The Fed

The folks who framed the Constitution drew on the experiences of European governments and formulated a 3 part federal government: the president, Congress and the courts. A system of checks and balances" among the 3 branches is supposed to prevent any one of them from becoming too powerful.

There are times when it is obvious that this system functions. Bush cannot wage war without the support of Congress. Appointments to the Supreme Court are nominated by the President but go through what appears to be an agonizing introspection by the media, those with political agendas on both sides and the Senate.

In many countries the military has the real power. This seems to work in smaller countries but in the US the military wields no substantial political power.

Like it or not, there is one pervasive power in the US - money.

Money is brought to you by the Federal Reserve. The Fed functions in a manner to make it something akin to the 4th branch of the government. The Chairman of the Federal Reserve, Alan Greenspan, has on his desk a sign saying "The Buck Starts Here".

Greenspan's replacement has been nominated. He appears to be a well-studied and competent person for the job. Let's review what the Fed is all about.

The Federal Reserve was created in 1913 see: http://landru.i-link-2.net/monques/FR1.html to provide, duh, a Federal Reserve - a way for banks to share each others' reserves if there was a "run" on one. After the Depression, Congress, in 1935, created the system whereby the Fed was able to create money by purchasing government securities. When it did that, it probably did not understand how important that decision was.

The Fed controls business and the economy by controlling the money supply and by its ability to control interest rates by buying and selling government securities on the open market. More
impressively, the Fed can send shock waves through the economy by merely talking about raising rates. The rate that the FOMC sets is the "target" for the Open Market yield of the 30-year Treasury bond. It is maintained not by edict but by persuasion and a active participation by the Fed itself in the market. It is, in effect, engaging in price fixing - perhaps "price control" would be a gentler term.

The "deterrent" force of Greenspan's mouth is akin to the nuclear deterrence of the '50's and '60's. The threat of raising rates has as much effect as actually raising rates.

In recent years that power had been mitigated by the run-up in equities. Real disposable wealth (i.e. money) was created. The Fed was unable to regulate the supply of this "money". To a significant extent, comments by Greenspan during 2000 served to "talk down" equities. Equities have been more "under control" sincethose comments. This is by design as much as anything else.

The Goals of the Fed

The Fed has the following goals: keeping GDP growing, keeping interest rates low, keeping inflation low, helping job growth, and keeping the dollar valuable. By nature, it is not always possible for the Fed's actions to benefit all four goals simultaneously. At present, the emphasis is on inflation.

What Powers Does the Fed Have?

The Fed has 2 main sources of power: 1) the power to "diddle with rates" both by resetting the actual Fed Funds target or by merely talking about it and 2) the "magic checkbook" whereby the Fed can create money out of nowhere and buy bonds on the open market. The power to create money out of nowhere (so called, "fiat money") is impressive. I'd like to be able to do that.

It is imperative that the Fed buy debt on the open market and not directly from the Treasury Department. This idea of "open market" is extremely important. The Fed can open up its checkbook (the magic one with the near infinite overdraft protection) and inject money into the economy by buying government notes and bonds. But, it must do so on the open market. Congress' sovereignty over expenditure is maintained by forcing the Fed to buy from private holders of government debt. If the Treasury Department ran the show, Congress would have succumbed its budget powers to the executive branch.

So What?

The Federal Reserve has very significant control over the economy. But it does not "make or break" the economy. It smoothes out the sizes of the economic cycles by avoiding potholes.

The Fed has looked so good lately because inflation has remained contained. With inflation contained, the Fed has the ability to "fine tune" rates and look great. Contained inflation is like driving down the highway on a clear, sunny day with dry pavement and little traffic. Everyone drives well. If inflation is out of control, the corrective forces of the Fed are like someone trying to avoid other cars on a wet road, at night with a 45 mile an hour crosswind. There will be some wrecks.

The success of the economy of the '90's was not due to politicians or even the Fed. It is due to the combined sanity of workers, businessmen, investors and the Fed. It is very easy for bankers
to make a lot of money and the Fed to look great in this environment.

The Fed has power in its ability to create money. But it has not created wealth and prosperity. Wealth is the product of hard work, a healthy measure of greed and a good bit of luck.

The Real Power of the Fed

I think that, in final analysis, the Fed is one big bank. It can create money but unlike other banks it operates with almost no control from other parts of the government. It is not subject to the audits that other banks are. (The Fed is audited by the GAO and the district branches are subject to outside audits but the audits do not look into the policy making, open market operations or discount window operations.) It is relatively free to buy and sell gold and US and foreign bonds and currencies. It is the lack of intervention from politicians that enables the Fed to work and gives it power. The Fed has served itself well by not causing any scandals - no Michael Milkens, no Espys, no Scotter Libby, no Chappaquiddick, no Oliver Norths.

Comments

[robertdfeinman]

One of the issues being faced now is that it seems as if the Fed has lost control of the money supply. Greenspan's recent comments about a runaway congress are one indication. Another is that there are other sources of money now that are not under control by the Fed. The most obvious one being credit cards. When banks made loans in the traditional way the amount of reserve they needed to keep on hand had a powerful effect on the size of their portfolio. With credit cards the customer creates money without asking anyone.

Another factor is the existence of hedging instruments. These can have the effect of creating money by means of forward looking contracts.

A last factor is the power of the international banking system. With so much of US wealth now held out of the country, small changes in foreign monetary trading policies can have a big effect on the local money supply.

It is a lot more complicated than when it was set up.

[Dick Lepre]

Robert,

I agree that Money Supply is an awful lot differenet than it once was. To a large extent this is the result of the fact that mutual funds rather than banks now control much wealth making it outside the control of the Fed. This started when investment house were allowed to get into the banking business. To a great extent this is why Money Supply is no longer the Fed's first concern and why so much effeort is concentrated on interest rates.

Nonetheless, folks still look at money supply and it may well be the case that attention should be paid to Flow of Funds rather than M2 much less M3.