Fed Explains Why It Is Great
by Robert Wenzel: Neither
Inflationst Nor Deflationist Should Thou Be (In the Short-Term)
American banking system is always on the edge of crisis because
of the Federal Reserve System.
For all practical
purposes, the United States has one bank, the Federal Reserve with
a bunch of branches that are treated with different degrees of respect.
Some are treated rudely, while others in the eyes of the Fed, can
do no wrong.
method the Fed uses to protect its favored "branches"
is the discount rate. At its blog site today, the New York Fed attempts
to justify this Fed tool that serves to prop up the entire convoluted
Federal Reserve System.
We can see
a key problem with the, Fed as overlord, current banking system
by taking a look at the first paragraph of a psot by NY Fed bloggers
applauding themselves. The
rationale for [the discount window] is that circumstances can
arise, such as bank runs and panics, when even fundamentally sound
banks cannot raise liquidity on short notice
But how can
a "fundamentally sound" bank ever face a liquidity problem?
A liquidity problem comes about only because the Federal Reserve
system encourages (partly through the discount window) the mismatch
between time structure of money deposited at the bank and money
loaned out. A liquidity problem simply means that a bank may have
loaned out money for 30 years, when a depositor has the right to
withdraw such funds after 30 days. Banks aren't too concerned about
this mismatch, since they know they can always go to the Fed to
get money (via the discount window) if withdrawals are occurring
that are greater than cash the bank has on hand or can borrow from
In other words,
it is the Fed's backstop that encourages the mismatch between length
of deposits and length of loans. Without this backstop, banks would
never create such a mismatch. It would be too risky for them (And
this is aside from the moral implications of promising to pay in
30ndays some funds on money that has been loaned out for years.)
Without a Fed,
banks taking in short-term money would loan it out for short-terms
and would make long-term loans with money that depositors had agreed
to keep on deposit for the long term. End of liquidity problems
for banks and the start of truly fundamentally sound banks.
the rest of the article
Economic Policy Journal
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