This reader question comes from Stephen Hall in Atlanta, Georgia who asks: ”Do you think the Federal Reserve should be abolished, shrunk or just left alone?”
What I Think:
Despite what Ron Paul might have to say on the issue, the last thing the United States should do is completely abolish the Federal Reserve System, especially if Congress attempts to abolish it without a suitable replacement. However, I do agree that the central bank needs to be reorganized to reduce the influence of the Reserve Bank of New York.
Why You Don’t Abolish It:
- If Congress abolished the Federal Reserve entirely, without creating a new monetary authority to put in its place, the American banking system would become unsustainable much in the same way it was before the Fed’s creation. Only the risks posed by failures of banks of modern-era size and scale are infinitely greater.
Prior to the creation of the Federal Reserve System in 1913, the American financial system went through continual boom-bust cycles with at least one major depression every 20 years or so. These banking ‘panics’ were laregely the result of banks being unable to access new capital on a short term basis to protect themselves against bank runs and negative fallout from speculative investments. The Federal Reserve System was created to deal with this problem by acting as a lender of last resort and managing check clearing between banks.
- Spreads for interbank, overnight, and consumer credit interest rates would grow wider with greater exposure and influence from market forces.
A critical component of our financial system is the interbank lending market, the money market used by banks to lend or borrow short-term capital to meet and maintain reserve requirements. Currently, the Federal Reserve modulates the interest rates on these loans through open market operations to keep credit flowing between the nation’s banks. Without a central bank to set targets for interest rates, the interbank market would become extraordnarily volatile, since banks would be able to charge whatever interest rates they see fit to each other without any reference for where rates should be to ensure markets stay liquid. Disruptions in the flow of credit have wide reaching consequences, as evidenced by the financial crisis touched off in 2008 in part because of this very problem.
- A financial system with no central monetary authority would make borrowing from and lending to foreign governments excessively difficult since the United States wouldn’t have a genuine fiscal agent to represent its government
The Federal Reserve is the primary fiscal agent of the U.S. government, meaning that it not only handles transactions between the government and the financial sector, but between the U.S. government and foreign governments around the world as well. Central Banks are the chief agents in the purchase and sale of government debt securities, so no Federal Reserve to provide access to U.S. treasury bonds would make it increasingly difficult for foreign governments to put their money here. As most modern economies have a central bank to implement monetary policy, America’s banks would be far less attractive for investment if simply left to do as they please.
How Can We Reform It?
The biggest areas of opportunity for the Federal Reserve lie in its organization and decision making.
- To reduce the influence of financial institutions operating in New York over the monetary policy of the nation, the Federal Reserve Bank of New York should lose its permanent seat on the Federal Open Market Committee.
- The Federal Open Market Committee membership should be expanded to include all 12 FRB presidents so that monetary policy decisions incorporate a more diverse set of viewpoints. To compensate for the absence of rotating membership, the terms of sitting FRB presidents should be shortened.
- Congress should create new legal definitions for the status of Federal Reserve Banks, re-establishing them as true government entities, as opposed to privately owned corporations.
- Due to the size of the American banking sector, Congress should amend the Federal Reserve Act to allow for the creation of new Federal Reserve Districts in order to reduce further the impact of the FRB of New York, and to allow the Federal Reserve System to increase its membership.
Despite its various faults and complexities, the Federal Reserve System shouldn’t be abolished, and its ability to regulate the money supply should also go unhindered by Congress. While bankers in New York should not be able to enact policy that affects the nation’s banking system, the Federal Reserve System still needs to be nimble enough to perform its central duty as our first line of defense against financial crises. The Great Depression proved the weakness of a central bank that can’t expand its balance sheet fast enough to get out in front of frozen credit and bank failures. Given the sheer size of today’s financial institutions, America needs a flexible Fed.