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The Federal Reserve’s Real Mandates

Tuesday, May 17, 2011

The Federal Reserve has a 'triple mandate.' Grasping this allows us to understand why the Fed, while not doing so well at stabilizing prices or maximizing employment, has nonetheless gained ever greater power and status.

Congressman Ron Paul recently held hearings of his Subcommittee on Domestic Monetary Policy and Technology to consider the role of the Federal Reserve, so it is not a bad time to reexamine the essential functions of the Fed.

Discussions of the Fed often cite its “dual mandate” of “price stability” and “maximum employment.” As for “price stability,” this goal was dropped long ago in favor of trying for a stable rate of increase in prices, or in other words a steady depreciation of the currency. As for “maximum employment,” nobody believes any more—as some did in 1977 when this goal was added to the governing statute—that there is some simple-minded trade-off between inflation and employment or that there is much the Fed can do to create lasting employment (except for the employment of economists, of course).

In any case, these two “mandates” developed rather late in central banking theories. The most fundamental functions of the Fed (and all central banks) are three other things: providing an “elastic currency,” managing the banking club, and financing the government.

The most fundamental functions of the Fed are providing an ‘elastic currency,’ managing the banking club, and financing the government.

The first function is made clear by the 1913 Federal Reserve Act itself, which begins: “An Act to provide for the establishment of Federal reserve banks, to furnish an elastic currency.” What does that mean? It means the ability to make loans and expand credit, and to print money, to match the cyclical exigencies of the time. The idea of the Fed was developed in the wake of the Panic of 1907 and the ability to furnish an elastic currency was practiced with a vengeance a century later in the Panic of 2008-2009. It is still very much in gear under the current moniker of “quantitative easing.” The old name is more clear and honest.

As to the second function, banking and central banking expert Charles Goodhart begins his intriguing monograph, The Evolution of Central Banks, with this thought: “Although central banks would appear to be firmly established in all major countries, academic economists have been far from convinced that these institutions are necessary, or even desirable in an optimal state of affairs.” So why do they evolve? Goodhart’s proposal, which seems precisely correct to me, is that central banks solve the coordination problems of the banking business by becoming the independent manager of the banking club. In this country, the club is now being expanded to include non-bank financial companies, making the Fed the manager of an even bigger financial club.

The idea of the Fed was developed in the wake of the Panic of 1907 and the ability to furnish an elastic currency was practiced with a vengeance a century later in the Panic of 2008-2009.

Finally, and most basic of all, is financing the government. This is exemplified in the deal that created the quintessential central bank, the Bank of England, in 1694. The deal was that the new bank got a monopoly in the issuance of currency; in exchange it would lend money to the government to finance King William’s wars. Central banks are exceptionally useful to governments in this fashion. This became evident very early in the history of the Fed, when America needed to finance its plunge into the First World War, as insightfully discussed in Bernard Shull, The Fourth Branch: The Federal Reserve’s Unlikely Rise to Power and Influence:

“From the outset … [the Fed] recognized its duty to cooperate unreservedly with the Government to provide funds needed for the war,” the Federal Reserve Board reported in 1920. Said the Treasury in 1918, the Fed “has measured up to every expectation and every requirement. Without this system, it would be impossible to finance…the tremendous credits required to assist foreign governments making common cause with us against Germany.”

(These foreign loans virtually all defaulted a decade later.)

So the fundamental reality is the “triple mandate,” which indeed makes a lot of sense from the government’s point of view. It allows us to understand why the Fed, while not doing so well at stabilizing prices or maximizing employment, has nonetheless gained ever greater power and status in the course of its first century.

Alex J. Pollock is a resident fellow at the American Enterprise Institute.

FURTHER READING: Pollock has recently written “Would You Settle Your Claims on Social Security for 83 Cents on the Dollar? (I Would),” “Municipal Debt Crises: Some Historical Perspective,” “Can Our Last International Advantage Withstand the Dodd-Frank Act?” and “Living in the Political Wake of the Bubble.” He has discussed “Taking the Government Out of Housing Finance: Principles for Reforming the Housing Finance Market” and offered “A Dozen Ideas: What to Do about Fannie and Freddie.”

Image by Darren Wamboldt/Bergman Group.

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