The Weiner Component Vol.2 #6 – Part 3: The Purpose of the Federal Reserve

The title page to Keynes' General Theory.

Unemployment rate in the US 1910–1960, with th...

Unemployment rate in the US 1910–1960, with the years of the Great Depression (1929–1939) highlighted. (Photo credit: Wikipedia)

The Federal Reserve was established on December 23, 1913. Its major mission was to avoid panics or major recessions in the future. It would at that time do this by being able to move money quickly anywhere throughout the National Economy. In essence since the nation functioned through its banking system the new Fed would protect its financial institutions from runs or panics where the depositors could all withdraw their funds, generally following a rumor that the bank was on the edge of failing.

 

In addition the United States economy had/has systematically gone through regular business cycles of recession, slump or depression, recovery, and boom. Invariably each of these stages of the economy leads to the next stage. During a boom period overproduction is invariably reached, workers are laid off, there is less income available, which accelerates the recession. This, in turn leads to a trough or low economic point which can be a depression with high unemployment. Eventually there is a shortage of goods and the amount of money being spent in the National Cash Flow increases; people are hired; there is more and more money available and recovery begins, continuing until a peak or production boom is reached again. The duration of the cycles can and do vary, going from less than a year to over ten years as the Great Depression did from 1929 to 1940. It was ended by World War II. These depressions can be regional or they can cover the entire nation, if not the world, as it did in 1929. They generally last between the two periods given above.

 

In simple terms this is the economic pattern of every industrial nation. Does it have to continue? That’s an interesting question. The probability is that it can be controlled by the Central Government’s actions.

 

In 1929 the science of economics was generally not understood well enough to determine exactly or why the depression was happening. In 2008 when the country had what is now called the Great Recession, enough was understood to avoid a greater depression than that of 1929. This depression was avoided by actions of the Federal Government.

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Even today economists disagree as to what caused the Great Depression and how it should have been dealt with. There are numerous theories. Probably The Keynesian theory is the most accepted. Keynesian economics deal with the various theories about how in the short run, mainly during recessions, economic output is strongly influence by aggregate demand or total spending. Aggregate demand does not necessarily equal the productive capacity of the economy. Instead it is influenced by a host of factors that can behave erratically, affecting production, employment, and inflation.

 

Keynes theories were first presented during the Great Depression in his 1936 book, The General Theory of Employment, Interest, and Money. Keynes’ approach contrasted with classical economics. Keynesian economists believe that the private sector’s decisions sometimes lead to inefficient economic outcomes which require active policy responses by the public sector (government). It is a combination of the two that stabilize output with the government exercising control over the private sector. Monetary policy actions are needed at times by the Central Bank and fiscal policy actions (Government spending.) in order to stabilize output over the business cycle. Consequently Keynesian economics requires a mixed economy, predominantly private sector with a strong role for government interventions during recessions and depressions.

 

Traditional or classical economics as developed by Adam Smith in his 1776 book, An Enquiry Into The Wealth of Nations, set the Market making all the societal decisions. The motivating force, according to Smith was the “invisible hand,” the profit system. Adam Smith was responding to an economic system called mercantilism, where gold was considered the basic wealth of the nation and the economic decisions were being made by the kings of the various countries.

 

John Maynard Keynes during the world economic disaster called the Great Depression was questioning the validity of this system, saying what was needed to solve this problem was a combination of private enterprise balanced by state control of the marketplace. To him unfettered classical economics had brought about the Great Depression.

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The actual causes of the 1929 Great Depression have been extensively discussed by economists and remains a matter of intense debate. In fact they are part of the larger debate about economic causes. The economic events that took place at that time have been studied thoroughly: a deflation in assets and commodity prices, dramatic drops in demand and credit, disruption of trade, widespread unemployment, over 13 million by 1932 the lowest point of the economic decline, and hectic poverty.

 

There is no consensus as to overall causes other than it started with the initial stock market crash that began on Black Tuesday, October 29, 1929 when panic selling of securities led to a continued dropping of value of the securities until the end of 1932 when it reached its lowest point. The Crash triggered the depression which had reached a high level of deteriorating economic conditions such as rising unemployment, over production, a totally unequal distribution of incomes, under consumption, and extremely high debt.

 

Both the stock market and the economy would slowly improve after 1933 with the new President, Franklin D. Roosevelt. It would rise to new heights after 1939 with the outbreak of World War II in Europe. The stock market and the economy would rise to new heights with a massive infusion of money for goods and services within the United States. War will have brought about its end within the U.S. It is interesting to note that it was the money spent during the war, first by European and Asian nations, then after December 7, 1941 also by the United States that specifically ended the Great Depression.

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Once the Great Depression had started there were massive mistakes made by the Federal Reserve. The Fed actually caused a shrinkage of the money supply and greatly exacerbated the economic situation. Deflation caused people and businesses to owe ever increasing amounts upon money they borrowed actually shrinking the money supply in the U.S. by about 1/3.

 

With the election of Franklin D. Roosevelt to the presidency in 1932 a form of Keynesian economics became the policy of the President from 1933 on when he assumed power. Roosevelt’s policy was the “3 R’s: Relief, Recovery and Reform.” This comprised Roosevelt’s “New Deal;” his attack upon the Great Depression, which essentially lasted from 1933 to about 1938. The Federal Government put itself in a position to help turn the country around. It brought about great improvement but not a complete end to the Great Depression.

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Toward the end of 2007 in the last year of the George W. Bush’s Presidency what is generally called the Great Recession began. The Housing Market in the United States collapsed. A great many people had been using their home as bank or checking accounts generally from the 1980s on, constantly refinancing their home and taking their equity out as property values continually increased. People bought the toys they always wanted: new cars, fancy trucks, boats, expensive vacations; just about anything they felt was desirable.

 

This had been going on for about thirty years, the entire career of many people in banking had taken place during this period. Housing loans or second mortgages were divided into miniscule fractions, put into a multitude of different Hedge Funds and sold to the general public as safe interest paying loans. The process brought the value of the home loans up millions, if not billions of dollars. The banks were earning large amounts in fees as the demand for loans actually forced up the value of the homes. By 2007 the end had been reached, property values had been raised beyond the point of sanity. The bankers were in denial that conditions could possibly change. Some banks were lending out 125% of the appraised value of the properties, working on the premise the housing values would rise endlessly.

 

The economic collapse began during the second week of March, 2008. It tended to be worldwide. In the United States, on Tuesday, with the encouragement of the President, George W. Bush and the Secretary of the Treasury, Hank Paulson, the Chairman of the Federal Reserve, Ben Bernanke injected $236 billion dollars into the American banking system. Citigroup, the world’s largest bank spent one billion dollars bailing out six of its hedge funds. Lehman Brothers, America’s fourth largest bank went under. AIG, the world’s largest insurance company, had moved into the business of insuring leveraged debt right at the time when the financial system was at the point of collapse. When the Housing Bubble burst Ben Bernanke, as chairman of the Fed, announced an $85 billion loan for them. Hank Paulson, the Secretary of the Treasury proposed buying up hundreds of billions of dollars’ worth of toxic assets.

 

With the accession of Barack Obama on January 20, 2009 as President of the United States that country and the rest of the Industrial Nations continued to hover on the point of economic collapse. This would have occurred if the governments had not interceded with masses of cash. They prevented, using taxpayer money, a depression that would have made the Great Depression of 1929 look like a weekend holiday. It would have been the total collapse of the banking systems which, in essence, run the economies of all those nations.

 

(Interestingly Donald Trump’s administration wants to do away with all the regulation in the U.S. which came about to avoid a repeat of this situation. Memories are short!)

 

President Barack Obama continued the bailout, saving the banks from their own stupidities, and he added the American automobile industry which was also on the point of total collapse. The governments of the various countries spent a lot of money saving their economies and returning the world to economic sanity.

 

Recently President Donald Trump commented in one of his speeches that President Barack Obama increased the National Debt more than any other prior President. He did so cleaning up the financial messes that they had helped to create.

 

We have passed beyond Keynesian economics to the point where the Free Market is today a farce. The governments of the United States and of the other industrial nations have assumed responsibility for the welfare of both the rich and the poor within their societies. How long will it take for the populations to understand this?

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In the United States and in most industrial nation there are groups that want to return to the good old days. Whatever they were. Everything is changing. The 21st Century will be completely different from the 20th Century.

 

It should also be noted that it was the Federal Reserve, under Chairman Ben Bernanke, who used creative Monetary Policy in a period of a little over 24 months, with strong encouragement from President Obama, to buy up the toxic mortgage pieces throughout the United States at the rate of 45 billion dollars’ worth a month and also he added another 40 billion dollars a month directly to the National Cash Flow.

 

The Republican dominated House of Representatives from 2011 on did nothing to help the situation. They should have applied Fiscal Policy, creating jobs by spending money on infrastructure modernization. Instead they tended to cut government spending and worsen the Great Recession. Mitch McConnell, the Republican majority leader in the Senate, announced that they would make Obama a one term president by not cooperating with him on anything. To them no price was too high in order to make Obama a one term president. Somehow the needs of the American people were lost.

 

It was the Federal Reserve and the President who saved the country from falling into the worst depression in its history. The Republicans, once they got control of the House of Representatives, refused to pass anything that would make President Obama look good. This was true even if it had a negative effect on the country and hurt the majority of its citizens. President Obama offered a Bill that would engender spending on our decaying infrastructure. It did not even come up for discussion in the House of Representatives.

The Weiner Component #141 – Fiscal, Monetary Policy & the Republican Party

English: James Earl "Jimmy" Carter

English: James Earl “Jimmy” Carter (Photo credit: Wikipedia)

English: United States mean duration of unempl...

English: United States mean duration of unemployment 1948-2010. Data source: FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis: Average (Mean) Duration of Unemployment [UEMPMEAN] ; U.S. Department of Labor: Bureau of Labor Statistics; accessed August 14, 2010. (Photo credit: Wikipedia)

English: A map of the 12 districts of the Unit...

English: A map of the 12 districts of the United States Federal Reserve system. (Photo credit: Wikipedia)

Historically and in the present, Fiscal and Monetary Policy are the two major tools that the Federal Government is supposed to use to continually fine-tune the American economy.   Fiscal Policy is used by the Congress passing specific economic enhancing laws signed by the President and Monetary Policy is used by the Federal Reserve continually adjusting the U.S. money supply to maintain a healthy economic national environment.

 

During the Presidency of Jimmy Carter (1977 – 1980) unemployment rose to 7%.  This was also the post Viet Nam War period.   From 1977 on the government engaged in an expansive fiscal policy; there was an expansion in Public Works strongly supported by the President.  It averaged $4.38 billion per quarter.

 

At that period I was teaching Social Science classes at a High School in Southern California.  The School District was asked by representatives of the Federal Government to make a wish list of what they would like for the District.  A list of ten items was prepared by District officials and, as an afterthought, someone suggested a second or girl’s gymnasium and it was added to the bottom of the list.  The government officials choose the girl’s or second gymnasium as the item that would create the most jobs.

 

I remember that the high school got a second gym which was gray, the color of the concrete.  The money that paid for the gym ran out at that point and it was a few years before the School District came up with the funds to have the building painted.

 

It seemed that all the tasks and labor involved in building the gymnasium, both directly and indirectly, would create the maximum employment possible for the expenditure of the funds required for the project.  I suspect that Troy High School in Southern California is one of the few secondary schools in the country that has two separate gymnasiums.

 

To understand how this expenditure works for the benefit of the overall economy we have to trace the money and see what happens to it.  Usually money spent is actually spent six to eight times; it is a volatile substance.  For example, in producing and packaging the concrete used in the building the manufacturer has to pay his employees.  They, in turn, have to pay rent or a mortgage or, for that matter, buy food.  The landlord, bank, or supermarket continues the same process, and on and on for six to eight times becomes part of the natural flow within the economy.  This occurs with everyone directly or indirectly involved in producing that building.

 

Every million dollars the government spends creates six to eight million dollars in the exchange of goods and services.  To use an analogy, a child throws a rock into a quiet lake.  There are a large number of ripples spreading out in all directions from where the stone hits the water.  They spread out and dissipate as the stone drops to the bottom of the lake, infinitesimally raising the level of the water.  Consequently the $4.38 billion that the government added quarterly to the economy of the United States was actually generating a little over 26.3 to 35 billion dollars in new productivity every three months.  This also gives us an idea of the volatility of new money added to the National Cash Flow.  Of course if the reverse were to occur for any reason, such as the 2008 Real Estate Crash, the 26.3 to 35 billion dollars would be removed from the National Cash Flow.

 

In 1977, when Jimmy Carter became President, the 95th Congress was elected.  In that Congress the Democrats had a majority in both Houses of Congress; in the House of Representatives they had 292 elected Democrats to 143 Republicans and in the Senate there were 61 Democrats to 30 Republican Senators, a super majority which made the Senate filibuster proof, as only 60 votes are needed to end a filibuster.  The Democrats could pass any legislation they felt was needed and they applied, among other things, fiscal policy to the post Viet Nam War period.  Unemployment during the Carter period was considered high, running from 6.9% to 5.8%, and ending in 1980 at 7%.

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From the beginning of President Lynden Johnson’s acceleration of the Viet Nam War inflation slowly began to increase in the country.  The country was both fighting a war and allowing the public to maintain their peacetime standard of living.  By 1980 it had reached two digits and would that year eventually rise to about 15%.  The economic situation that occurred was labeled, stagflation.  It consisted of both stagnation, high unemployment, and inflation, prices rapidly rising because of shortages brought about by having fought a major war, maintaining the military during the Cold War, and supplying all the needs of the American people at the same time.

 

Generally during a period of inflation there are not enough goods and services available to match the demand and prices rise until a new equilibrium is reached of the goods and services offered.  If anything there should be lower unemployment.  But in this case there was also stagnation; there were not enough jobs for everyone able to work and wanting employment.  This was stagflation, the concurrent existence of two economic opposites.

 

There was a way to break this economic condition by having the Federal Reserve raise interest rates far higher than they were, raising the rate of inflation until it exploded.  But this would throw a lot of small businesses and even some large companies into bankruptcy.  This action would bring about immediate adverse economic conditions for a large number of people; it would bring about a short term depression which would temporarily increase unemployment.

 

President Carter had the Federal Reserve Chairman, Paul Volker, begin this process but then after receiving innumerable complaints President Carter backed off.  The next President, Ronald Reagan, allowed Volker to carry out this policy.  It took about a year and a lot of human misery to break this economic cycle.

 

When this came about, early in the Reagan administration, the President got on national television holding a copy of the Sunday New York Times Business Section and said something to the effect of there were umpteen pages of jobs available according to the newspaper and that if there were no jobs where the people lived then they should go to where there were jobs.  This presentation exacerbated the problem because suddenly there were old jalopies crisscrossing the country, being driven by people looking for employment, following whatever rumor promised jobs somewhere else.  This so-called friendly advice or thoughtless act created the homeless problem in the United States.

 

This policy, by the Federal Reserve which was necessary that broke the inflation cycle which had been begun by President Lynden B. Johnson in the 1960s, created an instant depression but ended the stagflation.  Interest rates dropped to a low single digit where they remained until 2008, when they dropped even further almost approaching zero, where they remain today.

 

As a footnote it should be noted that the people who pay for this low interest are the people in the United States who deposit their money into the banks and receive an interest payment on most of their deposits of one tenth of one percent per year.  The amount of interest most people get on their bank holdings is so low it is not even taxable.

 

Fiscal Policy with other economic remedies ended this economic crisis.  The other equally important economic remedy was Monetary Policy.  This is controlled by the Federal Reserve.

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Monetary Policy is the process that the Federal Reserve uses to control the supply of money, its availability, and the cost of money or its rate of interest in the country.  Its objective is aimed at the growth and stability of the economy.

 

The Federal Reserve (FED) has twelve regional banking districts, each with a major regional bank and each with a possible auxiliary bank covering the entire United States, with the major one in Washington, D.C.  It is a private government banking system that controls all the public banks in the country.

 

The FED’s major function is to regulate the private or public banks and to help control economic growth and stability, as well as maintain low unemployment and maintain predictable exchange rates with other currencies.

 

The tools the FED uses are:

(1) Its Open Market operation, constantly buying and selling bonds to increase or decrease the amount of money available in the National Cash Flow.  Here it works from the Public or National Debt, increasing or decreasing it to fine-tune the economy.

2) Adjusting the Discount Rate, setting the interest rates in the private banks by the amount it charges them interest.  The private banks determine the interest they charge the public based upon the interest they pay the FED.  They have to make a reasonable profit above what they pay to the FED.  The higher the FED’s interest rate the more expensive the money is and the less is borrowed.  Conversely the lower the interest rate potentially the more will be borrowed and used for economic expansion.  And the more employment will occur.  Since the 2008 Real Estate Crash the interest rate has dropped to almost zero (one tenth of one percent), and expansion has very slowly occurred.  In fact we are still, seven years later, in the process of recovering from that crash.

(It should also be noted that since 2011, when the Republicans took control of the House of Representatives there has been no Fiscal Policy.  In fact the House has forced through bills increasing the unemployment level and exacerbating the recession.  They have been very good at worsening economic conditions and then blaming the Democrats for it.

3) The third method is raising the Reserve Requirements that the banks are required to observe.  The public banks have to keep a certain percentage of their deposits for every loan they make.  But regulating the amount that the bank has to keep the Federal Reserve can significantly increase or decrease the amount of money that a bank can lend.

 

Among all the dollars deposited in the banks this would also include demand deposits (checking accounts).  Most people deposit their paychecks and reserve funds in banks which pay them a token interest for these funds.  People can at any time withdraw part or all of their money.  Meanwhile the banks lend out this money.  By law they must keep a small percentage, about five percent.  The banks can then lend out or invest ninety-five percent of the money deposited.  This expands the amount of money in circulation.  If the FED were to raise the Reserve Requirement to ten percent this would lower the amount that the banks can lend out by 50%.

The actual amounts that the banks have to keep in reserve are: up to 14.5million 0%, over 14.5 million to 103.6 million, 3%, over 103.6 million, 10%.  It should also be noted that after a bank lends out all its available funds it can deposit its loan papers with the FED and lend out the money all over again under the same conditions.  It should be noted that once the money lent out is redeposited into the banks 95% of it can again be loaned out.  Interestingly the FED is now considering raising the current reserve requirement.

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Using their Reserve Requirements, up to the end of 2008, the major banking houses in the United States had created trillions of dollars in real estate value by constantly mortgaging and remortgaging individual properties at higher and higher rates throughout the 50 states.  This collapsed virtually overnight towards the end of 2008.  President George W. Bush, at the very end of his presidency bailed out the major banking houses which were then facing bankruptcy.  This process was continued by the new president in 2009, Barak Obama.  While a few banking houses went under and were absorbed by other banking houses the Federal Government had no choice but to bail out most of the banks.  For one thing all the commercial banks had all their deposits insured up to ½ million dollars each by the Federal Insurance Deposit Corporation (FDIC).  The Federal Government would be liable for all this money if most of the banks failed.  In addition most of the business transactions in this country are paid for by either checks or credit cards that are all processed through the banks.  If the major banking houses like the Bank of America, JPMorgan Chase, Wells Fargo and most other bands were to suddenly disappear the movement of money throughout the United States would practically cease and the country would face a depression that would make the Great Depression of 1929 look like a weekend disruption.

 

Interestingly the potential 2016 Republican presidential candidates in their Third Debate, on November 10, 2015, mostly stated that if they were elected to the presidency one of the first things that they would do would be to get rid of the Dodd/Frank Bill that was passed to avert a possible repetition of the 2008 Crash and, if there were to be another economic crash they would not bail out the banks, that nothing is “too big to fail.”

 

What this 3d Republican Debate illustrated was that these people are blatant liars who will say anything to get elected or that they are totally ignorant of Macroeconomics or any other type of economics.  I don’t know which position is worse?  I was also shocked that the “media,” who seems very conscious of “fact checking” didn’t pick up on any of this.

 

If another Banking Crash were to occur and one of them were President of the United States at the time he/she would be forced by their own advisors to again bail out the banks.  For one thing it would probably cost the Federal Government and taxpayers directly more money to not bail them out and the following economic breakdown of the society would last for well over a decade, which is how long it took for the Great Depression to end.

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President Barak Obama’s major problem, after he assumed office in 2009 was dealing with the Real Estate Crash that he inherited from the Bush Administration.  For his first two years in office he had a Democratic majority in both Houses of Congress that cooperated with him.  The Republicans at this point at a meeting agreed to oppose everything he did and make him a one term president.

 

In 2006 Ben Bernanke was appointed Chairman of the Federal Reserve by President George W. Bush.  Bernanke replaced Alan Greenspan.  Bernanke working with President Obama utilized creative Monetary Policy to essentially pull the country out of a major depression without being able, after 2011, to get any cooperation from the House of Representatives.  Up until 2015 there was no Fiscal Policy applied.  Toward the end of 2015 both Republican dominated Houses of Congress passed a bipartisan bill to extend Federal Funding on road construction and maintenance throughout the nation which had initially been passed into law before the Republicans took control of the House and was due to end.

 

Initially after 2011 Bernanke innumerably called for Congress to enact Fiscal Policy legislation.  Obama even presented a proposal for much needed infrastructure improvements which would also create a large number of jobs.  This proposal never even reached the floor of the House.  If anything the Republican House of Representatives cut Federal Government funding to a multitude of programs and decreased, on a number of levels, government jobs actually worsening unemployment under the guise of economizing.

 

The FED then came up with a creative twist to Monetary Policy.  One additional major problem that came with the Real Estate Crash was who owned the properties/homes that then had mortgages on them of greater value than the property was worth.  The mortgages had been divided up into fractional shares, distributed to innumerable hedge funds, and the banks had reorganized record keeping on a very sloppy basis.  It was, in many cases almost impossible to discover who owned 50.1% of many if not most of the properties.  This was a dilemma that would ordinarily take two or more decades to clear up.

 

The FED’s solution to this problem and the shortage of money in the National Cash Flow that was causing the massive unemployment was to add 85 billion to the economy every month for a period of over two years.  45 billion was used to buy mortgage paper (fractional pieced of mortgages) in all fifty states and forty billion was used to buy back debt paper (government bonds).  This added one trillion twenty billion dollars to the National Cash Flow a year.  It was gradually phased down and ended in 2015.

 

Currently it looks like interest rates for the public will remain at almost zero for at least the balance of 2015.  But unemployment has dropped nationally to around 5%.  Creative Monetary Policy had turned a possible great depression into a recession and brought the country well in the direction of economic recovery.  All this has been done under the administration of President Barak Obama largely with no cooperation from the Republicans in Congress.

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Issues are never simple cause and effect actions.  There are always multitudes of variable affected in addition to the major outcome desired.  Everything consists of hard choices.  These should be made by experts who are aware of all the possible outcomes.  Or, at the very least, it will be people who will listen to experts and act accordantly.

 

In November of 2016 a major election is coming up, the next Presidential Election.  Both major political parties will be presenting a host of candidates for the Presidency and Congress.  The entire House of Representatives will be up for election and also one third of the Senate. In addition there will be major elections in all 50 states.  The people will speak by voting or not voting.  If the Republicans maintain their majorities in both Houses of Congress and in the majority of the states then very little will be done in the next four years.  The public by their action or inaction will decide what the future will hold.