Why the Federal Reserve Controls So Much of the Economy | WSJ

Summary

The Federal Reserve, often misunderstood, plays a pivotal role in the US economy. Established in 1913 to stabilize the banking system and prevent bank runs, it has evolved to manage currency circulation and act as a lender of last resort. The Fed's structure, comprising 12 regional banks and a Board of Governors, was designed to distribute power and avoid concentration in one entity. The Great Depression highlighted the need for a centralized authority, leading to the Board's establishment in 1935. The 1970s saw the Fed given a dual mandate to maintain stable prices and maximum employment, leading to politically independent decision-making. The 2008 financial crisis and the COVID-19 pandemic further showcased the Fed's flexibility and willingness to innovate to stabilize the economy, including unprecedented measures like near-zero interest rates and expanded lending. Despite criticism for its power and the unelected nature of its leadership, the Fed remains a crucial institution in the US financial system, acting as an economy chaperone that steps in during times of crisis.

Takeaways

• 🏛️ The Federal Reserve (Fed) is the central banking system of the United States, responsible for distributing and managing the currency in circulation.
• 💵 The Fed has the power to 'print money', which became a popular topic with the 2020 meme 'Money printer go brr', reflecting its role in creating money.
• 📉 The Fed is often seen as the 'economy chaperone', sometimes making unpopular decisions like raising interest rates to maintain economic stability.
• 🏦 The Fed was created in response to financial crises and bank runs in the early 1900s, aiming to provide a more stable banking system.
• 🔄 After the Great Depression, the Fed was restructured in 1935 with a Board of Governors to centralize power and prevent future economic catastrophes.
• 🎓 The Fed's dual mandate, established in 1978, is to focus on stable prices and maximum employment, sometimes requiring trade-offs between the two objectives.
• 📈 High inflation in the 1970s led to political independence for the Fed, which was seen as crucial for better economic outcomes.
• 📊 Paul Volcker's tenure as Fed Chairman in the late 1970s involved raising interest rates significantly, which was unpopular but eventually credited with controlling inflation.
• 🏗️ The 2008 financial crisis saw the Fed take bold, unprecedented measures, including near-zero interest rates and expanding its role in the financial system.
• 📉 The Fed's response to the COVID-19 pandemic mirrored its actions during the Great Recession, with increased money circulation and loans to non-bank entities.
• ⚖️ Despite its essential role, the Fed's power and the fact that it's composed of unelected officials making significant economic decisions are subjects of criticism and debate.

Q & A

What role does the Federal Reserve play in the US economy?

The Federal Reserve plays a crucial role in managing the currency in circulation in the US economy. It is responsible for making decisions that affect interest rates and overall monetary policy.

How did the Federal Reserve originate?

The Federal Reserve was created in 1913 as a response to the need for a central banking system in the United States. It was established to address issues such as bank runs and to provide stability to the financial system.

What were the main motivations behind creating the Federal Reserve?

The main motivations behind creating the Federal Reserve were to prevent bank runs, stabilize the financial system, and provide a central authority for managing monetary policy.

What is the structure of the Federal Reserve System?

The Federal Reserve System consists of 12 separate Federal Reserve Banks located across the country. Each bank represents a different region and operates independently to set policies and interest rates.

What were the consequences of the Federal Reserve's actions during the Great Depression?

Historians widely agree that the Federal Reserve's tight control over the circulation of money and lending exacerbated the Great Depression, making it worse than it might have been otherwise.

How did Congress change the structure of the Federal Reserve in 1935?

In 1935, Congress established the Washington-based Board of Governors to oversee the Federal Reserve System. The Board consists of seven members nominated by the President and confirmed by the Senate.

What dual mandate was given to the Federal Reserve in 1978?

In 1978, Congress gave the Federal Reserve a dual mandate to focus on stable prices and maximum employment. This meant that the Fed had to consider both objectives when making monetary policy decisions.

Why did inflation become a significant concern in the 1970s?

Inflation became a significant concern in the 1970s due to a combination of factors, including bad policies and bad luck, which led to high inflation rates, reaching nearly 15 percent.

How did Paul Volcker address inflation during his tenure as Fed Chairman?

Paul Volcker, appointed by President Jimmy Carter in 1979, raised interest rates dramatically to combat inflation, even reaching nearly 20 percent. This action led to a period of high unemployment but eventually helped control inflation.

What bold measures did the Federal Reserve take during the 2008 financial crisis?

During the 2008 financial crisis, the Federal Reserve took unprecedented measures, including dropping interest rates to near zero, loaning money to non-banks, and purchasing assets like mortgage securities to stimulate the economy.

Outlines

00:00

💵 Understanding the Federal Reserve's Role 💵

The Federal Reserve, often misunderstood, is a crucial institution in the US economy. This paragraph explains the Fed's role in distributing US dollars, managing the currency in circulation, and its ability to 'print money.' It outlines the Fed's evolution, starting with its creation in response to financial crises in the early 1900s, such as bank runs that led to widespread economic panic. The narrative describes the establishment of the Fed in 1913 as a decentralized banking system, with 12 regional banks to prevent concentration of power. The Fed's initial missteps during the Great Depression are acknowledged, leading to the 1935 restructuring that centralized power in the Board of Governors in Washington. The paragraph also touches on the Fed's dual mandate for stable prices and maximum employment, given in 1978, and the challenges of balancing these sometimes conflicting objectives.

05:03

📈 The Evolution and Criticism of the Federal Reserve 📈

This paragraph delves into the Federal Reserve's historical context, highlighting its growth and expansion in response to various financial crises. It discusses the political independence of the Fed, which was reinforced during the Great Inflation of the 1970s, leading to the appointment of Paul Volcker and his aggressive interest rate hikes to combat inflation, despite the economic hardship it caused. The narrative then shifts to the 2008 financial crisis, where the Fed, under Ben Bernanke, took bold and unprecedented measures to stabilize the economy, including near-zero interest rates and expanding its lending to non-bank entities. The paragraph also addresses the Fed's increased regulatory role post-crisis through the Dodd-Frank Act and its central role in economic stimulus during periods of congressional inaction. The COVID-19 pandemic response is briefly mentioned, with the Fed again taking aggressive action to support the economy. The paragraph concludes with a critique of the Fed's power, questioning the decision-making of unelected officials and the outsourcing of economic policy by elected leaders.

Keywords

💡Federal Reserve

The Federal Reserve, often referred to as 'the Fed,' is the central banking system of the United States. It was established in 1913 to manage the country's monetary policy, regulate financial institutions, and maintain the stability of the financial system. In the video, it is highlighted as a critical institution that has evolved over time, taking on more responsibilities in response to various financial crises, and plays a significant role in the U.S. economy.

💡Currency Distribution

Currency distribution refers to the process by which money is made available to the public. The Federal Reserve is responsible for distributing U.S. currency, even though it may originate from the Treasury. This concept is illustrated in the video through the phrase 'money printer go brr,' indicating the Fed's ability to increase the money supply, which was especially relevant during the 2020 meme referencing the Fed's actions.

💡Bank Runs

Bank runs occur when a large number of customers withdraw their deposits from a bank because they fear the bank may fail. This was a common issue in the early 1900s and led to the creation of the Federal Reserve to prevent such crises. The video mentions the panic of 1907, which was a significant event that contributed to the establishment of the Fed as a safeguard against future bank runs.

💡Great Depression

The Great Depression was a severe worldwide economic depression that took place during the 1930s. The Federal Reserve's actions, or lack thereof, during this period are widely believed to have exacerbated the crisis. The video discusses how the Fed's tight money policies are thought to have made the Depression worse, leading to significant reforms in the central bank's structure and responsibilities.

💡Board of Governors

The Board of Governors is a seven-member body that oversees the Federal Reserve System. Established in 1935, it includes a chairman and is nominated by the President and confirmed by the Senate, similar to a Supreme Court Justice. The video explains that this group is crucial for the Fed's operations, as they are in charge of setting national monetary policy and interest rates.

💡Federal Open Market Committee (FOMC)

The FOMC is a key component of the Federal Reserve System, consisting of the Board of Governors and five Reserve Bank presidents. It is responsible for making key decisions regarding interest rates and the growth of the money supply. The video emphasizes the FOMC's role in setting monetary policy, which is central to the functioning of the U.S. economy.

💡Dual Mandate

The dual mandate refers to the two main objectives given to the Federal Reserve by Congress in 1978: to focus on stable prices (low inflation) and maximum employment. The video explains that these goals can sometimes conflict, as actions taken to reduce inflation might lead to higher unemployment, but the Fed is tasked with balancing these priorities when setting policy.

💡Great Inflation

The Great Inflation describes a period in the 1970s when inflation in the United States reached nearly 15 percent due to a combination of factors. The video discusses how this period led to a recognition of the need for a politically independent central bank, which could make decisions without political pressure, leading to better economic outcomes.

💡Interest Rates

Interest rates are the cost of borrowing money and are a key tool used by the Federal Reserve to influence economic activity. The video mentions how the Fed has the power to raise or lower interest rates to control inflation and promote employment. For example, Paul Volcker, a former Fed chairman, significantly increased interest rates to combat high inflation in the late 1970s.

💡2008 Financial Crisis

The 2008 financial crisis, also known as the Great Recession, was a severe economic crisis that resulted from a bubble in the U.S. housing market. The video highlights the Fed's response to this crisis, which included lowering interest rates to near zero and implementing unconventional monetary policies, such as quantitative easing, to stabilize the economy.

💡COVID-19 Pandemic Response

The COVID-19 pandemic led to significant economic disruptions, and the Federal Reserve responded by using strategies similar to those employed during the Great Recession. The video notes that the Fed increased the money supply and expanded its lending to non-bank entities to support the economy during this period of national emergency.

Highlights

The Federal Reserve (the Fed) is responsible for distributing US dollars and managing the currency in circulation.

The Fed has the power to 'print money', as seen with the 2020 meme 'Money printer go brr'.

The Fed is often seen as the 'economy chaperone', making unpopular decisions such as raising interest rates.

The Fed's creation was a response to financial crises, aiming to prevent bank runs and stabilize the economy.

The Federal Reserve System was established in 1913 as a decentralized central banking system to avoid concentration of power.

The Great Depression was exacerbated by the Fed's tight control over money circulation and lending.

In 1935, the Board of Governors was established in Washington to centralize control over the Fed.

The Federal Open Market Committee (FOMC) is responsible for setting interest rates and includes the Board of Governors and rotating bank presidents.

The Fed was given a dual mandate in 1978 to focus on stable prices and maximum employment.

The Great Inflation of the 1970s led to a push for politically independent central banking to avoid political pressure on economic decisions.

Paul Volcker's tenure as Fed Chairman saw a significant increase in interest rates to combat inflation, leading to short-term economic pain but long-term stability.

The 2008 financial crisis prompted the Fed to take bold, unprecedented measures, including dropping interest rates to near zero and expanding its role in the financial system.

The Fed's actions during the 2008 crisis were influenced by the desire to avoid repeating the mistakes of the Great Depression.

The Dodd-Frank Act granted the Fed more authority for oversight and regulation of the banking system.

The Fed has become the primary economic stimulus tool when government spending is constrained.

During the COVID pandemic, the Fed used strategies from the Great Recession playbook, increasing money circulation and expanding loans to non-banks.

Critics argue that the Fed's power and influence are too great, with unelected officials making significant economic decisions.

The Fed's evolution has been shaped by its responses to financial crises, growing its responsibilities and authority over time.

Transcripts

- [Narrator] At the top of any US dollar bill,

you'll see this.

That's because even though the bill

may have come from the Treasury,

the Federal reserve is who actually distributes it.

- They're the ones that's charged with managing the currency

in circulation in our economy.

- [Narrator] In other words, they can kind of print money.

- Money printer go brr, right?

That was a popular meme in 2020 when the Fed

was creating money outta thin air.

- [Narrator] The Federal reserve is in many ways

in charge of the US economy.

As a former chairman once said,

"They're the economy chaperone who has ordered

the punch bowl removed just when the party

was really warming up."

Which means they know their decisions,

like raising interest rates, aren't always popular.

- The Fed is just this poorly understood

and really important institution in our country.

It's important for people to know

what's going on in the economy.

They should understand why we have the Fed,

why it does what it does,

and what role it plays in the country.

- [Narrator] So let's explain.

How did the Fed get put in charge of the punch?

The Fed, as we know, it has evolved over time,

after responses to financial crises

gave it more and more responsibility.

So let's start with why the Fed was created

in the first place.

In the early 1900s, bank runs were pretty common.

If a bank, a private business went out of business,

that meant everyone lost their deposits.

Fearful, people would run to their healthy bank

to withdraw their money.

Only banks didn't keep that much cash handy,

so they'd fail, causing more people to fearfully run

to their bank.

And back then there was nowhere for these banks

to get more cash to stop these runs.

After a large run in 1907,

wealthy bankers like JP Morgan, put up their own money

to essentially bail them out.

- After that panic in 1907,

business and political leaders got together and said

maybe this isn't the best way to run a modern economy,

to rely on a few wealthy individuals doing the right thing

in a time of crisis.

And so discussions began about creating a central bank,

or what became the Federal Reserve System.

- [Narrator] In 1913, the Federal reserve was created to be

the United States Central Banking System.

Basically a bank for banks.

It's 12 separate Federal reserve banks set up

all across the country.

- You had a lot of distrust still in the country

over having one bank.

The idea was that it might be too powerful.

So, you could go to different parts of the country

and say, well, the power won't be in New York.

It won't be in Washington, it'll be here.

There'll be a bank in Atlanta.

There'll be a bank in Kansas City.

There'll be a bank in San Francisco and Minneapolis.

- [Narrator] And two in Missouri.

- There was a senator from Missouri who was instrumental

in creating the Federal Reserve System.

And lo and behold, there's a Fed Bank

in St. Louis and in Kansas City.

- [Narrator] The idea was they would each represent

different regions of the country,

and would independently set their own policies

and interest rates on the money banks would keep with them.

There was also a president put in charge of each bank.

Then, the Great Depression hit.

It's widely agreed by historians

that the Federal Reserve Banks in action

and them keeping the circulation of money

and lending too tight, made the Depression worse.

And by widely agreed, nearly a century later,

a Fed governor said, "We did it."

- There were concerns even before the Great Depression

that the political compromise that had been necessary

to create this thing

had created too much decentralized power.

Nobody really was in charge.

- [Narrator] So in 1935, Congress put the

Washington based Board of Governors in charge.

It would be a group of seven people

from different parts of the country, including a chairman,

each nominated by the President and confirmed by the Senate,

just like a Supreme Court Justice.

They oversee the Federal Reserve System, these banks.

They also serve on the Federal Open Market Committee,

the FOMC, which also includes five bank presidents,

one from New York and four that rotate.

This is the group of people who get together

and decide things like interest rates.

- When you talk about a Fed meeting,

you're talking about a meeting of the FOMC.

The terms become interchangeable,

because there are certain things that the FOMC does.

There are certain things that the Fed Board does,

and they all kind of blend together.

- [Narrator] So that's how we got to

the basic foundation of the Fed.

But the Fed as we know it today,

with its many responsibilities,

was built from responses to even more financial crises.

Let's start with inflation in the 70s,

and in 1978, when Congress gave the Fed,

or really the FOMC, two main priorities.

- The Fed was given a dual mandate to focus on stable prices

and maximum employment.

Now sometimes those goals conflict with each other.

When you're trying to crush inflation,

sometimes you're gonna do things that cause unemployment

to go up, but the mandate really said

the Fed should take both of these objectives into account

when they set policy.

- [Narrator] This was because in the 70s,

inflation was really high.

Called the Great Inflation now, a mix of bad luck

and bad policies saw inflation reach nearly 15 percent.

- There were concerns that the Fed succumbed

to political pressure in the early 1970s

because the Fed chair at the time, Arthur Burns,

was friendly with the president and Nixon did not want him

to raise interest rates before his reelection in 1972.

So the whole experience of the Great Inflation

reinforced this idea that we should have

politically independent central banking

that generally, when you kept politics out

of the FOMC boardroom, you had better economic outcomes.

- [Narrator] In 1979, President Jimmy Carter

put Paul Volcker in charge of the Fed,

and he raised interest rates, a lot, to nearly 20 percent.

Unemployment skyrocketed and rose above 10 percent,

and people blamed the Fed.

- Home builders would mail two by fours

to the Fed and say, "Stop these oppressive interest rates."

They would mail keys for cars and houses to the Fed saying,

"These are homes and cars that aren't being sold."

There were were tractors that protested,

driving around at the Fed's headquarters.

History has vindicated the moves of the Volcker Fed.

He's lionized today as this figure who did something

that was really hard and really unpopular.

But if you look at the US economy

over the 30 years that followed,

the US economy performed better

than most other advanced economies.

- [Narrator] The Fed gained credibility

because it was politically independent,

since politics don't always make great economic policies.

And when the 2008 financial crisis arrived,

the Fed Chairman, Ben Bernanke,

learned from lessons of the past.

- The bold measures the Fed took in response

to the recent financial crisis, reflected in part

its determination to avoid repeating

the same sorts of mistakes it made before and during

the Great Depression of the 1930s.

- [Narrator] Those bold measures included things

the Fed had never done before, like dropping interest rates

to near zero for the first time.

In addition to managing the currency

and circulation and the occasional treasury security,

it started loaning money, a lot of money to non-banks.

It also got into new markets,

buying things like mortgage securities,

all this to pump money into the economy.

This got the Fed even more involved in parts

of the financial system,

beyond just currency and interest rates.

- One of the things Bernanke was well regarded for

was that he just threw everything against the wall

to see what would stick.

He made sure that it didn't get worse.

We call it the Great Recession

and not the second Great Depression.

- [Narrator] And Congress also gave it more authority

of oversight and regulation of the banking system

through Dodd-Frank, and just kind of by default of inaction.

- Government spending retreated after the stimulus in 2009.

And so there was this saying that the Fed had become

the only game in town.

If you needed to stimulate your economy,

you weren't gonna be able to cut taxes or spend more money

because Congress didn't wanna do that.

What ended up happening was that financial markets,

to a greater and greater degree, began to hang on every word

and every utterance of the Fed chair,

because now monetary policy was just so important

to the markets,

and also to the economic outlook for the country.

- [Narrator] Then came COVID.

The Fed took from the Great Recession Playbook.

It bought those same assets.

It began loaning more money to even more non-banks,

and it raised the amount of money in circulation, brr.

- What you see is a central bank that during periods

of severe stress, really, you know, national emergency,

is willing to do quite a lot to make sure

that the economy and the financial system holds together.

- [Narrator] Including when inflation rises.

- Today, in support of these goals,

the FOMC raised its policy interest rate

by one quarter percentage point.

- [Narrator] The Federal reserve began as a response

to a financial crisis, and has only grown

with each one since.

Although, not always without criticism.

- The time has come, let's end the Fed.

- [Narrator] The Fed is primarily still a bank for banks,

but it has also become the stop gap

for most other parts of the financial system.

They can make decisions quickly

and without political fallout.

- To the extent you have a handful of unelected people

making huge decisions about the economy.

It's something that Congress and the White House,

our elected leaders, have really decided over many decades

to really outsource this to the Fed.

- [Narrator] Basically, it's easier for the parents

to rely on the chaperone.

(gentle music)