The Federal Reserve System was established on December 23, 1913, almost 100 years ago. It is the central banking system of the largest economy in the world. Its three aims when assembled where to create maximum employment, stable prices, and moderate long-term interest rates. Yet with almost a century of experience, immense resources, and some of the smartest economic minds on the planet, how could the Federal Reserve be blind to the looming recession? The focus of this paper is to explore the role of the Federal Reserve leading up to the Housing Crisis. The paper will begin with the history of the Fed, then explain how it functions, interpret the actions of the Federal Reserve leading up to the crisis, and finally evaluate the ethical implications of the case. My goal is to prove that the Federal Reserve was a main, if not the biggest, contributor to the housing bubble.
“Highly aggressive monetary policy ease was doutless also a significant contributor to stability” –Alan Greenspan, 20041
A Brief History:
The Federal Reserve was formed in reponse to an extremely volitle economy that led to a series of financial panics in the late 1800s and early 1900s. Officially it was created in order to “provide the nation with a safer, more flexible, and more stable monetary and financial system.”2 As mentioned before, its three objectives were to maximize employment, create stable proces, and moderate long-term interest rates. Two ideas were proposed in order to create this new banking system. The first was the Aldrich Plan, coming from the Republicans, which called for a board of private bankers to control the Federal Reserve system. This plan held little public support as it gave far too much power to the bankers. The second was the Glass-Willis Proposal which broke the federal reserve into twenty branches that were privately controlled. Woodrow Wilson, still the President-elect at the time, added his own twist on this proposal calling for the creation of a central board of directors made up of public officials. Wilson’s reasoning behind this centralized board of officials was “so that the banks may be the instruments, not the masters, of business and of individual enterprise and initiative.”3 This bill was attacked from both sides; the bankers claiming it gave too much power to the government, and the progressives claiming it gave the government too little authority. Wilson, with a democratic Congress, pushed through the Federal Reserve Act of 1913 which created twelve privately-held regional reserve banks and a central board of officials appointed by the President and approved by the Senate.2
“As the nation’s central bank, the Federal Reserve seeks to promote general financial stability and to help ensure that financial markets function in an orderly manner.” –Ben Bernanke, 20079
How the Fed Functions:
The Federal Reserve is a topic of great discussion and controversy, yet much of the public does not know how it works. There are twelve privately-held regional reserve banks and one central board that coordinates and oversees these branches. Every nationally chartered bank must be a member of the Federal Reserve, while each locally chartered bank is given the option to join or not. To be a member, a bank must buy shares of the region’s reserve bank which it is located in and hold a certain amount of money in that reserve bank. In return, the bank will receive a dividend from the shares of the reserve bank, and, more importantly, the bank can borrow money from the reserve bank in times of low liquidity. The central board decides what the interest rate, called the discount rate, is set to for a bank to borrow money from a reserve bank13, and also sets the federal funds rate which is the rate at which banks can borrow money from other banks. Here is where the controversy arises.
The central board can pass down policy to these regional banks in the form of setting the federal funds rate and the discount rate. The lower this rate is set to, the cheaper it is for the depository institutions to borrow money from the reserve bank and eachother. Because it is cheaper to borrow, these depository banks will then loan the money out at cheaper rates. Historically banks will set their interest rates at apporximately 4 or 5 points higher than the federal funds rate, the rate at which the bank is borrowing that money. In turn, consumers will be able to borrow more cheaply and it creates an incentive to borrow and spend more as interest rates are low. Central banks often lower interest rates in order to stimulate the economy during a financial crisis or economic downturn. In theory, they then raise the rates to more moderate levels when the economy begins to recover14.
The effects of lowering and raising the federal funds rate are fairly simple. Lowering rates usually creates more incentives for businesses and consumers to invest and spend. This stimulates the economy but can lead to inflation. If more people are purchasing goods, there is more demand for those goods and therefore prices can potentially rise. Conversley, raising rates causes consumers to borrow less because it is more expensive to pay those loans back. Consumers therefore spend less which can cause a slowing of the economy and deflationary pressure. If less people are purchasing goods, demand is lower and prices can potentially fall. Though these effects seem very simple on paper, in an advanced economy that contains many variables, the effects are complicated and often lag far behind the policy changes.
“America had not experienced a broad financial crisis since the Great Depression. A true financial crisis differs from falling stock prices, which are common. A financial crisis involves the failure of banks or other institutions, panic in many markets and a pervasive loss of wealth and confidence.” -Robert J. Samuelson8
Monetary Policy in the Early 2000s
The federal funds rate sat just above 6% at the end of 2000. But by the end of 2001 the rate was below 2% and stayed below 2% until mid-2004. The Federal Reserve then increased the rate over the next two years until it was just above 5% in mid-2006. The graph to the right shows the actual federal funds rate from 2000-2007, as compared to the Taylor rule’s suggested rate. The Taylor rule, named after its creator Standford professor John Taylor, is a guideline for interest rate manipulation based on inflation and employment levels.4 The Taylor rule was first intorduced in 1993 and was fairly consistent with monetary policy decisions until the early 2000s.
There are three primary reasons why the Fed decided to lower interest rates when they did. First, the Dot-com bubble had just begun to burst in early 2000 causing the stock market, mainly the NASDAQ exchange, to suffer. Secondly, the terrorist attacks of September 11, 2001 led to a great deal of fear in the market. To combat these two problems, the Fed hoped the lowering of the interest rate would incentivize people to spend money rather than save, as is expected when there is uncertainty in the markets. The final issue was Japan, specifically Japan from 1991 until 2000. In the 1980s, Japan had created a massive asset bubble. When the Japanese central bank raised interest rates to combat this problem, the bubble burst and a period of deflation and nonexistant economic growth commenced. Most refer to this time as Japan’s “Lost Decade”, though it has continued into the new milenia. With Japan fresh in the Federal Reserve’s thoughts, a recently burst Dot-com bubble, and a terrorist induced fear in the markets, the Fed chose to lower the federal funds rate.
Lowering the federal funds rate in the first place is largely seen as an expected and a correct action to take in order to stimulate the economy. However it is peculiar why the Fed kepts the rate so extremely low for such a long period of time, especially after all data pointed towards a fast recovery. For example, as we can see from the data to the right from the Department of Commerce5, the United States gross domestic product was growing at extremely high rates. In fact third quarter growth in 2003 was the largest GDP growth since the 1980s. President Bush convinced the public that spending was patriotic and consumer spending was leading the growth in GDP6. Finally, from 2004-2008 CPI inflation averaged 3.2%, far above the 2% target rate that is commonly seen from the Fed7.
With high GDP growth, soaring consumer spending, and no threat from deflation, why did the Fed not raise their rates? There is no one true answer to this question. In John Taylor’s words, “there was no greater or more persistent deviation of actual Fed policy since the turbulent days of the 1970s.”7 Alan Greenspan, the Federal Reserve chairman at the time, claimed that deflationary risks were too great to ignore. Greenspan also claimed that “the prescriptions of formal rules can serve as helpful adjuncts to policy…but at crucial points, simple rules will be inadequate as either descriptions or prescriptions for policy.”1 Whatever the reason, the connection is clear. With rates being held unreasonably low for well over 36 months, the economy overheated. Consumer spending sped to a frenzy, the economy grew at an unfounded pace, and the cheap flow of credit found its way to the real estate market. As the housing bubble grew into a monstrous size, the Fed raised interest rates and the unstable bubble burst.
“The classic explanation of financial crisis, going back hundreds of years, is that they are caused by excesses—frequently monetary excesses—which lead to a boom and an inevitable bust.” -John Taylor7
The ethical questions concerning the Fed of this past decade are largely dealing with their response to the crisis. Should the bailouts have occurred, when should the federal funds rate be raised again, etc. It is much harder to find specific ethical arguments dealing with the Fed’s monetary policy before the crisis, so my sources are somewhat less specific than I had hoped for.
To begin, it must be said that the ethical implications of any Fed action are immense. We live in a hugely connected world, therefore if the central bank of the largest economy in the world decides to lower or raise interest rates there will be a ripple effect touching every nation. That being said, I would argue that most believe the Federal Reserve Board takes this responsiblility extremely seriously and is wholly uncorruptable. No matter if you agree or disagree with the Fed’s past and present actions, the Board members of the Fed are acting in the way that they believe will create stabile growth for the good of the country. They use incredible amounts of data, hire hundreds of analysts, and work fairly hard to help the economy grow. As a result, if one was to gauge the ethics of the Fed’s actions before the crisis, it would satisfy Aristotle’s virtue ethics guideline to “act well” and Kant’s deontological ethics guideline to “do your duty”. The Fed’s actions are not as justifiable to the utilitarian school of thought because, as my paper argues, they did more harm than good.
Taking a step back, we can look at the Federal Reserve system on a broad basis and ask if this idea of allowing an organization to control the value of money ethical. The alternative would be to peg the dollar to gold as we had done on the Bretton Woods system from 1945-1971. The Austrian economist Jorg Hulsmann claims that “there is no tenable economic, legal, moral, or spiritual rationale that could be adduced in justification of paper money and fractional-reserve banking…[Money production] provides illicit incomes, encourages irresponsibility and dependence, stimulates the artificial centralization of political and economic decision-making, and constantly creates fundamental disequilibria that threaten the life and welfare of millions of people.”10 This topic however, should perhaps best be left for a separate paper.
“It is well enough that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning” –Henry Ford12
Conclusions and What’s Next?
The Federal Reserve is fairly innocent of any moral faults in its actions, but should be judged on its failure to interpret the economic situation of the early 2000s. My prescription would be to appoint a Fed chairman who interfered far less than Alan Greenspan did before the crisis and Ben Bernanke continues to do after the crisis. Unfortunately with current vice chairman Janet Yellen as the favorite to be picked as the next chairman after Bernanke in 201411, it appears the Fed will take an even more interventionist policy in the US economy.
Bonus Ron Paul Rant about the Fed:
1. Greenspan, Alan. “Risk and Uncertainty in Monetary Policy.” JSTOR. American Economic Association, Jan. 2004. Web. 26 Mar. 2013. <http://www.jstor.org/stable/10.2307/3592853>.
2. “Recent Developments.” Board of Governors of the Federal Reserve System. N.p., n.d. Web. 08 Apr. 2013.
3. Wilson, Woodrow. “Senate Document 23.” The Federal Reserve Act of 1913. House Floor, Washington D.C. 1913. Address.
4. “Taylors Rule.” Taylor’s Rule Definition. Investopedia, n.d. Web. 06 Apr. 2013.
5. Gongloff, Mark. “U.S. GDP Growth Revised Higher in Fourth Quarter.” CNNMoney. Cable News Network, 27 Feb. 2004. Web. 06 Apr. 2013. <http://money.cnn.com/2004/02/27/news/economy/gdp/>.
6. “U.S. Economy Posts Strongest Growth in Nearly 20 Years.” CNNMoney. Cable News Network, 30 Oct. 2003. Web. 08 Apr. 2013. <http://money.cnn.com/2003/10/30/news/economy/gdp/>.
7. Taylor, John B. “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong.” National Bureau of Economic Research. NBER Working Paper Series, Jan. 2009. Web. Mar. 2013. <http://www.nber.org/papers/w14631.pdf>.
8. Samuelson, Robert. “Why the Federal Reserve Slept before the Housing Crisis.” Washington Post. N.p., 22 Jan. 2012. Web. 08 Apr. 2013. <http://articles.washingtonpost.com/2012-01-22/opinions/35440126_1_financial-crisis-fomc-members-governor-susan-bies>.
9. Bernanke, Ben. “Speech.” FRB: Bernanke, Housing, Housing Finance, and Monetary Policy. FRB of Kansas City, 31 Aug. 2007. Web. 08 Apr. 2013. <http://www.c.federalreserve.gov/newsevents/speech/bernanke20070831a.htm>.
10. Hulsmann, Jorg G. The Ethics of Money Production. Auburn: Ludwig Von Mises Institute, 2008.
11. Cassidy, John. “Janet Yellen: A Keynesian Woman at the Fed.” The New Yorker. N.p., 3 Apr. 2013. Web. 06 Apr. 2013. <http://www.newyorker.com/online/blogs/johncassidy/2013/04/janet-yellen-ben-bernanke-federal-reserve-next-chair.html>.
12. Ford, Henry. BrainyQuote. Xplore, n.d. Web. 06 Apr. 2013. <http://www.brainyquote.com/quotes/quotes/h/henryford136294.html>.
13. Amadeo, Kimberly. “The Federal Reserve System and Its Function.” About.com US Economy. N.p., n.d. Web. 05 Apr. 2013. <http://useconomy.about.com/od/governmentagencies/p/fed.htm>.
14. Amadeo, Kimberly. “The Federal Funds Rate and How It Works.” About.com US Economy. N.p., 24 Jan. 2012. Web. 08 Apr. 2013. <http://useconomy.about.com/od/monetarypolicy/a/fed_funds_rate.htm>.