FAQ: Money and Banking

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1 Question 1: What is the Federal Deposit Insurance Corporation (FDIC) and why is it important? Answer 1: The Federal Deposit Insurance Corporation (FDIC) is a federal agency that protects bank deposits up to $100,000 per customer. There is not a lot of thought given to the possibility of banks closing and taking all of their customers' money and savings with them into bankruptcy, but that is exactly what happened during the Great Depression in the United States when 50% of the banks closed their doors permanently. It was a catastrophe of the first magnitude, and it left a generation with a permanent distrust of banks and bankers. Responding to this disaster, President Franklin Delano Roosevelt's administration created the FDIC to restore confidence in the banking system, which is essential for the effective functioning of a modern economy. All member banks were required to contribute to an emergency fund that guaranteed bank deposits up to a certain limit. If a bank closed for any reason, the FDIC would step in and reimburse all depositors to the legal limit. The whole idea of the FDIC was to avoid bank panics by assuring the public that the Federal Government would stand behind the bank, ready to pay off depositors if the bank should fail. The idea has worked splendidly so far, but the FDIC's funds are limited and will cover only a few major bank failures. If the entire banking system was threatened and people wanted their money back, the fund would run out of money after a few major bank closings. Then the government would have a tough choice: let the other banks fail, or make the taxpayer support the remaining failures. Make sure your bank is a member of the FDIC. All member banks have a sign near the entrance window indicating they are a member of FDIC. If your bank is not a member, move your money. Question 2: What should I know about the Federal Reserve System? Answer 2: The Federal Reserve is the single most powerful institution in the United States, more powerful in many ways than Congress or the President of the United States. While the president has the power to go to war, the Federal 1

2 Reserve has the power to encourage economic growth or to slow it down. Jobs are on the line when the Federal Reserve makes a decision regarding money supply and interest rates. After a series of financial panics in the late 1800s and early 1900s, the U.S. government created a Federal Reserve Bank in Its mandate included five major jobs: Conduct monetary policy, that is, control the rate of growth of money Serve as a lender of last resort in financial panics or potential financial panics Issue currency Provide banking services to the U.S. government Supervise and regulate financial institutions There are 12 Federal Reserve districts with a federal reserve bank in each district. Question 3: What impact does the Federal Reserve have on daily life? Answer 3: The Federal Reserve sets the base level of interest rates, which is the interest rate that member banks of the Federal Reserve System pay to borrow money from the Federal Reserve. The Federal Reserve does not directly control any other rates that you might encounter at a bank or marketplace, but when the Federal Reserve raises the discount rate, almost all other interest rates increase. In other words, if the Federal Reserve raised the discount rate, it is likely that mortgage rates would rise, credit card rates would rise, and auto loans would rise. Though often unnoticed and unseen, the Federal Reserve has enormous power to affect daily life. Question 4: Who or what controls the Federal Reserve System? Answer 4: The Federal Reserve is owned and funded by its member banks. It is not an agency of the Federal Government though it is influenced by politics. The President of the United States and members of Congress are free to call the 2

3 Chairman of the Federal Reserve when they have the urge, and they often do. The Chairman of the Federal Reserve feels political pressure but is not required to respond to it. It is a semiautonomous agency that wields enormous power yet is not accountable to either the President of the United States or Congress. This is a source of some consternation in certain segments of U.S. society that contend that no agency should have such incredible power yet be without representative oversight. The Federal Reserve is directed and controlled by the Federal Reserve Board of Governors, which is comprised of seven members. The board members are nominated by the President of the United States and confirmed by the Senate. Each member has a fourteen-year term and is eligible for a second term. Most members do not serve that long for financial reasons. As you might surmise, these individuals can make considerably more money in private industry. The Federal Reserve Board is headed by the Chairman of the Federal Reserve. Even when serving successfully, the Chairman of the Federal Reserve is something of a lightning rod for controversy. Some contend that the Chairman of the Federal Reserve has too much power; others contend that the Chairman of the Federal Reserve has more power than the President of the United States. In some ways, this is certainly true. The Federal Reserve can control interest rates and the supply of money in circulation two extremely important functions in a market economy. Question 5: Should the Federal Reserve remain independent, and what are the arguments on either side? Answer 5: As with many controversies, this one tends to follow ideological and political divides. Democrats and liberals tend to support more control and oversight. Republicans and conservatives argue for a continuation of the more or less independent Federal Reserve. Those who want more oversight argue that the Chairman of the Federal Reserve and the institution at large has too much power to be without some outside influence. They argue that the Federal Reserve can do whatever it wants whenever it wants based on its own interests. Those interests (the 3

4 argument continues) are banking interests and because banks technically own and control the Federal Reserve, it is a classic conflict of interest. On the other hand, a smooth and effectively functioning Federal Reserve depends on decisions that are not politically motivated. Those who support the current status of the Federal Reserve contend that it would be disastrous to allow any consideration other than economic concerns to influence the direction of monetary policy. Supporters of this position contend that politicians have a bias toward easy money, which would provide a quick fix for a bad economy especially when approaching an election. The approach to central bank oversight differs in various countries. For example, the Bank of England has relatively little independence from political control. The government sets interest rate targets and money supply objectives that the bank tries to hit. Unfortunately, the net result is that England has relatively high inflation rates. Canada and Japan allow their central banks a modicum of independence, but their banks are also pressured to produce interest rates and money supply that support a political agenda. Question 6: Is the Federal Reserve more effective in fighting recessions or inflation? Answer 6: As with most issues in economics, an argument can be made that the Federal Reserve has done a fairly good job on both recession and inflation until you look closely. The argument on the side of inflation is that the Federal Reserve can stop individuals and businesses from borrowing by raising interest rates and making less credit available, but the Federal Reserve cannot force businesses and individuals to borrow during recessions by lowering interest rates and making more credit available. Of course, the Federal Reserve can make cheap money very enticing, but the Federal Reserve cannot force people to borrow when they are not convinced they have the ability to pay the money back. This argument sounds plausible 4

5 and is a nice-sounding theory, but looking at inflation and recessions in the economy reveals a different story. Prices are now five times higher than in the base year of 1967 not exactly a resounding triumph. Recently the Federal Reserve has been doing a credible job, bringing the rate of inflation to approximately 3% with what is called a disinflation target. The argument that the Federal Reserve is doing a good job of fighting recessions is backed by strong evidence. Recessions in the last forty years have been mild and short and typically no longer than a year. Question 7: What are open market operations, and how are they conducted to fight inflation and recession? Answer 7: Open market operations are the buying and selling of U.S. government securities on the open market. This is done on a daily basis to meet the current objectives of the Federal Reserve to either fight inflation or aid in recovery from a recession. To fight a recession, the Federal Reserve buys government securities, which raises the price of securities and drives down interest rates; this encourages individuals and businesses to borrow money to spur economic growth. Eventually, the economy recovers and begins to show signs of inflation. To fight inflation, the Federal Reserve sells securities, which lowers the price of securities and drives up interest rates; this discourages individuals and businesses from borrowing money. The result is an economy that slows and an inflationary trend is stopped. Question 8: What two major banking laws passed in the last two decades, and how have they affected the industry? Answer 8: In response to complaints about inequitable treatment by both commercial banks and by savings and loans, Congress passed the Depository Institutions 5

6 Deregulation and Monetary Control Act of The bill had three major provisions: The major thrust of this bill placed commercial banks, savings banks, savings and loan associations, and credit unions under the regulation of the Federal Reserve. All depository institutions could now legally offer checking deposits, and they could pay interest. Previously, commercial banks could not pay interest on checking accounts and savings and loans. All financial institutions were now members of the Federal Reserve with check-clearing capability. Almost immediately, the banking industry was faced with a wave of consolidations, which formed huge megabanks. The Banking Act of 1999 repealed several sections of the Glass-Steagall Act of The Glass-Steagall Act forbids banks from selling stocks, bonds, and other financial products to their customers. The new law gave all financial firms, including banks, the chance to sell all sorts of investments. Supporters of the new law argue that this makes the banking and investment industry more efficient because the customer can buy all financial products under one roof, thereby creating a so-called financial supermarket. On the other hand, some observers argue that this creates a serious conflict of interest in the banking industry. Question 9: What was the savings and loan debacle of the 1980s, and what caused it? Answer 9: In the 1970s, interest rates had been rising to almost record highs, and people began taking their money out of the savings and loan associations and buying commercial bank Certificates of Deposit (CDs) and other financial instruments that were paying higher interest rates. The savings and loans institutions had trouble matching these high interest rates because they had nearly all of their assets tied up in low-interest mortgages, and savings and loan associations were legally barred from paying more interest. Early in the administration of President Ronald Reagan in the 1980s, the savings and loan industry was deregulated, allowing the industry to compete directly with commercial banks, credit unions, and other financial institutions. 6

7 Now free to compete on a level playing field, many savings and loan associations plunged into untested waters. They borrowed funds at very high interest rates. They bought billions of dollars of junk bonds that paid very high interest and then turned around and loaned that money out at even higher interest rates. Real estate speculators and very high-risk borrowers were the best customers of the savings and loans. Then real estate prices started to soften; sales of condominiums, townhouses, strip malls, office parks, and more faltered. Within a very short period of time, those high-risk borrowers defaulted on loans worth tens of billions of dollars. Hundreds of savings and loans went bankrupt. Two-thirds of the savings and loans disappeared, and depositors got their money back. More than $200 billion of taxpayer money was spent cleaning up the debacle. Question 10: What is monetarism, and whose idea was it? Answer 10: Monetarism is a relatively recent economic theory that postulates that if you control the amount of money flowing into an economy, you will control the three major problems all economies face: inflation, unemployment, and economic growth. Milton Friedman, Nobel Prize winner in economics, studied inflation and economic growth for nearly his entire career. In his book, A Monetary History of United States, , Friedman asserted that economic stability could be attained simply by increasing the money supply at a steady rate commensurate with the economic growth rate desired. If you want 3% growth in gross domestic product (GDP), then increase the money supply 3%. The result will be a stable economy with declining inflation and unemployment. Friedman claimed that this was the perfect nostrum for a perfect economy. Using an automobile analogy, Friedman pointed out that if you step on the gas, you will go much faster; but eventually, you will have to put on the brakes. Money supply is very similar. If you put too much money into the system, it will overheat and produce inflation; to slow the economy down, the 7

8 Federal Reserve would then be required to slow the growth of money. This stop and go monetary policy produced a galloping inflation in the 1970s. The Federal Reserve tried monetarism beginning in The Chairmen of the Federal Reserve at the time, Paul Volcker, announced that the Federal Reserve no longer would focus on keeping interest rates stable but would focus on monetary growth targets. By the early 1980s, inflation was declining rapidly. Unfortunately, the United States experienced two back-to-back recessions before inflation had finally been wrung out of the economy. Reference Friedman, M., & Schwartz, A. J. (1971). A monetary history of the United States, Princeton, NJ: Princeton University Press. 8