September 2011 Archives

This article was published in the Deseret News on Tuesday, September 6th.

Money in most countries in the world is issued by a central bank that is granted the monopoly right to issue the nation's currency.  In the United States the central bank is actually a system of 12 regional banks that are controlled by the Federal Reserve Board of Governors in Washington, D.C.  The Federal Reserve System, or Fed, is legally a private enterprise and is owned by member commercial banks.  Effectively, however, the Fed is 4th branch of the government.

The members of the Fed's Board of Governors are all appointed by the President of the U.S.   One of these is selected every four years to serve as the Chairman of the Fed.  Currently the Chairman is Ben Bernanke, who served as a member of the Board under the previous Chairman, Alan Greenspan.  While the Fed is legally owned by the member commercial banks, these banks have little direct input into the governance of the Fed these days.  Member banks elect six of the nine members of each of the 12 regional Federal Reserve Banks board of directors.  This board of directors, in turn, selects a president to run the regional Fed.  In practice, the members of the board and the presidents are chosen in Washington by the Board of Governors.

The Federal Reserve has a great many duties.  It was created in 1914 primarily to serve as a lender of last resort and address a longstanding problem the U.S. had been experiencing with bank runs.  Prior to 1914 the U.S. had no central bank.  There was a brief period early in U.S. history where the First and Second Banks of the United States were chartered and then disbanded, but these banks served mainly as depository and lending institutions for the U.S. government and not as modern central banks.  During most of the 19th century and up through 1913, the U.S. had no central monetary authority that would step in and loan funds to banks that were hit with bank runs.  As a result the nation experienced periodic bank panics where runs would occur on several banks simultaneously and led to nationwide financial crises.  The Federal Reserve System was set up to help alleviate this problem.

The Fed has many other duties as well, including regulatory control over banking, facilitation of check clearing and interbank transfers, and maintaining accounts for many U.S. government agencies.  The most important role the Fed plays, however, is as a creator and controller of the U.S. money supply.

One of the reasons the Fed is structured as it is, is to insulate it from political pressure.  The Fed is largely independent of the Federal government.  Day-to-day operational control is in the hands of the Board of Governors and the governors are appointed to very long terms of 14 years.   If the Fed were more susceptible to political pressure from the president or congress they would be more likely to use monetary policy to finance government spending.

Over the years since 1914 there have been period calls by people to disband the Fed.  The main reason that this has never been done is because the alternative is undesirable.  If you are one of those who is not pleased with the way congress has handled the U.S. budget, imagine what things would be like if congress was also in charge of the money supply.  By insulating the Fed from political pressure, we are able to maintain a much lower rate of inflation than we would otherwise have.  If congress were to take direct control of the U.S. money supply you can be assured that they would quickly give in to the temptation of simply printing whatever money they needed for their desired level of spending.  Delegating control to a central bank that is insulated from political influence makes it difficult or impossible to give in to that temptation.

While having an independent central bank does alleviate some problems, it creates others.  One argument against a central bank is that it is undemocratic.  Monopoly control of the money supply is placed in the hands of officials who are not answerable directly to the public.  This often leads to the perception that the money supply is in the hands of special interests who do not have the best interests of the public in mind.  In some countries and in many historical cases this perception is justified.  It is not so justified in the case of the Fed.

There are alternatives to the Federal Reserve System that are democratic in nature but not prone to inflation.    For example, from 1716 to 1845 Scotland had a free banking system of sorts, where two competing central banks each issued currency.  More generally, free banking would allow commercial banks to issue whatever currency they desired and they could back this currency however they wished as long as the backing was truthfully disclosed. Competitive free banking would allow some banks to issue monies backed by gold or other commodities.  Consumers would be free to choose what type of money they wished to hold and sellers could choose what types of money they would accept as payment.  One interesting new technological option that has many of the aspects of free banking is BitCoin, an online payment system that settles payments on a peer-to-peer basis without using a bank or even a currency controlled by a central bank.

Free banking is unlikely to be adopted as official U.S. policy anytime in the near future.  In the meantime, the Fed will continue to control the supply of dollars.  Despite its shortcomings, the Fed is a much better arrangement that most of the alternatives.


Authors

  • Richard W. Evans is an Assistant Professor of Economics at Brigham Young University

  • Jason DeBacker is an Assistant Professor of Economics at Middle Tennessee State University

  • Kerk L. Phillips is an Associate Professor of Economics at Brigham Young University