Did you buy a house in 2020? Did you change jobs in 2021? Are you holding off on buying a new car this year?
Believe it or not, only one institution stands behind all of your financial decisions: the US Federal Reserve.
In this episode of Fiscally Savage, Dylan takes a closer look at the structure, responsibilities, and work of the US central banking system. What does it do? Why do we have it? And how does it affect you and your money?
- [02:48] What the Federal Reserve System (FRS) is
- [03:48] Why the FRS was created
- [05:40] How the FRS works
- [08:22] The structure of FRS
- [13:13] Checks and balances of the FRS
- [16:33] The mandates and duties of the FRS
- [22:19] How the FRS impacts people
- [23:02] Is the FRS “good” or “bad”?
- [24:10] Closing statements
[00:00:00] Intro: Forget the civilized path. It’s time to break the chains of debt and dependency, take control of our financial lives, and live free. This is the Fiscally Savage Podcast.
[00:00:15] Dylan Bain: Hello and welcome to Fiscally Savage. I’m your host, Dylan Bain. Today, welcome to our Friday Current Event show, where I try to take something that’s in the news and explain it in plain English. And today, I’m gonna start by kind of just relating a story because there’s a lot in our lives that I think connects to the story.
[00:00:34] When I lived overseas, I had a friend who was living in Japan. And my wife and I had gotten on a plane, went over to Japan to visit her for one of our holidays. Now, while I was there, there were these statues, and on the statues there were these red hats that they had placed on the statues. And being somebody who was curious and wanted to know more about that culture, I asked our friend who was living in Japan, “Hey, what’s with the red hats?” Well, she didn’t know, so she went over to one of the locals and asked them about the red hats. And they sat there for a second and thought about it and turned to her and said, “Until you asked us this question, we had no reason to ask this question.” And I love this story because it really illustrates this idea that when you exist in a cultural context, you stop seeing the things that are somewhat unique about that context. And you just kind of take it for granted that, on this day, we put the red hats on the statue.
[00:01:28] In the United States, we do this with all sorts of stuff. We take it for granted that healthcare has to be this privately run thing. We take it for granted that car dependence is just the fate of a modern society. We take it for granted that we have to have credit cards and be in debt and that cash-based economies don’t work anymore. These are all things that are true as much as they’re not, and they’re worth examining.
[00:01:48] And there’s one thing like this that we all kind of talk about, we’re all aware is there, and that is the Federal Reserve, also known as the Fed. If you’ve been paying any modicum of attention to the current state of affairs and what’s going on, you know that we are in a middle of a inflationary environment, in my estimation, caused by a supply side-induced recession. That is to say that the supply has gone down. We’re having difficulty getting goods and services in to the economy, producing them, and getting them to the consumers. Therefore, prices are gonna go up because of supply and demand. And the Fed is, in response to this, raising interest rates in the hopes of actually reducing demand; to try to get demand down to reach supply. But one question that I think a lot of people fail to ask is: What is the Fed and how does it work?
[00:02:37] And so today, I’m going to start off with a baseline explanation of what is the Federal Reserve System. Where did it come from? Why do we have it? What do they do? And why does it matter to you?
[00:02:48] So ladies and gentlemen, we’re gonna start at the very beginning of what is the Federal Reserve System. Now, the Fed is actually a quasi public-private entity. It’s the central bank of the United States. When I say central bank, a lot of people don’t know what that is. So in brief, and these are all going to be horrendously simplistic answers to an incredibly complicated system, but a central bank of any economy or sovereign entity is the bank that is responsible for maintaining and creating the currency or medium of exchange in that economy.
[00:03:22] So for example, in the United States, we use the US dollar. The central banking system is what produces and maintains that dollar, and they’re in charge typically of holding on and creating the value of that dollar. That is to say, if they print more of them, they can do what’s called quantitative easing, which is trying to lower the purchasing value of that dollar, which has both positive and negative effects. Positive effects means we can export more. Negative effects means it’s more expensive to import.
[00:03:48] Central banks are typically tied to the government, but ours is not. Ours was created, at least the current incarnation of our Federal Reserve System or central bank, was created in 1913 through an Act of Congress after a series of what are called financial panics. Now, up until that point, it’s not that the US didn’t have a central bank or a centralized currency. That’s actually a really complicated and, quite frankly, ladies and gentlemen, really fun historical story if you like presidents who like to duel people. But we’ll get to that, if not in this episode, in a later one. But when the Federal Reserve was created, Congress was stepping in because we had had a series of what are called financial panics. We call these, or they’re similar to what we call today, a financial crisis. A panic is just when the value of the medium of exchange, whatever that is, it can be debt, it can be gold, it can be paper money, typically at this particular time backed by gold and silver, that panic means that people do what’s called a run on the bank. They run to the bank and they demand all their money back, and our banks don’t have all that money. If you’ve ever seen the film “It’s a Wonderful Life,” there’s a run on the bank in that film, and what the guy says is, “Well, the money’s not here. It’s in your house that is in that business,” because that’s what banks traditionally do, and they still do to a large extent today. But again, as with everything, it’s more complicated.
[00:05:12] But a financial panic is created when people lose faith in that currency that’s being issued by that bank, and that’s what it was prior to 1913. Different banks, particularly state banks, would issue their own currency backed up by gold or silver. And after a number of these that were actually having, you know, knock-on effects throughout the economy, Congress stepped in and said, “No, we want one central bank. We wanna be able to stabilize this financial system.” And so, the Federal Reserve System was created.
[00:05:40] Now, because we’re the United States, we, of course, didn’t do anything according to the standard rules of how this stuff is done. Our Federal Reserve System is unique in that it’s a public-private entity. That is to say that it is not a government-controlled entity; it is a government-regulated entity. That’s right, ladies and gentlemen. Our Federal Reserve System, our central bank, is actually a privately-owned and operated system kinda. Again, I am massively oversimplifying this. But in reality, what makes this work is that the Federal Reserve banks have a board of directors that then oversee the operations of those banks. If you are a national bank, so like think about who you bank with. Obviously, there’s, you know, very large national banks like Chase or Bank of America. But you might be banking at a national bank, First National Bank of Omaha, National Bank of Arizona — these are national banks. And what they have to do to get that national charter is they buy non-transferable stock in their regional reserve bank branch. And what that means is, is that the banks themselves that use the Federal Reserve are shareholders in this entity that we call the Federal Reserve who controls the currency for the United States.
[00:06:57] Where the public part comes in is that the board of directors for the Federal Reserve System is appointed by the presidents and then have the ability to act independently after that. So a president could appoint a director into the Federal Reserve System, and that director can then turn around and tell the president, “No, I’m not gonna do what you want.” Most recently, we saw this with the Trump administration, where he renominated Jerome Powell as president of the Board of Directors for the Federal Reserve System. He’s not actually part of the banking system; he’s part of the Board of Directors; he’s the chairman of the Board of Directors. And President Trump wanted Jerome Powell to take certain actions to be able to help with the COVID response, which Jerome Powell said “no.” Why? Because they’re an independent, quasi public-private entity where he was appointed by the president, but the president doesn’t actually have any authority to tell him what to do.
[00:07:46] Why? Why did we set it up this way? Well, stop and think about it, ladies and gentlemen. If we allowed the currency supply to be in the hands of politicians, they’re going to operate that currency supply for their own benefit. This gives us the ability to undercut a lot of the profit motives and perfectly admittedly, and be able to allow a lot more of the government to have a say in what’s going on in the economy. This system isn’t perfect. For damn sure, it’s not perfect. But it is a unique system that seems to work out most of the time, current events maybe notwithstanding.
[00:08:22] The Federal Reserve Bank is organized into 12 banking districts. And each one of those districts is in the control of some of the states within the United States. Now, each one of those 12 districts, they function as the bank of banks for all of those national banks that are within that district. So that Federal Reserve Bank, so for example, the Federal Reserve Bank of San Francisco is going to be the bank of banks for everything that’s within its territory, which includes the state of California, Nevada, Utah, Arizona, Idaho, Oregon, and Washington. So all the national banks that are within that territory, they bank at the Federal Reserve Bank of San Francisco. All of the large transactions that have to clear through the system, like if you’re sending a wire that’s going through the ACH, they function, the Federal Reserve Bank of San Francisco, functions as the clearing house for those transactions. They also manage the auctions and buybacks for federal debt. So when you hear about, Oh, well, we have efforts in spending, we’re having to issue bonds, this is where we’re running up the national debt — also known as the deficit, which contributes to the national debt, which is a separate thing. But the Federal Reserve Banks are the ones who run those auctions and people bid on them. And during quantitative easing, they were playing both sides. They were running the auction, and they were also bidding in them in a way to try to push interest rates down, which is how they manipulate those interest rates to make sure they’re artificially low, which is what they’ve been doing since 2008.
[00:09:51] Each one of those 12 districts has a governor who’s attached to it, who’s in charge of the banking operations for that district. So a couple other different districts that you have are Kansas City, St. Louis, Dallas, Chicago, Minneapolis, and there’s a bunch more. Now, each one of those governors is also taking economic surveys and collecting data that’s then compiled into what’s called a Beige Book. That Beige Book is kind of anecdotal evidence of what’s happening in the economy in those different areas. Obviously, the economy of California is going to be very different than, say, the economy of Michigan. And so, when the Federal Reserve is looking at what they’re going to do and how they’re going to play their role in the US economy, each one of these governors in these different areas is responsible for gathering and maintaining and interpreting the data from their individual districts. All those governors are then report to the board of directors.
[00:10:48] The board of director is, each one of the directors is appointed by the president, so like Jerome Powell, who’s the current chair of the Federal Reserve Board. He was appointed by the president, and he acts independent. Now, each one of them serves a particular term. I believe it’s four years, but they can’t serve more than 14. So they’re term-limited, which, you know, if you stop and think about it, is probably a good policy for people who have an outsized influence on the US economy. Hint, hint, the Senate. And once they hit that 14 years, they’re done and they have to step down from the board. Then they cannot just step down into becoming a governor and thus creating this infinite loop. A lot of them actually will spin out into the private sector. A lot of them will have become professors because, obviously, they have a lot of knowledge. They’ll do a lot of research because that’s what these people do. And by law, this board of directors must be made up of representatives of various elements of the economy, such as agricultural, industrial, commercial, etc. That is to say, you can’t just have all the bankers sitting there. You have to have somebody who has some knowledge of the agricultural sector, for example. And typically, the board of directors is going to encompass academics, traders, people who were working different banking jobs prior. So you end up with this eclectic mix of people both politically and also professionally that are on the board of directors.
[00:12:11] So again, this is a unique feature of the American system — that we use a corporate shell to house our central bank. Unlike the Bank of England or the Bank of Japan, which report directly to the government, ours does not. That board of directors, once appointed, has complete authority over the Federal Reserve System. Therefore, they also have complete authority over the US dollar. So these are incredibly powerful positions within the economy. And not to put too fine of a point on it, but if you add up all the assets that are maintained and controlled by the Federal Reserve of the United States, they total about $9 trillion. Let me just put a finer point on that. $9 trillion in assets is more than the entire yearly output of the German and Japanese economies combined. So if you think about that, the Federal Reserve Bank of the United States is holding more economic firepower than the number three and number four economies in the world.
[00:13:13] That’s a pretty big stick, if you stop and think about it, for an independent entity to have, which is why there are laws in place such that Jerome Powell, as Chairman of the Board of Directors for the Federal Reserve, has to show up on Congress and actually testify to what’s going on. The Fed is also subject to a number of different audits, both internal and external. So sometimes, you’ll hear people say “audit the Fed.” Well, they’re being audited. They’re internal audits, and there are some external audits. But there’s a lack of transparency there because, if you stop and think about it, $9 trillion is going to leave a mark on global economics, and an audit’s gonna go through all of that. So do we actually wanna publicly disclose that information? Well, I’m not gonna issue an opinion on that here because I can see it going both ways. I’ll leave that for you, the audience, to decide. But like it’s very difficult to overstate how much money we’re talking about here.
[00:14:09] And just to put this even in more of a finer perspective, remember there are 12 Fed districts and each one of those has its own independent bank that’s running its own district. And New York City is obviously one of the places that has a Federal Reserve Bank. And so each one of those Federal Reserve Banks, because they’re running those auctions — remember we talked about they are responsible for both the auctions and buyback of federal US debt — well, turns out, the Federal Reserve of New York City is holding 54% of that $9 trillion, which means that they have an outsized influence over all the rest of the Federal Reserve. We’re gonna come back to that in a second, but just keep that in mind. You might ask yourself: Well, why is that? Why does the New York Fed have so much financial firepower? And it’s a pretty simple answer: Where’s Wall Street? Oh, yeah. New York City. It’s where the stock market is. It’s where the bond markets are. It’s the financial headquarters of the entire United States economy. So it kind of makes sense.
[00:15:10] Now, this system, like we said, was created in 1913 in response to a series of financial panics. The entire idea of the US Federal Reserve System was to create stability within the economy. That is to say that we didn’t wanna be having to go through this constant boom and bust cycle. And now, ladies and gentlemen, please don’t flay me alive for hearing that the Federal Reserve stops the boom and bust cycle; that’s just a feature of capitalism. But not all booms and not all busts are created equal, as we’ve seen with the Great Depression and the Great Recession. The Federal Reserve has actually done a very good job. We’ve had, historically, since its creation, exceedingly long stretches of time without huge financial panics. That was not a feature prior to its creation in what was called the Free Banking Era or even in the early days of the Republic.
[00:16:05] So whether or not the Federal Reserve is creating the stability that’s promised is certainly debatable. But for my money, I’m gonna look at it and say, I mean, the data is pretty much there. The Federal Reserve does create more stability. It also creates a lot of outsized influence within the economy, mismatched incentives within the economy, and I can’t really think of a better system. Maybe that’s just my lack of creativity, but no system’s gonna be perfect and we shouldn’t let perfect be the enemy of progress here.
[00:16:33] The three main functions that the Federal Reserve Bank is required to do is price stability, maximum employment, and setting of interest rates, typically between banks. Let’s take apart each one of those. The price stability piece really comes from one of the most recent financial panics prior to the creation of the Federal Reserve, saw huge inflation because people lost faith in the medium of exchange, also known as the currency. Now, I’m not gonna get into as to why that was, but prices were widely varied across the economy, and there was a lot of ups and downs based upon whether or not the bank you were banking at was actually going to exist. Prior to the creation of the Federal Reserve Bank was known as the Free Banking Era. It basically stretches from the presidency of Andrew Jackson to Abraham Lincoln, where it got a little bit better, and then all the way to 1913. But during that time, the state banks would issue their own currencies against their gold and silver reserves. And if that bank closed up — and the average lifespan of banks was only five years — that would create a lot of price instability in the market. The Federal Reserve was created to be able to stabilize the currency. And Abraham Lincoln started this by passing the National Banking Act that allowed for the creation of a national currency. But it was still controlled by state banks, and if you know anything about trading across state lines and how things in the economy go when there isn’t a uniform standard, people are gonna try to find ways to make profits on the margin, which is exactly what was creating a lot of these panics.
[00:18:07] So price stability is one of the mandates of the Federal Reserve Bank. The second one is maximum employment. There’s a lot of different ways that they do this. But essentially, when the bank was created, one of the fears was the Federal Reserve would allow the consolidation of power in the hands of financiers and banking magnates. So this is the era in which we have banking trusts. J.P. Morgan’s kicking around, John D. Rockefeller’s kicking around. So the idea of creating this national government entity that is not wholly controlled by the US government and was actually being run by the bankers understandably created a lot of fear. And so, that second mandate, which is maximum employment, was put in there to say, “No, no, no. This bank is, by law, required to try to create maximum employment in the economy.”
[00:18:57] The price stability and maximum employment is what’s known as the Dual Mandate of the Fed. And as you can probably guess, they focus on one sometimes more than they focus on the other. Right now, we’re at maximum employment in the US economy. But our price stability, not so much. And Jerome Powell, Chairman of the Board of Directors, has been on record as saying, “Well, we’re gonna create price stability by unemploying a lot of people.” Obviously, he’s focused much more on the price stability piece of the mandate than he is in the maximum employment part of the mandate. So it’s important to understand that those two things, price stability and maximum employment, may be antithetical and that the Federal Reserve Bank only really gets to control those interest rate part pieces.
[00:19:40] The setting of interest rates is how they control and work with those two things. And they’re not setting interest rates for you directly. They’re setting interest rates between banks. Remember those 12 districts? Yeah. Your bank is probably banking at the local Federal Reserve Bank in that district. And so, when your bank turns around and hands their funds there, the Federal Reserve is applying the interest rate to those deposits. Those deposits might only be a day long, but when you’re putting in a hundred million dollars, a small amount of interest actually is a lot of money. And so, the Federal Reserve Bank can incentivize banks to allow them to hold cash by offering high interest rates or incentivize them to lend cash by lowering interest rates and, therefore, the banks are gonna seek a better return in someplace else. But your credit cards, mortgage rates, and other interest rates that you are experiencing in the economy are set by — you guessed it — banks who are setting their interest rates based upon what the Federal Reserve can offer them. So when the Federal Reserve charges a bank a higher or a lower interest rate just to hold on to your money that’s coming from that other bank, it’s going to have ripple effects through the economy.
[00:20:51] This setting of interest rates is done by what’s called the Federal Open Market Committee. And really, it’s just a committee inside the Fed. There are a number of people who make up this committee. The New York Federal Reserve Bank holding 54% of the assets obviously gets a seat at the table a hundred percent of the time, plus four other governors from those other 11 districts, and all seven members of the board of directors. They form the Open Market Committee, and that Open Market Committee are the people who will make the decision as to where the interest rates are going to be. So with the most recent inflation report, we’re expecting this committee that I’m talking about right now to raise their interest rates by 75 basis points or 0.75%. When they do that, they’re gonna have to all vote. So the New York Fed, plus the board of directors, plus four other governors — currently, the governors from Boston, St. Louis, Kansas City, and Cleveland — will all vote on this. And so, if you’re reading the financial news, a lot of times they’re gonna quote the other governors of those other banks. So like the St. Louis Fed, they maintain a lot of charts of money, supply, and currency within the economy. So if you’re gonna go search for the M1 or M2 money supply, chances are good you’re gonna end up at the St. Louis Fed. That guy gets quoted all the time in the news, and it’s because he has a seat at the table. And right now, the news is not talking about the governor out of San Francisco because he’s not really at that table. That’s really interesting.
[00:22:19] All this is to say, ladies and gentlemen, is that what we have in the Federal Reserve is a private-public entity with a great deal of control over your individual life. The decisions that are made in that Open Market Committee will dictate whether or not somebody can afford a home. It’ll dictate whether or not somebody can afford a car. It will dictate whether or not a car dealership continues or construction workers are actually going to be employed because all of that is run on loans from the banks. And all the Federal Reserve sets the rules for all of this. The checks and balances that we have in place is the president gets to appoint them. But once they’re appointed, they have tremendous amounts of power and not a whole lot of transparency with that power.
[00:23:02] Now, I am kind of agnostic on this. I have a tendency to look at it and say, a well-functioning, vibrant market-based economy requires a certain set of rules to be able to speed the medium of exchange. That is, if we all agree to transact in dollars, we can all agree on the value of one dollar’s gonna be the same in Massachusetts as it is in Colorado as it is in Arizona. That makes trade between those three states exceedingly easy. And so, a centralized place to be able to manage this currency, in my book, seems pretty good. On the other hand, when they’re raising or lowering those rates, when they’re auctioning off US government debt on the one side of the table and then bidding on the same debt on the other side of the table, it really creates market distortions, and true prices of things can’t really be found. So which side of this equation am I advocating we be on? Well, if we really wanna know, I’m advocating that we just be really brutally honest that there aren’t really bad choices; there are trade-offs here. And we have to decide what trade-offs we wish to accept when we have the option to choose them.
[00:24:10] That’s all the time I got for today, ladies and gentlemen. Next week, I’m gonna tell you a little bit more about the history because as I was actually looking into this topic, I gotta tell you, it gets kind of wild. So ladies and gentlemen, when you’re reading the news today, just kind of keep in mind what the role of the Federal Reserve that you can see in your local community, whether it’s in your credit card, interest rates, in the home sales around you, the car lots that are down the street, and just keep in mind that it’s worthwhile for us to understand how these levers work because those levers affect each and every single one of our lives.
[00:24:46] Thank you very much for listening, ladies and gentlemen. I would love to get my Instagram following up to 200 followers, and when I do, I’m going to be offering an “ask me anything” where you guys can submit questions and I will handle them on one of my Current Events shows. So head over to Instagram, you can find me @fiscallysavage, and hit that follow button and start following some of my content. And if you know somebody who could benefit from our message, please share the show with them. Thanks for listening.
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