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This article is from the July/August 2012 issue of Dollars & Sense magazine.

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Abolishing the Fed is No Solution to a Real Problem

Dear Dr. Dollar:

Is the Federal Reserve, the Fed, as important to the operation of the economy as it seems? How does it work? If it is so important, how can anyone take seriously politicians such as Ron Paul, who calls for the Fed’s abolition?

—Tom Prebis, Cleveland, Ohio

By Arthur MacEwan

Yes, the Federal Reserve, the central banks of the United States, is a powerful institution, important to the operation of the economy. By regulating the supply of money and influencing (if not fully determining) interest rates, the Fed has a major impact on the overall level of production, employment, and inflation. Also, the Fed has a large role (along with some other agencies) in regulating the operations of banks.

Yet the Fed is structured in a very undemocratic way. Although it derives its authority from Congress, its actions do not have to be approved by Congress, the president or any other segment of the government. Its funding is not set by Congress, and the members of its Board of Governors (the controlling group), though appointed by the president and approved by Congress, have terms that span multiple presidential and congressional terms. Also, while the Fed regulates the banks, bankers have a special role in the operation of the Fed. Some seats on the boards of directors of the twelve regional branches are reserved for bankers, giving them formal capacity to influence the Fed’s policies, including its regulation of the banks.

Not surprisingly, the Fed has exercised its regulation of the banks with “a light hand.” And its overall regulation of the economy—through affecting the money supply and interest rates—has often sacrificed employment to maintain the profitability of business in general and the banks in particular.

The Banks’ Man at the Fed

To get some useful insight on the undemocratic and pro-business bias of the Fed, consider:

Jaimie Dimon, the head of JPMorgan Chase, is a member of the Board of Directors of the Federal Reserve Bank of New York. Cheek by jowl with Wall Street, the N.Y. Fed plays a major role in the dealings between the Fed and the large private banks. As the financial meltdown became apparent in 2008, the N.Y. Fed was fully involved in the actions that the Fed and the Treasury took in their efforts to manage the crisis.

Dimon’s bank is one of the country’s largest, with $19 billion in after-tax profits in 2011. In 2008, the bank received $25 billion in the government’s bank bailout. Perhaps the bailout saved the economy from a more severe economic crisis, but it also saved the bankers—Dimon and the others—along with their absurd salaries. Other means of saving the system—such as temporary nationalization of the big banks (to say nothing of a permanent nationalization)—were never on the Fed’s agenda.

Dimon has become one of the most vociferous and aggressive opponents of bank regulation. In 2012, he has frequently been in the news because his bank experienced a huge loss—at least $3 billion and perhaps as much as $9 billion—in a complex and risky operation, exactly the kind of banking activity that regulation is supposed to prevent, and exactly the kind of activity that could generate another financial crisis. Dimon has not moderated his opposition to regulation.

Does anyone see anything wrong here? Does the metaphor “fox guarding the henhouse” seem appropriate?

It is only a slight simplification to say that the Fed is run by and for the country’s banks. If one believes that the interests of the banks are the same as the interests of the rest of us, no problem. This is the line that Dimon peddles, claiming that the banks play a crucial role in allocating funds to the most productive activity, supporting economic growth and jobs. More regulation, he claims, would prevent banks from doing this good work. In the wake of the financial crisis, it is impressive that anyone can spew such nonsense with a straight face.

Regulating the Economy

The Fed plays its role of affecting the money supply and interest rates by, in part, loaning money to the banks and then regulating the extent to which the banks can use this money to make loans to the businesses and public. More loans means more money in circulation; more money in circulation tends to reduce interest rates (i.e., the price of money), which tends to induce economic expansion. Also, in regulating the banks’ activities, the Fed is supposed to maintain economic stability—preventing the banks from undertaking excessively risky activities, which, by endangering the banks themselves, would undermine the operation of the whole economy.

In the period leading up to the financial crisis that emerged in 2007-2008, the Fed certainly operated “with a light hand” in regulating the banks. Indeed, Fed Chairman Ben Bernanke took a “what, me worry?” approach, denying the existence of the housing bubble and turning a blind eye to the signs of impending crisis.

Having failed to use its power to prevent the financial crisis, the Fed has in subsequent years attempted to push economic growth by acting to increase the money supply and to keep interest rates low. Its success in this direction has been limited partly because it has not pushed as hard as it could. Right-wing congressmen and others of their ilk have accused the Fed of encouraging inflation, and perhaps Bernanke and others on the Fed’s Board of Governors share this inflation fear. In earlier periods, the Fed has often given attention to maintaining low inflation at the expense of higher unemployment.

The Fed’s lack of success in promoting economic growth in the current period also results from the fact that private non-financial firms have been reluctant to make new investments, even with low interest rates. So instead of making new loans for productive, job-generating investment, banks have used the low-cost money from the Fed for their own speculative activity—the sort of activity that led to JPMorgan Chase’s multi-billion dollar loss, but which can also make lots of money for the banks.

The Appeal of “End the Fed”

Given the Fed’s history of frequently sacrificing employment in the name of preventing inflation, its support of banks and the role of bankers in affecting its operations, its failure to prevent the recent financial crisis, its role in bailing out the banks and the bankers, and its failure to act strongly enough in the current period, there is a good deal of animosity towards the country’s central bank. Ron Paul and others have been able to use this popular animosity to promote a broader agenda of reducing government regulation of the economy. Their call to “end the Fed” is one more effort to push the idea that the economy works best when the government works least. One would think that this is a pretty hard line to swallow in light of recent experience, when the “light hand” of government regulation was a key element in generating our current economic malaise. Yet it seems to have appeal.

In advocating an end to the Fed, Paul has called for a return to the gold standard as a means to regulate the money supply without government involvement. Ironically, at the center of Paul’s right-wing attack on the Fed has been the claim that it has debased our currency and is generating inflation; the gold standard would supposedly prevent this debasement. The argument is ironic because reality has often been the opposite of Paul’s claim—at many times in its history Fed policies have kept inflation in check but generated high unemployment, which tends to keep wages down.

In any case, the problem with the Fed is not the existence of a government authority that regulates the country’s money. Before the Fed started operating in 1914, economic crises had been at least as frequent and severe as in later years. The gold standard (which the U.S. abandoned in steps, especially in the 1930s and ultimately in 1971) certainly did not provide stability and general economic well-being. The problem is the nature of the regulatory authority, run as it is in the interests of the banks and bankers, in particular, and of business, in general. The right’s effort to “end the Fed,” however, would likely throw us into an era of even greater economic instability, having us jump out of the frying pan and into the fire.

What to Do?

So what should be done about the Fed? Unfortunately, the Fed is part of the general economic and political problems of the country, and we should not expect to have a central bank that serves people’s real needs until we have a more democratic society, a society in which money does not dominate politics and in which economic policy is not organized around the idea that maintaining profits is always the first priority.

Still, doing something about the Fed could be one step in doing something about those general problems. To begin a process of change, Dimon and other bankers should be removed from their positions of authority within the Fed. The removal of bankers from their positions of special influence would need to be followed by larger changes in the way members of the boards of directors of the regional Federal Reserve banks are chosen, and ultimately also the way members of the Board of Governors of the Fed are selected. Also, the Fed could be given a stronger mandate to act in ways that would reduce unemployment. Most generally, the goal should be to subject the Fed to democratic control.

At the end of the day, changing the Fed—changing how the U.S. economy is controlled—is a part of the larger struggle to change power in the United States so that it is in the hands of most people instead of the very few.

ARTHUR MACEWAN is professor emeritus of economics at the University of Massachusetts-Boston and a Dollars & Sense Associate.

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