Monthly Archives: December 2015

What does “The Fed” do?

Money

As probably the most misunderstood animal in American politics today, I think it’s important that essentially everybody understand what this organization does; because what the Fed does is deceptively simple. It’s not an instrument of shadow families wanting to control the world (you laugh, but people think this).

It’s not a traditional bank, and it doesn’t print money either (the Bureau for Engraving and Printing does that, and coins are made at Mint locations). It isn’t a formal government organization, but does have Congressional oversight and some appointees leading the organization.

In the end, the Fed serves a very specific function; and it’s pretty important. In general, the purpose of the fed is to stabilize the American economy. And how does it do that?


 

What is this thing!?

The fed is ground zero for the American economy. It’s a central banking system (there are 12 Feds in the country, located at major cities). At these locations, there are a whole bunch of people examining the performance of the economy.

How is the fishing sector? Imports v. exports? What is booming and what isn’t? Are there any areas that need an economic jump start; like farmers? Is there a decline in the housing market? Are there some areas where corporations are going over others? Why? … these are some of the questions that economic reports would target.

In operation, this system is neither private nor public; rather, it’s a marriage between government and business. The system itself is a hybrid.

At a private level, each Fed generates its own income by holding foreign currency reserves, earning interest from loans to private banks, offering payment solutions, maintaining banking for the U.S. Treasury, and other general banking stuff. Also, any profits leftover after operating costs go back to the Treasury. So it’s private, but not for-profit, technically.

At the governmental level, there is a Board of Governors in Washington, and the people in it are confirmed by Senate, and nominated by the president. There are two people that are then confirmed as chair and vice chair. Then those two people are essentially in charge of making decisions for the entire system (and the other members have voting rights) — so the pressure is on there.

Also, Congress can call in those people to ask questions, inquire about the economy, or just yell at them if something goes wrong.


OK, that’s cool, but what does this bank actually DO?

The question of what the Fed does is simple — actually, very simple. It regulates the money supply. The only real function of the Fed, other than general banking stuff and research, is to 1) increase currency into the economy when it needs a boost (fancily called quantitative easing), and 2) slow currency when the economy is inflating too much.

The overall objective is simple; however, it does get complex when you’re evaluating the entire U.S. economy and determining what to do.

So, let’s break this down:

Imagine that the real estate sector of the American economy (the building, buying and selling of homes) begins to take off. Imagine then that the rate of development booms, and therefore everyone who is in the sector begins to increase the cost of the product — because it’s a hot product. Home prices double over 5 years. What was once $100,000 is now $200,000.

We all know that people can’t afford stuff like that (but they REALLY want the product), and that’s why there are banks. So, if the people at the Fed want to encourage this development, what do they do? Easy, they offer private banks a SUPER LOW interest rate to borrow money, granted they’re a member bank. In turn, those banks are able to offer better interest rates to the person who wants the house (or whatever product it is).

But, now imagine that the private banks don’t want to give a loan at a fixed rate, because they know that the interest rates fluctuate, hence over the long-term, the private bank would make more money if the person buying the house pays the fluctuating interest rate. Thus the banks will give money to people with poor credit history granted they live with increased uncertainty. This, by the way, is dangerous because interest rates change a lot, and that can drastically change your monthly payment.

However, if the Fed finds that the sector is growing too fast to be sustainable, it can then up interest rates for loans, and consequently fewer banks take the money; or, if they do, then the consumer at the bottom has to pay a higher interest rate. Essentially the Reserve system attempts to guide growth, and help ensure its sustainability.

Here’s where stuff gets murky; that’s just one sector. Imagine the ENTIRE ECONOMY. Everything from chemical companies to Hollywood. Everyone needs to take out loans from banks, and banks get their money from the Fed (or private investors, but these days it’s mostly the Fed). Because of how banks operate, they must have enough currency in house to cover bad things (and this is another requirement the Fed can regulate); hence as banks get more business, they need more currency — thanks, government.


What if there were no Fed?

There was a time when the Fed wasn’t around. Here’s the problem when you don’t have the Fed: Imagine there is a real estate boom, and you have to go to the bank. Well, so does everyone else, and without a source for the bank to turn to for more money, they eventually run out of money. If the bank runs out of money, then everyone wants to cash in as well (because of panic), and before you know it anarchy ensues, and there is a collapse of that bank and perhaps others as well.

The Reserve system was created in 1913, so well before the Depression. The idea of the Fed was to increase stability in the market while at the same time reducing reliance on major financiers like JP Morgan or Rothschild. However, oddly, the Fed didn’t inject money into the market leading to the stock market collapse in 1929 — so, the people at the top made bad decisions (and perhaps they didn’t have the power to enact such changes, being a new institution and all).

Later in history, Alan Greenspan would inject too much money when there were bubbles in the economy (he used quantitative easing quite liberally), and banks and investors came to rely on the Fed to make things right any time a bubble was developing — so that was bad leadership as well.

All in all, it’s a balance of when to give lenders money, and when not too. If you give too much, they rely on the Fed too much and will probably keep creating exotic financial products with sketchy collateral.

But, if the Reserve gives to little, a bubble could become a depression. At the end of the day, the Fed needs sound research and information to make decisions, as well as solid leadership, in order to be effective.


 

Why CENTRAL BANKING!?

Just to reinforce why this system exists, there were all sorts of other banks in U.S. history before the Reserve system was developed.

In Colonial America, people relied on foreign currency — which was hard to transport and keep a decent supply of. Then, each state developed banks, and each state (and sometimes each bank) had it’s own currency, so that was pretty shaky. After all, if the bank didn’t have enough gold or silver to back up the notes (which themselves were backed by land or things), then what? There was no insurance.

Hamilton wanted a central bank; Jefferson didn’t. Hamilton got his first national bank, but Congress didn’t reauthorize it after a few years. Then there was a second bank, but that dissolved as well. It was after that when banking giants began to monopolize the banking system (JP Morgan even intervened in the stock market in 1907 or so to prevent a collapse).

So, where are we today?

Well, over the years the Fed has developed its role, and been given a bit more power. After all, people in America are skeptical of power, and, with the Reserve being the new kid on the block, it had to earn its reputation — which really became central with Greenspan. Over time, the Reserve was given a more prominent role after the Depression, and, most recently, it was given slightly more power to oversee Wall Street (following 2008).

Does this ensure a stable American economy? Not at all. But does it reduce the likelihood of economic panic and collapse? Yes, because it was developed to moderate between economic panic and prosperity.

… Alright you quick-witted political cats out there, this was laying some groundwork for some more economic-oriented articles, I’m kind of thinking. … We’ll see how interested in economics I get.

In the future, be on the lookout for more stuff like this — or really just more stuff in general, because you reading makes me happy, and when I’m happy, then I feel accomplished.

Also, be on the lookout for what the Fed does soon, because supposedly the Reserve will be upping interest rates from near 0 for the first time in a few years.

OUT!

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