The Federal Reserve is a Necessary Evil

Recently, Janet Yellen, the Federal Reserve Chairwoman, testified to the House Financial Services Committee.  In the process, she made some minor headlines by quibbling with Republicans on the Fed’s performance.

Without a doubt, many of my fellow classical liberals greeted these headlines with disdain over the fact that the Federal Reserve exists at all. And I don’t blame them. The reasoning behind the “end the fed” movement is well founded.

But I believe ending the fed would be a misguided policy given our current situation.

To demonstrate why, there is an interesting data trend that is relevant to the “end the fed” debate and should cause everyone to worry. This trend is the rapid expansion of the monetary base since 2008.

Following the 2008 recession and Obama’s election, the Federal Reserve has employed a policy of easy money, which allows lenders to obtain capital quickly. This flood of capital has been supported by the Fed’s long-time policies of Quantitative Easing (QE).

Most signs show that QE policies have failed. But that’s not all. Alongside QE, the Federal Reserve has begun paying interest on reserves held by banks. This policy is one which America has never seen before and its effects have yet to fully take hold. It is the combination of the two that is particularly troubling.

 

Thomson Reuters Datastream /BB

 

The graph above shows the grave symptoms of simultaneously paying interest on reserves as QE. First, banks receive easy money from the Fed and hold it in reserve. At the same time, they are receiving interest from these same reserves. It’s easy, guaranteed money.

Currently, the interest rate on held reserves is higher than most rates banks would receive from moving that money around in the market. The blue line in the graph shows the US monetary base, the orange line shows the S&P 500, used here as a proxy for the money supply. Typically, economies show what is known as the “money multiplier.” This multiplier is shown by the distance between the orange and blue lines. As funds enter the monetary base through the banks, they are loaned out into the economy. The multiplier is higher during a boom, when banks are most likely to hand out loans as confidence in returns are high, and lower during a bust, when banks are trying to hold onto as much money as possible in order to prevent the possibility of a bank run. The multiplier shown after 2008 on the graph above would amount to approximately 1, while under normal circumstances it is much higher than that.

The current picture – in which the monetary base is larger than the money supply – has never before been seen in the modern banking era, and it poses a massive problem.

Typically the monetary base acts as the short end of a trapezoid, expanding outwards into the money supply. For the first time this trapezoid has been flipped on its head, with the monetary base larger than the money supply. The only thing keeping the monetary base from exploding outwards is the Federal Reserve’s interest payments on excess reserves.

If the Federal Reserve were to stop paying interest today on those funds, banks would be incentivized to loan out as much of those excess reserves as possible, which would cause massive inflation instantaneously.

As a classical liberal, I have some major qualms with the existence of the Federal Reserve which are best reserved for another day. However, this graph alone shows why it shouldn’t be abolished. Its existence keeps those funds from entering the economy and incurring mass inflation. Hopefully the Federal Reserve will realize their mistakes and find ways of bleeding that money out of the monetary base, a sort of reverse-QE.

Yes, it is true that if the Fed were abolished today, America would find its way back onto its feet. but the blow dealt by instant abolition would be magnitudes larger than if we first found a way to reduce the monetary base.

Luke Robson

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