The Fed Explains Why It Is Great

by Robert Wenzel
Economic Policy Journal

Recently by Robert Wenzel: Neither Inflationst Nor Deflationist Should Thou Be (In the Short-Term)

The 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.

One support 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 bloggers write:

...the basic 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 other sources.

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.

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March 31, 2011

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