Federal Reserve is Critical to the Continuing Security Of Our Economy

A recent PolicyMic essay by Christian Rice pertaining to the Federal Reserve has received a fair amount of attention. It is unclear whether this notoriety resulted from a genuine feeling of distrust towards the Fed (which I believe is unfounded) or inspired by a cartoon that was part of the essay. The parody is an embarrassment to Americans who think that it accurately portrays the relevance of the Fed. Rice suggested I respond to his essay after I made comments about his essay.

This essay addresses most of the points made in Rice’s piece, as I discuss the role and importance of the Federal Reserve System.

By way of background, the Federal Reserve System is owned by 38% of the 8,039 commercial banks in the US. It had $3.097 trillion of assets as of February 20, 2013. These assets consisted primarily of loans to commercial banks and securities held in the ordinary course of business, which the Fed trades with its members to increase or decrease the country's money supply.

Rice refers to inappropriate "corporate influence" by commercial banks within the Fed in his essay. Yet, the ownership of the Fed by commercial banks "is symbolic; they do not exercise the proprietary control associated with the concept of ownership nor share ... in Federal Reserve profits." Hence, "Bank ownership ... [is] therefore devoid of substantive significance, despite the superficial appearance of private bank control that a formal arrangement creates." In layman’s terms, member banks are required to keep 3% of their capital with the Fed. For this, members receive access to competitively priced loans, but have little or no influence on the policies of the Fed. Incidentally, Jamie Dimon of J.P. Morgan no longer sits on the Fed Board of Directors.

Rice claims that the Fed is a secretive organization, but it is accountable to Congress, which frequently and regularly meets with the Fed Chairman. The Federal Reserve has a statutory mandate from Congress to "[promote] maximum employment, stable prices, and moderate long-term interest rates." The Fed must explain its monetary policies clearly to "[facilitate] well-informed decisions-making by households and business, [reduce] economic and financial uncertainty ... and [enhance] transparency and accountability, which is essential in a democratic society."

Another accusation in Rice's essay is that the Fed promotes inflation with its monetary policy. As part of its monetary policy, which is frequently a subject discussed in Congress with the chairman, the Fed lends money to member banks at rates which generate a profit and buys and sells securities. These actions, coupled with "printing new money," are part of a long-term program to minimize inflation (the target is 2%). The Fed is well aware that indiscriminate increases in the money supply to keep rates low can impact inflation. Annually, the Fed earns significant profits from its operations that are deposited with the Treasury.

Besides effective management of the money supply, there are two issues that are most often on Fed critic agendas are "too big to fail" and bailouts of commercial banks. It is important to consider these items in any assessment of the Fed.

Too big to fail has been a reality in America and throughout the world for centuries. Banks have always financed trade and provided capital for industrialization and commerce. Over the years, many banks have been established, yet only a few have grown into huge financial supermarkets that provide far more than loans and should be protected at all costs. Today, banks provide hedging alternatives as well as far-reaching investment opportunities for clients. As an aside, some of these services increase the asset size of banks without dramatically increasing embedded risk in the institutions.

Great size has resulted in a diversified menu of services. It is true that if a huge institution fails, it could have a material impact on world economies. This is not because of the solvency of the bank per se and the protection of stockholders. Rather, it is because trade, commerce, and depositor protection could be endangered. Today, regulators are desperately trying to develop contingency plans that would enable them to take over failed banks without curtailing services. The protection of stockholders and bank management are the lowest priorities.

Bailouts are necessary from time to time if a bank’s prospects deteriorate as a function of market aberrations, but not for inefficiency or unnecessary risk-taking. The 2008 crisis was a perfect example of how the Fed should step in and stem a crisis. The large banks were offered temporary cash infusions to instill confidence among investors. Surely, there were abuses and excessive risk, but no major situations called for liquidation of a large institution. The success of the bailouts by the Treasury that were orchestrated by the Fed is evident as most banks have recovered since the crisis and the Treasury, for the most part, has been repaid and fairly compensated for being a lender of last resort.

Americans should not demean the role of the Fed in protecting the banking system. This activity is critical and beneficial to the economy.