How powerful is the Fed?

Monthly Review, May, 1985 by Andrew W. Caughey

HOW POWERFUL IS THE FED?

The Review of the Month "Money Out of Control,' (December 1984) is a timely reminder that the Federal Reserve System plays an important but not a decisive role in the American economy. Probably no leading institution is less understood in the public media than the Fed. In seeking simple explanations for complex phenomena, commentators consistently ascribe more influence to the Fed than it actually has. They assume that it has almost unlimited control over the money supply and that through this control it can determine the level of interest rates, initiate a business upturn, or nip an economic recovery in the bud. Instead, as your article points out, the Fed is pretty much circumscribed by the needs of the banking system.

The article does not delve into one intriguing question: whether the Fed has been responsible for the great inflation of the past 25 years. This belief is held by certain right-wing elements such as the "hard money' letter-writers. It deserves an answer.

As you note, the Fed can add money to the banking system by purchasing government securities in the open market. These securities then become assets of the member banks, earning interest from the Treasury. When they mature, they are normally rolled over into new issues. But at the end of the year more than 90 percent of the interest earned on them is returned to the Treasury under the euphemism of "Interest on F.R. Notes.' In 1983, for example, $14 billion was returned in this way.

The significance of this arrangement is the fact that U.S. securities acquired by the Fed are, in effect, issued without payment of interest and need never be retired. They cost the Treasury almost nothing; they are "monetized' by becoming part of the money supply.

This is the only portion of the public debt that can be likened to the assignats or the greenbacks of earlier times. It is not really correct to say that "Washington inflates our currency by running the printing presses.' In reality the federal government borrows almost all of the money it needs in excess of income--and this is a fundamental difference.

At the same time, we should note that the technique of openmarket purchases (and direct-placement purchases) of government securities does provide an avenue for direct inflation of the money supply by the government. If investors ever lose confidence in the Treasury's ability to honor its commitments, this is the practice it would probably use. Such action would signal a financial crisis of unprecedented proportions.

The amount of U.S. securities held by the Fed grew as follows:

1950 $20.8 billion

1960 $27.4 billion

1970 $62.1 billion

1983 $160.8 billion

During this same period, total U.S. securities outstanding grew from $200 billion to $1,700 billion. Total private and public debt grew from $400 billion to over $4,000 billion. The proportion of total U.S. securities held by the Fed declined markedly.

If we look back at the inflation of the 1970s, a pattern is discernable. Business was strong as a result of worldwide economic expansion. Part of this strength was due to the billions of dollars loaned to third world nations, which created a strong demand for exports. As a result, leading monopolistic industries were able to raise prices with ease. Workers in these industries countered with demands for higher wages, which were granted after token resistance, since they could easily be recouped in the next price increase. Workers in most other areas won lesser raises on the basis of higher living costs. A pleasant cycle developed for most segments of society that went on for many years. Inflation became a way of life.

However, there were problems. With prices advancing faster than both income and labor productivity, effective demand tended to fall. More and more stimulus in the form of credit expansion was needed to sustain the cycle. Was the Fed responsible for this stimulus?

As noted above, the Fed monetized $140 billion of federal debt from 1950 to 1983, an average of $4.24 billion per year. During the same period federal budget outlays grew from $40 billion to $796 billion per year. The gross national product rose from $300 to $3,400 billion per year. And the consumer price index quadrupled.

Clearly, the monetizing of $140 billion when related to these huge increases in federal outlays and the gross national product could not have been the major factor in sustaining the inflationary process. The amount involved is simply too small.

The real basis for the economic boom and accompanying inflation is to be found in an unprecedented expansion of private and public debt--1,000 percent in 33 years. Every resource of the federal government was utilized to spur this growth: loan guarantees, subsidized mortgage rates, low down payments, easy terms, tax credits, secondary markets, deposit insurance. The long prosperity has been built on a mountain of debt. The central influence in creating it has been the federal government. At most, the Federal Reserve System has been supportive.