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YOU DECIDE: Should the Federal Reserve be changed?

August 07, 2009

MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu


Dr. Mike Walden
Media representatives:For a black-and-white or color copy of this photo, call 919.513.3127 or e-mail dave_caldwell@ncsu.edu.

The Federal Reserve is under fire today. In a recent poll a majority of respondents gave the Fed low ratings. There is a move in Congress to increase legislative oversight of the Fed's operations. And some in Congress and in the country even want to abolish the Fed.

But at the other end of the spectrum, many economists say it was only the quick and decisive actions of the Fed in the last year that saved the country from a financial meltdown and another "great" depression. These folks say the Fed should be applauded, not scorned.

So why is a relatively obscure organization - at least to most people - attracting such different views? Part of the answer lies in the power of the Fed. For despite the fact the Fed flies under the radar most of the time, it wields enormous financial and economic influence in our country.

The Fed was established almost a century ago as the nation's central bank, or "banker's bank" as some call it. Prior to the Fed, the nation would periodically go through financial panics, where some economic event would scare depositors and cause them to withdraw their funds - that is, create a run on a bank or banks. But because banks keep only a fraction of deposits on hand and loan the rest, the banks couldn't meet depositors' demands and would ultimately shut down, thereby creating big losses for depositors, investors and the economy.

The solution, many thought, was a banking backstop - some organization that could provide emergency funds to troubled banks and so avoid bank runs and closures. This backstop was created and called the Federal Reserve. Most other countries have a similar organization.

Thus, one key function of the Fed is to provide loans and other aid to troubled banks, especially when many banks face problems at the same time. In the current financial crisis we've seen the Fed offer interest-free loans to imperiled banks.

But the powers of the Fed go beyond those related to keeping the banking system intact. In the 1970s there was a concern about stagflation - sluggish economic growth combined with high inflation. So Congress passed legislation telling the Fed, in essence, to continually enact policies to keep the country on a growth path while at the same time maintaining stable prices.

This is a very big responsibility. Essentially, the Fed has a mandate to smooth out the business cycle - that is, to prevent economic booms and busts and keep the economic ship sailing in calm winds. Fed chairpersons are required to report to Congress periodically and answer questions about how they are accomplishing this goal.

So why then is the Fed getting a lot of grief today? I think there are two reasons, both related to each of the Fed's key responsibilities. First, the Fed has expended tremendous resources during the current recession assisting not only the banking system but also the "non-bank" banking system. The non-bank banks are financial institutions that have operated like banks but weren't classified as such. Some think the non-bank banks should have been off limits for Fed help. The Fed's view was that these institutions, if not rescued, could easily have caused an economy wide financial collapse.

Second, it may not always be possible to have economic growth and no inflation at the same time. So if the Fed focuses on growth, those who worry about inflation will criticize the Fed's policies. But, if the Fed makes low inflation a priority, some growth may have to be sacrificed, at least for a while. So someone will always be mad at the Fed.

The experience of the last 12 months is a good example of the Fed being pulled at both ends. A year ago when the economy was on the verge of free-falling, the Fed was hammered for not providing enough money and credit and low enough interest rates to cushion the drop. Now, as the economy appears to have stabilized, the inflation hawks are warning of an impending burst of higher prices.

So it's hard being the Federal Reserve. Maybe so hard, critics say, that perhaps the Fed should be dismantled. Some support a return to the pre-Fed gold standard and a privately financed bank insurance pool to prevent bank runs. But Fed supporters say these ideas were tried in the past and didn't work.

The Federal Reserve System is a key player in our economy, and given its recent actions, it will be receiving much scrutiny both in and out of Congress. So get to know the Fed, and follow the debate over its role. This really is a very big "You Decide."

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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 Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm

Related audio files are at http://www.ncsu.edu/waldenradio/

Posted by Dave at August 7, 2009 08:00 AM