The World's Most Powerful Institution

“Let us control the money of a country, and we care not who makes its laws.” – T.C. Daniel

We are now in the third installment of our new series on the Federal Reserve. Over the past two weeks we have looked at the history of banking in the United States, the various factors that led up to the formation of the Federal Reserve, and the first ten years of the Fed, which we are calling Act I of the Federal Reserve Era, culminating in the infamous Crash of 1929. In this week’s post we will look at two other important eras in the history of the Federal Reserve which are marked by turning points that expanded the Fed’s mandate and eventually turned it into, as some would argue, the most powerful institution in the world.

US Federal Reserve Era – Act II (1930 – 1976)

After the Great Depression, Congress realized that they needed to give the Fed more leeway to allow them to truly be a lender of last resort. In response they passed several acts to expand the power and authority of the Federal Reserve including the ability to conduct “open market operations” which we will address in more detail later on in the series. Additionally, the Federal Open Market Committee (FOMC) was established to oversee the Federal Reserve and implement the newly expanded policies. These changes were a major expansion of the Fed’s power and authority as they were no longer constrained by rules that aligned themselves with a “normal profit motive” (e.g. don’t make loans to troubled banks), but rather turned their focus to bringing stability to the banking system even if it meant there would be a cost.

By the mid 40’s after the end of World War II, Congress again expanded the Fed’s power and authority by giving them the mandate to “promote maximum employment” as soldiers returned to the workforce. More jobs equate to more votes for an incumbent politician, so there was more behind the directive than simple altruism. In response, the Fed kept interest rates at the same low levels they used to help finance the war for an extended period of time after the war was over. A prolonged period of time of low interest rates incentivized credit expansion in the private sector (e.g. more debt) which grew the economy and created more jobs in a period of time known as the Golden Age in American history.

Although the single mandate of maximum employment led to decades of prosperity in American history, because of the complex nature of our developed economy, it created a number of unintended consequences. After three decades of low interest rates, credit expansion, and economic growth, the US found itself in the grips of record high inflation in the 1970’s. To make matters worse, inflation turned into stagflation where the inflation and unemployment rates rose in tandem…a phenomenon many economists at the time believed was impossible.

US Federal Reserve Era – Act III (1977 – 2008)

In 1977 in the throngs of stagflation, Congress amended the Federal Reserve Act yet again to give the Fed a second mandate to pursue stable prices along with maximum employment, now commonly known as the Fed’s dual mandate. Fed Chairman Paul Volcker made the tough decision to temporarily ignore the maximum employment part of the mandate (very unpopular with politicians) and raised interest rates to levels never before seen in our country’s history. His actions finally tamed inflation, but it sent the country into a deep recession with the unemployment rate hitting double digits for the first time since the Great Depression.

By the mid 80’s, inflation was under control and the recession was over, so the Fed was free to pursue its dual mandate of maximum employment with stable prices. The two decades following this point in time became known as the “Great Moderation” due to the fact that GDP growth stabilized (see embedded chart) and many came to believe that the Fed had finally “tamed the business cycle.”

Mark Twain has been attributed with the quote, “History doesn’t repeat itself but it often rhymes” and Act III of the Federal Reserve Era was no exception. As we saw in Acts I and II, there is a familiar cycle to the Fed’s actions…

1. The Federal Reserve empowers the banking system by making it easier to lend out money
2. Individuals and businesses take advantage of the ease of credit and borrow money
3. Credit expansion leads to economic growth and a long period of prosperity
4. Some unintended consequence eventually ends the party for everyone
5. The Federal Reserve expands its power and reach to better address the needs of the banking system
6. Wash-rinse-repeat

Unfortunately, Act III ended in much the same way as Acts I and II where a long period of economic prosperity (The Great Moderation) abruptly came to an end during the Global Financial Crisis (“GFC”) of 2008. Long periods of economic prosperity often lead to a general sense of complacency. Such was the case for the period of time leading up to the GFC when bad loans which had been packaged into mortgage backed securities defaulted in record numbers and brought the global financial system to its knees.

Now to be fair, the Federal Reserve is not entirely to blame for the GFC. There were a number of guilty parties including greedy bankers, power hungry politicians, and willfully blind rating agencies. But the Fed’s policies definitely laid the groundwork for the largest financial crisis in our nation’s history since the Great Depression. In next week’s post we will begin to look at the various tools our modern day Federal Reserve has at its disposal as well as some of the “extraordinary measures” it took during the GFC.

Original Post: The World's Most Powerful Institution