It has been said time and time again that we are in the worst economic mess since the 1930s and that we have quite the problematic future.
A number of experts will associate this uncertain future to the loose monetary policy of the Federal Reserve. They have been engaging in purchases of bonds and quantitative easing, which is causing the interest rates to sit at a record low. These low interest rates have investors taking extreme risks so they can achieve the higher yields that they need to succeed. As it stands, the Fed is spending upward of $85 billion every month in the purchase of mortgage-backed securities and treasury bonds. To put that another way, that is the amount of the 2013 sequester. This has us looking inflation right in the face and we know this because history repeats itself.
History of the Federal Reserve
The Fed’s history goes back rather far to 1775 to 1791 when U.S. Currency was established. The American Revolution had to be financed, so the Continental Congress printed paper money. Rather than the dollars of today, they were known as “continentals.” The notes were issued in such a high quantity that the result was inflation. Inflation was mild, but it accelerated as the war roared on.
From 1791 to 1811, central banking saw its first attempt. The First Bank of the United States was established and it was dominated by money interests and big banking. The bank was opposed by many Americans that were uncomfortable with the idea of having a powerful bank oversee their money. In 1811, Congress chose not to renew the bank’s 20-year charter.
The second try at central banking occurred from 1816 to 1836 and it failed once again. Andrew Jackson was a major foe of central banking, so he made a vow to kill it. He was elected president in 1828, so the charter was not renewed when it expired.
Nonetheless, it was from 1836 to 1865 that the free banking era began. States chartered and unchartered “free banks,” issuing their own currency notes that were redeemable for specie or gold. Banks also started enhancing commerce through demand deposits. The New York Clearinghouse would be established during this time, which would lead to a way for the banks in New York City to settle accounts and exchange checks. This would lead to the National Banking act in 1863, which allowed for chartered banks at the national level. This meant the notes were backed by U.S. government securities. There would then be an amendment that would ensure national bank notes were not taxed, but state notes were taxed. This taxation resulted in the uniform currency. Despite the banking advancements, the worst depression the country had seen occurred in 1893 due to financial panics that had existed for years and started to grow. It was J.P. Morgan who intervened and brought stability.
But it didn’t take long for another bad year, which was 1907. Another banking panic occurred and J.P. Morgan was called upon again to intervene. By this point, Americans wanted the banking system reformed, but the citizens were divided on how this would occur. This was when Americans decided it was time for a central banking authority. The stage was set from 1908 to 1912. In 1912, Woodrow Wilson was elected president and considered a financial reformer, despite his lack of knowledge of finance. It was during his administration that the Federal Reserve was born.
The Federal Reserve would open for business in 1914. Twelve cities would be chosen as locations for regional Reserve Banks. From 1914 to 1919, the Fed would save the day during World War I because they enforced the Aldrich-Vreeland Act of 1908 that allowed for the issuance of emergency currency. The greatest impact, however, came from the ability of the Fed to discount bankers acceptances. Through this, the U.S. was able to aid the flow of goods to Europe, which helped finance the war for three years.
In 1920, open market operations began and the Fed established relationships with other central banks, such as the Bank of England. Unfortunately, the crash of 1929 that led to The Great Depression had the Fed scrambling. Approximately 10,000 banks failed. By 1933, Franklin Delano Roosevelt was declaring a bank holiday so that a remedy could be found. The Fed received a lot of the blame because of speculative lending. The aftermath of The Depression resulted in the separation of investment and commercial banking and required the use of collateral for Federal Reserve notes in the form of government securities. The FDIC was also established and the gold and silver standard ended.
The Fed Today
While the history of the Fed is quite interesting and we can easily see some similarities between yesteryear and today, there is something that we will always see: Inflation and deflation. The 1970s to the 1980s saw it. Inflation skyrocketed in the 1970s. In the 1980s, double-digit inflation was brought under control. The Monetary Control Act of 1980 called for the Fed to place competitive prices for its financial services against the private sector. The 1990s would see a very long economic expansion and it was great. There was a small recession in 2001, but it was not bad at all due to the Fed lowering interest rates drastically. At the same time, mortgage rates lowered and this expanded access to credit, making homeownership possible for people who would not qualify under traditional circumstances. This was due in part to adjustable rate mortgages that secured the low rate in the beginning, but the rate skyrocketed at a later time, causing the homeowners to not be able to afford the payments. The mortgages were so risky that the economy collapsed.
For investors, the investments are probably going to have to remain risky due to the fact that Ben Bernanke is expected to keep the Fed on its current path. His possible replacement, Janet yellen, is likely to move the Fed along on the same path even faster. Many economic experts feel that the chairmen of the Fed have been too humble and need to move toward more nontraditional methods when stimulating the economy. Then there are those in the government that feel the actions of the Fed can enable the government to continue their deficit spending for the long-term. As we saw from the history lesson above, history is saying that this cannot be a possibility and the country stay afloat.
Instead, experts say that the mortgage debt should be locked away so that the Fed can preserve its balance sheet to then start gradually raising rates so that investors are not risking so much to receive the yields that they need. Even during the recovery of the Reagan administration, interest rates were hanging between 5% and 7% after an inflation adjustment. The prices of commodities declined, which helped move the economy on a much better path. Now those same rates are in the negative and there is no change in sight.