The Fed Wouldn’t Cut it as a Normal Bank | SchiffGold

The Fed is governed by institutional rules that separate it in operation and incentive from all other banks. Rather than being driven by profit and benevolence, it is ruled by a convoluted system of spoken and unspoken incentives that are often at odds with one another. The purpose of the Fed is nominally to keep unemployment low and pursue monetary stability, but its role as part of the government adds in layers of motivational complexity. The Fed was initially created to provide safety from the bank runs and crises around the early 20th century. However, as part of an expansionary state, it has gradually come to hold more power. The Fed makes three critical mistakes that show how its tangle of motivations make it act irresponsibly compared to normal banks where the stakes are far lower. The Fed’s first mistake is treating all banks as having equal credit-worthiness. This sort of lack of distinction would destroy any normal bank. Additionally, the Fed is very bad at determining whether decreasing the interest rate will lead to more economic growth, because that is entirely dependent on the ability of the banks they loan to to lend to productive enterprises. Finally, the Fed exacerbates negative situations by lending precisely when it would be least wise for a normal bank to lend. 

The center of all free market lending is the ability of the lender to calculate a reasonable risk premium. This varies depending on the borrower, because their ability to pay back is the only factor of significance to that customer’s unique rate. The Fed’s inability to distinguish between different banks is a massive problem because equally flourishing fundamentals are not automatically given to every bank. Sometimes, less trustworthy banks must be given price signals that will lower their chance of survival. Because false support will only sustain irresponsible banks, the Fed risks hurting both “productivity” and citizens. The Fed’s influence on all banks through manipulation of the federal funds rate, even for undeserving ones, has already exacerbated disaster in every recent banking crisis. While it might be a good thing to have equal opportunity in education or other developmental areas, the cut-throat industry of banking is an industry where mediocrity cannot be supported.

In times of macro-economic weakness, the Fed feels compelled to cut interest rates as the fast flow of money into banks is intended to increase investment in businesses and spending. It is true that lower interest rates create greater investment, yet the effectiveness of this investment in creating higher economic growth is anything but guaranteed. The ability of the entrepreneur to create an innovative and simultaneously marketable idea has little to do with the Federal Reserve’s hopes for a booming economy. If banks are able to successfully recognize good entrepreneurs, the Fed’s thesis will hold true, but even the best banks are far from able to distinguish whether a business will thrive or fail. The inherent uncertainty of the increasing investment hypothesis means that the costs must be closely analyzed. For every increase in investment spending that is gained through loose monetary policy, there is a great amount of inflation and  malinvestment. Any ordinary business would be scared to freely take a large risk with so little guaranteed reward and such a nebulous outcome. The Federal Reserve has no responsibility to function like a business, but they could learn much by more rigorously analyzing whether their sacrifice of monetary stability is really paying off.

The idiosyncrasy of the Fed’s practices can be seen even more clearly if we model the United States as one gigantic customer. All at one time, the government owes an incredible amount to this customer, yet this customer needs constant short term loans from the bank. This customer is only able to do business because of these loans, and can primarily only get loans from this one bank. However, rather than receiving better rates on loans when their business is going well, this customer actually receives better loans when their business is doing poorly. The better their business does, the worse rates they get on their loans. As their business is poised to expand, they must weigh their desire for new capital with the increasing rates that the bank is charging them. The bank evens the difference between effective operation and near bankruptcy. Rather than holding the customer responsible for their good and bad behavior, the bank views their business outcome as a mere result of chance, and rewards the bad and punishes the good. Of course, the Federal Reserve, in its role as a government entity, is invested in the survival of the customer, but creating a strong system of poor incentives is not the only way to guarantee survival. In fact, the survival that the Fed is seeking might actually be hindering the emergence of the strongest possible version of the customer, because they are obsessed with keeping the customer on a predictable line of where the modeling thinks they should be. 

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