Why is the Federal Reserve Important in Todays’ Economy?
After the Banking Panics that essentially lasted in ebb’s and flows from a few years after the Civil War through 1907, the Federal Government was looking into ways to protect the financial system from “runs on the banks”. What is this? It is when enough people withdraw their money that the bank all of a sudden is forced to sell assets (aka their loans) at fire sale prices just to get those demanding their money, their money. This created a terrible dynamic over those 40+ years where the banking system was losing trust with the public. So understandably banks would hold onto more money, leading to less loans and a slower economy than otherwise would have been in good times. Also, when the public would panic, the money they kept on hand was still insufficient. This is because the trust in banks was so low that whispers of a banks’ insolvency would bring an overflow of withdrawals from it in a matter of days almost guaranteeing insolvency.
So after some emergency measures were put into place in 1908, the Federal Government set up a commission to look into a “long-term solution to the nation’s banking and financial problems”. By 1913, President Woodrow Wilson would sign the Federal Reserve Act into law. By the time the system was up and running, WWI was beginning.
After WWI, the Head of the NY Fed Benjamin Strong recognized that gold no longer worked as the central factor for controlling credit. In 1923, there was the beginning of a panic and Strong & company stood strong, purchasing government securities (when a gov. buys a bond, they essentially inject cash into the public realm) thus reinforcing the banking systems cash on hand for supplying withdrawals. This brought on a sense of confidence in the new established system. Sadly, Benjamin Strong would pass away in 1928 and we all know what happened afterwards.
In short summary, the Federal Reserve was extremely divided following Strong’s passing. Once the depression hit, this only lit a fire in the division. They couldn’t agree on how their actions should be done and while the bickering continued, so did the depression. By the end, almost 10,000 banks across our country failed. This is a good sign that they basically were trying to react to news rather than acting proactively.
After the depths of the depression had passed and the beautiful deleveraging began, there was another big change enacted coming in the form of the Banking Act of 1933. This established FDIC insurance. Now how does all of this relate to the importance of the Federal Reserve? This allowed the public over time to have increasing confidence in the banking system as a whole. This took some pressure off of the Federal Reserve’s shoulders because since then, there has not been a run on the banks as of today (2022).
Once we were through WWII and working out the post-war financings, there was huge problems in the worlds’ currency markets. Over time (and oversimplified here), the US was in a sense forced to officially leave the Gold Standard starting in 1971. Now this is when the FIAT ERA began. Money was now backed by the “full faith and credit of the issuer”, and the Federal Reserve was the “independent” financing arm of our Federal Government. By the end of a couple rough decades (70’s and of course 2000’s), the Federal Reserve in my opinion started to lose their independency. Outside of Paul Volcker in the 80’s, the Fed has seemingly accommodated the governments over-spending by issuing plentiful amounts of debt and keeping rates where they can pay the interest (the low interest rates leaves little to no ammo for the Fed Reserve during recessions outside of direct purchases of assets). Since the late 90’s, they have done this consistently leading to a monstrous federal deficit (and VERY LOW RATES). With this, the Federal Government has grown in power and thus the Federal Reserve has grown in influence across the US economy.
In 2021, the Federal Governments’ spending was 29.5% of the US GDP. The US Gov spent $6.8 Trillion and our GDP was around $23 Trillion (2). Also, the US Gov. only had just over $4 Trillion in revenue. So roughly $2.8 Trillion was financed via IOU’s aka US Treasury Bonds in one year (3). In 2020, the Federal Reserve started to use their balance sheet extensively as well (similar to 2009, but MUCH larger in scale) because interest rates could not go lower without threatening the US Dollar from losing its status as the Worlds’ Reserve Currency. So now, there is lots more debt than there was even a couple years ago. A good portion of this is new Government Debt too. This is why their impact on markets has only increased overtime. It is because they actually are financing more and more of our daily lives.
Maybe in future articles I will write my opinions about whether this is a good or bad thing, but no one can make the argument that their importance is diminishing. I would say that overtime, their influence cannot continue to expand. Eventually everyone has to learn to pay their bills. This will always include governments as well; they can just delay it longer than anyone. Why? Well because when we are in a pinch, we cannot create $ to pay our bills without working for it. When they are, the bills can be paid by printing or issuing new debt. The problem is that it damages their citizens. This is because new money OVER TIME creates inflationary pressures on their daily lives. Inflation is the cure to inflation itself because the money eventually sifts through the economy, but citizens are pressured while it sifts. All the best to you dedicated readers and let me know your thoughts! I hope you can take something from this and future articles to build a VERY successful financial future. The best opportunities occur when most believe there is none.
Riley Sisson
Branch Manager, RJFS
https://datalab.usaspending.gov/americas-finance-guide/deficit/
https://www.thebalance.com/us-gdp-by-year-3305543
Any opinions are those of Riley Sisson and not necessarily those of Raymond James.
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