Enough with the bashing of the Federal Reserve

I am tired of all the ignorant Fed-bashing. Sure, they do some things that aren't what some of us might have chosen, but without their actions over the past 4 years we would be up the creek without a paddle. Ben Bernanke may not be a progressive, but neither is he anything like a movement conservative. He is, in fact, a nerd who has spent almost his entire life studying monetary policy.

A little history will help here. I don't think most people who go around hating the Fed know why it was created in the first place. Back about a century ago we had a financial panic (NOTE FROM JOHN: 1907 to be exact, I had incorrectly added "1929" to the post when editing - sorry). That meant everyone was selling financial assets like crazy out of fear that the financial system would collapse and then they wouldn't be worth anything. It wasn't that most banks were actually unable to survive in the long term - they just couldn't survive everyone withdrawing their money at the same time because if they tried to sell their financial assets to cover the withdrawals they would be selling them into a panicked market for way less than they were really worth.

With no Fed on the scene the whole system was in danger of collapse. The savior of the day was none other than JP Morgan. Yes, that JP Morgan, who was the only person around with enough cash to buy all those financial assets so that banks could remain solvent. He bought up all those assets at rock bottom prices, was hailed as a hero and then sold them after the panic was over for far, far more than he paid for them.

The politicians of the day thought this was a bad idea for two reasons.  First, there might not always be a JP Morgan around to save the day. Second, in a democracy it is a bad idea to give that much power (not to mention profit) to a single person or entity. The Federal Reserve was created to perform the function JP had performed.  So when markets panicked and we needed to buy up shaky assets at a low price, and hold them until they matured, or until the panic was over, we could count on our own public institution to do it. In fact, the public institution could do it better because, unlike JP, the profits from buying panic-sale assets and holding them wouldn't go to a private individual. And more importantly, the Fed has unlimited ability to buy-up shaky bonds since they run the printing presses for money.

Lets be clear what is going on in a panic.  Large speculators are making a bet that the system will go down.  They are selling, selling, selling in hopes that the system will collapse and they can buy everything back cheaper later on. The Fed's job is to stomp all over this bet and make sure that the speculators lose money trying it. In short, the Fed is saying to the speculators: "Mine is bigger than yours, and if you mess with me I will ruin you."

As an aside, this is precisely the problem in Europe. The European Central Bank doesn't have the power to act as a lender of last resort, so the speculators may well be right that they can sell Euro denominated assets and win against the central bank. If the ECB could buy up all those, e.g., Italian government bonds, all the speculators would get burned and the ECB would have a portfolio of Italian bonds worth far more than they paid for them.

So what would happen if we eliminated the Fed? There are really two possibilities. One is that the next time there is a financial panic the system will simply collapse, and we really will have a reprise of the Great Depression. The second (and probably equally likely) possibility is that a modern day JP Morgan will step into the vacuum, save the day, and make obscene profits while vaulting into undisputed control of our financial system. I'll bet Goldman Sachs would be a likely candidate.  How would you feel about that?

So don't get me wrong. I wouldn't do a bank bailout the same way the Republicans under Bush did it. If it were me, we would have nationalized the banks, fired the management, and restructured them as we sold them back into the market. But we would still need a Federal Reserve.