IS-LM diagrams correctly and the like.

As for why contractionary monetary policy (a decrease in the money supply) may be desired: inflation, inflation, inflation! If there's "too much money chasing too few goods," as I like to think of it, prive levels rise. The value of currency itself falls, and this decreases the profits people reap from interest-bearing saving accounts and similar monetary investments. In fact, if inflation is too high, it may "overtake" the interest rate, making your interest-bearing financial asset worth less than what you paid into it originally. For example, let's say you invest $100 in your savings account in 2007, and the savings account earns a 1% annual interest rate (which is higher than what I'm getting ). For whatever reason inflation skyrockets to 10%. In nominal terms your savings account will be worth $101 in 2008, but in real terms it's only worth $91.82. I.e., you have $101 in the bank but you can only purchase the same amount of goods that $91 would have gotten you back in 2007. Argh, the real v. nominal topic is so hard to put into words.

Of course, things get more complex when you're talking about a large open economy with flexible exchanges rates such as the US, but it's getting far too late to broach tangentially-related subjects.

I agree that the Fed is indispensable, though I have two gripes with the way it does things. First, FOMC operations affect money supply by acting through those who hold securities -- and the wealthy are far more likely to hold securities than the working and lower middle classes. Beyond Bourgeoisie v. Proletariat talk, I think it may have some interesting ramifications because the wealthy and the non-wealthy likely have different marginal propensities to consume and marginal propensities to save. Give a buck to a wealthy individual, and he or she will most likely invest it. Give that same buck to a homeless dude, and he'll go grab a burger immediately. I have yet to analyze what effects, if any, conducting monetary policy by an alternate means would have, but it's a subject of interest I intend to investigate more.

Secondly, I think it's very important to make a distinction between cost-push and demand-pull inflation. Zeality already hit on this topic in relation to the 1970s stagflation. Cost-push inflation occurs when the price level is being "pushed" up by increased resource costs such as gasoline. Demand-pull inflation occurs when "too much money is chasing too few goods." I think contractionary monetary policy is an appropriate response to demand-pull inflation, but I'd hesitate to use it when cost-push inflation is occurring. If all the oil refineries are shut down by a natural disaster, you can probably bet your socks that prices are going to rise as businesses face greater transportation costs. But sucking money out of the economy to combat inflation in this case isn't going to solve any problems. Best to focus on getting the oil supply increased by, say, having the federal government construct a lot of refineries real fast.

But that's enough input for me. Anyone can feel free to correct me if I've misconstrued economic principles in any way. It only helps my education and debating skillz.

And if Ron Paul wants to make a positive contribution to the economy, I'd recommend he fly his blimp over Washington, D.C., and dump large sums from his war chest onto all the homeless people freezing their rears off in our nation's capital right now.

[Thought]

Why are we talking about a dead Pope? Oh wait, that is John Paul...

Anywho. I certainly agree that we need a lot more education in America on economics. I think my education of the matter largely started and ended with "Government and Economics" in High School. P.E. was its own class, but Economics apparently can get crammed together with everything related to the Government. Wasn't even covered in the GE requirements for a bachelor’s degree. I learned about Native Americans, but not basic principles of economics. Curiously, I've gotten far better use out of the smattering of knowledge I have on supply and demand than I ever have from how many treaties the U.S. broke.

Of course, the issue of education can easily evolve into its own discussion; not only could there be more time spent educating the population on economics, but the time that is spent could be put to better use. Get rid of a few layers of government control, for one. Which is slightly ironic, as getting rid of government control in this area would help people see why government control is needed in other areas.

As for why contractionary monetary policy (a decrease in the money supply) may be desired: inflation, inflation, inflation! If there's "too much money chasing too few goods," as I like to think of it, prive levels rise. The value of currency itself falls, and this decreases the profits people reap from interest-bearing saving accounts and similar monetary investments.

Quite true, however I feel I should also point out that in some cases, inflation is a good thing (which is why the U.S. moved away from a limited resource standard in the first place). Inflation helps the poor the most (aka, people with few investments and large debt), with business not far behind (as a good portion of business is fueled by loans). It hurts the rich the most (people with a lot of investments).

If one were to decrease the money supply (say, by switching from fiat money to gold based money), one would actually get deflation, which would in turn hurt the poor and business oriented and help the rich.

A problem with a finite resource, such as gold backed money, is that it is finite and the population isn't. Basic supply and demand. With a growing population there will be more people demanding the product (money). If supply cannot keep up with demand (and gold backed money is limited), the cost increases. Thus it is possible that simple population growth can cause deflation! Economies just can't run that way.

As a side note; savings accounts are crap, insofar as investments go. They are safe (thanks to the good ol Feds), but generally the interest you get from them only keeps up with inflation. Mutual Funds are almost as safe but the return is usually enough so that your money isn't wasting its time.

As another side note; it is slightly curious that there are so many "radical" ideas going about this election season. Ron Paul with denouncing the Federal Reserve, Huckabee with vowing to do away with the IRS (luckily an empty promise, since even as president he wouldn't have that kind of power), a Mormon with a chance of effecting the vote is running, as is a woman (well, technically), and an African American. I'm half-expecting to see one of the candidates declare that they are homosexual, that they've converted to Buddhism, or that they are not old (as U.S. Presidents are traditionally old, white, Christian, and male).

[FaustWolf]

Good points about the positives and negatives of inflation, Thought! Very true; it's a blessing for debtors and a curse for creditors as well as investors. Also, inflation can be good for businesses inasmuch as it brings real wages down; sucks for workers though. Since it isn't politically correct to cut wages directly in many cases, a business can just let inflation do it for them.

Have there been any episodes of "real" deflation since the Great Depression in the US? The econ texts claim it's a rare event, but I think we've seen deflation during the early 90's and currently, in a very roundabout way -- look at all the sales that are out there nowadays. 10%, 20% discounts, free shipping, etc. Sounds like unofficial deflation to me. But I may just be suffering from tunnel vision and just blowing what I'm seeing in stores and on the Internet out of proportion.

[Thought]

I don't know if I'd call those examples of "unofficial deflation" deflation at all. For one, it isn't an unheard of tactic for business to specifically raise the price of their products in order to then have a sale at XX% off. The same price is being paid, but the "sale" brings in more customers. Thus, though there may be more sales nowadays, one would need to compare the after "discount" price with the price of the same product ten years ago (or whatever).

The sale price isn't always the real price and I think (though again, I have a 1-course-in-highschool education here) inflation/deflation is ideally determined by the real price. That is, if shoes cost 10$ to make but they sell for 20$, the real price is still 10$. A store that raises the price from 20$ to 30$ for the shoes isn't necessarily responding to inflation; it might just be price gouging. However, if the cost of making those shoes goes from 10$ to 12$, then that is inflation.

As a side note, actually it is against a businesses long term interests to cut wages (but no one every said businesses knew what was best for themselves). The more money a business gives its employees, the more they can spend, which stimulates the entire economy and in turn brings more business to the business. Businesses (and people) should be more concerned with wealth than money (wealth being the "movement" of money). Say I have 10$, that isn't much. But say that I spend those 10 dollars to buy food, the food guy in turn spends 10 dollars to buy clothes, and the clothes guy gives me 10 dollars to get an education. Same 10 dollars, but a whole lot of goods and services came out of it. On one hand, I could have 10 dollars but on the other I could have 10 dollars and some food. The more money changes hands, the more wealth there is and thus the more a specific individual (or business) could have. I think it was Ford who said "the job of the industrialist is to make the best product possible, for the lowest price possible, paying the highest wages possible." It might sound odd, but it is really sound advice.

[FaustWolf]

Spoken like a true Keynesian, Thought. 

Ford's advice is called "efficiency wage theory" in my Macroecon textbook. Pay your workers a higher wage than what your competitors are giving out, and you can bet your workers will work harder/stay on the job longer, etc., compared to workers at other companies. Thus costs associated with turnover are drastically reduced. Sounds good to me; everyone benefits.

[Thought]

Keynesian, you mean like Paul Tergat?

But more than just in economics, I would certainly argue that when people (private, corporate, government, etc) cooperate, everyone benefits far more than otherwise. Heck, even if people were just polite and well mannered things would improve. Alas, life is a prisoner's dilemma and the guy in the other room is, to quote the ineffable Roman Moronie, a "fargin, sneeky bastidge."

[ZeaLitY]

Say your prayers, icehole.

[FaustWolf]

"...And Maronie continued to murder the English language and anyone who got in his way..."