Federal Reserve

Mohamed Badwan

15 April 2012

English 3010

THE FEDERAL RESERVE: ROOT OF ALL EVILS

The U.S. Federal Reserve activities cause many questions in the American public since the 2008 crisis, when it was charged that its policies has led to financial collapse. In 2012, the issue of the Federal Reserve is once again at the forefront of public interest in the U.S., primarily because this structure is under constant criticism of Congressman Ron Paul. Paul represents the libertarian wing of the Republican party and has influence on over a third of its voters.

In this paper it is necessary to speak about FRS, its functions and responsibilities. Do the Fed’s activities comply with the principles of political responsibility and tenets of the free market? Particularly it is necessary to point out how its activities influence the functioning of both American and global economy.

FED AN INDEPENDENT AGENCY

The Federal Reserve System (FRS) is system of 12 regional U.S. banks, which act as the Central Bank. The capital of the Federal Reserve was established through the sale of shares to private commercial banks, which became its members. The main functions of the Federal Reserve are: to issue banknotes; keep the required reserves of member banks of the Federal Reserve; give loans to commercial banks and rediscount; purchase of government securities; cash services to the federal budget; implementation of inter-bank clearing; operations with foreign currency and storage of gold reserves for foreign governments. (Hafer 2005)

The Fed is an important instrument of state-monopoly regulation and control. Its monetary policy aimed at mitigating the crisis of production, overcoming inflation, etc. (Hafer 2005)

The Federal Reserve System was established by the Law “On the Federal Reserve System”, adopted by Congress in 1913 to provide a more secure and more flexible banking and monetary system. Prior to the creation of the Federal Reserve System, the financial panic, from time to time, led to the bankruptcy of many banks, businesses, and reduced economic activity in general. That is why the Federal Reserve System was formed to give the country a flexible system of monetary circulation, to provide funds for payment of interest on commercial loans and improve control over the banking system. From the very beginning its priorities coincide with the directions of the national economic and financial policies. (Johnson 1999)

The Federal Reserve contributes to the achievement of economic and financial goals of the country. As the country’s central bank, it provides long-term economic growth within its capabilities, while ensuring reasonable price stability. The Fed seeks to pursue its policy to fight deflation and inflation processes as they occur. And as a lender of last resort in an emergency it is responsible for using the tools of their policies in order to prevent a national crisis of liquidity and financial panic.

Federal Reserve System was entrusted to a lot of control and regulatory functions. For example, it regulates foreign operations of U.S. banks and the activities of foreign banks, monitors compliance with the laws, regulates activities of bank holding companies, sets the rules for consumer protection (information and honest attitude towards them in certain credit transactions). But these powers cause many issues related with its large competence and independence.

The Federal Reserve System operates as an independent agency of the Federal U.S. Government. According to the law, the Federal Reserve is a working body of the U.S. Congress, even though it is the U.S. President appoints the members of the Board of Governors of the Federal Reserve on the basis of the recommendations and with the agreement of the Senate. As a representative of the U.S. Congress, the Federal Reserve System is accountable only to it, that is, has no obligations to the U.S. enforcement authorities. Only Congress can dissolve or liquidate the Fed, of course, if it considers such a decision appropriate. This distinguishes the Fed from other government agencies, which are formed on the basis of constitutional acts. Members of U.S. Congress jealously guard their authority over the Federal Reserve from encroachment by the executive power and never tire of reminding the newly appointed Fed officials about their responsibility only to the U.S. Congress. Members of Congress very often publicly protest interference of the U.S. executive bodies in the actions of the Federal Reserve System. For example, Congressman Wright Petmen, when he was the chairman of the Congressional Commission on Banking and Currency, has organized a series of hearings in Congress on these occasions.

Many experts have criticized the “independence” of the Federal Reserve System, believing that executive power must direct the activities of the Fed, and not legislative bodies. Their main argument in this dispute is to prevent conflicts between monetary measures and other (fiscal) measures of the federal government, aimed at preventing inflation and ensuring full employment. For example, prior to the adoption of the Banking Act of 1935, the Secretary of the U.S. Treasury had a right to informal membership at the Council of Governors of the Federal Reserve, but the Banking Act cancelled that practice.

Despite the legal independence from the executive branch of the federal government, it is reasonable and it is obvious to assume that the Federal Reserve shows proper understanding of the problems and concerns of the executive power, along with other departments and offices of the U.S. federal government. Those who follow the actions of the federal government, no doubt noticed that the open conflict with the most senior officials, representing the executive branch, never go to the benefit of managers of a department or organization. Some believe that the independence of the Federal Reserve System should be free from the slightest political pressure from the government. Such views often find support in the media, banking sector and even among the officials of the Federal Reserve. However, few experts seriously believe that the Fed has ever been independent in this sense - rather, monetary policy of the Federal Reserve System, a flexible or rigid, provides support to the economic policy of the President and members of Congress.

CRITICISM OF THE FEDERAL RESERVE SYSTEM

Ron Paul criticizes the Federal Reserve System (FRS) because of unfair practices, which bring harm to the economy and millions of ordinary Americans. Ron Paul once formulated his slogan “End of Fed”. He believes the FRS is “dishonest, immoral and unconstitutional” organization. Thus, he has three main claims to the Federal Reserve:

1) Federal reserve produce “dishonest”, “inflated” money, which often referred to as fiat (that is, having a certain rate due to authority of the state, and not due to any economic guarantees), rather than the so-called sound money, which, for example, had a circulation at the time of the gold standard.

2) Unfair practices against members of the free market, while manipulating interest rates and securities.

3) Lack of control, lack of transparency of the FRS actions, which are contrary to the economic interests of the country, its citizens and economic entities.

In this regard, Ron Paul requires put the Fed under the control of Congress, because under the Constitution the legislative branch has the exclusive right to conduct inspections and investigations in particularly important cases. And what could be more important than financial stability of the whole country. In the 2012 election Ron Paul goes with the slogan “Audit the Fed”.

The Federal Reserve has always resisted such an audit throughout its history. According to the Federal Reserve Act of 1913, the actions of FRS may be limited by laws adopted by Congress, but otherwise acts as an independent shareholder structure. It is necessary to note that such a position of FRS often gives rise to theories about the private Central Bank of the United States. As for the President, he has the authority to approve or not approve the Chairman of the Board of Directors of the Federal Reserve, however, director is elected by the internal vote of the Council.

Formally audit of the FRS may hold Governmental Accountability Office (GAO), which is a state audit commission and is a part of the legislative branch, but its effectiveness in spite of the extensive self-promotion, is highly questionable. For example, in 2010 GAO presented the Financial Report of the Government of the United States and a press release, stating that the Commission could not give its assessment of the consolidated balance sheet of the Federal Government because of the weak control over the vast material, a significant number of inaccuracies and due to other constraints.

The Federal Reserve according to the official statement has been operating as an independent agency within the government. That basically means that this institution is de facto a separate branch of government. Such a status is confirmed by the words of an official statement: “Federal Reserve… is regarded as an independent central bank because its decisions on monetary policy does not require the approval of the President or anyone else from the executive or judicial branches of government, it receives no funding approved by Congress and the decision of the board of directors includes a large number of conditions set by the President and Congress”. (www.bloomberg.com)

Ron Paul has consistently opposed such a situation and proposed the bill HR 1207, known as the “Law on Transparency of the Federal Reserve.” However, the bill was rejected despite the global financial crisis. Many of its provisions were included in other bills, but Ron Paul and his supporters refused to vote for the “half-solutions”. However, even these solutions (such as bill HR 3996, which in particular removes restrictions of GAO in auditing the Federal Reserve) met strong resistance from the monetary authorities, and as a result President Obama spoke out against it. There were not enough votes to overcome President’s veto, and the law “stuck” in the conciliation committees of the Congress. Opponents of such legislative initiatives say that it was not for the good of the American economy, but simple populism. For example, in 2009, when Paul’s bill was under consideration, Republican Senator Judd Gregg did not hide his anger: “It’s inexcusable to let Congress intervene in monetary policy… One of our strengths is an independent Federal Reserve, and the idea that comes from the House of Representatives is just a populist fever… this is absolutely the wrong decision, and it will bring a fundamental damage to our monetary policy”. (Romm 2009)

So, what we are dealing with: a violation of the Constitution, as says Ron Paul, or violence against the free market or the obvious need for an independent central bank, free from the dictates of populist politicians? There are two important questions that follow the critique of Ron Paul and his supporters: can the Federal Reserve be blamed for the financial crisis? Is it effective enough to prevent crisis or at least mitigate the crisis? Finally, we pose the question more broadly: does the existence of such a powerful structure as the Federal Reserve comply with conditions of economic freedom?

Mark Gertler, an economics professor at New York University, Scientific Adviser of the Federal Reserve Bank of New York, gave his opinion: “It is impossible to imagine the modern global system without a central bank. Central banks were established primarily to maintain the stability of the private banking system. The Fed was created in the early XX century, after the U.S. experienced several economic downturns caused by the collapse of banks. The main task of the Fed in times of crisis is to ensure the continuity of the flow of credit, as happened during the recent crisis”. (bloomberg.com)

Gertler said: “The Fed is independent and objective enough to ensure the stability of the economy. The Fed is really the only institution in the United States free from politics. In my opinion, it is generally the most successful institution in the United States, precisely because it is completely free from politics. If not actions of the Fed, the economic crisis for the U.S. and world economy would have been even worse”. (bloomberg.com)

With the position of Goertler disagreed Alan Reynolds, former head of the Directorate for Economic Research at the Hudson Institute. Paul Reynolds supported the issue of lack of control the Fed and its anti-market nature: “In contrast to the legislative and executive branches of government, the leadership of the Federal Reserve did not really accountable to civilian control. If the White House and Congress from time to time have inspections of the voters from different states, the Supreme Court, and so on, the Fed is free in its actions”. (bloomberg.com)

James Galbraith, professor at the University of Texas, a senior fellow of the Institute of Economic Levy also pointed to the global role of the Fed: “In its present form the Federal Reserve acts as a last instance, which is important to the whole world, not just to the United States. It became obvious at the time of crisis when the U.S. Federal Reserve has released huge amounts of currency to exchange with other major central banks”. (bloomberg.com)

However, the legal status of the Fed, according to Galbraith, has a lot of conflicts: “the Fed in Washington is a state agency, the Federal Reserve regional banks are also government agencies, but they strangely have private influences, endowed with legal status. That is the problematic fact in terms of American Constitution”. (bloomberg.com)

That is, the Fed has recently acted primarily in the interests of major U.S. banks. In a moment of crisis the Fed was completely unable to independently regulate the work of these institutions, although it is the purpose of the Fed. The real cause of the problems with the Fed is not the very existence of such an agency, but the fact that the Fed has become hostage to the interests of the oligarchic banking system - that the problem facing the U.S. today, and this issue that has not been solved yet.

The problem is that the Federal Reserve System has become a multi-functional agency. It not only deals with monetary policy, but does most of the fiscal policy, is engaged in saving banks, which are called “too big to fail”. But if the Fed has focused on domestic politics, it just might be more likely to prevent systemic crises.

FEDERAL RESERVE SYSTEM AND THE CURRENT ECONOMIC CRISIS

During the history of the FRS, there were only two periods when it was able to achieve both stable growth and low inflation. It was in the 1923-1928 years when there was a gold standard, and from 1983 to 2002, when it followed the so-called Taylor rule. But if we speak about the current crisis, the Fed contributed to it, as it kept interest rates too low for too long and also financed the growth of unsecured loans.

The main mistake of the Federal Reserve System is that it has no long-term plans, attention is paid mainly to what happens in a very short period of time. The leaders of the Federal Reserve never ask such important questions: if we do it today, what would be the situation in a year? What will happen in two years, three? For example, the Federal Reserve System has no, despite numerous statements by Chairman Ben Bernanke, coherent explanation of how to get rid of the burden of $ 1.5 trillion of excess reserves.

Works cited:

Hafer R. W. The Federal Reserve System: An Encyclopedia. Greenwood Press, 2005.

Johnson R. “Historical Beginnings… The Federal Reserve”. Federal Reserve Bank of Boston, 1999.

“Mark Gertler News”. bloomberg.com. Web. 14 April 2012

Plosser Charles I. “The Federal Reserve System: Balancing Independence and Accountability”. Federal Reserve Bank of Philadelphia. Web. 14 April 2012

Romm, T. “Sen. Gregg says Federal Reserve amendment panders to ‘populist fervor’”. The Hill, 20 Nov 2009. Web. 14 April 2012

Sewell C. “Tea Party Advocates, Anger at the Federal Reserve”. New York Times, 10 Oct 2010. Web. 14 April 2012

The Federal Reserve Board. “The Federal Reserve System: purposes and functions”. www.federalreserve.gov. Web. 14 April 2012

Thoma M. “Why The Federal Reserve Needs To Be Independent”. Cbsnews, 12 Nov 2009. Web. 14 April 2012

“10 Things That Every American Should Know About The Federal Reserve”. The Economic Collapse Blog. Web. 14 April 2012