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The Fed at 100: Omnipotent or Senile?

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The Federal Reserve turns 100 years old this year, so this week let’s take a quick look back at the most important episodes during its long history, and also consider its current role in the world.

  • In the early 1930s the Fed failed spectacularly in its original mission to prevent financial panics from turning into economic crises. A third of all US banks failed and the economy spiraled into a decade-long depression.
  • During World War Two, the Fed helped finance the war by buying government bonds and fixing interest rates at an abnormally low level.
  • In 1968, at the behest of President Johnson and with congressional approval, the central bank stopped backing dollars with gold, taking the country and the world from a commodity-backed monetary system to a pure fiat system. That change played a leading role in producing two rounds of double-digit inflation during the 1970s.
  • In 1981, Fed Chairman Paul Volcker crushed inflation by pushing up bank lending rates to 20%. The very high rates created a severe recession and caused the unemployment rate to jump to 10.8%.
  • From 1987 to 2006, Ayn Rand disciple-gone-astray Alan Greenspan reigned as Fed Chairman. He bailed out the speculating community so consistently following each and every market dip that the public came to believe that investing in stocks and property was a guaranteed path to riches. All the while, he championed financial sector deregulation and encouraged the development of a $700 trillion (largely unregulated) derivatives industry.
  • The period from 1984 to 2007 is sometimes referred to as the Great Moderation because inflation and interest rates came down from double-digits to low single digits and because swings in the business cycle became much less pronounced. The Fed frequently takes credit for these developments. The reality, however, is that inflation fell because the US began importing cheap manufactured goods from ultra-low wage countries, while a surge in credit supported consumption at home. In the process, the US Current Account deficit grew to $800 billion and the ratio of total debt to GDP rose from 160% to 370%.
  • In 2008 when the Great Moderation gave way to the New Depression, the Fed cut interest rates to 0%. When that didn’t halt the economic collapse, Fed Chairman Bernanke began creating money from thin air.
  • During the last four and a half years, the Fed has created roughly $2.5 trillion that way, using the money to buy government bonds and mortgage debt, of which the Fed now owns $1.9 trillion and $1.2 trillion, respectively. This has not only allowed the government to finance its massive budget deficits at very low interest rates (much as it did during World War Two), it has also generated a new boom in the equity and property markets. Now, that Fed-induced boom is the only thing keeping the world from plunging back into a very severe recession.
  • In 2012, the Fed “earned” $91 billion, making it (I believe) the most profitable business in history! That figure is double the highest corporate profits ever recorded: $46 billion by ExxonMobile in 2008. This year, with a much larger balance sheet, the Fed will earn even more.
  • Today – and every day so far this year – the Fed is creating (or should I write conjuring?) $2.8 billion from nothing and buying bonds with it. Each day!

The Fed is desperately trying to reflate the US economy and, thereby, the global economy – and it is succeeding, at least for the moment. The financial markets hang on Bernanke’s every word, facial expression and vocal intonation. If he speaks of monetary accommodation, asset values inflate by several trillion dollars. If he utters the world “taper”, trillions of dollars of net worth evaporate. In short, the Fed is far more powerful than ever before.

Preventing a worldwide credit bubble (largely of its own making) from collapsing is a lot of responsibility for a 100 year-old. But, the horrifying truth is that (at least for the foreseeable future) the fate of the global economy will be determined by what the Fed does during the months and years ahead. Now that the Fed has become nearly omnipotent, all that the rest of us can do is to hope and pray that senility (or megalomania) does not begin to cloud its judgment any time soon.

Original publish date: July 15, 2013

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