In 2008, banks stopped lending as much money, helping drag the economy down.
They started holding it in extra reserves, instead.
This caused deflationary pressure the Federal Reserve has been “protecting” us from ever since.
We’re so lucky we have the Fed.
But why did the banks start holding excess reserves instead of lending? Were they simply scared of the economic conditions?
No, they are being PAID to do it, by the Federal Reserve.
That’s right…the Federal Reserve that is “saving” us from the banks’ refusal to lend, is paying the banks to do it.
How the Banks Work
See, banks usually take the money you deposit, and invest it. They make business loans, home loans, buy securities, and so on.
The profit they make doing that pays for the banking services they “give” you “free”.
In a sense, they are acting like a mutual fund for you…investing your money and paying you “interest” in the way of free banking.
But they don’t invest all of your money. The Federal Reserve requires them to hold back a bit “in reserve”. This is to ensure that they have money in case people want to withdraw it.
The Fed makes banks hold 10% of your checking account (and everyone else’s) in their Reserve.
The other 90%, the bank invests, driving the economy through business loans, buying securities, et cetera.
Or it did.
The Fed Wags the Dog
But in 2008, the Federal Reserve started paying banks interest for anything they held in reserve.
Immediately, banks started holding EXTRA money in reserve. This is called “excess reserves”, and it had never happened in any large amount before.
Strangely, the Fed’s response to the banks doing what it is now paying them to do has been to complain that they’re doing it, and to expand its power even more, to “save” us from the lost money.
See, our capitalist economy depends on money being used to create wealth. With hundreds of billions being stuck in “reserves”, it’s not being invested to create wealth, and the economy is suffering.
In effect, the Fed is causing what Friedrich Hayek called “hording”, and identified as something that NO economic school considers healthy.
It is agreed that hording money, whether in cash or in idle balances, is deflationary in its effects. No one thinks that deflation is in itself desirable.
— Friedrich Hayek’s 1932 Letter on the Great Depression
If banks respond to free market demand by increasing their reserves, that’s good.
If the government (including the Fed, acting as its agent) forces more reserves, that’s bad.
The reason the Fed has added, or says it is adding, over a trillion dollars in “Quantitative Easing” (including the recent QE2) is to fight the deflationary effects of banks “hording” in their reserves.
This “easing” is the printing of temporary money the Fed uses to buy securities. It hopes that money will get spent without going into excess reserves…but this is dangerous, because that extra money could cause inflation after the economy recovers.
The Fed hopes to sell those securities and destroy the money it gets back, but history says it will respond almost two years too late, leaving us suffering inflation.
So the Fed is risking dramatic inflation, in order to save us from the risk of deflation it is paying the banks to create in the first place.
Many thanks to Steve Horwitz for his feedback during the writing of this article.
Among my political companions, “End the Fed” has been the hot, trendy thing for a while. This is mainly because Ron Paul correctly distrusts it, and has sponsored a bill to have it audited.
Now, I almost named this article Eff the Fed, because I, too, dislike it, and know it can never manage money properly…no government agency ever could. Instead of the a fiat dollar, we should have a free market in currency, like the Austrian economist Friedrich Hayek advocated . But when it comes to the fight to end it, there’s a problem.
The End the Fed crowd seems to think that getting rid of it is some magic bullet, that will accomplish all kinds of different things.
They believe it will:
- Bring back “sound money”, by imposing a gold standard.
- End the printing of new, extra money
- Restrain runaway government spending
- Prevent budget deficits
The problem is that ending it will accomplish none of those things.
In fact, it would probably make them worse.
Because the Fed isn’t what started those things happening, and none of them depend on the Fed’s existence.
Axe the IRS
In effect, fighting those things by attacking the Fed is like wanting to fight the income tax, and high taxes, by demanding “Ax the IRS”.
Obviously, we had taxes before the IRS, and we’d have taxes after it. In fact, the IRS was not created by the 16th amendment establishing the income tax, but five decades earlier, by Abraham Lincoln.
If we got rid of the IRS, we’d still have the income tax, and high taxes. Putting our time, energy, and money into attacking the IRS would be a waste of time, when we could have fought for actual tax reduction, reforming or ending the income tax, et cetera, directly.
What’s worse, the government would still want to oversee the taxes we failed to actually fix, and would probably end up using something worse than the IRS.
Well, all of this is true of the Fed, as well:
The Feds Don’t Need the Fed
The Fed and a Gold Standard are Compatible
Ending the Fed won’t bring back a forced gold standard, because they are two unrelated issues.
We had both at the same time for decades, anyhow.
The US had a fiat gold standard from 1873, through 1934.
The Fed, of course, was established in 1913. It existed alongside the gold standard for over two decades. It helped cause the Great Depression while the US was on a gold standard. It created floods of new money in the 1920s, and drew down the money supply by 30% (which would cause any economy, at any time, to collapse) in 1929…both of these things while we were on the gold standard.
Congress Would Just Print More Money
Not only did we have a gold standard while we had the Fed, but we also printed fiat paper money when we did not have the Fed. The reason the dollar is sometimes called the Greenback, is that this was the nickname commonly used for the paper money common in the United States in the 1860s and 1870s, printed to finance the Civil War, known for its green ink .
Right now, the Federal Reserve is a bureaucratic middleman, standing between Congress and simply printing money willy-nilly. The Fed uses what are ironically called “mechanical” means, to create its electronic, funny money for banks. In other words, it has a set of rules that cause the money to be created according to some specific set of conditions, not simply all the money the government wants.
Without it, Congress will simply mandate the printing of more money, on its own, surely in accordance to its bloated, and ever-snowballing spending. They printed floods of extra money before the Fed, and would print it after.
As with the IRS, however it replaces the Fed (and, in a sense, it will have to) will probably be with a mechanism that is even worse.
The US government issued treasury notes, and created deficits in other ways, for the majority of US history where there was no Federal Reserve Bank, and would do it again without it.
Restrain the Deficits…How?
This is the silliest one, and speaks to an ignorance of how the Fed works.
The Federal Reserve certainly responds to some deficit spending by selling more treasury notes…but as with printing money and collecting taxes, this would happen whether the Fed existed or not. It simply is the middleman, again.
You might as well blame the mailman for delivering your bills.
A Big, Fat Windmill
The problem with Don Quixote attacking windmills wasn’t just that the windmills wasn’t only that the windmills weren’t actually dragons, harming people.
It was also that he was wasting the energy and time that could have gone into fighting actual bad causes.
And that’s what the End the Fed noise is doing. This energy could be spent fighting deficit spending directly, which has run rampant under Democrat and RiNO alike…or any of dozens of other issues of government abuse.
It’s Going Nowhere
Of course the last problem with tilting at windmills was that it was never going to get rid of them, anyhow.
The Federal Reserve is in no danger of being “ended”. Ron Paul is actually only sponsoring a bill to audit the Fed, which (unfortunately) will not even permanently open its records to the public, the way they need to be. It will do even less to “end” it, since government self-investigations only ever are used to create a pretense that a few new regulations have “put the problem behind us”, and things usually just get worse, thereafter.
A majority of Americans oppose the drug war. Nearly all Americans not directly on the government teat oppose its massive spending and deficits. But the mechanisms for keeping the Fed in place, on both the private and public side, are massive. Not only would getting rid of it have no more effect than axing the IRS, but it’s no more likely to happen.
How To Actually Fix Things
What we need to do, rather than waste our time tilting at the Fed, is to directly address the problems we’re using it as a whipping boy to attack, or at least focus on their actual sources.
Balance the Budget; A balanced budget amendment would stop massive deficits, rein in government spending, and eliminate much of the incentive to print money and treasury notes, under the current system.
Line-Item Veto; Giving the President the power to veto any specific detail in any spending bill would be a step in that direction, as well. This may need to be an amendment, too, in order to override corrupt Federal courts claiming that it’s somehow unconstitutional.
Pull the Pork; Rules against pork, against Congress specifying projects in detail intended just to send money to their own cronies in their district, would be devastating not only to spending (which, unfortunately, is more centered on entitlements), but also to motives to give officials legalized bribes like campaign contributions.
Or maybe something else, entirely…but, whatever is done, it needs to be done. We need to choose surmountable obstacles that will actually matter, not waste our effort and attention on some scapegoat, however undesirable it is. The Fed is a poster child for government’s destruction of finance and economy, but what we need now is real solutions, not symbolic gestures, however satisfying this one would be.