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For what purpose was the Fed created?

By Thomas E. Brewton
web posted March 10, 2008

The role of the Federal Reserve has changed enormously, not for the good, since its creation in 1913.

Most people today assume that the Fed's proper function is to manage the economy via monetary policy.

A quotation in the March 8 Wall Street Journal in the "Ahead of the Tape" column reflects that understanding.

"We may be going from bubble to bubble," says Ed Yardeni, chief investment strategist at Yardeni Research. The problem is that the only other choice for the Fed is to do nothing and let the economy fall into a recession.

"The Fed was created to avoid financial crises and get us out of them when they happen, and that's what they're trying to do."

In the same edition, Wall Street Journal reporter Greg Ip writes:

The Federal Reserve, facing constraints on how much it can accomplish with lower short-term interest rates, is increasingly pressing alternative approaches to restore order to credit markets and combat the risk of recession.

On Friday, it fired its latest unconventional salvo, announcing it would pump as much as $200 billion into short-term funding markets through two separate mechanisms to ease strains on banks' funding and on mortgage markets. That followed Chairman Ben Bernanke's call Tuesday that both lenders and the federal government do more to write down the face value of troubled mortgages, forestalling foreclosures and helping stabilize the housing market, and his earlier support of fiscal stimulus.

None of this was envisioned by Congress in 1913. 

Professor Allan H. Meltzer (A History of the Federal Reserve, Volume 1: 1913 - 1951) writes that when Congress passed the Federal Reserve Act in 1913,  the act said little about the broad purposes of the Federal Reserve.  The reason was the sharp differences between partisans and opponents in Congress and the financial community.

Opponents feared that a central bank would be simply a monopoly for the benefit of bankers, chiefly J. P. Morgan and other New York bankers.

Not even the Fed's most ardent supporters imagined that it would be empowered to manage the whole economy.  Professor Meltzer writes that they wanted a central bank that would moderate fluctuations in market interest rates, particularly those caused by seasonal demands for currency and financing crop harvests. 

They also wanted the Fed to facilitate the development of a broad national market in commercial paper and bills of exchange, modeled on the London market.  A major reason was the National Banking Act limitation at that time on the amount of currency to the existing stock of government bonds.

Money center bankers also wanted the Fed to act as lender of last resort to provide temporary credit support to the banks in times of financial panic.  That, however, is a far cry from the Fed's present-day undertaking to prevent economic recession in the national economy.

What brought about the vast expansion of the Fed's mission?

The change was described in "Chickens Are Returning to the Roost". President Roosevelt was advised by his New Deal Brains Trust of socialist economists that centralizing management of the entire economy, for the first time in the history of the United States, would enable the Federal government to restore full employment and raise farm prices.

A main pillar in that new socialistic structure was devaluation of the dollar (see "How FDR Destroyed the Dollar"). 

To accomplish that end, among other things, the President had to bring the Federal Reserve system to heel by limiting the independence of the 12 regional Reserve banks and centralizing power in Washington at the Federal Reserve Board.  By appointing a Federal Reserve Board chairman who thought as he did, President Roosevelt could manipulate the entire banking system.  In 1934 he got his ideal man in Marriner Eccles, who in testimony at a Senate hearing before his appointment, had advocated socialistic economic policies. 

At the end of World War II, the Treasury pressured the Fed to keep interest rates artificially low to minimize the government's interest costs on its ballooning debt.  At that time, economists feared a major recession, which historically had followed major wars, and the Federal government intended to be ready for resumption of the New Deal's fiscal policy of massive, albeit feckless, spending to create full employment.

Recognizing that artificially low interest rates promoted inflation, the Fed protested, but was over-ruled.  Not until 1951, in the middle of the Korean War, was the Fed able to establish independence from the Treasury regarding monetary policy.

In the meantime, the Employment Act of 1946 had committed the Federal government to maintaining full employment.  That Act enshrined John Maynard Keynes’s socialistic economic doctrines as the official policy of the United States.  The Fed was expected to manage the economy via currency manipulation in order to maintain full employment. 

Professor Meltzer wrote that, "Woodlief Thomas, assistant director of research at the [Federal Reserve] Board, read the bill as an attempt to "legislate the Keynes-Eccles-Hansen-Beveridge theory of economic stabilization."  William Beveridge was a chief architect of the British Labour Party's socialization of the British economy after World War II.  Alvin Hansen was a Harvard economics professor, who in the 1930s was known as one of Keynes most fervent advocates in the United States.

Keynesian orthodoxy, which is still the ideology of the Democratic Party, dictates that every economic glitch can be cured by increased Federal spending.  The Fed’s ever-ready response to the spurs of Federal spending has made it an engine of inflation.

Only once, in the early 1980s under President Reagan and Chairman Paul Volcker, has the Fed managed monetary policy to stop inflation.  Otherwise, it has been the handmaiden of limitless expansion of Federal spending and concomitant inflation. ESR

Thomas E. Brewton is a staff writer for the New Media Alliance, Inc. The New Media Alliance is a non-profit (501c3) national coalition of writers, journalists and grass-roots media outlets. His weblog is The View From 1776. Email comments to viewfrom1776@thomasbrewton.com.

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