Financial stability and the Federal Reserve

The primary responsibility of the Federal Reserve is to manage monetary policy. It manages the supply of dollars in the economy, and in doing so determines the purchasing power of the dollar. But this was not always the case.

When the Federal Reserve was created, the United States was following the gold standard. A dollar is defined as 0.04837 ounces of gold ($20.67 per troy ounce). Monetary policy was not necessary; The gold standard determines the supply of dollars, and thus the purchasing power of the dollar.

The Federal Reserve was not created to manage monetary policy. It was created to enhance financial stability, to ensure that private banks can recover their dollar (i.e. gold) claims by providing emergency liquidity when necessary. The architects of the Federal Reserve Act explicitly denied that they created a central bank. They described the Federal Reserve as a publicly backed super clearinghouse.

In a healthy banking system, people treat dollars and dollar claims, including redeemable banknotes and checkable deposit balances, as near-perfect substitutes. The connection is so close that people rarely distinguish between the two. I might say I have 1000 dollars In my checking account instead of Claim $1000 (which I really have) because I fully expect the bank to meet its obligations on an equal footing when I am ready to withdraw or transfer the funds. No one would think it was weird for me to treat my dollar claim as if it were actual dollars. In fact, they might think it’s weird that I insisted so hard to disagree!

Of course, dollar claims are only treated as near-perfect substitutes for dollars if the issuer of those claims, the banks, are trustworthy. The public must believe that the assets of the bank (especially the capital) are sufficient to support its liabilities. But what if the issuers are not trustworthy? So, claiming a dollar is not as good as the dollar itself. When this link is broken, banks’ balance sheets are not strong enough to support their liabilities. This is how the bank rush and financial panic begins, and this was the primary problem the Federal Reserve came forward to address.

Was the Fed necessary to avoid bank flight and financial panic? True, the national banking system in America, which prevailed from 1863 to 1914, was unusually prone to panic. But this was due to misguided regulations, not inherent instability. The Federal Reserve was a middle measure, a middle way between an unsatisfactory status quo and a truly free banking system, as it existed in Scotland during the eighteenth century and Canada until the early twentieth century.

The Fed was supposed to stop panics by preventing the bank scramble from developing into a bank rush the system. When the public tries to redeem the liabilities of the banks en masse, the banks may become illiquid. They do not have enough basic funds on hand to recover their outstanding claims. But it may still be solvent if total assets exceed total liabilities. As a lender of last resort, the Federal Reserve can help concessional but illiquid banks find the liquidity needed to meet obligations.

Unfortunately, the Federal Reserve has been negligent in the performance of its duty. The Fed’s leadership has never acted as a responsible lender of last resort. The Fed allowed many soft banks to fail during the Great Depression and helped many insolvent banks stay afloat since then.

With the possibility of redeeming dollars for gold suspended in 1934 (domestic) and 1971 (international), the Fed’s mission was expanded to include control of monetary policy. Nor did she handle this responsibility very well. Inflation was higher and it was difficult to predict the future purchasing power of money under the Fed.

Looking back, creating the Fed was a mistake. Policy makers had to reform the American banking system to become a free banking system, which was an option at the time. Private banks do not need a central bank to stave off financial turmoil. They are well aware of the problem of illiquidity and bankruptcy and can take steps to combat it. The most important procedure is the establishment and maintenance of a special clearing house.

Banks naturally acquire each other’s obligations during the course of business. They are developing clearing houses as a low-cost way to settle their debts and credits. Clearinghouses also perform important functions that promote the health of the banking system. They monitor banks’ balance sheets even in times of calm, to ensure minimum capital standards. When the markets begin to falter, they facilitate emergency loans from banks with excess liquidity to banks in need of a temporary payment. In high stress scenarios, clearinghouses sometimes issue their own liabilities, backed not by the balance sheets of individual banks, but by the banking system as a whole. Clearinghouse obligations are valuable because of the promise to recover them when the crisis is over. In short, clearinghouses perform many of the functions of lending of last resort more effectively than “official” lenders of last resort. Voluntary cooperation by for-profit financial intermediaries can bring economic stability after all.

The Federal Reserve has failed in its primary mission of promoting financial stability. It also failed to manage monetary policy. Given the major fiscal and monetary policy mistakes the Fed has made since 2008, we must explore major structural changes.

Alexander William Salter

Alexander W Salter

Alexander William Salter is the Georgie J. Snyder Associate Professor of Economics at Rawls School of Business and a Comparative Economics Research Fellow at the Free Market Institute, both at Texas Tech University. He is a co-author of Money and the rule of law: generality and predictability in monetary institutions, published by Cambridge University Press. In addition to his numerous scholarly articles, he has published nearly 300 opinion articles in leading national media outlets such as The Wall Street JournalAnd the National ReviewAnd the Fox News opinionAnd the hill.

Salter holds master’s and doctoral degrees. He holds a PhD in Economics from George Mason University and a BA in Economics from Occidental University. He was a participant in the AIER Summer Fellowship Program in 2011.

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