A century of destruction

December 23 marked the 100th anniversary of the Federal Reserve System — a century’s worth of a economic management that has turned America’s relatively free markets into today’s crony capitalist mess.

Though Federal Reserve officials are often treated as godlike sages, descending from Mount Olympus to dispense wisdom upon us mere mortals, the Fed really does not serve the interests of the general public.

Instead, the Fed benefits two distinct groups: politicians and the financial sector.

The Fed gives politicians the magical ability to give voters something for nothing. Instead of imposing highly unpopular taxes on the citizenry, the government can rely on America’s central bank to simply print more money. Government promises are fulfilled by tapping the Fed’s funny money spigot. Of course cranking up the printing press will eventually cause price inflation, but since this always comes later the authorities are able to portray inflation as a natural phenomenon, not the natural consequence of their own profligacy.

Without the Fed constantly feeding it, our bloated financial sector would starve. The American banking system is based on fractional reserve banking. In a fractional reserve system, banks pyramid their loans on top of cash held in reserve. Hence, the larger the amount of reserves, the more loans a bank is able to make and the money it collects in interest. Obviously, the Fed’s propensity for constantly increasing the money supply has been obscenely profitable for the banking sector.

During the financial crisis of 2008 bank lending froze up, causing the system described above to come to a screeching halt. But the money center banks had nothing to fear as the Fed used its status as “lender of last resort” to help see them through the crisis. The Treasury’s $700 billion Troubled Asset Relief Program (TARP) was dwarfed by the Fed’s $7.77 trillion of loans.

The central bank then stabilized the balance sheets of chosen institutions by transferring so-called “toxic assets” (mortgage-backed securities, and collateralized debt obligations) onto its own balance sheet, thereby putting the American taxpayer on the hook for the bad bets that the banks had made.

Incidentally, financial instruments such as mortgage-backed securities and collateralized debt obligations (commonly known as MBSs and CODs) probably would have never existed if the federal government had not created a secondary market for home mortgages with its government-sponsored entities such as Fannie Mae and Freddie Mac.

In the housing bubble, we witnessed Fed monetary policy combine with government fiscal policy to create a perfect storm. The Fed created vast amounts of money out of thin air and the federal government funneled it into the housing market.

Unfortunately, the housing bubble is just the latest calamity for which the Fed is responsible. So long as our money and interest rates are centrally controlled we can expect more such Fed-created disasters in the future.