September 19, 2012

The Fed and Our Future

Among the least understood but most important issues confronting the future of our country is the fiscal policy of our government--and especially that of the current Obama Administration, how it is enacted, and the role of the Federal Reserve. Even with Ron Paul's (among the more well-known critics of the Fed) most recent run for President, I think the general public has very little understanding of what the Fed is, how it works, its status as a public-private entity, and the effect it has on the future of our country's fiscal (and therefore economic) viability. 

I often find the whole thing confusing so I take a few minutes every now and then to review relevant materials. That's why I found Monday's WSJ opinion piece, The Magnitude of the Mess We're In, by GP Shultz, et al, so interesting. He and his co-authors wade into discussing the fiscal mess with which we are saddling ourselves. Maddeningly, it doesn't have to be this way but we (as a country) seem unable or unwilling to stop from immersing ourselves in financial lunacy. 

Since the Federal Reserve features so prominently in the article, I thought it might be helpful to have a very concise explanation at hand. After scanning several sources for an overview of the Federal Reserve, Wikipedia actually had the most easily understood entry. Here is an edited extract from its article on the Federal Reserve System (the Fed), the central banking system of the United States:

     "The Fed was created on December 23, 1913, with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907. 

     "The Fed is independent within government in that "its monetary policy decisions do not have to be approved by the President or anyone else in the executive or legislative branches of government." Its authority is derived from statutes enacted by the U.S. Congress and the System is subject to congressional oversight. The members of the Board of Governors are chosen by the President and confirmed by the Senate. 

     "In its role as the central bank of the United States, the Fed serves as a banker's bank and as the government's bank. As the banker's bank, it helps to assure the safety and efficiency of the payments system. As the government's bank, or fiscal agent, the Fed processes a variety of financial transactions involving trillions of dollars. Just as an individual might keep an account at a bank, the U.S. Treasury keeps a checking account with the Federal Reserve, through which incoming federal tax deposits and outgoing government payments are handled. As part of this service relationship, the Fed sells and redeems U.S. government securities such as savings bonds and Treasury bills, notes and bonds. It also issues the nation's coin and paper currency. The U.S. Treasury, through its Bureau of the Mint and Bureau of Engraving and Printing, actually produces the nation's cash supply and, in effect, sells the paper currency to the Federal Reserve Banks at manufacturing cost, and the coins at face value. The Federal Reserve Banks then distribute it to other financial institutions in various ways."

As for the WSJ piece, here are some goodies:
- The amount of debt is one thing. The burden of interest payments is another...Treasury must raise $4 trillion this year alone. So the debt burden will explode when interest rates go up."
- President Obama's budget will raise the federal debt-to-GDP ratio to 80.4% in two years, about double its level at the end of 2008, and a larger percentage point increase than Greece from the end of 2008 to the beginning of this year
- Under the president's budget, for example, the debt expands rapidly to $18.8 trillion from $10.8 trillion in 10 years. The interest costs alone will reach $743 billion a year, more than we are currently spending on Social Security, Medicare or national defense, even under the benign assumption of no inflationary increase or adverse bond-market reaction. For every one percentage point increase in interest rates above this projection, interest costs rise by more than $100 billion, more than current spending on veterans' health and the National Institutes of Health combined.
- We cannot count on problems elsewhere in the world to make Treasury securities a safe haven forever. We risk eventually losing the privilege and great benefit of lower interest rates from the dollar's role as the global reserve currency. In short, we risk passing an economic, fiscal and financial point of no return...Our first Treasury secretary [Alexander Hamilton] famously argued that one of a nation's greatest assets is its ability to issue debt, especially in a crisis... As historian John Steele Gordon has written, our nation's ability to issue debt helped preserve the Union in the 1860s and defeat totalitarian governments in the 1940s. Today, government officials are issuing debt to finance pet projects and payoffs to interest groups, not some vital, let alone existential, national purpose.
- The fixes are blindingly obvious. Economic theory, empirical studies and historical experience teach that the solutions are the lowest possible tax rates on the broadest base, sufficient to fund the necessary functions of government on balance over the business cycle; sound monetary policy; trade liberalization; spending control and entitlement reform; and regulatory, litigation and education reform. The need is clear. Why wait for disaster? The future is now.

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