A Case Against (and For) the Federal Reserve
By Davis Clute
“We have all been asked to accept that ‘the market’ is a self-regulating system with rising and falling prices akin to the force of nature. Yet we are simultaneously expected to ignore the fact that the markets rise and fall mainly in anticipation of, or reaction to, decisions by Greenspan or Bernanke” — David Graeber, Debt: The First 5,000 Years
The main crux of this paper could be illustrated as thus: the Federal Reserve unequivocally saved us during the financial crisis of 2008 through the decisive action to inject liquidity, fund bailouts, and restore confidence in the financial system. Conversely, many say the housing bubble was caused by the Fed through excessively low rates and the “Greenspan put.” The Fed steered the ship into an iceberg, and then saved everyone on board.
So, what should we think about the Fed?
The Fed Created, Then Defused, the Financial Crisis of 2008
Many observers would contend without the Fed pouring alcohol into the “punch bowl” from 2001–2005, there wouldn’t have been a housing bubble and subsequent crisis in 2008. Interest rates should not have been so low during the early years of the 2000s, especially given how long personal savings rates are in the U.S. Furthermore, the implicit backing of the Fed (i.e. Greenspan Put) creates a moral hazard issue where unnatural amounts of risk are assumed because there’s no downside; the Fed will bail everyone out if things get bad enough. Without the Fed ‘selling’ the Greenspan Put for free, perhaps investors would have been more risk averse and demanded more of a risk premium on assets.
Yes or No on the Fed?
It’s hard to give a binary yes/no answer to the concept of a central bank. A natural question in this debate is, “Who then controls capital reserve requirements?” It’s tempting to let the market decide this one — banks fail if they don’t inspire trust or keep enough reserves. Unfortunately, in a fractional reserve banking system, one bad bank can take down all the other good, responsible banks. Perhaps fractional reserve banking is inherently unstable as it necessitates some sort of meta-systemic agency which can inspire confidence in the system (i.e. the FDIC). This meta-agency would necessarily make the economy more centralized and command-like, rather than allowing freer markets. Incidentally, full reserve banking is an option which would largely avert the possibility of a bank run and an easy collapse of the entire monetary system.
At some fundamental level, I would think you need an entity which has close to unlimited powers in the face of an existential threat. Of course, this is why the Fed was created: as a response to the panic of 1907. However, I believe our current Fed has become overactive and overly stimulatory. It seems that even a 5% drawdown in equity markets necessitates some sort of central bank attention (and subsequent stimulation). I’m not sure when the Fed’s mandate started to include maintenance of secondary equity markets — but this is a slippery slope.
Furthermore, the Fed’s mandate of a stable money supply and full employment is completely incoherent. This is extremely reminiscent of Soviet Union 5 year plans — where the economy is viewed as something to be actively managed by enlightened intellectuals. Additionally, many will point out that the mandates are very often mutually exclusive — which is true. Look no further than Paul Volcker’s time at the Fed for an example of when the Fed had to choose between unemployment and a stable monetary base.
In finality, I would think the Fed’s mantra should be thus, “do as little as possible, but not any less.” The Fed should allow the natural self-cleaning tendencies of the business cycle to occur — i.e. “do as little as possible.” Conversely, there will be times when the Fed will be needed to act quickly and decisively — i.e. “but not any less.”
Overall, I think an entity like the Fed is needed in times of extreme crisis. There is a spectrum, though, from passive to active — and currently the Fed is much too active.