Justin Brunelle

Professor Rob Cole

ENC 2135

3/16/2017

Is the Federal Reserve Making the Economy More Stable?

The Federal Reserve Bank, first established in 1913 with the Federal Reserve Act, was

formed to make the U.S. economy more stable. The act was passed during the Wilson

Administration, at a time where the global climate as a whole was unstable. The world was on

the brink of war, and new technologies rapidly clashed with old ideas. This created a climate of

uncertainty, one where a government body to take care of Americas most pressing issues, the

economy, certainly would have seemed favorable. Upon analysis, however, it becomes evident

that the Federal Reserve does not succeed in its

mission to provide economic stability.

Instead, it creates a climate of volatility.

This climate is counterproductive to

economic growth.

To support this assessment,

different time periods and their respective

events need to be analyzed. America had

just come off a period of unprecedented

economic growth. In an era that would

later be defined as the Gilded Age, the U.S.

GDP grew from $16 Billion in 1871, to $88 Billion in 1900 (Field, 3). Per the normal business

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cycle, however, any period of robust growth is bound to be followed be a period of economic

downturn. A series of panics, the most prominent being in 1907, led to a strong feeling of worry

for consumers. While panics were frequent and worrisome for consumers, they were usually

expected and ended relatively quickly. It was a result of high growth, followed by an

unfulfillable demand for liquidity in the market. With the failing of Westinghouse Electricity in

1907, the stock market fell nearly 50%. This led to a rush of consumers trying to withdraw

money out of their respective banks. These withdrawals occurred in such volume that banks

could not fulfill all these requests and had to shut down. Prominent banker J.P. Morgan had to

organize other banking titans to bail out the failing banks. To ensure that this would never

happen again, Woodrow Wilson established the Federal Reserve, an institution with the power to

give banks extra money if needed, and adjust the value of that money as required to maintain

stability.

Despite its intentions, any argue that the Fed has only led to more instability. Lehram

Lewis of the Cato Institute, a prominent Think Tank which studies monetary policy, states that

the Federal Reserves manipulation of interest rates has caused the value of the dollar to

plummet since the Feds inception (Lewis 422).

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Such has led to a noticeable level of volatility in the amount of investment activity, and therefore

declines the propensity of the U.S. economy to grow (Figure 1).

NYSE Volume of securities bought and sold by year.

Consumers and brokers alike tend to invest less when the economy is unstable, and more when

it is stable. Additionally, wild fluctuations in trade volume indicate a lack of stability in the

stock market. David Walker of the Journal of Financial Economic Policy found that the Federal

Reserves manipulation of interest rates on the dollar has had a strong correlation with

unemployment rates. It was determined that Recessions in the Fed era, while previously normal

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and expected under the normal business cycle, now tend to be unanticipated. Such tends to have

a negative effect on the growth of the economy as volatility rises (Walker 1). This is supported

by findings by the National Bureau of Economic research, which found an increase in the

volatility of bond rates corresponding to dates which the Federal Reserve board meet (Piazzesi

337). The CBOE Volatility Index, a common tool used to predict market volatility, has shown a

pattern of being above average around Federal Reserve meetings. We have also seen wild

fluctuations in GDP growth rate since the Feds inception. Instead of stable growth, we see

sharp peaks and troughs. Many describe this is as a business cycle on steroids.

Fluctuations in GDP growth are shown. Note should be taken of the sharp decline during the Financial Crisis of 2008.

A common theme to the arguments of Federal Reserve opponents is that if so much of investors

faith in the economy revolves around the Feds ability to maintain it through interest rate

fluctuations and money supply changes, is it really accomplishing its goal of stability?

A case which is often used to show the efficacy of the Federal Reserve is the 2008

Financial Crisis. Prior to the crisis, the Federal Reserve had interest rates at their lowest since

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1970. Peter Ireland of the National Bureau of economic research found that target rates were at

roughly 2%, down from an 8% peak 30 years prior (Ireland 24). In 2008, Banks took advantage

of the low rates on the dollar and offered a high volume of mortgages to people who otherwise

would not have qualified. They were structured in a way that mortgage recipients were able to

make small payments for a drawn out period of time, but eventually the interest rate would

increase. This hike would inevitably cause the recipients to default on their mortgages. This

crisis was made worse by the fact that these banks were using those mortgages as the backing to

securities sold to investors. These securities, called synthetic collateralized debt obligations

(synthetic CDOs), were sold across the world to pension funds, retired workers, and the

treasuries of major companies alike. Due to the ability of mortgage recipients to make payments

in their early stages, the investors earned a short term profit in these new mortgage backed

securities. Additionally, these securities were heavily insured. In products called credit default

swaps, any losses resulting from these mortgages would have to be paid back by the insurance

companies used. The insurance companies, fully believing in the soundness of the CDOs, gladly

raked in the early premiums for what appeared to be relatively low risk. Rating agencies such as

Moodys assured these insurance companies of the soundness of CDOs and other mortgage

backed securities. An overwhelming majority of such products were given the highest rating,

Aaa. At the very least, one of these securities would attain a rating of B, still far above junk-

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bond status.

Such security and early gains prompted an even higher amount of synthetic CDOs to be

sold. This caused the financial failing of many major insurance companies, further worsening

the crash This created a climate that endorsed lending in such volumes, and allowed banks to

issues mortgages at a much higher rate than before. This is simply because the cost of capital

was lower (Kibbe 1). Between 2008 and 2009, the Dow Jones Industrial Average fell more than

50%. People began to pull out of the stock market at high volumes. The amount of stocks sold

at the New York Stock Exchange skyrocketed. What would come to be known as the housing

bubble began to burst, and thousands of people lost their homes. In one month, 159,000 jobs

were lost (Amadeo 1). Unemployment sored from 5.5% to 10% (Dufour 3).

Both firms and individuals lost money, some losing their entire savings. In this

situation, it would be the job of the Fed to stabilize the economy and foster an environment of

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regrowth. In a paper written by Mathieu Dufour of the Review of Radical Political Economics,

the majority of the jobs recreated in the post-crisis era were low wage jobs. However, the

majority of jobs lost were mid-wage jobs (Dufour 5). In totality, 66% of jobs lost were mid-

wage jobs, and only 22% of jobs created were mid-wage. The Federal Reserve eventually

recommended congress pass a bill to bail out the defunct banks. This bill passed, public debt

rose, and most banks that had not already been acquired by larger ones were revived.

Many blame the Federal Reserve for the financial crisis. In 2008, Federal Reserve

Chairman Ben Bernanke claimed that the Fed was not expecting a recession. Forbes

contributor Matt Kibbe makes

the claim that although we do see

regular boom and bust cycles in

a normal capitalistic system,

monetary governance such as the

Fed increases the strength of

such cycles. This leads to

instability in the market and is counterproductive to economic growth. With the Federal Reserve

not only leaving interest rates at an incredibly low level, but also failing to identify the

impending financial crisis, many wonder whether or not the Fed effectively managed the income

instability.

In response to the crisis, the Fed began purchasing securities from the now struggling

financial institutions. Janet Yellen of the Federal Reserve claims that Investors have gone from

disregarding risk, to being paralyzed by it, to once again being willing to take on a reasonable

bit (Yellen 18). This policy of purchasing securities, in addition to keeping the federal funds

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rate low, did eventually lead to a slow economic recovery. Just 10 years later, unemployment is

nearly below its pre-crisis level. While many do blame the Federal Reserve for the crisis, it is

also evident that their role in stopping it was helpful to the economic recovery. The same

question must arise, however. If we are subject to a more intense business cycle under the

Federal Reserve, is the Fed really doing its job of creating stability? The Crisis of 2008

demonstrates how the Fed can cause such instability, that we enter a recession only rivaled by

the Great Depression.

Proponents of the Federal Reserve argue that while we may be subject to more intense

business cycle, the economy is still more stable than it would be without the Feds presence.

Mark Carlson of the St. Louis Federal Reserve Bank points out that financial shocks resulting

from a lack of cash reserves held by banks were very frequent prior to the Federal Reserves

establishment. These shocks were subverted by both the Fed holding reserves and requiring that

banks themselves hold cash reserves in the case of a higher liquidity demand (Carlson 9).

Figure 1 A clear decrease in shock risk is shown around 1913, with the inception of the Federal Reserve System.

Carlson contends that had more regional banks joined the Federal Reserve system, the shocks

related to the Great Depression would have been mitigated. The markets crash was amplified

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by a lack of available funds for future investment opportunity. Had the Federal Reserve been

able to lend cash to these failing banks, consumers and investors would have been able to

reinvest more quickly, expediting the inevitable economic recovery.

Eric Engen of the Federal Reserve board claims that many of the things done by the Fed,

such as purchasing treasury bills and securities, is not necessarily intended to grow the economy

by itself. Instead, it is intended and has been shown to positively impact investors confidence in

the economy. Such works to mitigate shocks be reducing investor scare. This tactic, in theory,

can be effective in limiting volatility in the economy.

A concern for Fed opponents is the lack of transparency of the Federal Reserve. The Fed

is meant to be a body independent of the normal federal government. Due to this, it falls outside

the governments requirement to provide information for citizens. Many activists have voiced

concern over such an important institution being so opaque. Former chairman Alan Greenspan

argued that an increase in transparency would create extra volatility in the market. Investors

would guess the direction of the market based on what the Fed was talking about in meetings.

Greenspan viewed this is irresponsible, as doing so would not necessarily present the way the

Fed officially felt about what needed to be done, only what ideas its board members might be

having (Roger 3). Despite Greenspans concerns, the Fed began publishing limited transcripts of

meetings for the public to view. Greenspan, however, admitted to being wrong on the potential

risks. The Fed ended up seeing a net benefit from this transparency. Such suggests that the

Federal Reserve may not recently have as big of an impact on investors as previously thought.

Since the financial crisis of 2008, wages are still growing more slowly than the rate of

inflation. This means that an average American today is less financially better off than they

would be in 2006 (Bivens 9). Such disappointing growth is widely accepted to be caused by

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previous volatility. It takes a considerable amount of time for normal investment activity to

resume after a major shock to the economy. Additionally, we still are at a net loss of 3 million

jobs since 2007. An argument can be made that had the federal reserve effectively managed

volatility in the market, we would see higher levels of growth. Instead, investors are worried that

another recession may be on the horizon, and avoid large capital investments at the risk of losing

money. This, despite the Feds best efforts, slows growth. If the economy was more stable,

investors would be in a better climate to invest money, and historically, this leads to more job

creation.

While we did see a measurable reduction in shock-risk near the Feds inception, the

economy has been noticeably fluctuating at levels unseen prior to the Fed. This is evidenced by

relative GDP growth, which sways at unpredictable levels. The panics that previously effected

the economy were much smaller in magnitude prior to the Feds inception. No drop in GDP,

aside from the Great Depression, was larger than 2008s Financial Crisis. This increase in

volatility is clearly correlated by the Federal Reserves inception.

While an argument

can be made that the Feds

increased transparency did

not effect volatility, it also

has to be taken into

account that investors

knew to take what was said

in those meetings with little

regard, at least until an official announcement was made. Volatility still rises around the dates

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that the Federal Reserve Board meets, but that level has not seen a noticeable increase since they

started releasing transcripts. This correlation still shows that Fed meetings do tend to make the

market less stable. Taking into account that the very nature of the Fed makes the market less

stable, in addition to its tendency to make the market fluctuate more intensely with its policies,

it becomes evident that the Federal Reserve does not succeed in its mission to make the

economy more stable. Additionally, the previous case study of the 2008 crisis points to the

Federal Reserves responsibility in the crisis itself. Had interest rates not been set at such a low

level, far less loans for mortgages would have been made. This would have slowed the volume

of the crash, if not completely offset it. Many prominent investors were able to point out that the

crash was incoming. Gold investor Peter Schiff repeatedly appeared on news networks to warn

the public about it, but very few took his warnings into account. While the Federal Reserve does

do some generally important things, such as providing cash reserves if necessary, its

management over the economy has proven time and time again to be detrimental to the stability

of the economy. So much so, that investment activity has shown to fluctuate widely and

economic recoveries are slowed.

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Rhetorical Rational Justin Brunelle

My topic was on the efficacy of the Federal Reserves plans to stabilize the economy. I
wanted to see whether or not the Fed actually made the economy more stable, or just made it
more unstable. To do this, I first examined the time period prior to the Feds inception.
Afterword, like any scientific study, I made the comparison to the economy after the Fed, or the
treatment, was administered. I also added a specific case study, the 2008 financial crisis. This
case study is appropriate because things of this sort are the duty of the Federal Reserve to
manage. Recessions are periods of wild economic instability, and the periods after are times that
are supposed to be stable. How the Fed managed this is a key piece of evidence in determining
whether or not it is effective in its mission. For this argument, it is important to include both
numerical and nonnumerical data. The numerical data is important because it can show a
definitive correlation between growth in the economy and policies that the Fed drafted. It also
can show how the Fed acted during different time period. Nonnumerical data, such as economic
theory, is also important because it can be a topic of contention. There is theory that both backs
and refutes the mission of the Fed, and so it is up to data to decide which have proven to be
correct.
Using a classical arguing structure, I first began with in introduction providing
background information on the topic and why it was established. After the introductory
paragraphs, I provided an argument supporting my thesis of the Fed being ineffective. The
argument was derived from 3 different sources, in addition to two graphs of different economic
indicators. These indicators were important because they showed how the economy grew, and
multiple fluctuations to that respect would demonstrate that the economy was unstable.
Per the classical arguing structure, the pro-thesis argument should be followed by a descending
argument. I provided different but related sourced arguments that the Fed does in fact provide
more stability. The arguments provided data that the suggested the publics knowledge of the
feds workings did not create a noticeably large increase in volatility.
The classical arguing structure is efficient for here because there is a good amount of
complicated information that the arguing style allows to be simplified. By providing information
for and against a topic, it makes it easier for the reader to understand that topic. Additionally, the
classical arguing style allows for persuasion. My thesis is a standpoint that may not be
frequently thought of due to the status-quo nature of the Fed. While many are against it, many
are also in its favor. The topic of whether or not it is effective is a widely disputed topic within
the economics community. The classical arguing structure is effective for widely disputed topics
because it provides arguments from both viewpoints, but still proves why one viewpoint is
correct over another viewpoint.
Because the transition of the classical structure is logical, it allows for thoughts to
transition better.

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