RateWatch #378 – The Real Power in the Federal Government

October 18, 2003 by Dick Lepre

What's Happening

The "industry that won't die" - housing - showed a strong performance last month with housing starts up to 1,888,000 annual. There are two underlying forces driving housing: low interest rates and the demographics of echo-boomers. The children of baby boomers are buying their first homes. The University of Michigan Consumer Sentiment Index was also up.  The picture remains:
consumers spending, consumers buying homes, business not spending - the formula for a flat economy.

The Real Power in the Federal Government

Since we are going to have (presumably) a presidential election  next year we are going to hear a lot of talk about how the president is responsible for what is good/bad about the economy.

This operates even on a local level.  Absent an economic downturn Gray Davis would not be writing his resume.

I think that people obsess about the connection between who's president/governor and the economy. The correlations are too tenuous and subjective.  Republicans want to credit the economic expansionof the '90's to the Reagan tax cut.  Democrats want to give Clinton credit.

I don't think that politicians make or break the economy.  The boom of the '90s was the result of a lot of hard work by a lot of people.  If there is any part of the Federal government that deserves
credit or blame for the economy it is the Federal Reserve.

Is the Fed the 4th Branch?

The folks who framed the Constitution drew on the experiences of European governments and formulated a three part federal government: the president, Congress and the courts. A system of "checks and balances" among the three branches is supposed to prevent any one of them from becoming too powerful.

There are times when it is obvious that this system functions. The Clinton-Lewinsky soap
opera was a great example of how little power any one of these branches really has. The fact that
there were 3 branches of the government involved made the event pass smoothly if uncomfortably.

In many countries the military has the real power. This seems to work in smaller countries but in
the U.S. the military wields no substantial domestic political power.

Like it or not, there is one pervasive power in the U.S. - money. Money is brought to you by the
Federal Reserve. The Chairman of the Federal Reserve, Alan Greenspan, has on his desk a sign
saying "The Buck Starts Here."

Briefly, the Federal Reserve was created in 1913 to provide, well, a Federal Reserve - a way for
banks to share each others reserves if a "run" was created on one. After the Depression, Congress, in 1935, created the system whereby the Fed was able to create money by purchasing government securities.

The Fed controls business and the economy by controlling the money supply and by its ability to control interest rates by buying and selling government securities on the open market. More impressively, the Fed can send shock waves through the economy by merely talking about raising rates. The "deterrent" force of Greenspan's mouth is akin to the nuclear deterrence of the '50's
and '60's. The threat of raising rates has as much effect as actually raising rates.

What Powers Does the Fed Have?

The Fed has 2 main sources of power:
1) the power to "diddle with rates" both by resetting the actual Fed Funds target or by merely talking about it and
2) the "magic checkbook" whereby the Fed can create money out of nowhere and buy bonds on the open market. The power to create money out of nowhere (so called, "fiat money") is impressive. I'd like to be able to do that.

Let's for the moment grant that the very ability to create money makes the Federal Reserve a
separate branch of the government. (Of course it is not, it is still part of the Treasury Department.)

Someone recognized that it was imperative that the Fed buy debt on the open market and not directly from the Treasury Department. This idea of "open market" is extremely important. The Fed can open up its checkbook (the magic one with the near infinite overdraft protection) and inject money into the economy by buying government notes and bonds. But, it must do so on the open market. Congress' sovereignty over expenditure is maintained by forcing the Fed to buy
from private holders of government debt. If the Treasury Department ran the show, Congress would have succumbed its budget powers to the executive branch.

Who's Interest?

The Federal Reserve has very significant control over the economy, but it does not "make or break" the economy. It smoothes out the sizes of the economic cycles by avoiding potholes. In his 1998 speech Greenspan spoke of the "virtuous cycle" that the economy was in.

To quote him: "Evidence of accelerated productivity has been bolstering expectations of future corporate earnings, thereby fueling still further increases in equity values, and the improvements in productivity have been helping to reduce inflation. In the context of subdued price increases and generally supportive credit conditions, rising equity values have provided impetus to spending and, in turn, the expansion of output, employment, and productivity-enhancing capital investment.The essential precondition for the emergence, and persistence, of this virtuous cycle is arguably
the decline in the rate of inflation to near price stability."

The Fed  looked so good  because, as Greenspan pointed out, inflation was contained. With
inflation contained, the Fed has the ability to "fine tune" rates and look great. Contained
inflation is like driving down the highway on a clear, sunny day with dry pavement and little traffic.
Everyone drives well. If inflation is out of control, the correcting forces of the Fed are like someone trying to avoid other cars on a wet road, at night with a 45 mile an hour crosswind. There will be some wrecks.

With inflation contained (perhaps by the global economy) the Fed is able to reduce rates to
"near-zero" without starting "wage/price" spirals.

The success of the 1990s economy was not due to politicians or even the Fed. It was due to the combined sanity of workers, businessmen,  investors and the Fed. It is very easy for bankers to make a lot of money and the Fed to look great in this environment. Perhaps the very weakness of politicians this decade (are there any real American political leaders at present?) has helped. Everyone else can just do their job. The Fed has power in its ability to create money. But it has not created wealth and prosperity. Wealth is the product of hard work, a healthy measure of greed and a good bit of luck.

The profits of business this decade have bred success. The profits have enabled American business to capitalize itself on a grand scale. This cycle may be coming to and end or at least
a pause.

The Real Power of the Fed

I think that, in final analysis, the Fed is one big bank with a gigantic amount of special rights and privileges. It can create money but unlike other banks it operates with almost no control from other parts of the government. It is not subject to the audits that other banks are. (The Fed is audited by the GAO and the district branches are subject to outside audits but the audits do not look into the policy making, open market operations, or discount window operations.) It is relatively free to buy and sell gold and U.S. and foreign bonds and currencies. It is the lack of intervention from politicians that enables the Fed to work and gives it power. The Fed has served itself well by not causing any scandals. No Michael Milkens, no Espys, no coke busts, no Chappaquiddick, no Oliver Norths.

The Fed is not a 4th branch of the government. It is a very powerful bank which draws its power from the quiet anonymity of doing a job with almost no supervision from the other branches of the government.

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