What You Need To Know About The US Federal Reserve

Guest Post by Market Authority 

Every economic transaction is an agreement between two motivated parties. It doesn’t matter what is being exchanged: cash for AAPL stock, airline miles for a first class upgrade, a used auto for bitcoin, or even a concert ticket for a little weed. For any transaction to occur, the buyer and the seller must believe that what they’re receiving will increase their utility (ie-happiness) and they won’t be ripped off. AAPL will not suddenly issue an earnings warning; the used auto must not be a “lemon”; and the concert ticket (and weed) must be real. There must always be an understanding that the other side is not withholding any secrets, and that the transaction is fully transparent. 

Market Authority

An economy only grows if people believe that others aren’t holding onto secrets. Secrets cause fear, and this anxiety permeates every transaction. If people fear they will be “ripped off”, they will hoard assets that are safe from secrets. They may sell their stocks for cash or gold; or, they may choose to hold the used car rather than upgrade to the new one. This psychological fear becomes self-fulfilling, manifesting itself in slower economic growth. We fear the economy won’t grow to justify our purchases today, so those transactions don’t occur now. As a result, the economy doesn’t grow and reinforces those original fears. 

The role of the Federal Reserve is to promote transparency and reduce secrets among economic agents. Before the creation of the Fed in 1914, secrets about banks (and subsequent bank runs) caused an overwhelming number of banks to fail. In our fractional reserve banking system, a bank keeps about 10% of depositors money and then lends out the rest. 

Market Authority

This arrangement is satisfactory for banks and borrowers unless depositors attempt to extract their money at the same time. Due to the low reserve requirements (about 10% in the US), banks aren’t capable paying back every depositor’s cash simultaneously. 

In the 19th century, there was no backstop for a bank run, so even the smallest concerns resulted in bank failures. With any negative secrets, people would immediately try to retrieve their cash, and the bank run would be self-fulfilling. Bank failures were crippling to the economy as it would take time for confidence to rise and people to transact again. In modern times, depositors don’t normally panic as the Fed (and the FDIC) will provide your local savings bank with the short-term financing necessary to allow access to your cash. 

Imagine a friend posted on facebook that your local savings bank had made some terrible loans and was now facing bankruptcy. Even if it wasn’t true, the line to withdraw your cash would likely be around the block and the bank would be forced to liquidate. Obviously this can’t happen today as the Fed and FDIC provide ample liquidity. 

Thus, the Fed provides stability for both the bank and the depositor. The bank can go about its business making loans; and the depositor can be confident that the money in the bank is safe. However, too much of anything is never a good thing. And, as we’ve seen, this stability eventually causes massive instability.