Resources

Request a Quote

Join Our Newsletter

Form Heading

Would Abolishing the Federal Reserve Be a Good or Bad Idea?

© 2019, by Daniel T. Jordan, ASA, CBA, CPA, MBA, based on talks by Milton Friedman1

Federal Reserve

In order to answer this question, we need to know the reason why the Federal Reserve was established to begin with.

You may think if you bring cash to the bank and deposit it, the bank takes that money and sticks it in a safe somewhere to wait until you need it again to turn it back over to you.  The bank does not do this.  It immediately takes a large part of what you put in and lends it out to somebody else.  The result is that if all depositors and all the banks tried all at once to convert their deposits into cash, there would not be enough cash in the banks of the country to meet their demands.  In order to prevent such an outcome, it is necessary to either stop people from asking for their money or to have some additional source from which cash can be obtained.

The Federal Reserve System, often referred to as the Federal Reserve or simply “the Fed”, is the central bank of the United States.  It was created in December 1913 with the purpose of providing the additional cash to the banks to meet the demands of the depositors when a run on the bank’s funds arises.  It was about reassuring the public they can get their money back and preventing financial crises. 

Looking back, did the Fed do a good or bad job in fulfilling its task?

According to Milton Friedman, there is no institution in the USA that has such a high public standing and such a poor record of performance as the Federal Reserve.  Established in late 1913, the Fed presided over doubling the prices during World War I.  It produced a major collapse in 1921.  It had a good period from 1922 to 1928 but then undertook actions that led to a recession in 1929-1930 and converted that recession by its actions into the Great Depression.  The major villain in the Great Depression in Friedman’s opinion was unquestionably the Federal Reserve System.  Since that time it largely presided over doubling the prices over World War II.  It financed the inflation of the 1970s.  On the whole, the Fed has a very poor record.  In Mr. Friedman’s informed opinion (based on his research, he has written and co-authored a series of books dealing with the monetary history of the United States and others), it has done far more harm than good. 

Milton Friedman passed away in 2006 before the financial crisis of 2007-2008.  So he could not comment on that situation.  The first decade in the 21st century has been a textbook example of a boom and bust cycle.  Between 2001 and 2004, the Federal Reserve injected new credit into the economy, pushing interest rates to their lowest level since the late 1970s. As a result, the economy was booming. This sent out false economic signals to businesses with respect to demand for their products. These businesses responded by hiring more staff, buying more resources, investing in capital, and so forth.  

As Friedrich Hayek, a Nobel-prize winning Austrian economist noted, prices play an important role in the economy, transmitting information that allows market participants to coordinate their plans. The Fed’s distortions create the boom and bust cycle by distorting the information that the price signal conveys to consumers and producers.  It may seem like businesses are overinvesting but they are simply responding to false economic signals sent by the Federal Reserve. 

The early 2000s marked the boom phase. We experienced a 52-month record streak of uninterrupted job growth from September 2003 to December 2007.  Treasury Secretary Henry Paulson in March 2007 said that “the global economy is more than sound: it’s as strong as I’ve seen it in my business career.” The stock market was growing fast, reaching its peak in October 2007, with the S&P 500 closing at 1,565.  Federal Reserve chairman Ben Bernanke even stated in January 2008 that “the Federal Reserve is not currently forecasting a recession.” They did not realize that an inevitable economic bust was about to happen.

The boom was followed by a bust because booms created by monetary inflation are unsustainable.  The stock market crashed in October 2008.  Many were quick to wrongly blame free market capitalism for the economic crash.  The free market has not failed since we’ve never had free market capitalism. Instead, government intervention in the economy failed.

Then again with the financial crisis reaching a pitch in 2008, the Federal Reserve took to flooding the financial market with dollars by buying up bonds.  The Fed began its program of quantitative easing (QE) (i.e., expansionary monetary policy) in December 2008 as a way to increase liquidity in the financial markets after the collapse of Lehman Brothers and the corresponding credit crunch.  

The Fed decreased interest rates dramatically, nearly to zero. The Fed poured billions of dollars into the bond market causing the Fed’s balance sheet to go from $2.1 trillion to $4.5 trillion.  The stock market benefited from the low rates as the banks barely paid any interest on savings.  The S&P 500 doubled in value from November 2008 to October 2014, coinciding with the Federal Reserve Bank’s “quantitative easing” asset purchasing program.  The S&P 500 grew another 1.5 times from October 2014 until it closed in September 2018 at a record level of 2,931, about 11 months after the QT program (see below) began.2

In its October 2017 meeting, the Fed began quantitative tightening (QT) (i.e., contractionary monetary policy) by decreasing the liquidity within the economy.  This is a technical move by which the Fed allows its Treasury holdings to mature and not replacing them, effectively shrinking its balance sheet.  The Fed is raising the interest rates gradually.  The impacts of the Fed’s normalization policies are not felt immediately in the equity markets.  There is always a time lag.  There has been a resurgence in volatility and a market sell-off of roughly 14% since the S&P 500 hit its all-time high in mid-September 2018.  The concern for a global bear market is increasing.  Whether or not we see more decline will depend on the health and growth of the economy in 2019.

The Fed created an environment in which Facebook FB could trade at $220, Apple AAPL at $230 and Netflix NFLX at $420, and it is that very same Fed that has created an environment in which each of those names has fallen at least 35% in less than 6 months time.

Fluctuations in the rate of growth of the quantity of money produce uncertainty.  When prices start to go up, businesses do not know whether the price rise is due to their product being in higher demand or because there is more money around and there is going to be general inflation.

We would not experience such dramatic economic swings were it not for monetary policies that distort real prices and encourage improper investment decisions.  Boom and bust cycles are inevitable when government interventions confuse market participants.

Mr. Friedman stated he would be in favor of abolishing the Federal Reserve and have the money rather controlled by a computer that would supply a stable rate of monetary growth that would eliminate the uncertainty that these short-term movements introduce.  However, since this is not happening and there is going to be a Federal Reserve System, the monetary policy should be concerned with trying to see how to make itself less harmful.

  1. Milton Friedman was an American economist who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the complexity of stabilization policy.
  2. There is always a time lag, which is why the stock market continued to grow for some time even after the QT program began.