No birthday wishes for the Fed

Given the Federal Reserve’s role in keeping the American economy afloat in recent years its 100^th anniversary has attracted remarkably little attention. The centennial of the central bank provides a good vantage point to examine the increasingly powerful institution.

Anyone who doubts the Fed’s part in bolstering the economy in recent years need only look at its burgeoning balance sheet. Total assets have increased from about $860 billion in August 2007 to over $4 trillion today. The surge reflects the Fed’s quantitative easing – or what it prefers to call credit easing – programme. Even with the advent of tapering, a slowdown in the rate of growth of asset purchases, the balance sheet is likely to continue its rapid expansion for some time.

But perhaps it is unnecessary to harness such figures to persuade those who follow the financial markets or the economy of the Fed’s importance. Ben Bernanke, the Fed’s chairman until recently, has become a household name among investors and financial professionals. His successor, Janet Yellen, is already in the process of becoming one too.

Given the ubiquitous role the Fed has come to play it might surprise some to learn it is relatively new in historical terms. The Federal Reserve Act, the law that brought the Fed into being, was enacted on December 23, 1913. There was no mention of the Fed in the US constitution, which came into operation in 1789, let alone in the War of Independence against Britain.

The Fed was a product of what in America is referred to as the Progressive Era. Its exact dates are debatable but it is usually seen as spanning the first two decades of the twentieth century. The high point was from about 1910 to 1917.

Essentially the Progressive Era marked a shift in America from a more agrarian, decentralised and free market society to a more industrial, centralised and interventionist one. The Federal government became relatively more important and the individuals states less so.

Advocates of progressivism, who included both Democrats and Republicans, supported such measures as the introduction of a federal income tax, enacted in 1913 under the 16^th amendment to the constitution. They were also generally in favour of the federal regulation of food production, strict immigration controls and the prohibition of alcohol.

Progressivism is generally seen as a radical movement as its supporters often used the rhetoric of fairness and justice. It also railed against corruption, opposed cartels and supported the regulation of inter-state commerce.

However, this is a misleading way to understand it. As some historians have argued it would be more accurate to see it as a cooperative drive involving both government functionaries and large corporations. Both sides were keen on developing the strong institutions they saw as more appropriate to a modern America.

The Fed clearly fits into this pattern. Its creation was supported both by the leaders of many powerful financial institutions as well as influential technocrats.
This history helps illuminate many contemporary fallacies about the Fed, the economy more generally and the financial markets. For a start it is a myth that America has a free market economy – if that is taken to mean an economy in which the state plays a minimal role. Both supporters and critics of the free market should acknowledge this reality.

On the contrary, the economy, including the financial markets, is subject to extensive state intervention. The Fed is only of many government institutions which plays a substantial economic role. It has also actively shored up asset prices at times.

From this perspective it should be clear that the Fed’s recent activist role marks a change of degree in the organisation’s activity rather than a fundamental shift. The Fed has certainly stepped up a gear since the advent of the financial crisis of 2007-8 but it is not doing anything fundamentally new.

Indeed the Fed’s recent activism can be seen as a sequel to the previous bout of activism. In the aftermath of the stockmarket slump of 2000, and the September 11 terrorist attacks of 2001, the Fed kept interest rates artificially low for several years. The goal was to help stabilise asset prices but it also helped pave the way for the housing bubble in the first part of the decade. Cushioning the stockmarket had the unintended consequences of helping to inflate a bubble elsewhere.

The broader context for these developments is the way in which the American authorities have evaded tackling fundamental economic problems for three decades. Rather than promote economic restructuring as a way of achieving investment and innovation the government has generally opted for short-term solutions. In particular it has pumped money into the economy, both from the Fed and through state spending, as a way of keeping things ticking over.

Under these circumstances it would be inappropriate to wish the Fed a happy 100^th birthday. It poses more problems for the economy than it offers solutions. It is time to consider new institutional arrangements that are better suited to tackling contemporary challenges.

This column first appeared in the February issue of Fund Strategy magazine.