Transnational Research Associates

Test Essay Question I

The Primary Roles of the Federal Reserve System of the United States

Art Madsen, M.Ed.

By establishing monetary policy, which impacts the timely availability of cash and credit, the Federal Reserve Banks, located in 12 cities around the nation, but forming one unified system, play a decisive role in keeping inflation under control and, at the same time, promote economic growth. By enforcing regulations established to control commercial banks, the Fed strengthens the U.S. financial system's safety and reliability. Finally, the Fed helps make commercial transactions more efficient by facilitating check-clearing and other payment services to private and semi-public institutions, handling deposits and withdrawals, and to the federal government.

In times of economic stress, the Federal Reserve system is empowered to provide cash liquidity in order to keep all banking institutions solvent and operational. This last occurred on a major scale during the stock market crash of 1987, when the Federal Reserve’s Chairman, Alan Greenspan, made an historical and dramatic decision to provide massive liquidity to ailing institutions. This courageous action temporarily restored confidence and stability to the banking and investment system, allowing time to find more suitable solutions.

It is important to distinguish between "monetary policy", the Fed’s responsibility, and "fiscal policy" which is essentially a Congressional prerogative. Fiscal matters are tax and expenditure issues that do not involve the actual control of the money supply or the setting of interest rates. Indeed, the Fed is responsible for interest rates and money supply control, as will be discussed in more detail.

The goals of the nation's economic policy are to safeguard the purchasing power and value of the U.S. Dollar, encourage economic expansion and an acceptably high level of employment. American monetary goals also include maintaining a reasonable balance in trade transactions with other nations over the long run, which was not accomplished, in relation particularly to Japan, in the late 1980s, causing a trade imbalance and, hence, a massive financial crisis. The Federal Reserve System strives to contribute to the Nation’s goals and objectives through its monetary policy decisions affecting the amounts available and the cost of money, in addition to short and long term credit for business growth. Ideally, when the financial climate is favorable, the Fed maintains a monetary and credit policy that is relatively stable and predictable.

One of the primary functions of the Federal Reserve is to balance the flow of money and credit with the requirements of the economy. The Fed, along with its Board of Governors, achieves this balance by manipulating the levels of financial reserves within banks, which in turn impacts the institutions' ability to transact loans or investments (usually purchases). These reserves, required by law of all U.S. banking depositories, must be equal to pre-determined percentages of deposits and can be held either in the form of cash-on-hand or account balances, but the account balances must be at the Federal Reserve, not demand deposits belonging to clients.

The Fed is empowered to engage in open-market operations, influencing, indeed offering, the sale of government securities such as bonds and other instruments. This is a powerful tool. If the Fed wants to make money more difficult to obtain, it sells government securities and lowers the balance of its own holdings, making the price of money higher and credit tighter. The opposite is true, as well, if more liberal credit is needed. Under those conditions, the Fed makes large deposits to banking institutions when buying securities. This causes an influx of "easier" capital into the marketplace.

Banking institutions sometimes borrow money from the Federal Reserve to cover their obligations, and they do so at the prevailing "discount rate." When the Fed wants to restrict economic growth, it raises this interest rate and banks lend less money to their customers, since less capital is available and it is more costly to borrow. Again, the opposite is true as well.

In addition to supervising banks, determining credit and monetary policy, and attempting to fulfill the economic goals and objectives of the Nation, the Federal Reserve Bank provides other services, not as widely used, but extremely useful. One service that comes to mind is the Discount Credit Window. Under difficult or unusual circumstances, the Fed serves as the "lender of last resort" for private or public depository institutions. Banks, for example, that find themselves temporarily low on reserves because of unexpected loan demands, deposit drains (such as panic or semi-panic conditions), or seasonal economic factors (especially in agricultural areas) may be eligible to borrow from a Reserve Bank.

This reliable ‘availability of credit’ from the Federal Reserve stabilizes individual institutions, as well as the banking and financial system as a whole, during times of liquidity crisis. This system was devised in the early days of the Fed’s existence to counter the types of bank runs and panics that occurred periodically during the early 20th century in the United States. In summation, that, in conjunction with those mentioned earlier, is the Fed’s most critical and valuable function.

Test Essay Question II

Bretton Woods and Monetary Restructuring Thereafter

In July of 1944, as World War II was drawing to a close, 700 financial leaders from 44 nations around the world met in the small New Hampshire town of Bretton Woods. Their task was no less than to restructure the entire world’s monetary system, and to create institutions that would ensure stability and development for the whole international community. Their legacy was a system of currency alignment, the International Monetary Fund (IMF), and the International Bank for Reconstruction and Development (IBRD), still part of the World Bank in today’s system. This essay will focus, not on the 1944 to 1970 expansionary period of techno-industrial growth and economic diversification, but rather on the changes that occurred after 1970 due to criticism, crisis and realignment characterizing this less stable period in the financial history of the United States and the world in general.

The financial crises of the 1980s and 1990s called into question, in the eyes of financial leaders, the purpose and legitimacy of some aspects of the Bretton Woods decisions. However, ultimately, in spite of the 1987 crisis and the recession of the early 90s, the World Bank, the IMF and the system of currency alignment were basically left intact -- but were weakened, modified, or re-proportioned in some important respects to accommodate new realities.

The initial intent of Bretton Woods was to prevent a recurrence of protectionist policies, and a consequential shrinking, even collapse, of the world economy. The IMF, the IBRD and the International Trade Organization (ITO) were a response to this fear. In the 1970s, economists seem to agree, (1) the period of post-war expansion began to decline, (2) there was war in Vietnam, (3) the Cold War and the Arms Race were at their height, and (4) tensions were considerable, adversely affecting the world financial climate.

In anticipation of these events, the perception that the ITO needed reform came about as early as 1947 with the establishment of GATT (The General Agreement on Tariffs and Trade). But, an outgrowth of these reforms, the World Trade Organization – the one causing such foment in Seattle recently – did not come about until 1995. So, from the standpoint of international trade, which is directly linked to the financial well-being of whole nations, changes have definitely occurred since the initial concepts bequeathed by Bretton Woods.

From a purely financial viewpoint, the 1987 stock market crisis, ultimately traceable to trade imbalances with Japan, according to our No. 4 Reading, and the 1990-91 recession caused essentially by oil price fluctuations (the Saddam ultimatum), led to further examination of the underlying financial structure of the world’s economies. All of this was worsened quite recently by the Asian Financial crisis, triggered initially by the Bangkok Bank of Commerce’s inability to honor its obligations and the spiraling chain of events that ensued affecting Indonesia, Malaysia, the Philippines, Singapore, Hong Kong and Korea.

While 1987 resulted in re-examination of trade imbalances (with pressure placed on Japan to accept more American goods), and 1991 resulted in Desert Storm, the Asian Monetary Crisis caused a memorable clash between the Clinton Administration and Congress over IMF policy as to whether or not to bail-out Asian economies. Eventually, the IMF intervened and stabilized Thailand, through devaluation of the Baht and a strict program of internal economic reform. In this sense, the role of the IMF has not changed over the four or five decades since Bretton Woods.

If we examine the functioning of the IBRD and the World Bank, we can see a similar pattern of perpetuating the role and purpose originally intended for these institutions. There has, however, been a diminishment of the influence of both over the years. Obviously, post WW II reconstruction came to an end long before the 1970s, and so development has taken new turns in the intervening decades. The people of the world have become increasingly sensitive to issues of technology transfer and the environment and, in this sense, the World Bank has come under fire. This represents a major change in the initial intent of both the IBRD and the World Bank; both have been, on balance, less influential than in years prior to 1970. Projects are still funded, of course, but the days of the environmentally risky mega-project have passed.

In terms of monetary policy, a major modification of the Bretton Woods agreement has occurred since 1970. Currencies now float freely in relation to one another and nations’ central banks have considerably more latitude to determine and modify the value of their currencies in relation to those of other nations. The advent of the Euro has also had an impact on the international community as this new European Currency struggles to maintain rough parity with the dollar (now at only $0.85 approximately). Asian currencies have also ascended to new strengths and have caused ‘rethinking’ of original monetary arrangements whereby the US Dollar, the Pound Sterling and the French Franc once dominated foreign trade transactions.

The financial events of the 80s and 90s were demonstrably related to modification of the original Bretton Woods agreements, and, while most post WW II institutions have remained intact, their purpose and importance have been modified by ever-shifting socio-economic trends in Asia, Europe and North America.

Test Essay Question III

Volcker, Greenspan, The Crash of 1987 and

The Recessions of the 70s and 90s

In the previous essay question, a number of changes were described in the original Bretton Woods international monetary and trade system. The precise role or reaction of the Fed was not featured necessarily in that question, since it was important to grasp the full dynamics of the actual changes in the original post WW II monetary system that had occurred. So, before speaking of the Stock Market Crash of 1987, the Inflation and Recession of the 70s and 80s, and the 1990-91 recession, it is important to review, in brief, how the Fed reacted to the changes of the 1970 – 2000 era.

Alan Greenspan’s predecessor had been Paul Volcker who served as head of the Fed from 1979 to 1987. He pursued a tight monetary policy to fight inflation that had ravaged the economy in the previous decade. But, because of his actions, he was ultimately forced by a poorly performing economy and high unemployment to support dramatically increased monetary growth during the 1980s. At the risk of over-simplification, this led to complications that were ultimately set straight by Alan Greenspan who ‘inherited’ the 1987 stock market crash essentially resulting from a combination of Volcker’s policies and the Japanese-American balance of trade deficit, as clarified in our class readings. Volcker was widely respected for his wisdom during his tenure, but was seen, later, by followers of Greenspan as perhaps having caused many of the banking sector’s problems of the late 1980s.

Let us turn now to a concise analysis of the three 1970 to 1990 financial events that shook some of the most venerable institutions underpinning the American economy.
Because of an overheated economy in the 1970s, in which money was readily available and credit could be obtained without difficulty, inflation reached double-digit levels. It had also been soaring in the high single digits for several years as well. Political pressure was brought to bear on this situation, in order to stabilize the dollar overseas and protect the personal wealth of hard-working Americans, particularly those about to retire.

As measures were enacted, in the 1982-83 timeframe, to restrict the too rapidly expanding economy, money became tight and the financial dynamics shifted, resulting in what many called a recessionary period. U.S. productivity, in the absence of monetary incentive, dropped and the balance of trade moved more heavily into deficit territory. This situation went largely unnoticed for nearly a decade, until the crisis of 1987. Stocks plummeted, the Fed intervened to increase liquidity and the Japanese Finance Minister, in order to ‘justify’ Japan’s having pulled its money out of US Treasury Bonds, criticized the United States for not producing efficiently or sufficiently.

The increasing ‘internationalization’ of trade and the growth of Asian and European economies in relation to the US economy served as new factors in reassessing the predicament of the American economy in the late 1980s. As the immediate crisis was resolved in 1988, the 1990s approached. It seems as if each move the Fed made to counter ‘the trend of the moment’ resulted in consequences for the following years. Alan Greenspan, however, was quite astute in avoiding major calamity and the 1990-91 period of recession was neither particularly severe nor devastating, in comparison to preceding events such as the 1987 crash, unparalleled except for 1928-29. However, the 1990-91 situation could easily have gotten out of hand. Indeed, Greenspan referred to it as a "balance sheet" recession similar to the Great Depression scenario. In 1991, Greenspan was dealing with three potentially devastating problems, namely: (1) a shrinking pool of international capital for savings investment, (2) higher interest rates because of this shortage of capital and (3) lingering (but not exorbitant) inflation. How he managed to put the economy back on track in the succeeding years constituted a delicate balancing act for which President Clinton gave him considerable, and well-deserved, credit.

In addition to the foregoing problems, Greenspan confronted the effects of the "Saddam Shock" in which oil jumped from $18 to $30 per barrel. Because of fears generated by this scenario, banks stopped lending money and indebted businesses began to fail or approach bankruptcy. This occurred in the years just prior to President Clinton, under the Bush administration. In December of 1990, the Fed used all three of the tools referred to in essay question one. It lowered the Funds Rate in the open markets; it cut the discount rate; and it dropped the 3% reserve requirement for banks. These actions of the Fed loosened capital and created growth-like conditions.