YOU DECIDE: Should you celebrate the Fed’s birthday?

Date posted: November 22, 2013

Dr. Michael Walden is William Neal Reynolds professor of agricultural and resource economics at N.C. State University.Dr. Michael Walden is William Neal Reynolds professor of agricultural and resource economics at N.C. State University.

Media Contact: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

By Dr. Mike Walden
North Carolina Cooperative Extension

My wife loves her birthday. Ever since she was a child, she considered it her special day and wanted others to do likewise. Needless to say, I’ve remembered her feelings about her birthday, which has probably contributed to our marriage lasting — to date — over a third of a century!

Speaking of birthdays, an important institution in our country is celebrating its 100th birthday this year. The Federal Reserve, commonly called the Fed, has reached the century mark. In 1913, President Woodrow Wilson, who lived in Wilmington for part of his childhood, signed the legislation creating the Fed.

Persistent problems in the banking industry led to this landmark institution. In the 19th and early 20th centuries, banks were periodically plagued by “runs” or “panics.” Some economic calamity — or even the rumor of a calamity — would cause depositors to want their money from banks. But since banks were also in the lending business, they never had all depositors’ funds in the vault.

The double whammy of loans going bad and withdrawal of deposits could push banks into collapse. However, if banks collapse and lending is curtailed or stops, commerce can grind to a halt. So bank panics directly led to recessions or – even worse, depressions in the 1800s and early 1900s.

As the economy grew and became more intertwined, and as the role of credit expanded, bank panics became more costly. Private and public leaders searched for a solution and ultimately settled on the Fed as the answer.

The modern Federal Reserve has two broad roles. First is to be a lender of last resort, effectively riding to the rescue of the banking system when depositors get nervous, and thus avoiding a collapse of the financial system.

The second is to create economic conditions that will prevent banking panics in the first place. The Fed uses its powers to try to have the economy expand at a steady pace with low inflation and job growth consistent with low unemployment.

And how does the Fed attempt to meet these two goals? It uses its three extraordinary powers. First, the Fed regulates how much of the deposits in banks’ vaults can be loaned. So if the Fed wants to moderate lending and perhaps keep the economy from overheating, it reduces banks’ ability to loan from deposits.

Second, the Fed effectively controls the level of short-term interest rates, such as those on overnight business loans and consumer loans with variable interest rates. If the Fed wants to cool the economy, it increases these rates; if it wants to stimulate spending, it lowers the rates.

Yet clearly, the most controversial of the Fed’s powers is its third — the Fed’s ability to create money. Yes, with the stroke of a keyboard key, the Fed can manufacture money, essentially out of thin air! The Fed can use this new money to augment the loanable deposits in banks’ vaults, or it can purchase financial assets — such as mortgages — with the funds.

Faced with a banking panic and potential financial collapse of historic proportions, the Fed used its powers to an unprecedented degree in the last five years. Short-term interest rates were cut from 5 percent to almost 0 percent. Plus, the Fed has created close to $3 trillion of money and used it to increase bank reserves and purchase a wide array of financial assets.

Supporters of the Fed’s actions say it was all necessary to head-off Depression 2.0. They say that without the Fed’s swift moves, the financial system would have frozen, business would have stopped, and unemployment would have soared well into the 20 to 30 percent range.

Critics of the Federal Reserve disagree. They concede that without the Fed’s support, the economy would have plunged more but claim the downturn would have been short and the recovery swift. Plus, they argue, it would have taught bankers and investors a lesson about not over-lending and over-spending, lessons that perhaps could help prevent similar economic slides in the future.

There is, however, something that both Fed boosters and Fed detractors agree on today. This is that the Fed’s massive support of the economy will at some point have to be pulled back. Historically, rapid money creation has been associated with higher inflation. Although we have not yet seen this occur, it could in the future.

When the Fed does begin to assume a smaller role in the economy and sell many of the financial assets it accumulated in recent years, there is a danger interest rates will jump. This will create a further challenge for the economy.

So should you celebrate the Federal Reserve’s 100th birthday? It depends whether you think the Fed has — in the long run — helped or harmed the economy. This is a big “you decide” for all of us.

Which reminds me, I have to plan my wife’s next birthday party!

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The College of Agriculture and Life Sciences communications unit provides his You Decide column every two weeks. Previous columns are available at http://www.cals.ncsu.edu/agcomm/news-center/tag/you-decide

Related audio files are at http://www.cals.ncsu.edu/agcomm/news-center/category/economic-perspective/

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