Bank Crisis Through The Ages

According to "Bank Crisis Through The Ages" on National Public Radio's Weekend Edition on Sunday, June 28, 2009, "Each financial crisis in American history has brought sweeping changes and pledges that bank failures will be averted in the future. Planet Money's Chana Joffe-Walt and Alex Blumberg take a tour of financial regulation through the ages."

Click the link above to listen to the story (6 min 39 sec).

Fed says recession easing, inflation not a threat

In the June 24, 2009 story "Fed says recession easing, inflation not a threat", Associated Press economics writer Jeannine Aversa reports the U.S. central bank left the federal funds rate unchanged because is sees signs the U.S. economy is recovering:

WASHINGTON – The Federal Reserve signaled Wednesday that the weak economy likely will keep prices in check despite growing concerns that the trillions it's pumping into the financial system will ignite inflation.
Fed Chairman Ben Bernanke and his colleagues held a key bank lending rate at a record low of between zero and 0.25 percent, and pledged again to keep it there for "an extended period" to help brace activity going forward.
Even though energy and other commodity prices have risen recently, the Fed said inflation will remain "subdued for some time." This new language sought to ease Wall Street's concerns that the Fed's aggressive actions to revive the economy will spur inflation later on.
The Fed also decided to maintain existing programs intended to drive down rates on mortgages and other consumer debt. Instead, the central bank again reserved the right to make changes if economic conditions warrant.
The Fed in March launched a $1.2 trillion effort to drive down interest rates to try to revive lending and get Americans to spend more freely again. It said it would spend up to $300 billion to buy long-term government bonds over six months and boost its purchases of mortgage securities. So far, the Fed has bought about $177.5 billion in Treasury bonds.
The Fed is on track to buy up to $1.25 trillion worth of securities issued by Fannie Mae and Freddie Mac by the end of this year. Nearly $456 billion worth of those securities have been purchased.
Fed policymakers noted that the "pace of economic contraction is slowing" and that conditions in financial markets have "generally improved in recent months." That observation about the recession was stronger than after the Fed's last meeting in April.
Economists predict the economy is sinking in the April-June quarter but not nearly as much as it had in the prior six months, which marked the worst performance in 50 years. The economy is contracting at a pace of between 1 and 3 percent, according to various projections.
Fed policymakers said its forceful actions, along with President Barack Obama's stimulus of tax cuts and increased government spending will contribution to a "gradual "return to economic growth.
Bernanke has predicted the recession will end later this year. Some analysts say the economy will start growing again as soon as the July-September quarter.
Fed policymakers noted that consumer spending has shown signs of stabilizing but remains constrained by ongoing job losses, falling home values and hard-to-get credit.
Even after the recession ends, the recovery is likely to be tepid, which will push unemployment higher.
The nation's unemployment rate — now at 9.4 percent — is expected to keep climbing into 2010. Acknowledging that the jobless rate is going to climb over 10 percent, President Barack Obama said Tuesday he's not satisfied with the progress his administration has made on the economy. He defended his recovery package but said the aid must get out faster.
Some analysts say the rate could rise as high as 11 percent by the next summer before it starts to decline. The highest rate since World War II was 10.8 percent at the end of 1982.
The weak economy has put a damper on inflation.
Consumer prices inched up 0.1 percent in May, but are down 1.3 percent over the last 12 months, the weakest annual showing since the 1950s. The Fed suggested companies won't be in any position to jack up prices given cautious consumers, big production cuts at factories and the weak employment climate.

Government policies to reduce the severity of recessions and reverse economic declines

The government has two broad options for managing the overall economy: monetary policy and fiscal policy.

In the United States, expansionary monetary policy is the Federal Reserve system´s use of the money supply, interest rates, and the banking system to encourage commercial banks to lend more money to the public in the hope that this will increase overall spending on newly produced U.S. goods and services. The collapse of credit markets in 2008 reduced most types of lending and will require a restoration of confidence (perhaps by improved oversight and regulation) before monetary policy can assist in economy recovery (by lending more money to encourage more overall spending).

Fiscal policy is taxation and government spending. The logic of using tax cuts to counter a recession is that if the government takes less money from individuals and businesses, they will have more money to spend. Remember the cause of the U.S. economic downturn is insufficient overall spending on newly produced American goods and services. In this regard, tax cuts are essentially identical to the federal government handing out money. The goal is to put more money in the hands of individuals and businesses in the hope that they will spend it on products that are newly made by U.S. workers. Many debates about tax cuts are essentially decisions about to whom the government should be giving money. Tax cuts and other increases in government handouts are relatively quick ways to inject purchasing power into the economy and increase the potential for increases in aggregate demand. There is no way to guarantee that these income supplements will result in purchases of newly made U.S. products, however. For example, much of the increased disposable income caused by the tax cuts of 2001 and 2003 resulted in paying down consumer debt rather than increased consumer spending. And even when spent, if the products purchased are not American-made there is limited benefit to the U.S. economy and its workers. Even though tax cuts or other government handouts can be done quickly, they may be poor choices if they do not significantly increase overall spending on newly produced U.S. goods and services.

An alternative fiscal policy to counteract economic declines is an increase in government purchases. The primary benefit of this choice is that government procurement policies can ensure that this increased spending goes to U.S. businesses that employ American workers. A difficulty with this approach, however, is that it may be difficult to spend sufficient quantities of money quickly enough on projects of long-term benefit. Infrastructure projects can take long periods of time to complete and thus may not inject additional income into the economy quickly enough. Similar arguments can be made for proposals to improve energy efficiency, develop alternative fuel sources, or reform the health care industry. Projects that can be quickly implemented, however, may be of questionable long-term benefit. Yet, if the result is increased purchases of new products made by U.S. workers and suppliers, they still may be preferable to tax cuts (if the tax cuts are used to pay down debt or buy used or foreign products).

Tax cuts and increases in government spending both increase budget deficits and the national debt. Criticisms of stimulus proposals on the basis of reluctance to increase public borrowing apply equally to tax reductions and increased spending programs. Running deficits is not always bad, however. For example, many students borrow substantial sums of money in order to attend college. This indebtedness is easily justified, however, because it leads to a college degree that increases earnings potential for the remainder of one´s career. Similarly, it can be reasonable for a society to borrow money from future generations if the funds are spent wisely on things that increase the productive ability of the economy and improve future living standards. Future generations may not mind if money is borrowed from them to develop alternative energy sources that result in less environmental degradation. It is less arguable to accumulate massive public debt based on willful ignorance, selfishness, or simple reluctance to pay one´s way. The 2001 and 2003 tax cuts were the first wartime tax decreases in U.S. history. Previous generations were willing to make sacrifices for causes they believed in.

Tax decreases are popular and are undoubtedly of short-term benefit to those allowed to pay less in tax. The dramatic increases in U.S. budget deficits and public debt since 1980 have been of great short-term benefit to many sectors of the economy. But they have done substantial harm to the long-term benefit of the U.S. and global economies (for many of the reasons cited by critics of current stimulus proposals). It is akin to allowing large numbers of people to go to the mall, stuff shopping bags with items, and walk out without paying. It is of great short-term benefit to those who get away with it. But these strategies are not sustainable in the long-term. Selfish and misguided choices over the previous three decades have left American policymakers with few, if any, desirable options. The more important question may be how long will it take before U.S. citizens become willing to make the sacrifices and tough choices necessary to correct the abuses of the past and demand more honest, reasoned leadership.

See also "Recessions & Depressions: Questions & Answers."

"The Fed Today" video

Join radio and television journalist Charles Osgood as he explains the workings of the Federal Reserve System. 

This 13-minute video covers the Fed's history from its creation in 1913 to the technological innovations of 21st century banking. It explores the structure of the Fed as well as monetary policy, banking supervision, financial services, and more.

Fed set to pay interest on banks' deposits

According to the May 8, 2008 article "Fed set to pay interest on banks' deposits" in The Independent, the U.S. Federal Reserve System is adding a new tool to monetary policy: the ability to pay interest on deposits at the Fed. When commercial banks deposit money in accounts at the Federal Reserve System, that money is not available to be loaned to the public. The Fed can alter the amount of money in circulation by altering the interest rate on deposits to influence how much money is loaned to the public. According to writer Stephen Foley:

The Federal Reserve is adding another weapon to its armoury for dealing with the credit crisis, with plans that would allow it to pay interest on deposits from thousands of US banks.

The scheme, which the Fed chairman, Ben Bernanke, is requesting permission for from Congress, is the latest in a series of innovations designed to help the central bank keep credit markets moving – efforts for which it has so far been roundly praised.

All of the country's commercial banks are required to keep a proportion of their cash at the Federal Reserve in order to ensure their solvency, but they do not currently receive interest. Paying interest will give the Fed an important lever for controlling interest rates throughout the financial system. Congress has agreed to allow the Fed to do so, but there was concern about the costs to the taxpayer, and the law will not take effect until 2011. Mr Bernanke is pressing lawmakers to remove the delay.

Paying interest would in effect set a floor for market interest rates, since banks would have no incentive to lend cash at a lower rate than it can get from the Fed. That means the Fed can flush the financial system with new money, without risking interest rates collapsing and setting off inflation.

Since the credit crisis began last summer, the Fed has made a series of seemingly arcane, but important changes to the way it interacts with financial markets. It has expanded the collateral it will take in when making new loans, acted to remove the stigma for financial institutions borrowing from the Fed and – most importantly – begun lending directly to Wall Street firms as well as just to commercial banks.

Instruments of Monetary Policy

Instruments of Monetary Policy


The Federal Reserve System uses three instruments of monetary policy: (1) the required reserve ratio, (2) the discount and federal funds rates, and (3) open market operations. All three instruments affect the economy by influencing the amount of money commercial banks create through loans.

In order to understand how the Fed uses these monetary policy instruments to influence the economy, it is necessary to understand the fractional reserve banking system.

Structure of the Federal Reserve System

Structure of the Federal Reserve System

The Federal Reserve System is composed of three parts: (1) the Board of Governors (BOG), (2) the Federal Open Market Committee (FOMC), and (3) twelve regional Federal Reserve Banks

The Board of Governors sets policy for the Federal Reserve System. Its seven members are appointed by the President of the United States and confirmed by the Senate. The Federal Reserve governors are given 14-year terms to insulate them from political pressure. The terms are staggered so one term expires every two years. The chairman of the Board of Governors is the most important member of the Fed. The chairman oversees the Fed staff, presides over board meetings, reports regularly to congressional committees, and influences the direction of monetary policy. The President of the United States appoints the Fed chairman to a four-year term. It is not uncommon for a Fed chairman to serve many consecutive terms. For example, Alan Greenspan was originally appointed in 1987 by President Ronald Reagan, and later reappointed by Presidents George H.W. Bush, Bill Clinton, and George W. Bush.

The Federal Open Market Committee (FOMC) conducts open market operations to alter the money supply and influence the economy. Open market operations are the purchases and sales of U.S. government securities by the Federal Reserve System. The FOMC is composed of the seven members of the Board of Governors and five of the 12 regional bank presidents. The president of the New York Fed is always on the FOMC because the purchases and sales of government bonds are conducted at the New York Fed’s trading desk. The other four positions on the FOMC are rotated among the remaining 11 regional bank presidents. Open market operations are the Fed’s primary tool for conducting monetary policy and influencing the economy. The FOMC typically meets every six weeks in Washington, D.C. to discuss the condition of the economy and to consider changes in monetary policy.

The United States is divided into 12 Federal Reserve districts with one regional Federal Reserve Bank headquartered in each district. The 12 regional Federal Reserve Banks oversee the health of the banking system. They are headquartered in Atlanta, Boston, Chicago, Cleveland, Dallas, Kansas City, Minneapolis, New York, Philadelphia, Richmond, St. Louis, and San Francisco. The presidents of the regional banks are chosen from each bank’s board of directors, who are typically leaders of the region’s banking and business community.

The 12 regional Federal Reserve banks perform the following functions:
1. clear checks
2. issue new currency
3. withdraw damaged currency from circulation
4. evaluate some merger applications
5. administer and make discount loans to banks in their districts
6. act as liaisons between the business community and the Federal Reserve System
7. examine state member banks
8. collect data on local business conditions
9. use their large staffs of professional economists to research topics related to the conduct of monetary policy[7]


Figure 2. A map of the twelve Federal Reserve districts, their regional headquarters, and branch offices. Source: The Board of Governors of the Federal Reserve System (http://www.federalreserve.gov/)

Functions of the Federal Reserve System

Functions of the Federal Reserve System

Function #1: Conducting Monetary Policy

The primary function of the Fed is the conduct of monetary policy. Monetary policy is the management of the nation’s money supply, interest rates, and banking system to promote economic growth, low unemployment, and low inflation.

If the Fed thinks the economy needs a stimulus (e.g., to fight unemployment), it will increase the money supply by inducing commercial banks to create more money through loans. Commercial banks are financial institutions, chartered by the federal or state government, that generate income primarily by accepting deposits from the general public and using these funds to create loans. Commercial banks are usually referred to simply as banks. Depositors are paid little or no interest on their deposited funds. Borrowers are charged moderate to high interest rates on their loans from commercial banks, however. Most commercial banks attempt to earn profits for their stockholders (i.e., the owners of the bank). Credit unions are not-for-profit organizations that provide banking services to members. Credit unions usually offer more favorable interest rates than other financial institutions. Many credits unions pay slightly higher rates of return on deposits and charge slightly lower rates of interest on loans than traditional banks.

If the Fed thinks the economy needs to slow down (e.g., to fight inflation), it will decrease the money supply by inducing commercial banks to create less money through loans.

Open market operations are the purchases and sales of government securities by the Fed to or from the general public. Monetary policy is conducted primarily through open market operations by the Federal Open Market Committee (FOMC). The FOMC meets approximately every six weeks to discuss the condition of the economy and consider changing the nation’s money supply. The 12 regional Federal Reserve Banks play an important role in monetary policy by providing economic data and research to the FOMC for its consideration. After each meeting, the FOMC directs the Open Market Desk at the Federal Reserve Bank of New York to increase, decrease or maintain the growth rate of the nation’s money supply. To increase the money supply, the Open Market Desk buys Treasury securities each day from the general public (i.e., in the open market). These transactions are open market purchases. To decrease the money supply, the Open Market Desk sells Treasury securities each day to the general public (i.e., in the open market). These transactions are open market sales.

If the Board of Governors thinks the economy needs more influence than is provided by the open market operations, it can change the discount and federal funds rates, which are the interest rates charged on loans to commercial banks. Low interest rates provide an incentive for commercial banks to create more money in the form of loans to the general public. The discount rate is the interest rate charged on loans from the regional Federal Reserve Banks to commercial banks. Loans from regional Federal Reserve Banks to commercial banks are called discount loans. The federal funds rate is the interest rate charged on loans from commercial banks to other commercial banks. The federal funds rate is one half of a percentage point less than the discount rate. Federal funds are reserves that are loaned overnight from a commercial bank with excess reserves to a commercial bank with a shortage of reserves. Reserves are explained later in this chapter.

If the Board of Governors wants to make a major adjustment to the economy, it might change the required reserve ratio. Decreasing the required reserve ratio allows commercial banks to create more money in the form of loans to the general public. Increasing the required reserve ratio causes commercial banks to create less money in the form of loans to the general public.


Function #2: Supervising and Regulating Banks

The Federal Reserve System maintains the stability of the financial system and protects the credit rights of consumers. Prior to the creation of the Federal Reserve System in 1913, the United States endured many banking panics. So to stabilize the banking system, Congress gave the Fed the responsibility to supervise and regulate banks. The Board of Governors develops the written rules that define acceptable behavior for financial institutions. The 12 regional Federal Reserve Banks supervise the enforcement of these rules by overseeing state-chartered member banks, the companies that own banks (bank holding companies) and international organizations that do banking business in the United States. The Federal Reserve System also ensures the stability of the banking system by acting as a lender of last resort. This means that if a commercial bank is in danger of going bankrupt, the Fed will provide the bank with enough funds to keep it solvent. A bank is solvent if it is able to meet its financial obligations, such as providing money to all depositors who wish to wish to withdraw their funds.






Function #3: Providing Financial Services[6]

The Federal Reserve System provides financial services to the U.S. government, the public, financial institutions, and foreign official institutions.

The Federal Reserve Banks and their branches provide a safe and efficient method of transferring funds throughout the banking system by offering banking services to all financial institutions in the United States.

Each Federal Reserve Bank provides banking services to all financial institutions in its geographic region. These services include the provision of currency as needed by the area’s financial institutions and the processing of commercial checks and other electronic payments.

The electronic payment services provided by the Fed are funds transfers and the automated clearinghouse (ACH). Funds transfers occur between financial institutions or government agencies. ACH transactions include payroll deposits, electronic bill payments, insurance payments, and Social Security distributions.

Because the Federal Reserve System provides banking services to financial institutions, such as commercial banks, the Fed is sometimes called the bankers’ bank. The Federal Reserve also provides banking services to the U.S. government. These services include the maintenance of U.S. Treasury accounts, the processing of government checks, the sale, service, and redemption of U.S. Treasury securities, savings bonds and postal money orders, and the collection of federal tax deposits.

Overview of the Federal Reserve System

Overview of the Federal Reserve System

Monetary policy is the management of the nation’s money supply, interest rates, and banking system to promote economic growth, low unemployment, and low inflation.

The Federal Reserve System (the Fed), the central bank of the United States, conducts U.S. monetary policy. The Fed is a quasi-government agency that was created in 1913, after a series of bank failures, to ensure the health of the banking system of the United States.

The Federal Reserve System is composed of a Board of Governors (BOG), the Federal Open Market Committee (FOMC), and twelve regional Federal Reserve Banks. These three parts work together to accomplish the Fed’s three main responsibilities:

(1) conducting monetary policy to promote economic growth, low unemployment, and low inflation;
(2) supervising and regulating banks to maintain the stability of the financial system; and
(3) providing financial services to the U.S. government, the public, financial institutions, and foreign official institutions.

The Federal Reserve System does not print currency. U.S. currency is printed by the Bureau of Engraving and Printing, which is part of the U.S. Department of the Treasury.

Monetary Policy - Topics

The primary macroeconomic policy goals are economic growth, low unemployment, and low inflation. The main tools to achieve these goals are monetary policy and fiscal policy.

Monetary policy is the central bank's use of the money supply, interest rates, and the loans generated by the banking system to influence the overall level of spending in the economy. The U.S. central bank is the Federal Reserve System (the Fed).

Click on the hyperlinks below to take you to a portion of the blog devoted to that topic:

Monetary Policy - Learning Objectives
Macroeconomic Policy Tools
How Monetary Policy Affects the Economy
Money and its Functions
Types of Money
Definitions of the U.S. Money Supply
Overview of the Federal Reserve System
Functions of the Federal Reserve System
Structure of the Federal Reserve System
Membership of the Board of Governors of the Federal Reserve System, 1914 to present
Instruments of Monetary Policy
Fractional Reserve Banking - An Introduction
Fractional Reserve Banking: How Required Reserves Keep the Banking System Solvent
Fractional Reserve Banking: The Relationships Between the Monetary Base, the Reserve Ratio, and the Money Supply
Fractional Reserve Banking: Using T-accounts to Illustrate How Banks Create Money
An example of how $100 of currency could create $1000 of money in the form of deposits in bank accounts if banks hold 10% of all deposits as reserves
How the Instruments of Monetary Policy Affect the Economy
Monetary Policy Instrument #1: the Required Reserve Ratio
Monetary Policy Instrument #2: the federal funds rate
Monetary Policy Instrument #3: open market operations
Example of How the Fed Uses an Open Market Purchase to Increase the Money Supply in a Fractional Reserve Banking System with 10% Required Reserves.
Example of Fractional Reserve Banking with 20% Required Reserves
Important Definitions Related to Monetary Policy
Monetary Policy - Questions for Further Study
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