1. Financial Panics!!! Or, Why We Would Have to Invent the Federal Reserve if it Didn’t Already Exist Steven Kyle Dyson School - Cornell University

2. What is a Bank Run? First, we need to understand how banks operate and make money They take deposits but they don’t just put all that money in a safe Instead, they loan it out or buy other assets with an interest rate that is higher than the one they pay people who make deposits They are only required to keep around 10%* of the money on hand

3. What Happens When People Panic? When people are afraid (for whatever reason) that banks won’t be able to give them their money back there is a universal response Run to the bank and get your money out first!!! (i.e. start a “bank run”) If the amount people want to withdraw is more than the cash the bank has on hand they need to start selling some of their assets to raise the cash

4. What Happens When ALL of the Banks are Involved It is not a major problem when this happens to one bank. Typically, some other larger bank simply buys them out and makes good on the deposits But if EVERY bank is suffering from a run at the same time, then EVERY bank is trying to sell assets to raise cash at the same time That means the market is flooded and price of those assets crashes and no bank can raise the cash they need – SYSTEM FAILURE!!!!

6. How Does the Federal Reserve Protect Us from This? If ALL or MOST banks are trying to raise money by selling assets and Nobody wants to buy them Their price crashes, banks are insolvent and depositors are out of luck But if SOMEBODY steps in to buy the unwanted assets the system can be saved. And that somebody is the Federal Reserve

8. The Fed as the “Lender of Last Resort” If the Federal Reserve owns the printing presses for cash then there is no limit to the amount of assets they can buy That means that they ALWAYS have the power to stop a bank panic if they act fast enough and are willing to “do whatever it takes” Paradoxically, the mere fact that they can do this is enough to prevent a panic – People know they won’t let the system collapse and so they don’t panic. (We also have the FDIC as another layer of safety)

9. “Lender of Last Resort” in Action in 2009

10. Could We Operate Without a Fed? Yes, markets do “self correct”. They do it by having periodic crashes My heart doesn’t bleed for bankers or bank stock holders It DOES bleed for my savings and retirement funds I WANT the Fed to do whatever it takes to save my money. They can fire the bankers if they like as far as I am concerned.

11. What Happened Before There Was A Fed? There was a huge panic in 1907 It was a typical panic just as described above But there was no Federal Reserve. How could collapse be prevented? Enter J. P. Morgan!!

12. Yes. THAT J. P. Morgan – The Richest Man in the World

13. What JP Morgan Did in 1907 He decided to save the banking system by buying all the assets the panicked banks were trying to sell By providing the necessary cash he saved the banks and restored stability to the system He also made bundles of money by purchasing their assets at panic level prices and reselling them later when the market had stabilized

14. Congress Saw Two Problems With This First, we can’t always count on some rich guy showing up to save the day when there is a banking panic Second, why should JP Morgan or some other millionaire make such a huge profit? So Congress decided to invent the Federal Reserve to prevent such problems in the future

15. Congress, Lobbyists and the Federal Reserve Act Then, as now, there was a powerful financial lobby which fought with the faction that wanted to create the Federal Reserve as a government agency The financial lobby wanted private banks to control the Fed The opposition wanted the government to control the Fed

16. The Structure of the Fed is a Compromise We ended up with a strange sort of public/private hybrid The Board of Governors (7 of them) are appointed by the President and confirmed by the Senate The Federal Open Market Committee consists of the 7 governors plus 5 regional reserve bank presidents who serve on a rotating basis (but one of them is always the NY Fed President)

18. The Open Market Committee (FOMC) This is the group that determines interest rates and related monetary policy for the country and is by far the most important part of the system Note that presidential appointees always comprise a 7-5 voting majority But the private sector does get a voice through the participation of 5 of the 12 regional Fed presidents

19. The Regional Fed Banks The Federal Reserve has 12 regional reserve banks which supervise and monitor banks in their regions The president of each regional bank is appointed by a board representing the banks in its region (subject to approval by the Board of Governors in Washington) Commercial banks which are members of the Federal Reserve System own the stock of these regional Fed banks This stock is not allowed to be traded. It is rather like an entry fee for member banks

21. Should Congress Have More Control Over the Fed? As it now stands, the Fed has considerable independence on a day to day and even a year to year basis The Chair is required to report to Congress and to listen to what they say but is not required to do what they want Central Bank independence from politics is widely regarded as a key foundation of good economic management

22. What Happens When Central Banks Don’t Have Political Independence? Politicians have one universal goal – To get re-elected (or to stay in power) Using monetary policy for this purpose usually leads to inflation and a “political business cycle” No modern industrial nation has such an arrangement (The EU’s central bank does NOT have complete political independence and it is causing a world of problems for them)

24. Should We Reorganize the Fed to Lessen or Eliminate Private Bank Influence? From a variety of perspectives it would be desirable for the private banking interests (whose primary goal is profit) not to have even as much of a voice as they have now But …… it would take a new act of Congress to achieve this Does anyone really believe that private bank lobbyists have LESS influence over Congress now than they did in 1913?

26. The Crash of 2008 -2009 Immediate cause was collapse of Lehman – If a bank as old and established as that could collapse then nobody was safe Note that “allowing” Lehman to go down was a judgement call by the Federal authorities. They could have instituted emergency measures to save them Why were banks so vulnerable? Housing market collapse and shaky derivative markets