Getting Fed Up

Getting Fed Up

What is the Fed?

Photo: Tania Thompson. Source: Shutterstock

For most people, the Federal Reserve is this mysterious place that makes mysterious announcements and that tells the banks where to set interest rates. Academics and politicians may rail at the Fed for various reasons, but their debates often sound like medieval scholastics debating how many angels can dance on the head of a pin: interesting but irrelevant.

The Fed is an essential part of our financial infrastructure—the banker’s bank—that keeps things going when there’s a crisis of confidence. It was created 100 years ago because a modern economy needs a central monetary authority. Banks are subject to crises of confidence. That’s the way finance works.

Calls to “end the Fed”—if they are genuine—are fundamentally misguided. If the Fed hadn’t backstopped the financial system in 2008, most people believe we would have entered another Great Depression. Yes, the Fed is subject to a “knowledge problem,” in that the information it needs to set policy is dispersed among bankers and fund managers and corporate managers and consumers, and that too much aggregation can obscure the data. But this is an issue for tweaking the system, not for fundamentally changing it. Every bureaucratic system faces a knowledge problem.

A modern economy—with trillions of dollars in daily, global money flows—needs a central authority backed by the national treasury. There is no alternative. When a high-profile failure shocks the economy, someone has to be able to step in decisively and restore confidence in the system. Otherwise we will see the “Paradox of Aggregation” in practice—each of us acting in our own rational, private interest creating an irrational, public problem.

Federal Reserve Liabilities. Source: Alephblog

The Fed should be modest in its goals and open about its operations. Shooting for stable prices and a sound banking system is enough for any agency. It shouldn’t try to micro-manage the economy—no one can do that. It needs to be transparent and accountable, because every public institution needs public accountability. We all need to be accountable. But the last thing any central bank should have is a bunch of politicians looking over its shoulder publically criticizing the latest decision.

Because driving down the road with 535 back-seat drivers isn’t just distracting, it’s dangerous.

Douglas R. Tengdin, CFA

Chief Investment Officer

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