March 14, 2014

CONSUELO MACK: This week on WealthTrack as the Federal Reserve celebrates its 100th birthday, is it a cause for rejoicing or despair? Two financial historians, NYU’s Richard Sylla and Grant’s Interest Rate Observer’s James Grant debate the case for lighting candles or snuffing them out- next on Consuelo Mack WealthTrack.

Hello and welcome to this special edition of WealthTrack, I’m Consuelo Mack. What is the proper role of a central bank? Can any institution prevent or control the booms or busts that dynamic market-based economies produce? Can they control interest rates and inflation, or insure robust employment? Should they try to?

Those are questions being raised anew as the Federal Reserve officially marks its one hundredth anniversary. On December 23rd, 1913, President Woodrow Wilson signed the Federal Reserve Act into law. As the current Federal Reserve describes it: “the Federal Reserve Act stood as a classic example of compromise- a decentralized central bank that balanced the competing interests of private banks and populist sentiment.” That rivalry and tension between private financial interests and populist sentiment is alive and well today and has been with us since earliest days of the republic.

Prior to 1913, populist forces killed two attempts to establish a permanent central bank. The nation’s business was financed by state banks, but it was also disrupted by a series of financial crisis and bank runs. Financier and banker JP Morgan had to come to the rescue twice- first in the banking panic and depression of 1893 and again in the banking crisis of 1907.

Calls for reform of the banking system became widespread. It took years of debate before the Federal Reserve Act of 1913 was signed by President Wilson, creating a decentralized system of 12 reserve banks with branches around the country and independent decision-making powers.

It wasn’t until the 1920s that the buying and selling of Treasury securities was coordinated as a monetary tool to influence the availability of credit.  Even so, the new Federal Reserve system didn’t seem to have much effect on the market crash of 1929 or the Great Depression that followed. Thousands of banks and businesses failed and one in four Americans was out of work.

In response, President Franklin Delano Roosevelt’s New Deal brought big changes to the financial system and the Federal Reserve. One of the biggest, the Glass-Steagall Act of 1933 separated commercial banking and investment banking and gave the Fed authority to supervise multi-bank holding companies.

The Banking Act of 1935 changed the Fed’s structure by establishing the Federal Open Market Committee as a separate legal entity and removing the Treasury Secretary and the Comptroller of the Currency from the Fed’s governing board. But it wasn’t until the 1951 Treasury-Fed Accord that the Fed gained the independence to pursue monetary policy on its own.

Meanwhile the Fed’s duties continued to expand. The 1977 Community Reinvestment Act required the Fed to ensure banks lent to low and moderate-income individuals. And the Federal Reserve Act of 1977 codified the Fed’s dual mandate of stable prices and maximum employment.

The Fed has been widely blamed for the double-digit inflation of the 1970s. But starting in 1979, the new Fed Chairman, Paul Volcker, took on the role of the nation’s number one inflation fighter, hiking interest rates to restrict credit and cut off inflation. His painful, recession-inducing strategy succeeded in killing inflation. His successor, Alan Greenspan, continued to use monetary policy to “serve as a source of liquidity to support the economic and financial system” from the market crash of 1987, the bursting of the tech bubble and the terrorist attacks of 9/11.

But it wasn’t 9/11 that revolutionized the Fed’s role. It was the subprime mortgage bubble, which morphed into a global financial crisis in 2008. Under Fed Chairman Ben Bernanke, the Fed invoked emergency authority to launch a series of new programs and assistance packages to rescue global financial markets and economies. The Fed also slashed short term interest rates to record lows in 2008 and have kept them there ever since. Nearly four trillion dollars of stimulus later, the Fed continues its activist role. In the words of Ben Bernanke, the Fed has “come full circle back to the original goal of preventing financial panics.”

Should that be the Fed’s goal and can it really succeed in doing it? Joining us are two WealthTrack favorites, each a respected financial historian and author.

James Grant is the Editor of Grant’s Interest Rate Observer, a twice monthly, self-described “independent, value-oriented and contrary minded journal of the financial markets” that is considered to be a must read by many institutional investors. He is a vocal critic of current Fed policy.

Richard Sylla is the Henry Kaufman Professor of the History of Financial Institutions and Markets and Professor of Economics, Entrepreneurship, and Innovation at the New York University Stern School of Business.

I began the interview by asking them to go back to basics: what is the role of a central bank?

JAMES GRANT: Well, one might start with the role that was assigned in legislation 100 years ago. It was to lend against sound collateral. It was to create a market in commercial paper, meaning business loans. It was to furnish so-called elastic currency and it has to be a lender of last resort, and that was it. Oh, yes. They added “and for other purposes” and we have all too many of the other purposes, but my suggestion is the Fed think more about the roles for which it was created rather than the ones it has arrogated to itself.

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