The Fed is Putting Free Markets at Risk

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For those who believe that capital markets should be free from undue government interference, the Fed’s adoption of expansive programs raises the question of whether it has gone too far.

The Fed has taken unprecedented action to bolster the economy and prop-up the financial markets in the face of the COVID-19 pandemic. In addition to lowering short-term interest rates to zero, reducing the interest rate that banks can borrow from the Fed and cutting bank reserve requirements, it has again implemented asset-purchase programs, known as quantitative easing (QE). However, unlike the first QE programs adopted during the 2008 financial crisis, today’s QE is far more expansive in the amount of money that can be spent and the type of assets that can be purchased.

The Fed’s purpose

In considering the question I raised at the outset, it is helpful to examine the Fed’s purpose. The original and still primary purpose of the Fed, or any central bank, is to manage the stability of the fractional reserve banking system by acting as a lender-of-last resort to commercial banks. Because commercial banks are permitted to lend out more money than they are required to hold in reserve to cover deposit withdrawals (i.e., fractional reserve banking), a central bank is needed to back-stop the deposits of commercial banks in case they experience financial difficulty and a subsequent run by depositors. Through the central bank’s discount window and other direct lending programs, commercial banks can borrow from the Fed any time they need additional liquidity. It is primarily through these means that the Fed acts as lender-of-last resort to maintain the stability of the banking system.

With the enactment of the Full Employment and Balanced Growth Act of 1978, Congress expanded the Fed’s purpose to include the creation of monetary policy that promotes long-term economic growth, maximum employment and stable consumer prices. Those purposes were not part of the Fed’s original mandate, and arose primarily due to the United States’ adoption of a fiat money system and its subsequent battle with stagflation. Under a fiat money system, the value of the dollar is determined not based on a specific exchange rate tied to the value of an underlying scarce asset such as gold, but rather, purely on its supply and demand in the world markets. This decoupling of the dollar from an asset-based exchange rate made it possible for the federal government to engage in unlimited money creation. However, unconstrained money creation can lead to uncontrolled inflation. In order to curtail the inflationary effects of a non-fiat money system and its impact on the broader economy, the Fed was specifically tasked with the role of managing the price of money through its power to set short-term interest rates.

Under its evolving mandate, the Fed has assumed the broader purposes of maintaining the stability of the financial system and the entire economy. One of the ways that it has chosen to do this during times of crisis is through QE. However, if pursued without constraint, these programs can lead to inappropriate government interference in private markets and the degradation of our free market system.