The Federal Reserve – Purpose And Motivation

With each succeeding day, obsession with the Federal Reserve continues. And the obsession is a good indicator of just how misinformed most of us are.

This is true with respect to various policies, statements, and actions; and includes comments made by board members, either in speeches or interviews. But it is also true regarding purpose and motivation.

To a large extent, it is a matter of perception. Some, maybe most, people see the Fed as the lead driver. There is an assumed aura of authority and control. On all matters economic, we look to them for direction. But where are they taking us? 

That question might be better answered by asking where they/we have been. And not just since last month or last quarter.

The Federal Reserve Bank was established in 1913. One of its stated purposes is to manage the economic cycle (stages of the cycle: prosperity, inflation, recession, depression).

The intention was to smooth out the changes in the cycle so that a more consistent and positive level of economic activity would endure. And, in addition, avoid recessions and depressions.

One of the biggest motivating factors behind this attempt was the fear of panics and crashes.

Panics and crashes had occurred on a reasonably regular basis throughout the country’s economic history.  But they are not unique. And they did not last long. What they did do was allow the necessary correction of imbalances and excesses to take place.

However admirable the efforts to avoid recessions, depressions, and their effects may be, it is simply not possible. Nor is it wise.

When someone suffers from a cough, one of the first things most people do is to take a cough suppressant. The cough and its symptoms are seen as undesirable. Unfortunately, this action stems from a misunderstanding about coughs.

Coughing is a sign of healing – not illness. Coughing is one of the body’s most efficient ways to eliminate toxins. By suppressing a cough, one is altering or delaying the healing process. The toxins will remain in the body and contribute to more severe problems later on.

Over the course of the last century, the Federal Reserve has managed to suppress and smooth out the stages of the economic cycle to a degree. We have had seemingly longer periods of prosperity and less frequent downturns in our economy. But at what cost?

For one thing, they have destroyed the value of our money. The U.S. dollar today is worth less than 2 cents compared to its purchasing power in 1913, when the Fed began its life on earth. This is a direct result of the inflation which they (the Fed) create continually by expanding the supply of money and credit.

For another, their initial attempt at managing the economic cycle ushered in the most severe depression in our country’s history beginning with the stock market crash in 1929. Even former Fed chairman, Ben S. Bernanke agrees:

“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. 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.”…Remarks by Governor Ben S. Bernanke (At the Conference to Honor Milton Friedman, University of Chicago Chicago, Illinois November 8, 2002)

Candid. And refreshing. Unfortunately, they did do it again.

A mere six years after his speech, Governor Bernanke presided over absolute catastrophe in the financial markets. Cheap credit and ‘monopoly’ money had blown bubbles in the debt markets that popped.

It has taken years to recover; but I’m not sure that we have. All of the efforts were geared at suppressing the natural effects of excess and they have resulted in another super bubble today which is even more dangerous.

To whatever extent the Federal Reserve has altered or suppressed the natural rhythm of the economic cycle, they have only succeeded in postponing the inevitable consequences. On the surface of it, that may not sound like such a bad thing.

For example, do we want to suffer the effects of bad economic policy this year; or a few years down the road? Or maybe, with the passage of time, something will happen to mitigate those effects. Better yet, if we are lucky, the chickens won’t come home to roost.

But it’s not just a matter of delaying the inevitable negative consequences and indulging in wishful thinking. The Fed, as a result of their efforts, has made things worse.

The frequency of recessions may be less under the Fed’s watch, but the severity and duration of negative economic events is much more extreme.

Postponing short-term pain has led us to situations of systemic urgency which are unpredictable and highly volatile.

What is truly ironic is that the Fed itself, causes and exacerbates the negative events that it tries to avoid.

The Depression of thirties, the crippling effects of high inflation in the seventies, and the near cataclysmic events of ten years ago; all were the result of actions taken by the Federal Reserve. Specifically, there are two basic issues: inflation and the manipulation of interest rates.

Inflation is reflected in the ongoing loss of purchasing power of the U.S. dollar. This leads to increases over time in the general level of prices for goods and services. The higher prices have nothing to do with profits and growth in the economy. In fact, without the effects of inflation, the general level of prices for goods and services would remain basically stable.

As more and more people realize the extent to which their money (in this case, the U.S. dollar) has been debased, they become less likely to accept and use it in payment and exchange.

This leads to situations such as the 1970s when merchants raised prices frequently. In the anticipation of ever higher  prices, people would purchase what they wanted quickly. Holding cash, even for emergency savings, was shunned.

The spiral of higher prices and further rejection of the circulating money can lead to total rejection of the  currency. Examples of this are Germany in the 1920s, and currently, Zimbabwe and Venezuela.

Manipulation of interest rates by the Federal Reserve is an ongoing attempt to influence economic activity in ways that will bring about desired results. Mostly this is an effort to encourage people to spend more money. If they don’t have the money, or choose not to spend it, then they are encouraged to borrow it. Borrow and spend has been the mantra for nearly two decades.

Cheap credit and lots of it were the direct result of Federal Reserve influence re: low interest rates in the late nineties and early 2000s. Home ownership became a new entitlement program. Fueled by mortgages granted with monopoly money, real estate prices soared.

When things began unraveling, the Fed tried to suppress the natural and necessary cleansing effects by overwhelming the ‘patient’ with more of the same poison which caused the illness. They also did something else which they had not done before.

They directly purchased huge amounts of rapidly declining debt securities. In addition to U.S Treasury Securities, they purchased and held mortgage-backed securities and other debt obligations. And more than a few of them are of dubious quality.

This was done in order to stem the selling pressure on these securities in the market place. This may sound innocuous, until you realize how much all of this cost. And how it was funded.

Currently they are trying to find a way to dispose of these assets without upsetting the markets.

The Fed’s attempt to manage the economic cycle is in defiance of fundamental economic law. It is an impossible task and their efforts have made things worse, not better. What is ironic, is that they cause the problems themselves, and their response to the problems is very predictable: more of the same.

What, then, is the motivation behind this path of wreckage? That motivation is embodied in the Federal Reserve’s ‘other’ purpose.

I believe it is the fundamental, underlying justification for existence of the Federal Reserve. It is the reason why they are allowed to practice their craft with little or no interference. It is also why they are allowed to continue to fail in their stated objective and purpose – managing the economic cycle.

From my article, The Federal Reserve And Interest Rates – Definitely Not What You Think:

In addition, the Federal Reserve Bank is also charged with ensuring the financial operation of the U.S. Government. Or, in other words, maintaining their (the U.S. Government’s) ability to borrow money by issuing more and more debt in the form of Treasury securities. In my opinion, this is the sole and overriding purpose behind the existence of the Federal Reserve. And it drives every decision they make. It is not about the economic effects of their policies on U.S. citizens. It is ALL ABOUT KEEPING THE US GOVERNMENT SOLVENT. The U.S. Government is not solvent, of course, but maintaining and reinforcing the confidence in their financial viability is absolutely essential. And nothing else takes precedence. …Kelsey Williams

Now consider and ponder any statements made or actions taken by the Federal Reserve. Also consider specific actions not taken. Imagine the unfolding of any economic scenarios you think are possible, whether desirable or not.

But think about them in the context of what you now know about purpose and motivation behind the existence of the Federal Reserve and its  activities.

Any activities or actions of the Federal Reserve are always taken with this specific objective in mind:  Maintain the viability of the market for U.S. Treasury Securities.

Kelsey Williams is the author of two books: INFLATION, WHAT IT IS, WHAT IT ISN’T, AND WHO’S RESPONSIBLE FOR IT and ALL HAIL THE FED!