The Federal Reserve: A Failure Of The Rule Of Law

“Money is power.” We’ve all heard this aphorism many times before. Too often it’s a lazy shorthand dismissal of the finding of mainstream economics, which show that the pursuit and possession of money often entails innocuous or even beneficial consequences for society. Dr. Johnson was right after all: “There are few ways in which a man can be more innocently employed than in getting money.”

But there are some contexts in which the saying is apt. An obvious case is the Federal Reserve. The Fed has a monopoly on the creation of base money, the fundamental asset underlying the banking and financial system. And over decades, with each instance of financial turbulence, the Fed has become less constrained in how, when, and why it creates base money. Since the Great Recession, the Fed has been able to bestow purchasing power, liquidity, and solvency on just about any financial organization it pleases. If that isn’t power, there’s no such thing.

The Federal Reserve System was created in 1913. It was intended to be a formalization of the interbank clearing system that then existed in the National Banking System. It was not intended to be a central bank. Even in the early 20th century, economists and politicians had some idea of what central banks did and how they behaved, and the existence of such an institution was widely regarded as inherently un-American, in the sense that it could not be reconciled with a self-governing society. That’s why so many proponents of the Federal Reserve System bent over backward to insist they were not advocating the creation of a central bank. And at the time, their repudiations were reasonable; there was no reason the Federal Reserve System had to acquire the powers it did.

But then the US entered the First World War. Wars have a way of eroding society’s long-established institutions. And the political process has a logic of its own. These forces combined to transform the Fed into what its critics feared it might become: a genuine central bank.

The Fed began supporting the market for US government debt during the First World War using techniques that were the forerunners of modern monetary policy. Once the Fed got a taste for tinkering with credit and money markets, it insisted benign monetary management was consistent with its mandate. And it’s been tinkering ever since, often to the detriment of millions of workers who have no control over the Fed but must suffer the consequences of its errors.

It’s well accepted in macroeconomics that the Fed bears a large share of the blame for putting the “Great” in Great Depression. The turmoil that gripped not only US but global markets starting in 1929 was so disruptive, in part, because the Fed bungled its handling of the money supply. Milton Friedman and Anna Schwartz famously demonstrated this in their much-celebrated Monetary History of the United States. So compelling was their case that in 2002, future Fed Chairman Ben Bernanke admitted, “I would like to say to Milton and Anna:Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.”

But the Fed did do it again. The 2007-8 crisis was a replay of central bank mismanagement. Bernanke’s Fed focused more on shoring up the balance sheets of politically connected banks and nonbank financial houses than combating the liquidity crunch that characterized the early day of the crisis. The result was many irresponsible banks got bailouts, while financial markets as a whole were left scrambling for liquidity. The reverberations of this misdiagnosis were not limited to financial markets: as the spike in unemployment and the precipitous decline in output demonstrate, the Fed’s actions had dire consequences for those far removed from the financial sector..

https://www.zerohedge.com/news/2019-03-13/federal-reserve-failure-rule-law