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A World Without the Federal Reserve

The Federal Reserve is, without a doubt, one of the most controversial entities in the world. This is always a strange notion for me because, at its most basic level, the Federal Reserve is actually a very boring entity. It is, for all practical purposes, just a big clearinghouse where banks have deposits that they settle among one another for the purpose of interbank payments.  All the stuff that the Fed gets attention for (like QE and setting interest rates) is a side story to what the Fed primarily does – help banks settle payments all day every day.

Anyway, I often hear complaints about the Fed and see people say that the Fed should be abolished. But let’s think about that for one second and try to be, oh, pragmatic about this. If the Fed didn’t exist then we’d essentially revert back to the old private clearing system we had before the Fed existed. For instance, the New York Clearinghouse was established in 1853 as the dominant clearinghouse for interbank payments.  In the 60 years between 1853-1913 when the Fed was created the US experienced TEN different banking panics. It was an unstable system because it was comprised of private entities who would lock up during panics. Similar to 2008, the private banks would stop doing business with one another for fear of counterparty risk. The private clearinghouses improved the system by creating joint liabilities, but this did not halt the panics.

The Federal Reserve was created to stem the panics. In the 102 year period from 1913-2015 the USA experienced just 4 banking crises (the Great Depression, S&L crisis, LTCM crisis and the Great Recession). In essence, the Fed is used to leverage the powers of the government to support the banks and the broader economy. In doing so the Fed could step in and support the banking system at a time when no other entity would be willing to do so. This would allow payments to continue settling and halt contagion from the banking system into the broader economy.  So, reverting back to a system without the Fed wouldn’t achieve much. It would simply bring back the old clearing system which would very likely result in broader financial panics which would inevitably require taxpayer assistance because the payments system is such an integral piece of everyday life.

What about interest rates? We constantly hear that interest rates are being “manipulated” by the Fed. I guess this is true. The Fed is setting interest rates in a manner in which it so chooses. But the Fed just sets the overnight rate. So, if the Fed didn’t exist then the overnight rate would be set by the banking system. It would resemble something like the LIBOR system where bankers set the overnight interest rate. But we all know about the LIBOR scandal in recent years. So again, letting private banks manage the interest rate system doesn’t seem like a much better alternative.

Basically, the Fed is a necessary evil in a world where the payment system is run by private banks. This hybrid public/private clearing system is superior to having a totally private clearing system. History has shown us the flaws in allowing the payment system to be run in an entirely private fashion. So it makes sense to leverage the government in such a crucial part of the financial system. Yes, it’s hardly perfect. I’ve had my own complaints about monetary policy and the Fed. But when you understand the history of banking and the inherent structure of our banking system it becomes quite clear that the Fed might not be as evil as some make it out to be. In fact, we might all be much worse off without it.