HAPPY BIRTHDAY TO THE FEDERAL RESERVE

By Filipe R. Costa & Ben Turney 

European central banks have been around for over 300 years. The Bank of England was formed in 1694. On the other side of the Atlantic, however, the Federal Reserve is a relative newcomer to the world of monetary policy, soon to celebrate its centenary on December 23^rd this year.

Until 1913, the United States didn’t need a central bank. The gold standard was working efficiently and the country, as we know it today, was still in its infancy. This started to chance after the American financial crisis of 1907, when bankers recognised the benefits of a single institution acting as lender of last resort to individual banks to alleviate any liquidity problems they might experience.  

In October 1907, Otto Heinze attempted to corner the market of the United Copper Company (UCC), manipulating the price of the stock higher to put the squeeze on short sellers. His hope was that to cover their shorts, the short sellers would be forced to pay the inflated prices, he had managed to contrive. Unfortunately for Mr Heinze, he made some terrible miscalculations along the way and underestimated how much capital he would need to execute his plan. Having not bought enough shares to corner the market effectively, his scheme soon failed and he was faced with enormous debts. In quick succession, a line of banks that had lent him money suffered runs and the largest, the New York City Trust, went bankrupt.  

In response to this, one of the founding fathers or modern finance, J.P. Morgan, saw an opportunity in this crisis and lent money to the stricken banks. He also encouraged many other influential people at the time to follow his lead. The echoes of this bailout still resonate today and the responses of the Federal Reserve to the LTCM collapse in 1998 and the Credit Crisis in 2007/08 were remarkably similar.

Soon after J.P. Morgan’s intervention, the crisis of 1907 abated and a commission was set up to study the European central banking system, with a view to replicating its strengths to avoid future trouble. By December 1913 the commission had reported its findings and the Federal Reserve was born.

What exists today is a far cry from the institution laudably set up solely to avoid financial crashes. Instead, we now live in a world dominated by monetary experiments, influenced heavily by highly politicised decision making. Quite whom the Federal Reserve acts on behalf of is anyone’s guess.

The main goal of a central bank should be to give a cushion of safety to a nation, maintaining financial stability. Avoiding inflation, ensuring liquidity and providing a secure and reliable currency backed by assets should form the bedrock of sound monetary policy. These principles started to evaporate, once governments became alive to the power offered by control of the printing press. After the Nixon Shock of the early 1970s, the world’s major economies cut their bonds with the gold standard and became issuers of currency. Money was no longer backed by physical assets, but rather became a product of rules and regulations. Those in charge of the rules and regulations were those who held control.

Over the following decades governments and policy makers have chased one another in finding new and innovative ways of exploiting this system. Gone are the days of fiscal discipline. Instead all they needed to do to cover deficit spending was print more money. This has had an incredibly distortive effect on trader balances, wealth distribution, credit creation, over-leveraging and many other aspects of our daily lives. What is worst about this is that the new rules of the game appear to have benefitted minority interest groups over the interests of the majority. History tells us time and time again, that this situation cannot last forever.

However, I would not go as far as The Economic Collapse Blog, blaming the Fed for the lack of growth, higher inflation and for printing money out of thin air. The real responsibility goes to President Richard Nixon, who in August 1971 ended the Bretton Woods agreement and dollar convertibility into gold. After decades of price stability, with gold averaging $35/oz, gold has since shot up to the current $1,360 we see today. The reasons behind President Nixon’s action were remarkably similar to those of today. At the time, America was embroiled in the Vietnam War and had the need to pay the vast bills it had racked up. There wasn’t the political will to follow disciplined policies, which would have required lengthy periods of adjustment. Until Nixon’s Shock inflation had been relatively benign. As the table below shows, this suddenly changed;  

During the period 1873-1971, US inflation averaged about 1.36% per year. During the period 1972-2012, this number rose to 4.36%. In the years following the collapse of the gold standard, between 1972 and1976, the annual inflation rates, in sequence were: 3.3%, 6.2%, 11.1%, 9.1% and 5.7%.

Do you see why they ended the gold standard? Yes, exactly, to inflate their way out of a fiscal crisis. Sound familiar?

Intervention by intervention, the Fed has seen its grip on the economy increase dramatically. Now, it has been able to increase its balance sheet by trillions of dollars within a few short years. For every problem it has apparently solved, other bubbles have sprung up. Over the last 15 years, there have been three major bubbles; the dotcom boom leading up to 2000, the housing bubble leading up to 2007 and now the debt bubble, which is growing and growing;  

I’m sure on December 23^rd I’ll raise an ironic cheer to the Federal Reserve Banking System in honour of its hundredth year. Let’s see if it lasts another hundred years. Or for that matter another ten?!