Tuesday, August 27, 2013

Has the Federal Reserve Failed?



The Federal Reserve System (commonly called the FED) was implemented in 1913 in an attempt to prevent financial panics. The FED serves as the central bank of the United States, sets interest rates, and issues currency (Federal Reserve Notes) on behalf of the US Treasury Dept. They are deeply involved in monetary policy and do a fair amount of other things not listed above. Contrary to popular belief, the FED is not a government entity. Technically it is a quasi-government entity, but in practice it's a private corporation with its own set of rules and regulations. The inventors of the FED system were among the wealthiest and most powerful bankers and businessmen in the nation at the time and included folks like J. P. Morgan and Rockefeller, and they held a closed-door ten-day meeting at Jekyll Island, GA in 1910.

On paper, the FED is under congressional oversight, however a number of their activities and meetings are not subject to oversight - in fact they're not even required to respond to an individual congressman's inquiries into certain activities. One example of this lack of oversight is the Consumer Financial Protection Bureau. On top of the CFPB, many of the meetings the FED has (particularly with various banks and businesses) are not open to the public, nor are the minutes of the meetings. The FED is made up of twelve regional reserve banks and their Board of Governors (comprised of seven members who serve 14-year non-renewable terms) oversees the entire enterprise.

The original congressional mandates for the FED were: maintaining maximum employment, stable prices, and moderate long-term interest rates. Since then, the FED's powers and responsibilities have grown significantly. According to the FED's website their primary purpose is:

  • Conduct the nation's monetary policy in such a way as to provide full employment and stable prices
  • Supervise and regulate to ensure the safety and soundness of the nation's financial system
  • Maintain stability and contain systemic risks (prevent booms & busts)
  • Provide certain financial services to the US government, US financial institutions, and foreign government banks  

So how good of a job has the FED done in its 100 year history? 


Maximum and Stable Employment


One of their stated goals is to provide maximum employment. The following graph shows the US labor participation rate since records began in 1948. This rate is defined as the percentage of people working out of the entire available workforce. This chart comes directly from the Bureau of Labor Statistics

(click on any image for a larger view)

As you can see, the LPR has never been stable nor has it been 100%. And since 1999, the rate has fallen continually. As of July 2013, the rate is 63.4%, a rate not seen since 1978. Furthermore, one would expect that once the country came out of the "Great Recession of 2008", the rate should rise.

Here is the rate since 1999. You will notice the large drop in 2008...and the continued drop.


This metric (the LPR) has fallen at a faster rate in the past 5 years than at any other time since the mid-1960s.  

Next, let's look at the overall unemployment rate. There are six ways to measure unemployment. Some focus solely on those actively looking for work, others include everyone who is looking for work, plus those in part-time jobs who would like to be full-time, and those who have given up looking for work. The officially released unemployment figures, called "U3", does not include the number of people who have lost hope and given up looking for work. The current U3 shows a 7.4% unemployment rate. However, the U6 (which includes those who are working part-time because they can't get a full-time job and those who have given up looking) shows a staggering 14%. 

Of course, stability is a part of the FED's mandate. How stable has the unemployment rate been since 1950?



So, has the FED achieved maximum or stable employment levels? FAILED

Stable and Sound Financial System

The boom & bust cycle (periods of rapid economic growth followed by a period of recession or depression) has arguably been less severe since the creation of the FED. That being said, our financial system has been far from stable and sound. Since 1913, there have been 17 recessions and two depressions. These periods resulted in an average GDP contraction of 9.5%. If you remove the two depressions, the avg. contractions were still at 7.16% each. 

This graph shows you the growth (or contraction) of national GDP between 1923 and 2008 (the height of the last big recession).


And this one shows you real GDP growth from 1950 to 2010, also not exactly a "stable" situation. The "Great Moderation" refers to a period of less volatility in the economy.  


Without an adequate increase in production and economic growth, the amount of national (public) debt can severely degrade the viability and soundness of an economy. Since 2001, the national debt has increased 176.6% while the GDP has only risen 64.7%. 


Each month the government pays $30 billion just on interest payments. For 2012, we spent nearly $360 billion...just on interest! That's $1,149 for every person in the country. 

Next comes the stock market. While the Dow Jones Industrial Average is only a portion of our economy it is a good indicator of the general health (or at least, mood) of the economy. If interest rates, inflation, wages, employment etc were all stable and growing at a more healthy rate you would expect a nice smooth incline throughout history. Instead, we see a relatively smooth transition until about 1994. Then we see long periods of rapid growth followed by a bust, with multiple periods of tremendous growth and severe busts dotted throughout. 


Wages are a key indicator of economic health. The growth of wages should be fairly uniform year-over-year and the gap between the various percentiles should also stay somewhat uniform. From 1950 to the mid-70s both wages and the income "gap" had remained stable in their growth. From about 1980 onward, things get interesting. 


And since 2000, median household income has been very erratic with a huge drop since 2009. 



The last series of economic indicators I'll use are the historical prices of two popular commodities, gold and silver.



None of this meets the criteria of stable or sound. FAILED

Dollar Strength and Interest Rates

Since 1913, when Federal Reserve notes were first issued, the value of $1 today is the equivalent of $0.04 in 1913. That is a reduction in value of 96%. 


Here is a chart showing the Consumer Price Index (CPI) from 1913-2006. The CPI measures the changes in pricing of a basket of commodities. Thus, an increase in the CPI equates to an increase in prices for goods & services (and serves as a way to measure the cost of living). Incomes growing at the same rate as the CPI would mean a stable economy. Incomes & CPI growing at a commensurate rate with the changes in the dollar's value should also be expected. 


We do see a relation between the overall CPI and the devaluation of the dollar, but when added to the rest of the economy it does not bode well.
Falling wages, increased prices, and the devaluation of the dollar means that people have to work harder and longer to purchase the same things over time. Wealth is defined not as the amount of currency a person has, but as the amount of goods that currency can purchase. The debasement of the dollar quite literally means that a person who began saving as a teenage worker, when they retire, the money they saved is worth less today than when they saved it - their earnings were in essence stolen. 

The US Dollar Index (USDX) shows the relative strength of the dollar compared to a basket of other currencies (currently six including the Euro, yen, and Pound). A stable and strong money supply is one of the key purposes of the FED.

Looks like a chaotic roller coaster with an overall trend of devaluation. So much for stable.  

The last metric we will look at is the Federal Funds Rate. This sets the interest rates lenders are allowed to use. When the economy is good the FED raises the rate and when the economy contracts the FED lowers the rate to encourage lending and economic growth. The problem is that the FED can't accurately predict market behaviors and often, economic policies actually contribute to the problems they're trying to avoid or fix. A great example of that was the housing crisis.


In the end, looking at the FED's own reasons for its existence and looking at the information provided by the government itself, the necessity and value of the Federal Reserve System must be called into question. The amount of good the FED has brought to the system when compared to all the negatives really equates to a simple grade.

Federal Reserve grade: F

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