Role of America's Federal Reserve in Contributing to Actions Leading to the 2008 Financial Crisis - Essay Example

? The role America's Federal Reserve Played in Contributing to the Actions Leading to the 2008 Financial Crises Introduction The Federal Reserve of the United States was established in 1913 as a means of stabilizing currency issues within the country. Since its emergence the Fed has prominently functioned in response to the major crises of the 20th and 21st centuries. Essentially, the Fed operates by raising and lowering interest rates in accord with the current United States financial climate. In enacting these changes the Federal Reserve infuses currency into the economy through private intermediaries. One considers that the Federal Reserve was actively involved in attempting to stem the tide of unemployment following the 2008 recession. While the Federal Reserve is a cornerstone institution of the United States, critics have argued that in the long-term the Fed is actually bad for the economy. This research evaluates the extent that the Federal Reserve contributed to the actions leading to the 2008 financial crises. Analysis One of the most prominent critics of the Federal Reserve has been former Republican Presidential candidate Ron Paul. Paul’s perspective follows a line of logic that is directly related to the way the Fed functions. Paul indicates that when the American economy is lagging the Federal Reserve infuses new currency into the system. This new currency results in lowered interest rates. The lowered interest rates correspondingly result in capitalist expansion, as business and individuals increasingly engage in borrowing practices. The problem, as Paul indicates, is that such practices are artificial and don’t reflect the economies’ true and proper functioning. Paul has seminally noted, “When central banks like the Fed manage money they are engaging in price fixing, which leads not to prosperity but to disaster” (Paul 2011). Paul, citing the Austrian school of economists, argues that rather than aiding the economy this infusion of currency into the market only creates a short-term boom. As this boom period is artificially inflated, it necessarily results in a period of economic decline. The Austrian perspective of economics has been implemented elsewhere as a means of criticizing the Federal Reserve’s actions leading up to the financial crisis. Kibbe (2011) argues that many Austrian economists predicted the 2008 financial crisis. Kibbe contrasts the Keynesian school of economics, which attempts to implement mathematical models in predicting future economic movements, with the Austrian school that argues later economic shifts can only be understood by examining human behavior. Similar to Ron Paul, Kibbe makes a number of sensational statements regarding the impact the Federal Reserve had on the financial crisis. In both perspectives their criticism is less about specific policy measures the Fed took, but rather with the entire existence of the Fed; as such, they believe that any actions this institution makes is ultimately bad for the economy. Just like Paul, Kibbe (2011) notes, “we would not experience such dramatic economic swings were it not for monetary policies that distort real prices and encourage improper investment decisions. Boom and bust cycles are inevitable when government interventions confuse market participants.” When one couples Kibbe’s perspective regarding boom and busts with statements made by the United States government leading up to the financial meltdown startling consideration emerges. For instance, he notes that Treasury Secretary Paulson said in 2007 that the global economy was at the strongest he had seen it in his career. Additionally, he states “Between 2001 and 2004, the Federal Reserve injected new credit into the economy, pushing interest rates to their lowest level since the late 1970s. As a result, the economy was booming just a few short years ago” (Kibbe 2011). Still, one recognizes that Kibbe provides little empirical evidence for the predictions of the Austrian economists against the failure of the Keynesian predictive models. The evidence he supplies, while on the surface appears conclusive, is also taken out of context. In these regards, it is possible that Paulson’s statements did not reflect the best collated knowledge of the Keynesian models but instead merely was a political statement made to calm the public. Similarly, Kibbe’s (2011) recognition that the Federal Reserve’s policy regarding interest rates leading up to the financial crisis created the housing bubble ignores the true complexity of the crisis. It was not merely the Fed’s policies that inflated home prices, but the complex interaction of collateralized debt obligations that exceeded traditional investment bank liquidity, government policies, and homeowners spending beyond their means. Paul further criticizes the Fed indicating that the system it has in place mirrors the system implemented by the Soviet Union during the communist period. Namely, both of the aforementioned have a team of economists and financial analysts working to mirror the mechanisms of the free market. While Paul’s contentions in these regards seem to make sense, it is possible that he is oversimplifying the way the Federal Reserve operates. Baghestani & AbuAl-Foul, (2010) note that rather than simply infusing currency into the economy during recessionary periods, the Federal Reserve takes into consideration possible factors of supply and demand and push/pull economics. In these regards, rather than simply inflating the economy the Federal Reserve is timing out specific periods where demand is low and triggering this demand this infusions of currency. Ultimately, then, rather than artificially inflating the economy the Federal Reserve is enacting real actual economic activity that had simply become stagnant in relation to a variety of conditions. Even more potent is Paul’s claim that, “the price of housing was artificially inflated through the Fed's monetary pumping during the early 2000s” (Paul, 2011). One considers that in large part it was these inflated housing prices that largely contributed to the fallout that caused the 2008 financial crisis. The extent that Paul’s criticism is accurate in these regards has been a hotly debated issue. While the Federal Reserve chairman at the time was Alan Greenspan, current Fed chairman Ben Bernanke has supported the Fed’s actions involving interest rates during this period (Financial Times, 2012). Still, Greenspan himself spoke in front of the House Government Oversight Committee and admitted to making some mistakes in the period that preceded the financial collapse (Bawden 2008). It’s noted that, “The panel chairman, Henry Waxman, criticised Mr Greenspan's approach to mortgage regulation while he was Fed chairman. The Fed "had the authority to stop the irresponsible lending practices that fuelled the sub-prime mortgage market," Mr Waxman said, but Mr Greenspan "rejected pleas that he intervene"” (Bawden 2008). Representative Waxman is referring to the lending practices that were occurring in banks granting mortgages to large blocks of people with poor credit ratings. Rather than halting this lending Greenspan, a long-term free market enthusiast, believed that the most responsible actions were to let the private institutions decide their own market concerns. One recognizes that in-large part Greenspan’s perspective on the economy mirror Ron Paul’s in that both believe the free market system should regulate itself. To an extent then it seems that Paul is ignoring the Greenspan’s recognition that the Federal Reserve should have been more active in halting the practices of these financial institutions in taking on sub-prime mortgages. Within this perspective the Fed does not create booms and busts, as Paul claims, but rather functions as a vital cautionary force in the American economic system. While critics such as Paul disagree with the entire institution of the Federal Reserve other individuals have criticized the Federal Reserve’s immediate response to the recession. As one might expect the Federal Reserve has strongly supported its actions before and after the financial crisis. Notably, the Federal Reserve supported insurance conglomerate American International Group (AIG) and also aided with the sale of investment bank Bear Stearns. Many individuals have argued that the Fed should have allowed these organizations to fail and that bailing them out has resulted in increased recession and substantial government debt. Federal Reserve chairman Ben Bernanke countered these claims noting, “The Federal Reserve's responses to the failure or near failure of a number of systemically critical firms reflected the best of bad options, given the absence of a legal framework for winding down such firms in an orderly way in the midst of a crisis a framework we now have” (Economic Times, 2012). One recognizes that there is a strong challenge in determining which path is the more functional for long-term economic sustainability. Bernanke is claiming that the Fed’s actions in bailing out these institutions were justified as had they not taken action they would have failed, resulting in the widespread collapse of the American economic system. In these regards, the Federal Reserve functioned not to cause the recession, but as the last bastion preventing the complete dissolution of American society. However, individuals would counter that allowing these institutions to fail would not have caused such complete disillusion and instead would have been consumed by the invisible hand of the market. The United States Government Accountability Office specifically considered the Federal Reserve’s actions in regards to American International Group (AIG). The primary consideration from the Federal Reserve’s perspective was aiding the organization in avoiding the liquidity crisis. While the Federal Reserve explored a number of options, the report argues that the Reserve did not have time to consider other options, and proceeded by taking control of the toxic collateralized debt obligations. While the process of Federal Reserve in treating these liquidity challenges has been well considered, this report is perhaps most significant for what it indicates about the financial crisis and about future actions. Notably, the report demonstrates the extreme levels to which the banks were allowed to assume collateralized debt obligations that would result in such extremities. It seems that either a dramatic oversight was made on the part of the Federal Reserve in allowing these institutions to assume this degree of risk, or the Federal Reserve’s economic models were incapable of recognizing the true structural dimensions of the housing market and assumed the nation could sustain the stark increase. As the Federal Reserve had provided no significant narrative regarding the spike in housing prices during this period, it seems that they did not implement enough financial practicality in their decision-makings. A number of researchers have examined the Federal Reserve’s specific actions in the periods surrounding the financial crisis. Cecchetti (2009) explains that as the housing bubble burst American banking institutions found themselves at great risk to the substantial amount of subprime mortgage loans that had been issued. As banks are only able to loan certain amounts of money, based on their existing funds and assets, the issue of the subprime mortgage crisis created a situation where banks would have to extremely limit loans. This liquidity crisis could have potentially had a long-standing impact on the events of the crisis as without available money for loans economic growth would stagnate. Cecchetti (2009) argues that once the housing bubble burst the Federal Reserve found themselves at a great disadvantage to stopping the crisis as the banks were in such a crisis because of the poor investments that they would need for the economy to fundamentally recover before they would have the capital to make new loans. For Cecchetti (2009) then the issue wasn’t so much the Federal Reserve’s response to the crisis, but rather not acting more pro-actively in preventing the extreme levels of risk that were incurred in the pre-recession period. One considers that the Fed’s current quantitative easing policies function as a means of retroactively taking the toxic assets off the books of American banks. The Federal Reserve itself has conducted research into the specific causes of the financial crisis. Chari, Christiano, & Kehoe (2008) conducted specific research into elements relating to the financial crisis. Their research revealed that many misconceptions exist regarding the actions during the financial crisis, notably the amount of interbank lending and bank lending to non-financial institutions. Perhaps more significantly their research argues that conventional analysis of the financial crisis focused on interest rate spreads, such that the higher the interest rate the more risky the investment was perceived. Rather, this study posits that, “even if current increase in spreads indicate increases in the riskiness of the underlying projects, by itself, this increase does not necessarily indicate the need for massive government intervention” (Chari, Christiano, & Kehoe, 2008). The extent that the Federal Reserve acted under the previously mentioned paradigm is not directly stated, but it seems clear that in part the Fed may have over-acted in its change of interest rates, without considering enough the underlining mechanisms for these policy actions. Chari, Christiano, & Kehoe’s (2008) perspective is seemingly supported by Taylor (2008). Taylor’s research collated a variety of empirical studies on the causes of the financial crisis and the Federal Reserves actions therein. Taylor’s (2008, p. 18) research concluded by noting, “that government actions and interventions caused, prolonged, and worsened the financial crisis.” There are a number of specific elements that Taylor references. For an overarching perspective Taylor argues that the Federal Reserve deviated from traditional practices that had worked for historically. Rather than stopping the crisis, he argues that the Federal Reserve further contributed to the crisis through emphasizing liquidity rather than risk. Notably, Taylor’s insights intersect with those established by Chari, Christiano, & Kehoe (2008) as both studies argue that the Federal Reserve’s central mistake was broadly implementing interest rate policies rather than considering the underlining diagnosis. In recommending specific policy actions that could be implemented in future contexts Taylor (2008, p. 18) indicates that the Federal Reserve should, base any future government interventions on a clearly stated diagnosis of the problem and a rationale for the interventions” and “create a predictable exceptional access framework for providing financial assistance to existing financial institutions. The example of how the International Monetary Fund set up an exceptional access framework to guide its lending decisions to emerging market countries is a good one to follow. Essentially what both researcher studies have touched on is the recognition that in diagnosing and treating the elements of the financial crisis the Federal Reserve did proceed in enough of a systematic way. Instead, the Fed aided certain financial institutions and not others. As such the organization did not go far enough in altering the underlining structure of the economic climate. Conclusion In conclusion, this essay has examined the extent that the Federal Reserve contributed to the actions leading to the 2008 financial crises. Within this spectrum of investigation a variety of critical perspectives have been evaluated. Ron Paul levies one of the prominent critical perspectives. The research demonstrates this perspective is that of the Austrian economists who believe that the Federal Reserve contributes only to establishing booms and busts by artificially inflating economic action. While Paul’s perspective is a structural critique, further perspectives consider that the Federal Reserve was too open with their policy. This perspective argues that the Federal Reserve contributed to the rising home prices by lowering interest rates. Ultimately, it seems that the Federal Reserve is responsible in that they became involved in the same institutional culture that plagued the financial institutes they were charged with overseeing. References Baghestani, H., AbuAl-Foul, B., (2010), "Factors influencing Federal Reserve forecasts of inflation", Journal of Economic Studies. 37 (2), p.196- 207, [Online], Emerald, [Available] http://www.emeraldinsight.com/journals.htm?issn=0144-3585&volume=37&issue=2&articleid=1860225&show=html, [Accessed: 10/04/2012] Bawden, T.,  (2008) "Alan Greenspan admits to some mistakes", The Times. Bianco, K., M., (2008), “The subprime lending crises: Causes and effects of the mortgage meltdown” CCH Mortgage Compliance Guide and Bank. Chari, V.V, Christiano, L. and Kehoe, P., J., (2008) "Facts and myths about the financial crises of 2008", [Online] Federal Reserve Bank of Minneapolis Research Department. [Available]http://www.mpls.frb.org/research/wp/wp666.pdf [Accessed] 12 April 2012 Cecchetti, S., G., (2009) “Crisis and responses: the federal reserve in the early stages of the financial crises”, Journal of Economic Perspectives, 23 (1), p.51-75, [Online] UCL, [Available] http://www.ucl.ac.uk/~uctpnpa/cecchetti.pdf, [Accessed] 12 April 2012 Kibbe, M., (2011) “ The Federal Reserve deserves blame for the financial crisis”, [Online] Forbes, [Available] http://www.forbes.com/sites/mattkibbe/2011/06/07/the-federal-reserve-deserves-blame-for-the-financial-crisis/ [Accessed] 12 April 2012 [Online]Paul,R. (2011)"Blame the Fed for the financial crises", The Wall Street Journal, [Online] WSJ, [Available]http://online.wsj.com/article/SB10001424052970204346104576637290931614006.html [Accessed] 13 March 2012 The Economic Times (2012), "Ben Bernanke defends Federal Reserve response to the financial crises", [Online] The Economic Times, [Available] http://articles.economictimes.indiatimes.com/2012-04-14/news/31342084_1_ben-bernanke-central-banks-financial-system, [Accessed] 12 April 2012 Taylor, J., B.,  (2008) "The financial crises and the policy responses: an empirical analysis of what went wrong", [Online] Stanford, [Available]http://www.stanford.edu/~johntayl/FCPR.pdf [Accessed] 12 April 2012.  United States Government Accountability Office, (2011), “Review of federal reserve system financial assistance to American Insurance Group Inc.” Report to Congressional Requesters, [Online] Cryptome, [Available] http://cryptome.org/0005/gao-11-616.pdf, [Accessed] 12 April 2012 Read More