Pragmatic Capitalism

Practical Views on Money, Finance & Life

Common Myths About the Federal Reserve

Few institutions invoke more emotion and mythology than global central banks.  And the Federal Reserve, being the central bank in the world’s largest economy, happens to garner a special amount of attention.  Unfortunately, not all of this attention is warranted and much of the understanding about this institution is misleading or incorrect.  This page will clarify some of the myths and misunderstandings about the Fed.

Myth #1 – The Fed Controls the Money Supply. 

This nefarious myth results from decades of bad economic theory and academic misunderstanding of how banking works. The story usually says that the Fed sets a quantity of reserves and banks then multiply those reserves into loans meaning that the Fed has a direct control over the quantity of money being created. But the financial crisis proved that this theoretical view is precisely backwards. In fact, banks make loans first and find reserves after the fact. In other words, the Fed accommodates the quantity of loans by supplying the necessary quantity of reserves. As a result, the money multiplier that we all learn in school is wrong and the Fed has no direct control over the quantity of loans/deposits issued meaning that the predominant form of money (deposits) is controlled almost entirely by private banks and not the Central Bank.

See also, “Where Does Money Come From?“, “The Basics of Banking” and “The Myth of the Money Multiplier

Myth #2 – We Should “End the Fed”

In recent years there have been numerous calls to “end the Fed”. This is usually based on the idea that the Fed manipulates the private sector economy and distorts what should be the “real” price of goods, services and financial assets. These concerns are not unwarranted entirely, however, we really wouldn’t want to end the Fed.

At its most basic level, the Federal Reserve (and all Central Banks) is just a clearinghouse. This means they operate a very simple purpose of helping banks settle interbank payments daily. This is a service that can be handled more efficiently by private banks in 99% of instances, however, we have this interbank clearinghouse for the 1% of the time when the market becomes dysfunctional. That is, during financial panics a private clearinghouse will generally fail and exacerbate how deep a recession will be as problems filter from the banking system into other parts of the economy simply because the average business can’t settle a payment.

Prior to the creation of the Fed we saw numerous instances where garden variety recessions turned into depressions because the banking system would fail. This was due, in large part, to the failure of private clearinghouses that would shut down during panics. This is because private entities, being concerned about solvency and profitability, would often shut down their payment clearing service to other banks they didn’t trust. This was essentially what started to transpire in 2008 when big banks wouldn’t clear payments with other big banks. But the Fed created a market in overnight loans thereby skirting this worry. In other words, we created an entity that could leverage the powers of the government to keep the payment system open even during periods when private entities wouldn’t operate.

At its most basic level a Central Bank is a clearinghouse before all else. This is a very practical and useful service as it insures against the private banking system from shutting down during financial panics. This doesn’t mean there aren’t reasonable arguments against some of the Fed’s other interventions in the interest rate market or policies like Quantitative Easing, however, ending the Fed would take us back to the days of private clearinghouses and we know, based on our turbulent history, that this is a design that doesn’t function very well when we most need our banking system to operate smoothly.

Myth #3 – The Fed is a “public” or “private” institution.  

There’s a tendency to imply that the Fed is either a public or private institution depending on your politics.  Some people tell fantastic stories about how the Fed was formed by a secret cabal of bankers designed only to serve the banks.  Some others tell stories about how the Fed is purely a part of the US government and serves only a public role.  Neither story is a balanced perspective of the reality of the Fed’s role in the monetary system.

When we start to discuss the Fed, it helps to understand why the Fed even exists in the first place.  During the late 1800’s and early 1900’s the US financial system underwent a series of financial panics that crippled the private banking system for long stretches at a time and led to much deeper recessions than necessary.  The health of the US monetary system was largely tied to the health of individual banks as there was no national currency and bank notes were not only unstable (due to excessive lending, near zero regulation and counterfeiting), but were also susceptible to bank runs.

The National Banking Acts of 1863 & 1864 resolved many of these issues (including the national currency and regulatory issues), but did little to improve the liquidity problems that could arise during a crisis.  Some central clearinghouses arose in the late 1800’s, but they were not broad enough to span the scope of the nation’s growing banking system.  In 1907, the US suffered its largest banking crisis as the entire US banking system seized up.  The lack of a central clearinghouse made it impossible to trust other banks.  The crisis only ended when JP Morgan effectively acted as a central liquidity provider and made a series of enormous loans to the NY banks.  This crisis made it clear that the nation needed a more secture central clearinghouse to oversee and interconnect the national banking system.

In 1913 the US Congress passed the Federal Reserve Act of 1913 thereby establishing the nation’s central bank.  This established the Federal Reserve System which established a nationwide central clearing system for the nation’s banking system.   The system is comprised of both public and private components.

The Board of Governors is the national component of the Fed System.  The Board of Governors establishes monetary policy, exercises regulatory control over the financial services industry and oversees the nation’s payments system.    The Fed System is also comprised of 12 regional Reserve Banks which are owned by member banks, private banks.  The regional bank offer services as “banks for bankers”.

Although these regional banks are owned by the private banks, the ownership structure actually affords the private banks only marginal control over the regional bank.  For instance, shares of stock in the regional Fed banks cannot be sold, entitle the banks to just a 6% dividend and do not give the member banks full control of determining Fed leadership.  Member banks elect 6 of the 9 Directors of Regional Banks to manage daily operations of the banks.   Of these Directors, Class A Directors are elected by member banks to “represent the stockholding banks”.  Class B Directors are elected by member banks, but represent the public.  And Class C Directors are appointed by the Federal Reserve Board to represent the public.   And the 7 members of the Board of Governors is appointed by the President of the US.

The Federal Reserve System is often viewed as being conflicted because it serves two masters.  It enacts all of its policies through the banking system, but has a public purpose serving dual mandate to help achieve maximum employment and price stability.  Of course, it cannot achieve its dual mandate if the banking system is not healthy so the Fed often serves as lender of last resort and an aid to private banks.  If this appears like a conflict of interest you’re probably not entirely wrong to assume so.  The Fed serves private banks as well as the public.

Because of this public/private design the Fed has sometimes been referred to as a “hybrid” system.   It is neither a purely public serving institution nor private serving institution and while components of it are owned by the member banks, the system as a whole is not technically owned entirely by anyone in particular.   There’s no need to think of the Fed as a purely public or private institution.  It serves both the public as well as the private sector and has elements of ownership that make it both a public and private institution.  Those who are selling an extremist “this or that” perspective are usually trying to pitch a political agenda.

Myth # 4 – The Fed is not audited.

The Fed is regularly audited by multiple parties:

“Yes, the Board of Governors, the 12 Federal Reserve Banks, and the Federal Reserve System as a whole are all subject to several levels of audit and review:

In addition, the Reserve Banks are subject to annual examination by the Board. The Board’s financial statements and the combined financial statements for the Reserve Banks are published in the Board’s Annual Report.

See our audit page for more information on all of the above audits and more information on the accounting, financial reporting, and internal controls of the Federal Reserve Board and Federal Reserve Banks.”

Myth #5 – The Fed “Manipulates” Interest Rates

It’s very common to hear that the Federal Reserve “manipulates interest rates”.  This is based on the idea that interest rates would be better “set” if they were controlled by a private market instead of a government entity like a Central Bank.  Unfortunately, this is based on a lack of understanding of banking and central banking.

A Central Bank is little more than a central clearinghouse where payments settle.  Before there were central banks payments between banks were settled at private clearinghouses.  The problem with this arrangement was that banks would stop settling payments during financial panics and this would exacerbate depressions.  A central bank leverages government powers to ensure that this doesn’t happen.  The 2008 financial crisis was a great example of this.  When private banks stopped lending to one another the Fed operated as the “lender of last resort”.  This meant that even though many banks were insolvent mom and pop could still buy necessities via the banking system because most banks didn’t stop operating thanks to the Fed’s backstop.  Had the Fed not lent to firms in need the crisis would have bankrupted even the largest banks and the economy would have certainly entered a substantially more catastrophic crisis.  You literally wouldn’t have been able to buy anything unless you had cash under your mattress.

In order to operate as a central clearinghouse the Fed needs to set an overnight rate at which it lends to banks.  Since the Fed requires most banks to utilize this system the banks naturally try to lend their reserve deposits which puts downward pressure on overnight interest rates.  Therefore, the natural rate of interest on overnight loans is 0% in the Fed Funds market.  This means the Fed actually has to manipulate rates HIGHER from this 0% rate. This is not theoretical, this is simply a mathematical reality of a system with a Fed Funds market in which banks operate within this closed system.

While the overnight rate is important to overnight loans it is not the dominant rate in the economy as is often portrayed in economic textbooks. No, the banking system controls most other rates as a function of creditworthiness. For instance, your mortgage and your credit card rate are more a function of your creditworthiness than anything else. While the overnight rate influences the bank’s ability to earn a profit it is not the overriding factor driving what rate you borrow at.  Additionally, the Fed determines the overnight rate by gauging the health of the economy and the banking system. So it’s better to think of Central Banks as setting overnight rates in response to the economy. And banks set the more important rates (like mortgages and credit card rates) mainly based on demand for their products and the creditworthiness of those using those products.

Side note – of course, we could operate without this central clearinghouse at all.  But we already know how that works.  The panic of 1907 and the 6 depressions in the 1800’s were mainly a function of a flawed clearinghouse system where economic panics turned into banking panics which turned into depressions.  The Fed system helped improve that flaw.  Additionally, we know from the recent LIBOR scandal that private banks are no more reliable at setting interest rates than central banks are.  So, what we have is essentially a system that is the lesser of two evils.

Myth #6 – The Fed exists as result of a conspiracy to create an entity that only serves private banks.

In 1910 a secret meeting was held on Jekyll Island off the coast of Georgia to discuss the potential future of the nation’s central bank, an idea that had been in motion ever since the Panic of 1907.   Attendees included Senator Nelson Aldrich, Frank Vanderlip of National City Bank, Henry Davison of Morgan Bank, and Paul Warburg of the Kuhn, Loeb Investment House.   The plan that came out of this meeting was known as the Aldrich Plan and created a loose structure for the Federal Reserve Act that was passed in 1913.  The original Aldrich Plan, however, was defeated in the House of Representatives in 1910 so if there was a conspiracy to pass the plan in its original form it surely failed.

More importantly, the very creation of the Federal Reserve System increased regulations and national control immensely.  This act was in no way empowering the banks relative to the previous system in which the nation’s banks acted largely independent of federal control.  If anything, the Fed Act clamped down on banking and gave the federal government substantially more control.  If anything, the Federal Reserve Act wrestled some control away from banks and into the hands of the Federal government.

It’s certainly true that the nation’s bankers played an influencing role in developing the Federal Reserve System, but the system was designed not only to strengthen the nation’s banking system, but also to provide the federal government with more central control over it.  The Jekyll Island meeting and the Aldrich Plan played an influencing role in the formation of the Fed, but it is not quite the conspiracy theory to enrich the banks that some people make it out to be.

Myth #7 – The Fed operates against the interests of the US government and costs taxpayers money. 

The Federal Reserve System was created with the intention to provide a central clearinghouse for the nation’s banking system as well as a more coordinated regulatory framework for banking.  This system helps maintain a stable payments system and works in favor of stabilizing the US economy.  Further, the power of monetary policy is designed to give the central bank some policy control over the nation’s money to help achieve its dual mandate of maximum employment and price stability.  As a whole, this is a public good even if it is not always perfectly managed and often gives the appearance of enriching banks.

At times, it is implied that the Fed is a financial burden on the nation, but the Fed does not cost the US taxpayer anything.  The stockholders of the Fed contribute paid in capital and the annual operations of the Fed are maintained by its own income.   In fact, any excess profit the Fed earns is returned to the US taxpayer via the US Treasury (and by law, used to pay down federal debt or buy gold).  In 2012 this income was substantial and amounted to over $90B.  As a whole, the Fed is actually a substantial revenue source that the US government would not otherwise have.

Myth #8 – The Fed is unconstitutional.  

The Federal Reserve Act of 1913 was established via Congress.  But this wasn’t the first time the constitutionality of the nation’s central bank had been tested.  On many occasions the constitutionality of a central bank has been questioned and continually upheld by the Supreme Court:

  • The most famous instance was McCulloch v. Maryland in which the Supreme Court ruled 9-0 that the Second Bank of the United States was constitutional.
  • The case was affirmed in Osborn v. Bank of the United States.   The decision was upheld under the justification that the nation’s central bank provides necessary support in aiding the power to tax, borrowing money and regulating interstate commerce.
  • Nixon v. Individual Head of St. Joseph Mortgage Company upheld Federal Reserve Notes as Legal Tender.

Myth #9 – The Fed is Omnipotent.  

A good deal of mainstream economics is based on the idea that the Fed is an extremely powerful policymaker.  The Financial Crisis has shed a good deal of doubt on this idea as cutting interest rates and huge policies like QE have been relatively ineffectual. This makes sense from an operational perspective since the Fed has a limited set of transmission mechanisms through which it can impact the private sector.

For instance, the Fed is largely just a clearinghouse serving as a bank for the banking system. This means that most of its operations rely on working through the banking system in an indirect route to the private sector economy.  For instance, when the Fed changes interest rates it does so by altering the quantity of reserves or the Interest on Reserves in the banking system.  This directly impacts the balance sheet of banks, but does not have a direct impact on the private sector as most interest rates are not controlled by the Fed and correlate more closely with the state of the real economy.  As a result, the Fed often times can’t induce borrowing with a policy lever.

Furthering this is the fact that banks don’t lend reserves.  Many mainstream economists have assumed over the years that there is a money multiplier between the quantity of reserves and the quantity of loans that are made. This has been proven false over the years as we now know that banks don’t lend out reserves and altering the quantity of reserves has no direct impact on whether or not banks make more loans. The money multiplier we all learn in econ 101 is completely wrong!

The bottom line is that many of the assumptions in mainstream economic models are based on flawed assumptions about the efficacy and operational reality of the Central Bank’s policy impacts.  While Central Banks are certainly not powerless, we should be careful assuming they are more powerful than they really are.

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