The Fed and the Economy

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For those seeking an end to the recession and protection from a similar economic catastrophe in the future, government banking policy and fiscal regulation seem like the only plausible option.  With the National Bank Act, the United States economy is largely at the mercy of the major banks and even the Federal Reserve has proven ill-equipped to regulate or even influence the actions of those banks.  It is important to understand the Fed’s role in the economy and the challenges it faces in fulfilling that role.

There was a lot of criticism leveled toward the government for bailing out the major banks when they faced insolvency.  This situation is neither new nor simple, however, and warrants an objective analysis. Under the Basel II fiscal policy recommendations, which the U.S. is currently employing until Basel III is implemented at some point in the near future, it was cheaper and easier for banks to borrow from the market than from customers for their liquidity.  When the market turned down, that liquidity vanished and if the banks had been forced to unload their illiquid securities, it would have crippled the economy by leaving all those banks’ customers without the money the bank had been holding.  Protecting these banks from insolvency also protects the clients of those banks and prevents large scale economic collapses from a sudden and unexpected absence of funds for millions of businesses and individuals (Persaud).  Bailing the banks out was the only practical option.  Letting them fail would have been a punishment spread far wider than just the bank shareholders. Letting banks fail in the 1930s resulted in the Great Depression and letting Lehman fail in 2008 crippled the domestic economy for five days (Krugman). Except for anarchists, few would argue that a complete collapse of the economic system would do anyone any good.

That is not to say the bailouts were a perfect solution.  Protecting the banks from their own follies was a necessary evil that unfortunately encourages them to carry on the practices that caused this situation in the first place. “Too-big-to-fail” banks are free to take outrageous risks and are then protected from the consequences (Johnson “Where”).  Effectively telling the banks that their failures are okay is not an acceptable response.  Unfortunately, that seems to be the official position, “The Treasury line, then and now, was that the ‘essential functions’ of the financial system had to be preserved, and this meant no one could be ‘punished’” (Johnson “TARP” is Gone”).  A more complex response is required for this complex problem.  The bailout option runs the danger of validating risky banking practices which means no real change will happen; the same old way of doing things will endure even though it is a major contributor to these problems (Persaud).  In this way, the critics of bank bailouts have a very valid point that needs to be accounted for in future policies.

The Fed’s ability to influence banking policy and the economy, in general, is somewhat limited.  Their most significant role is controlling the amount of money in the economy at any given time which in turn influences the value of money and the confidence in that supply. The Fed primarily controls the money supply through the sale and purchase of government bonds.  By selling bonds to financial institutions, the Fed can withdraw liquid currency from the economy, reducing the amount of available M1.  Conversely, by purchasing bonds, the Fed can increase the amount of liquid currency in the economy, boosting the amount of M1.  The Fed can also change the required amount of available assets held by financial institutions to keep more currency in the liquid M1 category rather than getting it tied up in long-term investments, or it can allow banks to spend more of their reserve on investments which reduces the supply of M1.  Finally, the Fed can indirectly affect M1 through its influence over interest rates.  Investors tend to risk less money when interest rates are high which increases the relative amount of M1 without altering the monetary base. The money multiplier has classically indicated the correlation between the monetary base and money supply.  The more the base is increased, the less effect it has on the money supply as inflation dilutes the value of the M1 being created (Kelly).  The game seems to have changed, however, and that multiplier is no longer a reliable predictor.

There are many reasons that the old rules no longer apply.  One of the most significant is the shadow banking phenomenon and its various mechanisms for influencing M1. Shadow banking and securitization, in particular, has created a virtually unregulated means of turning debt instruments into M1 grade liquid assets.  This liquidity is highly unstable though, because of the risk juggling that occurs outside the existing system of safety nets.  The more M1 that exists because of the shadow banking, the less reliable that supply is (Claessens et al. 8-10, 27).  This means trouble for the traditional role of the Federal Reserve. The controls that the Fed does have over M1 are diminished in effect because of the increased M1 produced by shadow banking (Kelly).

This problem also extends to the lack of power the Fed has over the big banks. Fed authority over major banking institutions is limited by their own regulatory scope and by their relative lack of power compared to the “too-big-to-fail” institutions.  The Fed has no choice but to keep these banks afloat or risk crashing the entire economy.  This limits the freedom of the Fed to influence major economic components like M1 (Acharya et al.). The power that the Fed can exert is also too easy for banks to ignore. The Fed can affect reserve requirements, but they cannot determine what the banks do with those reserves.  After the failure of Lehman, banks started hoarding massive amounts of liquid assets instead of reinvesting which the Fed is currently unable to regulate (Washington).  Until the Fed can affect actual changes, their policies will remain relatively impotent in the national economy.

The power to influence interest rates does appear to remain effective, however, it also remains a delicate balancing act that does not always turn out as planned. Lowering interest rates increases the amount of capital in the economy.  This can be a boost to spending and investment, but can also lead to inflation.  Raising interest rates can increase the value of money in the system to a point, by reducing the amount of money and driving prices down, but if they run too high it results in recession and deflation as spending and investment are reduced.  The interest rate can be influenced when the Fed raises or lowers the rate at which banks can borrow from a Federal Reserve Bank in response to demands for liquidity that exceed their own reserves.  If it costs more for banks to get money, then interest rates go up to compensate.  If it costs less, then banks can afford to charge less interest and boost investment and spending.  The Fed can also set the rate charged for liquid asset loans between banks which has a similar effect. 

These two functions are tightly related to the reserve ratio required by the Fed.  Raising this ratio increases interest rates because it increases the cost to banks to maintain their overnight reserves. Managing the interest rates they directly control is intended to encourage banks to lend their assets, putting that money into circulation and boosting the economy (Washington). As has been stated, this has not been significantly effective.  Other areas affected by interest rates, particularly unemployment, has been positively affected. Forcing low-interest rates has boosted the housing market by making building and buying more affordable and it has increased available assets for investment and consumer spending. They are using this mechanism primarily to improve unemployment rates and raise minimum wage (Kurtz).  In this way, interest rate management has a very direct and meaningful effect on the economy, though it is more of a band-aid than a cure.

While the Federal Reserve is obviously a critical influence in the U.S. economy, it is also underutilized and underpowered in many ways.  The ways that it can affect change are either too easily ignored or too insignificant.  Any improvements to the economy that have been made have been reactionary and will only be proven as actual improvements over the course of many years.  This is almost always the case with economic policy, however, and the history of big banks proves that they need some kind of overseeing power.  The Fed is the obvious organization to fulfill that purpose in the future.

Works Cited

Acharya, Viral, Thomas F Cooley, Matthew Richardson, Richard Sylla, and Ingo Walter. "A Critical Assessment of the Dodd-Frank Wall Street Reform and Consumer Protection Act." Vox. N.p., 24 Nov. 2010. Web. 15 Mar. 2013. <>.

Claessens, Stijn, Zoltan Pozsar, Lev Ratnovski, and Manmohan Singh. "Shadow Banking: Economics and Policy." International Monetary Fund. N.p., 4 Dec. 2012. Web. 14 Mar. 2013. <>.

Johnson, Simon. "TARP Is Gone – But May Soon Be Back." The Baseline Scenario. N.p., 30 Sept. 2010. Web. 15 Mar. 2013. <>.

---. "Where is the Volcker Rule?." The New York Times. N.p., 15 Dec. 2011. Web. 15 Mar. 2013. <>.

Kelly, Brian. "M1 Multiplier Indicates The Fed’s Gas Pedal Is Broken." iStockAnalyst. N.p., 11 Mar. 2009. Web. 15 Mar. 2013. <>.

Krugman, Paul. "Six Doctrines in Search of a Policy Regime." The New York Times. N.p., 18 Apr. 2010. Web. 15 Mar. 2013. <>.

Kurtz, Annalyn. "Fed: Low Rates Until Unemployment Below 6.5%." CNNMoney. N.p., 4 Jan. 2013. Web. 15 Mar. 2013. <>.

Persaud, Avinash. "Do Not be Detoured by Bankers and Their Friends; Our Future Financial Salvation Lies in the Direction of Basel." Wall Street Pit. N.p., 23 Sept. 2011. Web. 15 Mar. 2013. <>.

Washington. "The Fed Is Responsible for the Crash in the Money Multiplier ... And the Failure of the Economy to Recover." Washington's Blog. N.p., 16 Mar. 2010. Web. 15 Mar. 2013. <>.