The Federal Reserve System, commonly known as "the Fed," has faced various criticisms since its establishment in 1913. Critics have questioned its effectiveness in managing inflation, regulating the banking system, and stabilizing the economy. Notable critics include Nobel laureate economist Milton Friedman and his fellow monetarist Anna Schwartz, who argued that the Fed's policies exacerbated the Great Depression. More recently, former Congressman Ron Paul has advocated for the abolition of the Fed and a return to a gold standard.[1]
Critics have also raised concerns about the Fed's role in fractional reserve banking, its contribution to economic cycles, and its transparency. The Fed has been accused of causing economic downturns, including the 2007-2008 financial crisis,[2] and of being influenced by private interests. Despite these criticisms, the Federal Reserve remains a central institution in the United States' financial system, with ongoing debates about its role, policies, and the need for reform.
An early version of the Federal Reserve Act was drafted in 1910 on Jekyll Island, Georgia, by RepublicanSenatorNelson Aldrich, chairman of the National Monetary Commission, and several Wall Street bankers. The final version, with provisions intended to improve public oversight and weaken the influence of the New York banking establishment, was drafted by DemocraticCongressmanCarter Glass of Virginia.[3] The structure of the Fed was a compromise between the desire of the bankers for a central bank under their control and the desire of PresidentWoodrow Wilson to create a decentralized structure under public control.[4] The Federal Reserve Act was approved by Congress and signed by President Wilson in December 1913.[4]
[I]t is undeniable that, ever since the Fed was visited upon us in 1914, our inflations have been more intense, and our depressions far deeper, than ever before. There is only one way to eliminate chronic inflation, as well as the booms and busts brought by that system of inflationary credit: and that is to eliminate the counterfeiting that constitutes and creates that inflation. And the only way to do that is to abolish legalized counterfeiting: that is, to abolish the Federal Reserve System, and return to the gold standard, to a monetary system where a market-produced metal, such as gold, serves as the standard money, and not paper tickets printed by the Federal Reserve.[6]
Effectiveness and policies
The Federal Reserve has been criticized as not meeting its goals of greater stability and low inflation.[7] This has led to a number of proposed changes including advocacy of different policy rules[8] or dramatic restructuring of the system itself.[9]
Milton Friedman concluded that governments do have a role in the monetary system,[10] he was critical of the Federal Reserve due to its poor performance and felt it should be abolished.[11][12] Friedman believed that the Federal Reserve System should ultimately be replaced with a computer program.[9] He favored a system that would automatically buy and sell securities in response to changes in the money supply.[13] This proposal has become known as Friedman's k-percent rule.[14]
Several members of Congress have criticized the Fed. Senator Robert Owen, whose name was on the Glass-Owen Federal Reserve Act, believed that the Fed was not performing as promised. He said:
The Federal Reserve Board was created to control, regulate and stabilize credit in the interest of all people. . . . The Federal Reserve Board is the most gigantic financial power in all the world. Instead of using this great power as the Federal Reserve Act intended that it should, the board . . . delegated this power to the banks.[20][21]
Representative Louis T. McFadden, Chairman of the House Committee on Banking and Currency from 1920 to 1931, accused the Federal Reserve of deliberately causing the Great Depression. In several speeches made shortly after he lost the chairmanship of the committee, McFadden claimed that the Federal Reserve was run by Wall Street banks and their affiliated European banking houses. In one 1932 House speech (that has been criticized as bluster[22]), he stated:
Mr. Chairman, we have in this country one of the most corrupt Institutions the world has ever known. I refer to the Federal Reserve Board and the Federal Reserve banks; . . . This evil institution has impoverished and ruined the people of the United States . . . through the corrupt practices of the moneyed vultures who control it.[23]
Many members of Congress who have been involved in the House and Senate Banking and Currency Committees have been open critics of the Federal Reserve, including Chairmen Wright Patman,[24]Henry Reuss,[25] and Henry B. Gonzalez. Representative Ron Paul, Chairman of the Monetary Policy Subcommittee in 2011, is known as a staunch opponent of the Federal Reserve System.[26] He routinely introduced bills to abolish the Federal Reserve System,[27] three of which gained approval in the House but lost in the Senate.[28]
Congressman Paul also introduced H.R. 459: Federal Reserve Transparency Act of 2011,[29][30] This act required an audit of the Federal Reserve Board and the twelve regional banks, with particular attention to the valuation of its securities. His son, Senator Rand Paul, has introduced similar legislation in subsequent sessions of Congress.[31]
Milton Friedman and Anna Schwartz stated that the Fed pursued an erroneously restrictive monetary policy, exacerbating the Great Depression. After the stock market crash in 1929, the Fed continued its contraction (decrease) of the money supply and refused to save banks that were struggling with bank runs. This mistake, critics charge, allowed what might have been a relatively mild recession to explode into catastrophe. Friedman and Schwartz believed that the depression was "a tragic testimonial to the importance of monetary forces."[32] Before the establishment of the Federal Reserve, the banking system had dealt with periodic crises (such as in the Panic of 1907) by suspending the convertibility of deposits into currency. In 1907, the system nearly collapsed and there was an extraordinary intervention by an ad-hoc coalition assembled by J. P. Morgan. In the years 1910–1913, the bankers demanded a central bank to address this structural weakness. Friedman suggested that a similar intervention should have been followed during the banking panic at the end of 1930. This might have stopped the vicious circle of forced liquidation of assets at depressed prices, just as suspension of convertibility in 1893 and 1907 had quickly ended the liquidity crises at the time.[33]
Essentially, in the monetarist view, the Great Depression was caused by the fall of the money supply. Friedman and Schwartz note that "[f]rom the cyclical peak in August 1929 to a cyclical trough in March 1933, the stock of money fell by over a third."[34] The result was what Friedman calls "The Great Contraction"—a period of falling income, prices, and employment caused by the choking effects of a restricted money supply. The mechanism suggested by Friedman and Schwartz was that people wanted to hold more money than the Federal Reserve was supplying. People thus hoarded money by consuming less. This, in turn, caused a contraction in employment and production, since prices were not flexible enough to immediately fall. Friedman and Schwartz argued the Federal Reserve allowed the money supply to plummet because of ineptitude and poor leadership.[35]
Many have since agreed with this theory, including Ben Bernanke, Chairman of the Federal Reserve from 2006 until 2014, who, in a speech honoring Friedman and Schwartz, said:
Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression, you're right. We did it. We're very sorry. But thanks to you, we won't do it again.[36][37]
Friedman has said that ideally he would prefer to "abolish the Federal Reserve and replace it with a computer."[38] He preferred a system that would increase the money supply at some fixed rate, and he thought that "leaving monetary and banking arrangements to the market would have produced a more satisfactory outcome than was actually achieved through government involvement".[39]
In contrast to Friedman's argument that the Fed did too little to ease after the crisis, Murray Rothbard argued that the crisis was caused by the Fed being too loose in the 1920s in the book America's Great Depression.
Some economists, such as John B. Taylor,[40] have asserted that the Fed was responsible, at least partially, for the United States housing bubble which occurred prior to the 2007 recession. They claim that the Fed kept interest rates too low following the 2001 recession.[41] The housing bubble then led to the credit crunch. Then-Chairman Alan Greenspan disputes this interpretation. He points out that the Fed's control over the long-term interest rates (to which critics refer) is only indirect. The Fed did raise the short-term interest rate over which it has control (i.e., the federal funds rate), but the long-term interest rate (which usually follows the former) did not increase.[42][43]
The Federal Reserve's role as a supervisor and regulator has been criticized as being ineffective. Former U.S. Senator Chris Dodd, then-chairman of the United States Senate Committee on Banking, Housing, and Urban Affairs, remarked about the Fed's role in the 2007-2008 economic crisis, "We saw over the last number of years when they took on consumer protection responsibilities and the regulation of bank holding companies, it was an abysmal failure."
The Federal Reserve does not actually control the money supply directly and has delegated this authority to banks. If a bank has a reserve requirement of 10% and they have 10 million dollars in bank deposits, they can create 100 million dollars to loan out to borrowers, or make other investments if it is an investment bank. It is essentially going on margin 10:1 without having to pay interest on the margin, because it is in effect money that they created themselves. According to this critique, this is the primary cause of credit cycles or business cycles, because money supply creation is not under any single entity's control and is decentralized among many banks that are trying to maximize profits individually.[citation needed] The Federal Reserve indirectly controls this process by manipulating the Federal Funds Rate that sets the tone for interest rates on new debt throughout the economy, and intentionally puts the economy into a recession (hard landing) or slow the economy without a recession (soft landing) to tame inflation.[44]
Republican and Tea Party criticism
During several recent elections,[when?] the Tea Party movement has made the Federal Reserve a major point of attack, which has been picked up by Republican candidates across the country. Former Congressman Ron Paul (R) of Texas and his son Senator Rand Paul (R) of Kentucky have long attacked the Fed, arguing that it is hurting the economy by devaluing the dollar. They argue that its monetary policies cause booms and busts when the Fed creates too much or too little fiat money. Ron Paul's book End the Fed repeatedly points out that the Fed engages in money creation "out of thin air."[45] He argued that interest rates should be set by market forces, not by the Federal Reserve.[46] Paul argues that the booms, bubbles and busts of the business cycle are caused by the Federal Reserve's actions.[47]
In the book, Paul argues that "the government and its banking cartel have together stolen $0.95 of every dollar as they have pursued a relentlessly inflationary policy." David Andolfatto of the Federal Reserve Bank of St. Louis said the statement was "just plain false" and "stupid" while noting that legitimate arguments can be made against the Federal Reserve.[48] University of Oregon economist Mark Thoma described it as an "absurd" statement which data does not support.[49]
Surveys of economists show overwhelming opposition to abolishing the Federal Reserve or undermining its independence.[50][51] According to Princeton University economist Alan S. Blinder, "mountains of empirical evidence support the proposition that greater central bank independence produces not only less inflation but superior macroeconomic performance, e.g., lower and less volatile inflation with no more volatility in output."[51]
Ron Paul's criticism has stemmed from the influence of the Austrian School of Economics.[52] More specifically, economist Murray Rothbard was a vital figure in developing his views. Rothbard attempted to intertwine both political and economic arguments together in order to make a case to abolish the Federal Reserve. When first laying out his critiques, he writes "The Federal Reserve System is accountable to no one; it has no budget; it is subject to no audit; and no Congressional committee knows of...its operations."[53] This argument from Rothbard is outdated, however, as the Federal Reserve presently does report its balance sheet weekly as well as get audited by outside third parties.[54]
Rothbard also heavily critiques the Federal Reserve being independent from politics despite the Federal Reserve being given both private and public qualities.[54] The acknowledgment of the Federal Reserve being a part of government that exists outside of politics inevitably becomes a "self-perpetuating oligarchy, accountable to no one."[53] This ignores the fact that the Federal Reserve Board of Governors is a federal agency, appointed by the president and Senate.
Because the regional Federal Reserve Banks are privately owned, and most of their directors are chosen by their stockholders, it is common to hear assertions that control of the Fed is in the hands of an elite. In particular, it has been rumored that control is in the hands of a very few people holding "class A stock" in the Fed.
As explained, there is no stock in the system, only in each regional Bank. More important, individuals do not own stock in Federal Reserve Banks. The stock is held only by banks who are members of the system. Each bank holds stock proportionate to its capital. Ownership and membership are synonymous. Moreover, there is no such thing as "class A" stock. All stock is the same.
This stock, furthermore, does not carry with it the normal rights and privileges of ownership. Most significantly, member banks, in voting for the directors of the Federal Reserve Banks of which they are a member, do not get voting rights in proportion to the stock they hold. Instead, each member bank regardless of size gets one vote. Concentration of ownership of Federal Reserve Bank stock, therefore, is irrelevant to the issue of control of the system (italics in original).[56]
According to the web site for the Federal Reserve System, the individual Federal Reserve Banks "are the operating arms of the central banking system, and they combine both public and private elements in their makeup and organization."[57] Each of the 12 Banks has a nine-member board of directors: three elected by the commercial banks in the Bank's region, and six chosen – three each by the member banks and the Board of Governors – "to represent the public with due consideration to the interests of agriculture, commerce, industry, services, labor and consumers."[58] These regional banks are in turn controlled by the Federal Reserve Board of Governors, whose seven members are nominated by the president of the United States and confirmed by the Senate.[59]
Member banks ("about 38 percent of the nation's more than 8,000 banks")[60] are required to own capital stock in their regional banks.[60][61] Until 2016, the regional banks paid a set 6% dividend on the member banks' paid-in capital stock (not the regional banks' profits) each year, returning the rest to the US Treasury Department.[62] As of February 24, 2016, member banks with more than $10 billion in assets receive an annual dividend on their paid-in capital stock (Reserve Bank stock) of the lesser of 6% percent and the highest yield of the 10-year Treasury note auctioned at the last auction held prior to the payment of the dividend. Member banks with $10 billion or less in assets continue to be paid a set 6% annual dividend. This change was implemented during the Obama administration in order "to implement the provisions of section 32203 of the Fixing America's Surface Transportation Act (FAST Act)".[63] The Fed has noted that this has created "some confusion about 'ownership'":
[Although] the Reserve Banks issue shares of stock to member banks...owning Reserve Bank stock is quite different from owning stock in a private company. The Reserve Banks are not operated for profit, and ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan….[64]
In his textbook, Monetary Policy and the Financial System, Paul M. Horvitz, the former Director of Research for the Federal Deposit Insurance Corporation, stated,
...the member banks can exert some rights of ownership by electing some members of the Board of Directors of the Federal Reserve Bank [applicable to those member banks]. For all practical purposes, however, member bank ownership of the Federal Reserve System is merely a fiction. The Federal Reserve Banks are not operated for the purpose of earning profits for their stockholders. The Federal Reserve System does earn a profit in the normal course of its operations, but these profits, above the 6% statutory dividend, do not belong to the member banks. All net earnings after expenses and dividends are paid to the Treasury.[65]
In the American Political Science Review, Michael D. Reagan[66] wrote,
...the "ownership" of the Reserve Banks by the commercial banks is symbolic; they do not exercise the proprietary control associated with the concept of ownership nor share, beyond the statutory dividend, in Reserve Bank "profits." ...Bank ownership and election at the base are therefore devoid of substantive significance, despite the superficial appearance of private bank control that the formal arrangement creates.[67][68]
Transparency issues
One critique is that the Federal Open Market Committee, which is part of the Federal Reserve System, lacks transparency and is not sufficiently audited.[69] A report by Bloomberg News asserts that the majority of Americans believes that the System should be held more accountable or that it should be abolished.[70] Another critique is the contention that the public should have a right to know what goes on in the Federal Open Market Committee (FOMC) meetings.[71][72][73]
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of financial panics led to the desire for central control of the monetary system in order to alleviate financial crises. Over the years, events such as the Great Depression in the 1930s and the Great Recession during the 2000s have led to the expansion of the roles and responsibilities of the Federal Reserve System.
Milton Friedman was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the complexity of stabilization policy. With George Stigler, Friedman was among the intellectual leaders of the Chicago school of economics, a neoclassical school of economic thought associated with the work of the faculty at the University of Chicago that rejected Keynesianism in favor of monetarism until the mid-1970s, when it turned to new classical macroeconomics heavily based on the concept of rational expectations. Several students, young professors and academics who were recruited or mentored by Friedman at Chicago went on to become leading economists, including Gary Becker, Robert Fogel, and Robert Lucas Jr.
Monetarism is a school of thought in monetary economics that emphasizes the role of policy-makers in controlling the amount of money in circulation. It gained prominence in the 1970s but was mostly abandoned as a direct guidance to monetary policy during the following decade because of the rise of inflation targeting through movements of the official interest rate.
The Specie Payment Resumption Act of January 14, 1875 was a law in the United States that restored the nation to the gold standard through the redemption of previously unbacked United States Notes and reversed inflationary government policies promoted directly after the American Civil War. The decision further contracted the nation's money supply and was seen by critics as an exacerbating factor of the so-called Long Depression, which struck in 1873.
The Federal Reserve Act was passed by the 63rd United States Congress and signed into law by President Woodrow Wilson on December 23, 1913. The law created the Federal Reserve System, the central banking system of the United States.
The monetary policy of the United States is the set of policies which the Federal Reserve follows to achieve its twin objectives of high employment and stable inflation.
In macroeconomics, money supply refers to the total volume of money held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circulation and demand deposits. Money supply data is recorded and published, usually by the national statistical agency or the central bank of the country. Empirical money supply measures are usually named M1, M2, M3, etc., according to how wide a definition of money they embrace. The precise definitions vary from country to country, in part depending on national financial institutional traditions.
The causes of the Great Depression in the early 20th century in the United States have been extensively discussed by economists and remain a matter of active debate. They are part of the larger debate about economic crises and recessions. The specific economic events that took place during the Great Depression are well established.
The quantity theory of money is a hypothesis within monetary economics which states that the general price level of goods and services is directly proportional to the amount of money in circulation, and that the causality runs from money to prices. This implies that the theory potentially explains inflation. It originated in the 16th century and has been proclaimed the oldest surviving theory in economics.
The Great Contraction, as characterized by economist Milton Friedman, was the recessionary period from 1929 until 1933, i.e., the early years of the Great Depression. The phrase was the title of a chapter in the 1963 book A Monetary History of the United States by Friedman and his fellow monetarist Anna Schwartz. The chapter was later published as a stand-alone book titled The Great Contraction, 1929–1933 in 1965. Both books are still in print from Princeton University Press, and some editions include as an appendix a speech honoring Friedman in which Federal Reserve Governor Ben Bernanke made this statement:
Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression, you're right. We did it. We're very sorry. But thanks to you, we won't do it again. — Ben S. Bernanke
This history of central banking in the United States encompasses various bank regulations, from early wildcat banking practices through the present Federal Reserve System.
The United States Gold Reserve Act of January 30, 1934 required that all gold and gold certificates held by the Federal Reserve be surrendered and vested in the sole title of the United States Department of the Treasury. It also prohibited the Treasury and financial institutions from redeeming dollar bills for gold, established the Exchange Stabilization Fund under control of the Treasury to control the dollar's value without the assistance of the Federal Reserve, and authorized the president to establish the gold value of the dollar by proclamation.
Ben Shalom Bernanke is an American economist who served as the 14th chairman of the Federal Reserve from 2006 to 2014. After leaving the Federal Reserve, he was appointed a distinguished fellow at the Brookings Institution. During his tenure as chairman, Bernanke oversaw the Federal Reserve's response to the 2007–2008 financial crisis, for which he was named the 2009 Time Person of the Year. Before becoming Federal Reserve chairman, Bernanke was a tenured professor at Princeton University and chaired the Department of Economics there from 1996 to September 2002, when he went on public service leave. Bernanke was awarded the 2022 Nobel Memorial Prize in Economic Sciences, jointly with Douglas Diamond and Philip H. Dybvig, "for research on banks and financial crises", more specifically for his analysis of the Great Depression.
The Austrian business cycle theory (ABCT) is an economic theory developed by the Austrian School of economics seeking to explain how business cycles occur. The theory views business cycles as the consequence of excessive growth in bank credit due to artificially low interest rates set by a central bank or fractional reserve banks. The Austrian business cycle theory originated in the work of Austrian School economists Ludwig von Mises and Friedrich Hayek. Hayek won the Nobel Prize in Economics in 1974 in part for his work on this theory.
Anna Jacobson Schwartz was an American economist who worked at the National Bureau of Economic Research in New York City and a writer for The New York Times. Paul Krugman has said that Schwartz is "one of the world's greatest monetary scholars."
A Monetary History of the United States, 1867–1960 is a book written in 1963 by future Nobel Prize-winning economist Milton Friedman and Anna Schwartz. It uses historical time series and economic analysis to argue the then-novel proposition that changes in the money supply profoundly influenced the United States economy, especially the behavior of economic fluctuations. The implication they draw is that changes in the money supply had unintended adverse effects, and that sound monetary policy is necessary for economic stability. Orthodox economic historians see it as one of the most influential economics books of the century. The chapter dealing with the causes of the Great Depression was published as a standalone book titled The Great Contraction, 1929–1933.
Benjamin Strong Jr. was an American banker. He served as Governor of the Federal Reserve Bank of New York for 14 years until his death. He exerted great influence over the policy and actions of the entire Federal Reserve System and indeed over the financial policies of all of the United States and Europe.
Market monetarism is a school of macroeconomics that advocates that central banks use a nominal GDP level target instead of inflation, unemployment, or other measures of economic activity, with the goal of mitigating demand shocks such those experienced in the 2007–2008 financial crisis and during the post-pandemic inflation surge. Market monetarists criticize the fallacy that low interest rates always correspond to easy money. Market monetarists are sceptical about fiscal stimulus, noting that it is usually offset by monetary policy.
A Program for Monetary Stability is a book by the US economist Milton Friedman. It has been published by Fordham University Press in 1960 with consecutive re-prints appearing in 1961, 1963, 1965, 1969, 1970, 1975, and 1980. In the Prefatory Note Friedman states that the book is a revised and expanded version of the third of the Moorhouse I. X. Millar Lecture Series, which he gave at Fordham University in October 1959. At the same time, he claims that the book has resulted from the joint research with Anna Schwartz under the NBER project.
The real bills doctrine says that as long as bankers lend to businessmen only against the security (collateral) of short-term 30-, 60-, or 90-day commercial paper representing claims to real goods in the process of production, the loans will be just sufficient to finance the production of goods. The doctrine seeks to have real output determine its own means of purchase without affecting prices. Under the real bills doctrine, there is only one policy role for the central bank: lending commercial banks the necessary reserves against real customer bills, which the banks offer as collateral. The term "real bills doctrine" was coined by Lloyd Mints in his 1945 book, A History of Banking Theory. The doctrine was previously known as "the commercial loan theory of banking".
↑ Friedman, M. (1996). The Counter-Revolution in Monetary Theory. In Explorations in Economic Liberalism (pp. 3-21). Palgrave Macmillan, London. "It is precisely this leeway, this looseness in the relation, this lack of a mechanical one-to-one correspondence between changes in money and in income that is the primary reason why I have long favored for the USA a quasi-automatic monetary policy under which the quantity of money would grow at a steady rate of 4 or 5 per cent per year, month-in, month-out."
↑ Salter, A. W. (2014). An Introduction to Monetary Policy Rules. Mercatus Workıng Paper. George Mason University.
↑ Reagan, Michael D. (March 1961). "The Political Structure of the Federal Reserve System". American Political Science Review. 55 (1): 64–76. doi:10.2307/1976050. JSTOR1976050. S2CID147189298.
↑ Mittra, S. (1970). Money and Banking: Theory, Analysis, and Policy. New York: Random House. p.153.
↑ Poole, William (6 October 2004). "FOMC Transparency"(PDF). Federal Reserve Bank of St. Louis Review. 87. Federal Reserve Bank of St. Louis: 1–9. Archived(PDF) from the original on 30 December 2014. Retrieved 30 December 2014.
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