Signed into law by Woodrow Wilson on December 23, 1913, the Federal Reserve is the central bank of the United States. After the Panic of 1907, which led to a bank run, bankers such as JP Morgan lobbied for the government to establish a central bank to try to stabilize the money supply of the country.
The Federal Reserve has has five main jobs. Conducting monetary policy, promoting financial system stability, supervising and regulating financial institutions and activities, fostering payment and settlement system safety and efficiency, and promoting consumer protection and community development.
I shall make the case that the Federal Reserve should be abolished based on several reasons.
First, the Fed has failed at its jobs, most notably when it comes to promoting financial system stability. An example of this—the elephant in the room—would be the Great Depression. I spoke briefly about this in a previous article.
“The original cause of this depression was over-speculation of stock prices, which led to more investment. Massive amounts of people took out loans to get starting capital for investing. The wealth of the nation increased drastically during this time, while the real money supply kept in reserves only increased by a little. Investments in the real estate and stock markets shot up. Equity prices rose in multiples of over 30, and Dow Jones rose 500% in just a few years. Then, on October 24, 1929, the bubble popped, and the markets crashed, as the nation came to realize that most of their money could not be withdrawn from the banks. People watched, helplessly, as their wealth dropped to nothing.”
Not only could the Federal Reserve have prevented this from happening, they were its main cause. In 1917, the Fed cut reserve requirements down to 3% while keeping interest rates low. The money supply grew $28 billion, bank deposits increased 51.1%, and reserves for life insurance policies grew 113.8%. The Federal Reserve’s expansionary monetary policies resulted in this rapid increase in the money supply, and that surplus caused the bubbles in the stock and real estate markets that eventually burst.
After the markets crashed, the Federal Reserve made the decision to cut the money supply by a third, prolonging the issue and making it more difficult for banks to recover. Thousands of banks collapsed out of bankruptcy, as massive amounts of their wealth had nothing to back it up.
The late Chicago economist Milton Friedman argued for decades that it was the Federal Reserve that caused the Great Depression, and in 2002, at a celebration of Friedman’s 90th birthday, former Federal Reserve chairman Ben Bernanke finally admitted it. “I would like to say to Milton and Anna: Regarding the Great Depression,” he said. “You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
Similar arguments could be made about the mortgage lending crisis in 2008.
Back in 2002, New York Times columnist and Keynesian economist Paul Krugman wrote this about the recession of 2001:
“To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.”
I am a strong critic of the ideas of John Maynard Keynes. I am so for many reasons, and let this statement of poor economics be one of them. Indeed, most situations of government intervention in the economy are unnecessary, but to suggest that the Federal Reserve create an economic crisis to fight another economic crisis is simply disturbing. What is more troubling is that the Fed did just that.
After the dot-com bust, Fed chairman Alan Greenspan lowered interest rates for an extended period of time. From 2002 to 2006, the Fed bought $200 billion in Treasury bills, injecting that money into the economy. With a reserve ratio of 10%, this leads to an increase in the money supply of $2 trillion. Lowering interest rates and increasing the money supply is precisely the same thing the Federal Reserve did with the Great Depression, and it gave way to similar results.
My second reason is that the Federal Reserve is simply unnecessary, and we could have a financial system just as stable, if not more stable, under an alternative, free market system.
The United States had several different systems of currencies before the Federal Reserve Act was signed into law in 1913. Between 1791 and 1811, and then between 1816 and 1836, the US had a national bank. The charters for both of these banks were not renewed for political reasons, which resulted in a mix of state-chartered banks and a few banks without charters. All of these banks were heavily regulated; for example, they were not allowed to branch, they were forced to hold specific reserves, and they were forced to hold $100 in government bonds for every $90 they issued in notes.
These regulations would cause issues with bank notes not being accepted in other states, and often the bond requirement would require banks to pay cash from their assets, leading to a suspension of payments.
Without government interference in the banking process, a natural system of clearing houses would form to gather the cash and assets of members and issue loan certificates to banks with deficits. A clearing house, in the case of banks, is an organization which acts as an intermediary between banks to improve efficiency and allow members to improve cooperation among each other in times of crisis. During some panics, clearing houses illegally issued issued new money to prevent collapses of members.
“During the Panics of 1893 and 1907, clear-inghouses used small denomination certificates for hand-to-hand currency in addition to large denominations to settle their balances,” FEE writes. “The public obviously preferred legal currency to these small certificates as evidenced by the fact that the makeshift currency usually fell to a discount until suspension of cash payments ended. Yet these free market arrangements mitigated each panic by preventing the fractional reserve collapse that was to occur after the Federal Reserve was in operation.”
This was an efficient system in which banks utilized free market resources and systems to keep the system running and prevent crises from getting worse. These panics, however, were likely caused by the regulations the government placed on banks in the first place.
A similar system, put into place today, would be an excellent alternative to the Federal Reserve. Its regulation would be the natural checks of the free market. As I stated in a previous article as well, “a bank in a competitive market with other banks must either be safe with their lending practices or risk the almost inevitable possibility of a run.” The owners must gauge the risk of their activities and act intelligently, as the result of irresponsible behavior could result them losing everything. While the profit motive today is an incentive to take huge risks, with the abolishment of “too big to fail” bailouts, the profit motive would become an incentive to take less risks.
Because the Federal Reserve is a financial system which creates more issues than solutions, and the free market would create a more stable and efficient system, the ideal course of action for the United States is to abolish the Federal Reserve and allow the free market to create its own system of currency.
Investopedia Staff. “Clearing House.” Investopedia, Investopedia, 27 June 2015.
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Krugman, Paul. “Dubya’s Double Dip?” The New York Times. The New York Times, 01 Aug. 2002. Web. 28 Apr. 2017.
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Lewis, Nathan. “Assuming We ‘End The Fed,’ What’s The Next Step?” Forbes, Forbes Magazine, 2 Apr. 2013.
Murphy, Robert P. “Evidence That the Fed Caused the Housing Boom.” Mises Institute, Mises Institute, 9 Dec. 2008, mises.org/library/evidence-fed-caused-housing-boom.
Pethokoukis, James. “How the Fed Helped Cause the Housing Bubble and Financial Crisis.” AEI, AEI, 29 Mar. 2012, http://www.aei.org/publication/how-the-fed-helped-cause-the-housing-bubble-and-financial-crisis/.
Tamny, John. “Ron Paul, Fractional Reserve Banking, and the Money Multiplier Myth.” Forbes. Forbes Magazine, 11 Aug. 2012. Web. 7 May 2017.
“The Fed – Purposes & Functions.” Board of Governors of the Federal Reserve System, http://www.federalreserve.gov/aboutthefed/pf.htm.
Wells, Donald. “Banking Before the Federal Reserve.” FEE, Foundation for Economic Education, 1 June 1987.