On the Federal Reserve System

March 20th, 2009 at 10:45 pm - by admin

The Federal Reserve, arguably the most significant central bank in the world, is a source of controversy and critique internationally — its history of establishment and its system of accountability is one of question: does the accountability structure provide an adequate and acceptable solution to an exploitable problem?

Those highly critical of the Federal Reserve often cite the Great Depression as being caused by the System. Current chairman Ben Bernanke acknowledged this claim in 2002, saying “[he] would like to say to [Milton Friedman]: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

The responsibilities of the Federal Reserve, are, especially in times of crisis, possibly the most important economic variables controlled by the government. Or… almost the government. The Federal Reserve is only quasi-public, with a dependency on the Act under which it is established; but little in terms of direct accountability and auditing potential. The System has no mandated budget, has no system of proper audit, and has limited and internally determined Congressional availability of supervision — many believe that this system, combined with a wide-spread misunderstanding of economic variables, has created a scenario where middle class citizens consistently sacrifice their standards of living in exchange for the written responsibilities of the Federal Reserve.

To some, this veil of secrecy is intentional: weak answers to the “why” question are often shrouded with suggestions that in fact, the people should not know what is going on with their dollar. As the value of the dollar dwindles towards nothing, macroeconomists sometimes suggest that anything but the most soft-spoken, rational and censored output from a body entrusted with so much could easily create panic. To none, at least none effected, are the costs to living standards acceptable: inflationary policies at the Federal Reserve (and other central banks worldwide) generally encourage a two per cent reduction in the value of money, per year; often rationalized under the guise of “keeping labour markets fluid.”

Inflation is a complicated issue; strictly, it is created by the increase of the money supply, which can happen at a number of places. In the current system, the Federal Reserve and U.S. Treasury create money: often with the goal of driving down the Fed Funds Rate or general interest rates, and the fractional reserve banks can create money by loaning it through what is called the money multiplier. In a central bank-free economy, the economy’s condition and productivity determines the interest rate, which in turn determines how the supply-and-demand factors come together to determine the amount of lent money; which would, in theory, shift the inflation rate to settle near zero (assuming a unit of account that did not change whatsoever; a clear impossibility). In a nutshell, the central banks allow the money multiplier to have effects on inflation that slowly eat away at savings for those who are not positioned to take advantage of the boom-and-bust nature of cyclical inflation.

The responsibilities of the Federal Reserve are, primarily, the management of monetary policy, maintaining stability and handling systemic risk in financial markets, and the regulation of banking institutions; a goal that the International Monetary Fund says is not being fulfilled. Finally, the Federal Reserve provides “certain financial services to the U.S. government.” Combined, these goals are intended to provide a “safer and more stable monetary and financial system,” according to the Federal Reserve’s online publication.

These goals are lofty, yet respectable. As an institution that was created shortly before the Great Depression, in 1913, it often takes blame for that particular systemic shock, as well as changes in the monetary climate which followed. In reality, central banking was in effect long before 1913 in the United States: First Bank of the United States, chartered in 1791 — and later, in 1816, the Second Bank of the United States — both assumed many of the same responsibilities of the Federal Reserve: the establishment of “financial order,” to resolve and cleanse the numerous currencies in circulation at the time; to collect, store and account for taxes on behalf of the U.S. government; and to manage national credit, both at home and abroad.

The establishment of the First Bank of the United States marked the beginning of monetary inflation — the Bank, which needed to secure funding to begin operations, petitioned the First Congress for a purchase of $2 million in stock; the U.S. government did not have $2 million, so rather, a plan was established where the Bank would loan the United States $2 million — to be paid back in 10 annual installments — which would in turn be used to purchase the stock.

The First Bank lost public support in 1811, when its original twenty-year charter came up, only to be followed by the Second Bank of the United States in 1816. Andrew Jackson, vehemently opposed to the creation of such a bank, was reelected in following years and removed all public funding from the Second Bank. Finally, the renewal of the charter was denied in 1836.

This, clearly, did not mark the end of centralized banking for the United States. The aptly-named Free Banking Era which followed the end of the Second Bank, allowed states to regulate and manage their own charters and banking systems; regulating reserve requirements and interest rates much like today’s banking establishment. 1863 marked the end of yet another historical era of U.S. banking, when Free Banking came to an end with the passing of the National Banking Act: an act which provided loans to the Union and appointed a Comptroller of the Currency to manage the new system of national banking. This system imposed a 10 per cent tax on state-issued bills, effectively destroying the state banking establishment in favor of the national banks, who were mandated to fund Treasury spending and in turn, the side of the Union, by holding T-bills to back private loans.

1907 brought an end to this, when the Panic of 1907 — a bank run caused by a cyclical monetary aggregate and a number of traumatic natural disasters — and an international move towards central banking systems encouraged the public on similar motifs. A rise of fiscal power had established itself over the recent years in a number of families and financiers, but this was not of great concern to the community: of greater concern was the instability seen in recessions and bank runs like that of 1907 and the inability of a disconnected financial system to regulate itself — at least, this is how it is seen today; this is where things become a little murky.