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.