October 2, 2012

Is It Time To End the Federal Reserve?

Lawrence H. White

Distinguished Senior Fellow, F. A. Hayek Program for Advanced Study in Philosophy, Politics and Economics

James Broughel

Senior Research Fellow
Summary

Since it began operations 98 years ago, the Federal Reserve System has performed functions that are vital to the financial system. Yet the fact that the Fed now plays some important roles doesn't show that the Fed is the only institution capable of playing those roles, much less the best at doing them. In fact, history shows us that private institutions have been more capable at carrying out many of the Fed's activities. As the Fed begins a new and indefinitely large round of quantitative easing, it's time to consider whether the Fed, compared to its alternatives, has been doing more harm than good.

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Since it began operations 98 years ago, the Federal Reserve System has performed functions that are vital to the financial system. Yet the fact that the Fed now plays some important roles doesn't show that the Fed is the only institution capable of playing those roles, much less the best at doing them. In fact, history shows us that private institutions have been more capable at carrying out many of the Fed's activities. As the Fed begins a new and indefinitely large round of quantitative easing, it's time to consider whether the Fed, compared to its alternatives, has been doing more harm than good.

One of the Fed's main roles is to clear and settle payments that occur between banks. The Fed totals up the net obligations that banks incur to one another, and settles them by transferring balances from one bank's account at the Fed to the other's. Historically, private clearinghouse associations cleared and settled all interbank payments. Today, they still handle about half, and credit card payments are entirely cleared through private systems. Private clearinghouse associations are owned by the member banks that they serve. The Fed's operations could be privatized by turning them over to the member banks that nominally own shares of the regional Federal Reserve Banks.

The Fed also regulates commercial banks. The regional Federal Reserve Banks examine commercial banks' balance sheets to ensure they have sufficient reserves and capital to meet their day to day obligations. In the past, regional clearinghouse associations fulfilled these roles. Member banks had to disclose their financial statements to the clearinghouse so that it could determine which of its members were sound and which were not. Banks that had problems had to shape up or risk being kicked out. We moved away from this system when the Federal Reserve Act effectively nationalized the regional clearinghouses. The power to set banking standards and to supervise compliance is now concentrated in Washington D.C. Given the failures of regulators leading up to and during the financial crisis, it is hardly clear that the Fed is up to the task.

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