The Fed - Part 1 (Lender of Last Resort)

The Federal Reserve System in the United States is the most intrusive part of our federal government and is probably one of the least understood by the public. Many of the macroeconomic and financial market distortions we experience have their root cause in the Federal Reserve.

Recently there has been a lot of anger and outrage over the actions taken by the Fed – particularly bailing out banks. This anger has come from frustration at the seemingly endless power of the Fed that is very loosely regulated by Congress. The anger and frustration is very justified, but the actions being discussed (oversight by Congress) will only make the situation much worse. The only permanent solution is to eliminate the Fed entirely.

How would our economy look without the Fed? In order to answer that question we need to look at exactly why the Fed causes problems. This is a topic that has divided economists for decades and most mainstream economists are currently drinking the central bank kool-aid. The Federal Reserve has two major responsibilities: regulator and lender-of-last-resort to banks and conductor of monetary policy. These two responsibilities are separate and yet closely integrated.

The Fed is a lender of last resort for depository institutions (traditional banks) by legislation and through practice and precedent has extended this power/responsibility to investment banks and other financial institutions in general. As lender of last resort the Fed is supposed to safeguard our lending institutions by preventing bank runs. This task is divided into 2 parts: the FDIC guarantees deposits and the Fed stands ready to lend. In the event a bank were to experience withdrawals that exceeded capital on hand and the reserves the bank is required to keep on deposit with the Fed the bank is able to seek funds from other banks through the Federal Funds market (a market of interbank lending managed by the Fed) or from the Fed itself at the discount window. The idea is that banks will not fail if their deposits are backed by the FDIC and they can always get capital loans from the Fed. This is supposed to help prevent the public from starting bank runs and stabilize our financial system.

This system is of course seriously flawed. Most people can readily see the flaw in this system if put another way. Suppose you tell your children that you demand they learn to live on a budget for the year. You tell them you expect them to manage it wisely, but if they don’t you will bail them out. I can imagine most of you see the potential flaw here. It is really no different for banks. They take our deposits and are supposed to manage them responsibly – lending to facilitate investment, but not lose all our money so we can get it back on demand. The risk here is of course that if everyone asks for their money at once, because they have lost faith in the bank, the bank will of course fail. Banking lending only works because we have confidence in our ability to get our money back. The Fed basically says to banks we will watch over you, but you are free to try and make profits oh and if you lose it all we will lend you money to bail you out. It is kind of a heads-you-win/tails-I-lose situation. The bank has little incentive to manage its risk effectively. This has led to excessive lending, over use of debt, and high risk gambling by our banks because they believed and we proved they were too big to fail. The major issue with this recent crisis wasn’t the bailouts (by the time we got here it was too late, we had to bail them out or the whole system would fail) but it was sticking with a system that encouraged the behavior that got us here.

When we create a system that allows banks to benefit when they win and face virtually zero consequences when they fail we should not be surprised that it doesn’t turn out so well. Removing the Fed would of course fix this messed up incentive system.