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Wake up students: the Fed has too much power

Agora Staff

Published: Friday, April 29, 2011

Updated: Monday, May 2, 2011 14:05

Joe Prestia

Joe Prestia


Over the last few years, in light of all of the country's financial troubles, there has been increasing interest and concern amongst Americans regarding the actions and policies of the United States' central bank, the Federal Reserve.

Oddly enough, many (if not most) people are not really sure what the Fed (Federal Reserve) is, what it does, and why its recent activity has been so detrimental to the economy.

In order to answer these questions, we have no choice but to take a closer look.

A central bank is an institution that holds and lends assets and monies of other banks, large and small. The Fed is the banks' bank. It sets interest rates, discount windows, and (most importantly) issues and distributes currency. Ultimately, the Fed is supposed to help regulate market changes and banking transactions to maintain economic stability.

After two failed attempts at central banking from 1791-1811, and from 1816-1836 - the current version of the Fed was established in 1913.

The first attempt was a federalist measure strongly supported by Alexander Hamilton, and fiercely opposed by Thomas Jefferson.

 "I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs," Jefferson said.

In 1913 the Federal Reserve Act was passed in response to a series of banking panics. In charge of drafting the bill was Republican Senator Nelson Aldrich. Coincidentally enough, Aldrich had close ties to rich bankers such as John D. Rockefeller, who was Aldrich's son-in-law.

Originally the Fed was to issue elastic currency, which is more or less a supply of currency that can be contracted (removed) or expanded (added to) as a method of fighting economic downturns, in the form of Federal Reserve notes based on the nation's gold reserve.

In 1945, in an effort to rebuild the world monetary system during the closing years of World War II, 730 delegates met from around the world, setting up the International Monetary Fund (IMF) and creating a system where the U.S. dollar would become the basis for the exchange rate for currencies worldwide. This was done in an effort to simplify international trade. This resulted in giving the dollar the status of "world reserve currency'.

This system would suffice for the next 25 years, but by 1970, trouble was on the horizon. With an outpour of gold from the U.S. and the irresponsible printing of the dollar, international confidence in the U.S. dollar had declined greatly. The U.S. dollar would remain the core world reserve currency, but due to its inflation and erratic exchange rates, it could no longer be pegged to the price of gold. This would mark the end of the previous system, and the beginning of our current system of fiat currency, which is a system where paper money is no longer based on gold, but on the government promise of its market value.

This new power of elastic currency based on government promise has been a quick treatment for many funding problems since, but has facilitated the financial mess that the United States is in today. Wars that we otherwise could not have afforded have been financed by this system. Social programs that we could not have afforded have been funded by this system.

Most of America would probably never become aware of the unjust power of the Fed had it not been for the financial crisis we are currently in. People were saying, "Why does AIG deserve to get bailed out? If I file bankruptcy, nobody bails me out!"

During the last several years of Alan Greenspan's tenure as the Fed's chairman, he set the interest rate near zero.  Greenspan believed that this would encourage liquidity, but it gave large firms the opportunity to borrow from the Fed irresponsibly.

Game on.

When a law known as the Glass-Steagall Act, which forbid investment banks to own or "hold" commercial banking entities, was repealed by congress in 1999, Pandora's Box began to open, and the stage was set for what would become one of the worst financial crises in U.S. history.

Banks began giving out loans to people who could not afford to pay them back. Predatory lending caused the value of homes to rise fictitiously, and created what is known as a bubble. These mortgages were repackaged, then traded on the market as "mortgage-backed securities".  Investment companies encouraged investors to buy into these investment vehicles by guaranteeing solid returns and deemed these securities as AAA-rated. The reality of the situation was the AAA-rated investments were actually toxic and high risk.

Finally, in 2008 the bubble began to burst. Borrowers started defaulting on their loans, and all those so-called AAA-rated investments were worthless. The stock market began to crumble as investor confidence declined. Giant firms such as Bear Stearns, Lehman Brothers, Fannie May, Freddie Mac, and AIG were in bankruptcy.

 Check.

Then something interesting happened.  See, one of the Fed's purposes is to act as a lender of last resort. This creates a loophole where large firms can invest irresponsibly because they are deemed "too big to fail". Then U.S. Secretary of Treasury Henry Paulson used fear tactics to pass hundreds of billions of dollars in bailouts in the form of TARP (Troubled Asset Relief Program). AIG was bailed out (amongst others).

Checkmate.

 Some companies even profited from both the collapse and the bailout, most notably investment firm Goldman-Sachs (counterparts in trading toxic assets with AIG. They then made bets against those investments for a profit, and received a ton of money from the TARP).

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