The Fed Has Failed By Its Own Terms

On the one hand, many people defer to the Fed as the experts on the arcane processes of the economy.

On the other hand, quite a few people accuse the Federal Reserve of being a private cabal owned by the banks, with the sole purpose of making the elite richer.

But let’s sidestep these black-or-white approaches and instead focus on how well the Fed has done according to its own terms.

Specifically, the Fed’s main justification has been that it can provide a “counter-cyclical” balance. In other words, during boom times, it can put on the brakes, and during busts it can get things moving again.

So how well has the Fed done in implementing counter-cyclical policies?

As economist Jane D’Arista points out, as quoted by veteran journalist William Greider (who literally wrote the book on the Federal Reserve in 1987) in his new essay in the Nation, the Fed has failed miserably using its own yardstick:

Instead of frankly acknowledging the problem, Fed governors proceeded in the past two decades to engineer exaggerated swings in monetary policy–raising interest rates, then lowering them, in widening extremes. This led to the series of bubbles in financial prices–first stocks, then housing and commodities–that collapsed with devastating consequences, climaxing in the present crisis. In other words, the central bank’s weakened condition and its misguided policy decisions have been a central factor in destabilizing the American economy. More to the point, the Fed’s operating disorders are directly threatening to recovery; the economy is not likely to get well if the dysfunctional Fed is not also reformed….

Jane D’Arista, a reform-minded economist and retired professor with a deep conceptual understanding of money and credit [has a] devastating critique of the central bank. The Federal Reserve, she explains, has failed in its most essential function: to serve as the balance wheel that keeps economic cycles from going too far. It is supposed to be a moderating force in American capitalism on the upside and on the downside, the role popularly described as “leaning against the wind.” By applying its leverage on the available supply of credit, the Fed can slow down a boom that is dangerously overwrought or, likewise, stimulate the economy if it is sinking into recession. The Fed’s job, a former chairman once joked, is “to take away the punch bowl just when the party gets going.” Economists know this function as “counter-cyclical policy.”

The Fed not only lost control, D’Arista asserts, but its policy actions have unintentionally become “pro-cyclical”–encouraging financial excesses instead of countering the extremes. “The pattern that has developed over the last two decades,” she wrote in 2008, “suggests that relying on changes in interest rates as the primary tool of monetary policy can set off pro-cyclical foreign capital flows that tend to reverse the intended result of the action taken. As a result, monetary policy can no longer reliably perform its counter-cyclical function–its raison d’être–and its attempts to do so may exacerbate instability.”…

Most politicians do not even know the Fed is broken. The central bank’s awesome authority is an intimidating mystery to most elected officials, and they typically defer to its oracular pronouncements. But the Federal Reserve, like all human institutions, is subject to folly and error. In fact, it has experienced colossal failure once before in its history. After the stock market crash of 1929, the Fed was utterly disgraced because its response led directly to the Great Depression. Fed governors were motivated by conservative orthodoxy and their desire to protect the profitability of the largest banks, but they misunderstood the mechanics of monetary policy and also stuck to outdated theory that produced the disastrous results. D’Arista’s analysis is chilling because she suggests the modern central bank, albeit in very different circumstances, may again be pursuing wrongheaded theory, blinded by similar political biases and obsolete doctrine

Meanwhile, acting at the behest of bankers, the Fed has practically eliminated the old safety cushion by allowing reserve levels to fall nearly to zero. Bankers complained that reserves were a drag on profits and were no longer needed given the capital rules. In a shocking new arrangement, the Fed, with approval from Congress, has started to pay interest to the banks on their reserves. The commercial banks already enjoyed privileges and protections from the government that were unavailable to any other business sector. Now they insist on getting paid for their public subsidy….

By its very design, the cloistered central bank is an offense to democratic principles–and now the Fed’s secretive, unaccountable political power has failed democracy again. The question of how to democratize the temple or whether to tear it down has to be on the table too, the subject of future discussion.

Should the Fed be abolished or reformed?

D’Arista argues that the Fed should be reformed.

Followers of the Austrian school of economics, such as Ron Paul and Mish, on the other hand, argue that the Fed should be abolished altogether.

I personally agree that the Fed should be abolished. At the very least – given that the Fed plunged the United States into the Great Depression and failed to prevent the current crisis, and that it is an “offense to democratic principles” since its deliberations are hidden from the public and it is not answerable to the American people or its representatives – the Fed should be made part of the government, made fully transparent, and made wholly accountable to the American people.

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