By Dr. Mike Walden for the SNAP
Monday, October 29, 2012 —
When I began teaching 35 years ago, few people knew — or cared — about the Federal Reserve. That’s certainly changed. Especially since the financial meltdown in late 2008, the Federal Reserve has been front and center in both policies and debates on the economy. Fed chairman Bernanke has even become an issue in the presidential campaign, with some candidates bluntly saying they would not reappoint him when his current term expires.
Recently, the Federal Reserve added to their headlines by announcing a major new program designed to boost the economy — but also involving the printing of more money. This move will only fuel the differing views over the role and actions of the Fed.
So what exactly is the Federal Reserve, what does it do and what impacts can it have? Let me try to answer these questions and then let you decide if the Fed is a plus or a minus for the economy.
The Federal Reserve was created a century ago as the country’s “bank of last resort,” a backup to the financial system. Prior to then, when an economic calamity or scare occurred and bank loans failed, depositors would make a run on the bank to withdraw their funds. Banks wouldn’t have enough money, so they too would fail, depositors would lose and the economy would sink further.
The idea was that the Federal Reserve could short-circuit this financial collapse by using its major power — the ability to create money — to restore funding and confidence in the banking system during economic crises. Once the gold standard was abandoned in the 1930s, the Fed could use its money-creation power at its discretion.
Most people raise an eyebrow of surprise and concern when told the Fed has the power to manufacture money out of thin air (actually, today it’s done electronically). Many people understandably think paper money ought to have something of value, like gold, backing it.
Supporters of the Fed say money doesn’t have to be inherently valuable; it just has to be trusted and accepted. So if the Fed prints money during an economic downturn and uses the funds to support banks’ deposits or to purchase investments before their values fall further, it can prevent a financial collapse.
Some say this is exactly what the Fed did in 2008 and 2009. From late 2008 to mid 2009, the Fed doubled the money supply. This appeared to stop the massive bleeding in the economy from the virtual free-falls in the housing and stock markets. Indeed, aggregate production in the economy began to rise in mid-2009. The Fed performed a similar monetary rescue in 1987 after the single largest daily percentage point loss in the stock market.
There are, of course, plenty of critics of the Fed. Some question the need for a Federal Reserve at all. These folks say the threat of widespread financial system insolvency could be handled by private insurance of deposits and diversification of banks’ investments.
Fed doubters worry most about the central banks’ money creation power and the possibility it could lead to rampant inflation and devaluing of the dollar. This is a real concern. Many economists say excessive money-printing by the Fed in the early 1970s led to double-digit annual inflation rates later that decade. Some also say the Fed’s generous monetary policy in the early 2000s was behind the housing boom of that decade. Of course, the housing boom eventually turned into a housing bust.
So where does this leave us in our evaluation of the Federal Reserve?
Here’s my take. Chairman Bernanke and his colleagues are, in my opinion, well aware of the potential downside – in terms of future higher inflation – of the policies the Fed has followed for four years. But Congress, which controls the Fed’s charter, has given it two marching orders: implement policies that will lead to low inflation and full employment.
Accomplishing both of these goals is a very tough job. Inflation (including food and fuel) appears right now to be modest, rising between 2 percent and 3 percent annually. But obviously we are nowhere near full employment.
My assessment is that Chairman Bernanke and his fellow managers of the Federal Reserve are focusing on helping increase economic growth and job creation now. They are doing this by being very generous with their monetary powers as well as with their influence over interest rates. They don’t have a magic wand, but they are trying to be helpful.
However, if – and we hope it’s soon – the economy does begin to expand faster and unemployment does begin to drop more, then the Fed will face another challenge. This will be to unwind some of the programs and policies they have been following so as to prevent significantly higher inflation and steeper interest rates.
So if Ben Bernanke is still in charge, his greatest challenge may be ahead. Should he be there, and will he succeed? You decide.