The U.S. Congress created the Fed in 1913. One of its duties is to prevent, or at least, to mitigate the adverse consequences of major financial disruptions, like the one that occurred in the Panic of 1907.
Financial panics, like the one we recently experienced, are characterized by (among other things) a sudden lack of “liquidity.” What does this mean? It means that all sorts of debt instruments are treated like junk, whether they “deserve” to be treated as junk or not. In a panic situation, the baby frequently gets thrown out with the bath water. Good assets (well-collateralized debt instruments) get penalized (severely discounted) along with bad assets.
A part of the Fed’s mandate is to serve as lender-of-last-resort. What does this mean? It means that it stands ready to discount what it perceives to be good quality paper at a rate less than the market discounts such paper. This means lending cash at a lower-than-market interest rate on a short-term loan, if the debtor is in a position to put up high-grade collateral. This is what happens at the Fed’s discount window. This is what happened with the Fed’s other emergency lending facilities. The Fed was doing what Congress (representing the wishes of its citizens) has mandated.
What was the result? All the loans due have been paid back with interest. Yes, that’s right. Contrary to the impression one gets from the media, the Fed did not “give” people or firms money. It lent them the money on a short term basis and in exchange for high-grade collateral (even if ascertaining the quality of collateral in emergency conditions can sometimes lead to mistakes).
The Fed has made a healthy profit on these activities. Last year, it remitted an extra $25 billion to the U.S. Treasury (the U.S. taxpayer). What sort of “bailout” makes money for the U.S. taxpayer?
So what is the source of all the outrage directed at the Fed? My own interpretation is that members of Congress like to use the Fed as its whipping boy. The Fed is a central bank and the Fed helped banks. And people hate banks. They hate banks because…well, because they won’t lend people money. They also hate banks because they lend people too much money (leading to crisis). Go figure.
Addendum: 03 Dec 10
I said above that the Fed only accepts high-grade collateral when it makes a short-term cash loan. While this describes normal Fed practice, it evidently does not describe all the lending that took place in its emergency facilities during the crisis; see here: Crisis-Hit Banks Flooded Fed with Junk.
What I should have said is that when the Fed makes a short-term cash loan, it does so only when it has a high expectation that it will be paid back. The collateral for the loan is put up to protect the Fed in the event of default. And as the article mentions, when the collateral put up was lower-grade material, the Fed protected itself by applying a large “haircut” (discount) on the collateral. (Presumably, the haircut applied by the Fed was less than the haircut the market was willing to give, but so what–this is the point of being a lender-of-last resort!).
In any case, my basic point stands. The Federal Reserve Act of 1913, an Act of Congress, explicitly allows and expects the Fed to act the way it did during any financial crisis. Section 13(3) of the act reads as follows:
13.3. Discounts for Individuals, Partnerships, and Corporations
In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.
So maybe you don’t like what the Fed did. That’s fair enough. But this is no reason to blame the Fed. If you want something different, you should lobby Congress to change the Federal Reserve Act. Or lobby Congress to abolish the Fed. And then you’ll have Congress managing monetary policy (unless you live in the fantasy world of Ron Paul, and actually believe that Congress would shackle itself to a gold standard). At the end of the day, I am sure that American voters will get what they deserve.
Disclaimer: This page contains affiliate links. If you choose to make a purchase after clicking a link, we may receive a commission at no additional cost to you. Thank you for your support!