In terms of public opinion, the past couple of years have not been kind to people who work in financial markets. The subprime mortgage meltdown and recession have generated negative feelings among a substantial number of Americans toward financial markets and the people who profit from them. Recent rhetoric in the Republican presidential primaries concerning Mitt Romney's role at Bain Capital and Bain's role in the economy has revived the issue.
Are financial markets a net benefit to society? Or are they an instrument for exploitation of one group of people for the benefit of another? To answer these questions we need to understand what exactly it is that financial markets do.
Financial markets exist to do a variety of things. One role they serve is to move wealth around over time. Very rarely is it best for a person to consume all of his income as soon as it is received. Financial markets facilitate delayed (or accelerated) consumption by allowing consumers to purchase financial assets today when they have a lot of income, and sell them later when their income level is low. In economics this is referred to as the consumption-smoothing motive, since it is driven by a desire to keep consumption constant over time, or at least to have it change gradually if it does change.
Middle-aged workers generally want to save because they realize they will have much lower income after they retire. Young and old consumers, on the other hand, often want to dissave. Young people may borrow when young to finance an education, for example. Retirees want to draw down their savings so they can continue to consume at a level close to what they did while working. This type of trade can be supported by relatively simple financial assets, like bank loans, or bonds.
Another role that these markets serve requires more sophisticated financial assets, however. That is the buying and selling of riskiness.
Some types of risk can be completely eliminated by appropriately diversifying. Auto insurance is a good example. The insurance company collects premiums from all its customers and makes payments equal to damages for those who have accidents. With a large number of customers the payouts over a given period of time can be predicted quite accurately. In the end all the customers end up mostly the same when it comes to their cars. They have all paid the premium and they all have a working car.
Some other types of risk cannot be eliminated by diversification. This type of risk is called aggregate risk. Even though it can't be eliminated, it can be transferred. This is perhaps the most important role that financial markets serve. Some people, like myself, are very averse to risk. They are often referred to as "hedgers". They buy relatively large amounts of insurance and they take safe jobs at places like universities. Other people, like my next-door neighbor, Brent, are less averse to risk. We call these people "speculators". They tend to buy less insurance, or buy policies with larger deductibles, and they are more willing to take jobs that have greater income risk, like being self-employed.
Suppose I unexpectedly inherit an old abandoned gold mine from a rich relative. No one knows if the mine still has any gold in it. Suppose the mine has a 50% chance of being worthless and a 50% chance of generating a million dollars in profit. This is a risky asset. I don't like risk. My neighbor, Brent, doesn't really like it either, but is more tolerant of risk. I could offer to sell the mine to Brent for $450,000. I would prefer have $450,000 for sure than the risky mine. Brent will end up with a net profit of $550,000 if the mine is viable and a net loss of $450,000 if it is not. As a result I end up with a much safer portfolio but lose an average of $50,000. Brent ends up with an average of $50,000 more than before, but his income is really risky.
In terms of dollars this is a zero sum game. It appears Brent gained $50,000 at my expense. Before anyone starts occupying his front yard, note that in terms of overall well-being, we both end up better off. I am happy to take my loss in order to avoid risk and Brent is happy to accept that risk in exchange for $50,000.
One of the things financial markets do in general is transfer both risk and wealth to people who are less risk averse from people who are more risk averse. As a result some people end up quite wealthy (Brent nets more than half a million dollars if the mine pans out), but they offered something of real value in exchange. They took on risk that other people did not want to face.
As with any group there are a few dishonest and immoral people dealing in financial markets. But generally speaking high payoffs are a payment for willingness to take on risk. Financial markets, rather than being arenas for fraud and theft, are efficient ways of reallocating risk to for the benefit of all participants.
]]>The U.S. job market is showing signs of improvement if the latest data are accurate. On Friday the U.S. Bureau of Labor Statistics reported that the unemployment rate has fallen to a three-year low of 8.5%. Of particular note is that private sector employment was up more than expected in December. Tall of this could just be a one-month data fluke, but it is also encouraging that the number of new jobless claims has been declining recently as well.
Jobs are important to the economy for a number of reasons. One of the most important reasons is that jobs are by far the primary source of income for U.S. households. The Bureau of Economic Analysis estimates that for the 3rd quarter of 2011 the total of all income earned in the U.S. was 13.4 trillion dollars (seasonally adjusted at annual rates). Of that total, 8.3 trillion dollars or just shy of two-thirds was paid in the form of wages and salaries.
Most of us think of unemployment as a bad thing for exactly this reason; jobless people earn no wages and, as a result, suffer from a whole host of associated problems. The reason we have programs like unemployment insurance and other jobless benefits is to help alleviate these problems to some degree.
But another very important reason that jobs are important is that jobless people who want to work are a valuable resource that goes unused.
Of course not everyone who is without a job represents a wasted resource. Retired people and children are two obvious groups of people who generally do not work for money. For retired people the benefits of working are outweighed by the benefits of leisure time. In addition, retired people generally have a stock of savings to draw upon and are not so heavily dependent on wages for their income. For children, the benefits of working when young are outweighed by the benefits of enjoying a happy childhood and also of increasing their education to be more productive when older.
Many people between these two extremes in age also choose not to work. This is particularly true for married couples with children where often only one person works for wages. In these cases the benefits from working are outweighed by the benefit of having one parent at home.
However, when qualified workers seek for jobs and are unable to find them, we can legitimately view this as an aggregate waste.
In this context, however, not all jobs are equal. Some jobs add value in the aggregate, some do not, and some may even lead to a decrease in total economic well-being. For example, if your shiftless brother-in-law who is currently jobless begins working as a jewelry-store thief, the economy as a whole would be worse off due to all the broken windows he creates in the course of doing his job despite the fact that he is now employed and has a source of income.
Politicians and policy makers often talk about the challenge of creating jobs, but there is no challenge at all if the objective is simply turning idle workers into paid employees. All that is required is the ability to tax or create money and one can pay workers to do all sorts of things. Milton Friedman once suggested that two jobs could be created by hiring one person to dig holes and simultaneously hiring a second to fill the hole up again.
What is challenging is to foster the creation of meaningful jobs that add net value to society. Much well-meaning public policy is counterproductive in this regard. For example, income taxes can act as a power disincentive to work. It is often argued that these disincentives are very powerful for the wealthy because they face higher taxes on each additional dollar earned. However, the burden at the other end of the income distribution is often heavier. Going back to that shiftless brother-in-law of yours; suppose he has a knack for fixing cars and wants to work as a mechanic. If values his current leisure time at $14 per hour and an auto shop were willing to shell out $16 per hour for his effort, he would likely turn the job down. Right now the combined burden of Social Security and Medicare taxes alone would amount to $2.13 per hour, meaning if he took the job he would net $13.87 per hour. Loss of jobless benefits and welfare payments when wages are earned can make the effective "tax" on earned income much higher than this.
This is only one example of the many ways public policy distorts employment. The challenge our policy makers face is not in creating jobs, but rather in fostering an environment where meaningful jobs can be created and sustained for the long-run.
Eyebrows raise when you hear about any interest rate on credit more than 30 percent. If you're discussing payday or title lending, the implied interest rates (in annual percentage rate) can be above 500 percent. Put in those terms, short-term consumer lending markets sound immoral and predatory.
With a first impression like that, it is no surprise
that the short-term consumer lending industry is often the target of
restrictive regulation proposals and public ire.
However, looking more closely suggests that these loans are smaller in both total market size and individual interest expense than the APR interest rate would suggest. And these markets receive fewer complaints from their users than any other lending industry.
In a new dataset collected during summer 2011, I surveyed all of the Utah payday and title lending firms, as well as some pawn lenders. The data include average interest rates (in APR), average loan amounts, average duration of loan, default rate and total principle lent for more than 50 percent of all the payday and title lending store locations in Utah.
A response rate of more than 50 percent makes this survey one of the most representative of its kind. The dataset also contains a level of detail that no other source in the state has available.
The first gems that emerge from these data are the respective sizes of the Utah payday- and title-lending markets. Payday lenders in Utah issued an estimated total of $280 million in payday loans in 2010, and Utah title lenders issued about $35 million of title loans. Compare these to the size of Utah's more traditional revolving and non-revolving credit markets of $6.4 billion and $10.8 billion, respectively, as reported in a 2009 Utah Foundation publication.
In addition to the fact that the Utah payday and title lending markets are small potatoes compared to the more traditional credit markets, they also differ in duration of loan and potential interest that can be charged.
The average Utah title loan in 2010 was $920 for 6 months with a 268 percent APR. In contrast, the average Utah household in 2007 had $13,000 of non-revolving credit and $7,700 of revolving credit, both with average interest rates of less than 25 percent. One reason for the high title loan interest rate is that 17 percent of title loan borrowers defaulted to some degree on their loan.
Utah's payday lending market is even more distinct. The average Utah payday loan in 2010 was about $410 for 17 days with a 490 percent APR. In the case of a payday loan, quoting the interest rate in an annual percentage rate can be particularly misleading. This is a two-week loan. The APR of 490 percent amounts to about a $15 fee every $100 borrowed. That $15 fee barely covers the hourly wage paid to an employee to process each loan, not to mention any increased administration costs from the 14 percent of payday borrowers who went into default to some degree on their loan.
In addition, the 490 percent payday APR represents the interest rate that would result if the payday loan were compounded for a year rather than the average of just over two weeks. Utah law prohibits payday lenders to charge interest on loans beyond 10 weeks (2.5 months). This makes the 490 percent APR a significant overstatement of interest expense charged to payday borrowers. To my knowledge, no other credit market in the country has that type of restriction.
Lastly, consumers who borrow from Utah payday or title lenders file the fewest complaints to the Department of Financial Institutions of any type of borrower. In 2010, DFI received less than 10 complaints regarding Utah payday lenders. That is likely the lowest number of consumer complaints for any Utah credit industry. This is not evidence of a population of borrowers who are being preyed upon.
In summary, this new dataset of Utah payday and title lenders provides a view of the Utah short-term consumer lending market that has not been seen before. When deciding whether government regulation of any industry is justified, a policymaker should answer the following three questions. 1) What is the market failure that the regulation addresses? 2) Do the benefits of the regulation outweigh the costs? 3) How is this industry different from other related industries that don't have the proposed regulation? This new dataset will provide more answers to the questions above regarding Utah's short-term consumer lending industry.
]]>In February of 2009 congress passed and President Obama signed the American Recovery and Reinvestment Act. At the time it carried an estimated price tag of $787 billion. Commonly referred to as "the stimulus bill," it was intended to reinvigorate an economy battered by the subprime mortgage financial crisis. In September of this year, President proposed the American Jobs Act, which is also intended to invigorate the economy and spur jobs creation. Under this act an additional $447 billion will be spent, leading some people to refer to it as "Stimulus Jr."
How exactly is increased government spending supposed to stimulate the economy. The basis for this prescription lies in a particular school of macroeconomic thought known as Keynesianism. The name comes from the famous British economist, John Maynard Keynes. When he came up with his theories Keynes had in mind an economy mired in recession or depression, as was the case around the world during the 1930s. In this environment Keynes claimed that workers and firms stood ready and willing to produce goods at the prevailing prices, if only someone would buy them. This is the description of a market surplus, which occurs in individual markets occasionally for a variety of reasons. Keynes argued there was an economy-wide surplus of goods, not just a surplus in a few scattered markets.
Normally with surpluses markets respond by lowering prices to clear the market, so that all goods offered for sale are purchased. Think of sales on day-old bread or DVDs in the discount rack and you get the right idea. However, Keynesian theory postulates that prices are slow to adjust, particularly downward. This is referred to as price "stickiness" and it implies that markets will remain in surplus for long periods of time. In the long run prices will eventually fall and markets will clear, but as Keynes famously quipped once, "In the long run we are all dead." Hence, we may be quite concerned about what happens in the short run while prices are not adjusting.
In this scenario the problem with the economy is coming from consumers on the demand side. They are not spending enough to purchase all the goods offered for sale. A Keynesian prescription is to let the government purchase goods and services instead. In theory this increases the demand for goods. Firms sell goods that would otherwise remain unsold or not even produced in the first place. And workers go back to work producing those goods.
There are complications, however. The government needs to get the money to pay for these purchases somehow. If it raises taxes, and uses the increased revenue to buy goods, it is also lowering the income of the households and businesses it taxes. As a result, they spend less even as the government spends more. Whether this leads to a net increase in the demand for goods depends on whether those taxes reduce their consumption of goods by more or less than the government increases its consumption. Economists call this the marginal propensity to consume or MPC and argue that the MPC of the government is close to 100% (at least for stimulus spending) while the MPC of consumers in less than that. Hence, a stimulus increases government spending more than it depresses private spending and yields a net increase in demand.
If, however, the government pays for spending by running a deficit, private spending need not fall, because households are not taxed and need not reduce spending. This reasoning is why the traditional Keynesian policy prescription is to stimulate via deficit spending in a recession.
Since Keynes, macroeconomic theorists have run across flaws in this reasoning, however. For example, when the government runs a deficit, it borrows more money from the general public. When domestic households lend to the government, they voluntarily reduce spending and buy government bonds instead. Hence, deficit-financed stimulus looks very similar to tax-financed stimulus in its overall effects.
Another reason why stimulus spending may be less effective than Keynesian theory suggests is that the effects depend crucially on how the money is spent. For example, older and younger people may have different MPCs. The old have less of a savings motive than the young. Indeed most retired workers are dissavers, withdrawing funds on net from savings accounts and pensions. If a stimulus package reroutes money from the old to the young it can actually reduce demand.
Recent studies suggest that much of the money from the 2009 stimulus was transferred to state and local governments for local spending projects. However, many of these governments had quite low MPCs and used these stimulus funds directly or indirectly to pay off or avoid debt. In other words they saved the money rather than spent it. This may be one reason the stimulus was so much less effective that its proponents believed it would be.
Additional problems with stimulus spending include the effect it has in the long-run on burdens of taxation and expectations of future taxes. More on those issues will be forthcoming in a later column.
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Last Monday the Nobel prize in economics was awarded to Tom Sargent and Chris Sims. Both are well-known macroeconomists and both have worked on economic issues relevant to the 2008 recession and recovery.
Forecasting the future of the economy is tricky business. For one thing it is very complicated, with millions of goods and services changing hands. Another reason is that it is subject to changes in the economic environment that are not economic in nature; weather and politics being two good examples. Forecasting how the economy will behave requires simplifying models that capture most of its features without adding too much complexity. Over the years, economists have developed increasingly sophisticated ways of doing this.
By way of analogy consider the portion of U.S. Highway 6 that runs between Spanish Fork and Price. I drive this stretch of road on occasion on my way to the San Rafael Swell. The road goes up Spanish Fork Canyon, over Soldier Summit, and down Price Canyon. It is necessarily winding and steep in many places. Suppose you were tasked with forecasting the fate of a convoy of vehicles traveling over this road.
A simple first stab at the problem might involve using elementary physics. The vehicles have given weights, they travel at certain speeds over different portions of the road, the road's gradient and curvature are known. Based on this information you could, with some effort, derive a forecast for the progress of the convoy.
However, to improve your forecast, you might also consider the weather. Unfortunately, the weather is changeable. You have a general idea of conditions, but the specifics at each point on the road are not known. Furthermore, these conditions can change unexpectedly. You need to make a best guess and factor this into your forecast. You will also need to update it as the convoy progresses and available information changes. The same principle applies to other factors like the mechanical condition of the vehicles, and the mental condition of the drivers.
When you make your forecast you realize that it is only a best guess. It is subject to change due to factors that are difficult to predict.
If you had some control over the highway or the vehicles you might be able to reduce the chances of a serious slowdown or pileup. Suppose you had a radio controller that could uniformly boost or reduce the amount of fuel all the vehicles consume. If conditions looked dangerous you could dial down consumption of gas, slow the convoy down, and reduce the chances of something bad happening.
This type of forecasting and policy recommendation corresponds roughly to state-of-the-art economic forecasting prior to the introduction of Rational Expectations theory thirty to forty years ago. Tom Sargent was an important contributor to that literature. Chris Sims' contribution was to develop statistical techniques that identify how economic variables influence each other as time progresses.
When you cut back gas consumption you assumed this would make the cars go slower. However, drivers are not automatons and they adjust their driving behavior based on the conditions they observe. They do this by gathering all the relevant information they can: direct observation of the road through the windows, listening to the radio, talking with other drivers on cell phones, etc. When things look dangerous, they slow down on their own. If you dial down the gasoline flow, drivers will simply push harder on the accelerator to compensate and will maintain the speed they think is best. . Ignoring the responses of the drivers (decision makers) in the convoy (economy) to your manipulation of the gas flow (economic policy) gives bad forecasts. Good forecasts will incorporate these rational responses.
The 2008 financial crisis and recession have been held up by some people as evidence that Rational Expectations is incorrect. If decision makers are gathering information and processing it effectively, how could they have missed the subprime meltdown? Why did they ignore the warnings of those who were warning against just such a meltdown at the time?
Go back to the convoy. Suppose you have a fellow forecaster who believes the brakes on a large semi-truck are about to fail. As the convoy makes each turn along the route he announces over the radio to all concerned that the semi is about to run out of control, tip over, and cause a massive pileup. However, for the first several turns the brakes hold and the convoy continues on unharmed. Eventually, everyone discounts his predictions of doom. If the brakes finally do fail, it comes as big surprise to almost everyone. Why did drivers not foresee the crash? Why did they ignore the voice on the radio? Because the problem was small, subtle, not readily apparent to anyone but an expert, and the exact moment of failure was largely random.
The problem is not that the forecasting methodology is wrong. Rather, it is that unexpected or difficult to predict events can in some circumstances have huge consequences. They are easy to see in hindsight, but not so easy to see before they happen. One message the Nobel committee sent was that rational expectations is still an important piece of economic theory.
]]>According to the National Bureau of Economic Research (NBER) our most recent U.S. recession began in December 2007 and ended 18 months later in June 2009. There are no precise criteria for deciding when recessions begin and end. Instead, the NBER uses a variety of economic data to reach a consensus on the dates. The general idea is to look for turning points in economic activity. A peak, when economic activity begins a sustained fall is the beginning of a recession. A trough, when the economy stops shrinking and begins to expand again is the end. One commonly used rule of thumb is that a recession is at least two quarters of falling inflation-adjusted gross domestic product (GDP), while a recovery is two quarters of rising GDP.
Not all recessions and recoveries are equal, however. A downturn can be mild as the one from July 1990 to March 1991 was, when GDP fell by 1.3%. Or it can be severe like the most recent one where GDP fell by 5.1% from peak to trough. In addition, recoveries can be anemic or robust. For example GDP grew almost 14% in the two years following the 1981-82 recession, while it has only grown 5% in the two years since the end of the last recession.
What exactly causes a recession is a matter of intense debate amongst macroeconomists. It is likely that there are many causes.
Keynesian theories focus on the role that consumer confidence plays in recessions. When consumers begin to feel pessimistic about the future, they will save more and spend less. This leads to a decrease in demand for goods and services. If the prices of goods are slow to adjust, this will, in turn, lead to a surplus of production and firms will begin to lay off workers.
New classical economic theories point to the role of technology. When there is a drop in productivity, firms will be unable to produce as many goods as they could previously. The drop in worker productivity leads firms to lay off workers and leads to a recession. It also causes capital to be less productive and this leads to large drops in purchases of investment goods. New classical economists realize that technology rarely decreases, but they point out that energy price increases and increases in taxes are often identical in terms of their effects on firms.
Financial crises can also cause recession if they have a major impact on the banking sector. When banks are in financial trouble they are reluctant to lend to businesses, and many sectors of the economy rely on bank lending to cover up front costs. Residential construction and shipbuilding are two good examples. A loss of lending forces these firms to lay off workers since they cannot borrow the money to pay their wages.
Our most recent recession was caused primarily by the subprime mortgage financial crisis. The resulting drop in consumer confidence was likely an important contributing factor. The anemic recovery, however, is likely due to other causes. One facet of recent recoveries has been the slow rebound in employment. This is especially true of the past two years. A great deal of this is due to government policy. Increases in personal and corporate income taxes are very similar to drops in technology from the point of view of firms hiring workers. It makes no difference to the firm if revenue is lost because the firm is less efficient than before or because the government takes more in taxes. Expectations of increased taxes act as a powerful disincentive to businesses. Since most business operators dislike dealing with uncertainty concerning the future business environment, even uncertainty about whether taxes will go up or not, can act as a drag on the economy. The expectation of increased government regulation can also mimic a productivity drop. When particular methods of production are banned or made more costly, this forces firms to adopt different production techniques that are likely less efficient (else the firm would already be using them).
Are we headed toward another recession soon? It is difficult or impossible to say for certain. Unpredictable future events will have bigger effects than anything foreseeable right now. The unfolding sovereign debt crisis in Europe has the potential to stress the banking sector. But a banking meltdown is not a foregone conclusion. Increased taxes are a possibility, particularly with the increased attention the public and policymakers are placing on reigning in government deficits. However, budgets can be balanced by cutting spending rather as well, so it is entirely possible that tax rates will not be raised. The implementation of Obamacare has the potential to impose costly regulation on firms that would lead to a drop in productivity.
One thing that is certain is that there will be another recession sometime. It may begin this year or we may be lucky enough to go a decade or more without one. When making financial plans for the future it is always a good idea to remember that recessions are a recurring feature of the economy.
]]>The Greek financial system is in big trouble right now. The fundamental problem is that the Greek government has been on a bit of spending bender over the past few years and has borrowed a lot of money to pay for this, all of it denominated in euros. It has become frighteningly clear that this level of debt is unsustainable and the Greek government needs truly radical fiscal reform to avoid defaulting on its outstanding debt. Much of that debt is held in the form of Greek government bonds by Greek banks, but a large amount is also held by various financial institutions outside of Greece.
By itself this is not really a very interesting or important situation. There are a large number of countries in the world and inevitably, some of them get into fiscal trouble. Some sort of financial crisis of this sort happens on a fairly regular basis. Greece is, however, a member of a monetary union. And its financial health could have an effect on the financial health of other members of that union.
The euro is a unique currency because it is issued by a collection of sovereign states, rather than by a single country as is usually the case. The currency was formally introduced into circulation in 2002 and replaced the national currencies of the participating countries. Control of the euro money was given to the European Central Bank (ECB), which was created with the sole purpose of managing the euro. When the euro was created it was very clear that all member countries would be using a single currency and would therefore be unified monetarily. It was not clear, however, how unified these countries would be in fiscal terms, however. There is no governmental equivalent to the ECB. There is a European parliament, but there is no central government with authority to tax and spend for the European Union as a whole. Fiscal matters are, in theory, left entirely to the individual member countries. This means there is no natural central source of funds to "bail out" the Greek government. The two bailout packages worked out so far have been hammered out via complex negotiations between Greece, the ECB, and other European governments.
Suppose Greece decides it is going to default on its government bonds. Does this necessarily mean that the euro as a currency is in trouble? Not necessarily. In fact, if there is no expectation that Europe is a fiscally united, then there should be no issue at all. Greek bonds, though denominated in the same currency as German bond, already pay higher interest rates due to their higher probability of default. If the Greek government decides to default, things could get really bad for Greece, but it need not affect other European countries. The fact that German and other European banks hold Greek government bonds could lead to increased stress on the banking sectors in those countries, but it need not lead to dissolution of the euro as a currency.
However, a problem does arise with one the way that Greece might choose to default on its debt. Rather than default outright, the Greek government could choose to drop out of the euro zone and reintroduce their previous national currency, the drachma. They could do this by initially trading all euro amounts in Greece one-for-one with drachma, for example, and legally rewriting all contracts in euro to contracts in drachma. Then the Greek central bank could drastically increase the number of drachma in circulation and repay its nominal debt with this new money. The result would be a devaluation of the drachma. Greek assets would be worth less on the world market, just like a default, but a formal default would be avoided. In effect, Greece would be solving its fiscal problems by imposing an inflation tax and at least some of the burden of that tax would fall on non-Greek holders of Greek government bonds.
Now suppose you had a time machine and knew for certain that this was going to happen on Dec. 31st 2011. What should you do today? You should sell any Greek assets you hold today to avoid the inevitable loss in their value when the drachma is devalued. If you are a savvy investor you might take profits by short-selling Greek debt. Even if you don't have the time machine and are uncertain what is going to happen, you might still find it prudent to sell. When all or most investors do this, the result is a worsening of the financial crisis.
If investors feel that Greek devaluation is becoming more and more likely, it is only natural that they begin to look at other European countries with similar fiscal problems. These countries include Ireland, Spain, Portugal, and perhaps even Italy & France. If enough countries choose to withdraw and devalue their currencies - particularly if either of the latter two do - then the euro as a multinational currency will effectively be dead.
Greek fiscal problems don't automatically mean the euro is doomed, but it is very easy to see why policy makers in Europe and elsewhere are worried that events are moving in exactly that direction.
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.