Why We Need the Fed

For years, Rep. Ron Paul (R-TX) has been on a crusade to reduce the influence of the Federal Reserve. Indeed, he even wrote a book called "End the Fed," which suggests that the U.S. would be better off without a central bank. While it might have been easy for Congress to dismiss such calls to abolish the Fed in the past, Paul was recently named chairman of the House Domestic Monetary Policy Subcommittee. In other words, he runs the committee that oversees the Fed, so he will probably challenge the central bank every chance he gets. As a result, now might be a good time to wonder why we need the Fed.

What Does the Fed Do?

The natural place to begin is with the Fed's responsibilities. Here are its four central duties, from a document (.pdf) on its website:

1. Conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates
2. Supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers
3. Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets
4. Providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation's payments system

So the first important point is that the Fed actually does a lot. You can't simply eliminate these functions. If you got rid of the central bank, you would need to push many of these functions to other regulators or private firms. For example, inflation has to be kept in check somehow. Prudential supervision is also important. The problem with eliminating the Fed is that you would need to delegate these responsibilities to another entity that could do them better.

Let's consider two of the most important of the Fed's duties: supervision and monetary policy.

Supervision

As a bank supervisor, the Fed oversees a number of financial firms such as bank holding companies, state chartered banks within the Federal Reserve System, and foreign branches of member banks. Although the Fed isn't the only bank supervisor out there, it plays a key role as supervisor of these institutions.

Monetary Policy

The U.S. needs some monetary policy. The government has chosen to allow the Fed conduct monetary policy with significant independence, directing it to achieve two objectives: price stability and full employment. This means the Fed has a fair amount of freedom to play with interest rates, purchase assets, and even conduct emergency lending activities to achieve those ends.

What If There Was No Fed?

Now that we understand some of the most important duties of the Fed, what would happen if we simply eliminated it? Obviously, these duties would still have to be carried out so they would have to become the responsibility of someone or something else. I spoke with two former Fed officials who argued that providing the Fed these responsibilities is better than other alternatives.

Supervision

One of those former Fed officials, Richard Spillenkothen, is possibly the perfect person to explain why it's so important that the Fed is involved with supervision. Through 2006, he was the lead banking regulator for the Fed. He now serves as a director with Deloitte & Touche's Governance, Regulatory, and Risk Strategies services practice. He explains that the supervisory function of the Fed is important for a few reasons:

Supervision is a way, not only to learn about what's going on in the financial system, what are the emerging points of systemic vulnerability, the principal emerging weaknesses, but it also gives the central bank an important role in settling financial and macroprudential policies. And all of that contributes to its broader financial stability responsibilities.

For the Fed, supervision is a two-way street. On one hand, it provides the central bank with a great deal of additional information about the banking system, which it can use for its other functions like ensuring financial stability. On the other hand, the Fed has a unique perspective to offer when it comes to supervision, because it has a great deal of data on and experience with financial markets, global regulation, and macroeconomics. So not only will supervision help the central bank to be more effective, but its background will help it to be an unusually well-informed supervisor.

This isn't to say that the Fed should necessary be the only regulator out there. "Regulators bring their differing perspectives to the table," Spillenkothen noted. The Fed's point of view is just one of many. Other regulators like the Securities and Exchange Commission, Federal Deposit Insurance Corporation, and others also make important contributions to supervision. But a team approach that includes the Fed will provide a robust supervisory framework.

When trying to understand the monetary policy function of the Fed, who better to talk to than the recently retired vice chairman of the Board of Governors and 40-year Fed veteran Donald Kohn? He now works as a Senior Fellow for the Brookings Institution. He believes that an independent central bank is the best way to control money supply to achieve price stability.

Of course, there are other ways in which monetary policy could be conducted. One option would be to put the government directly in charge of monetary policy. For example, the Treasury could do it, or Congress could directly vote on changes to interest rates or policy shifts.

"There tends to be an inflation bias to central banking when (monetary policy is) closely controlled in the political process," Kohn explains. He says history has shown that politicians worried about re-election tend to engage in short-term monetary policy easing to stimulate the economy, while ignoring long-term price stability. This can lead to excessive inflation.

Another way to conduct monetary policy could be to peg currency to a commodity like gold. The U.S. used to take this approach through the gold standard. With this strategy, some think you don't need a Fed, because the quantity and value of the currency depend on the quantity of the commodity. Kohn says that this approach can be inflexible and dangerous:

Periodic bank panics occurred under the gold standard; the Fed was founded to deal with those. And you're at the mercy of the supply of gold in the world, and its distribution among countries. You get situations as had occurred in the 1920s, when some countries accumulated large volumes of gold and they put downward pressure on the price levels of other countries that didn't have those large quantities of gold. It wasn't until after the U.S. went off the gold standard that we were able to begin emerging from the (Great) Depression.

He believes central bankers can do a better job of achieving price stability and other objectives with more flexibility than a commodity standard that ties the money supply to rigid rules.

If Not the Fed, Then Who?

This is not meant to be an exhaustive argument proving that an independent central bank is utterly necessary. Instead, these are just a few reasons why those with first-hand Fed experience believe that having a central bank like the Fed is better than other alternatives. And remember, quibbling over what objectives at which a central bank should aim as a part of its monetary policy philosophy isn't an argument against Fed; it's argument for reform. If you were to get rid of the central bank entirely, then you would need to find other regulators and/or mechanisms to take over its essential responsibilities. And as the sources above explain, trying to do so could get sticky.

(Image Credit: wwarby/flickr)

Monetary Policy