The Federal Reserve Act was signed into law in late 1913, and the System was set up in 1914, making this school year the centennial of the Federal Reserve System. It seems like a good time to ask students to consider the Fed’s future, so the theme of this year’s essay contest is The Federal Reserve: The Next 100 Years.
With 100 years of history to learn from, you can ask what sorts of roles the Fed should play in the economy going forward, if any. You might argue that the Fed should be abolished or that it should stay in its current form. Or you might argue for any number of changes in the Fed, including taking on new responsibilities or giving up some that it currently holds. Whatever you argue, be prepared to build your case based on economic reasoning and historical experience.
This primer is intended to get students thinking about the topic. It is far from the last word on the subject, but rather is a stepping-off point for students who want to write a good essay.
In order to think properly about the future of the Fed, you must first understand what the Fed does. The Fed’s activities generally fall into three categories: regulation, payments and monetary policy. However, the original purpose for which the Fed was created was to prevent financial crises.
Because banks use some of depositors’ money to make loans and return interest to depositors, they are prone to occasional runs—if all depositors demand their money back, they can’t all be paid. Even the safest banks face this risk. If left unchecked, these runs can lead to full-blown financial panics with dire consequences for the economy, and there are numerous such episodes throughout American history. The role of central banks around the world is to serve as a lender of last resort in such situations, providing short-term credit to banks that are facing temporary stress.
In serving this role, it is important for the Fed and other central banks to distinguish between banks that are illiquid—that temporarily don’t have cash on hand immediately to meet depositors’ demands—and those that are insolvent, or will never have enough cash because they have made poor loans or investments with depositors’ money. In order to make this distinction, and to ensure that banks don’t end up in trouble in the first place, the Fed also serves as a supervisor and regulator of banks. It regularly monitors member banks’ finances and practices to ensure that they are in accord with the law and the goal of a safe and sound banking system.
Another role the Fed plays to keep the economy running smoothly is to manage the payments system. This means processing monetary transfers between financial institutions and between individuals. Examples include check clearing and electronic funds transfers; if you have a paycheck automatically deposited into your bank account, it may go through the Fed. Most visibly, the Fed also manages the supply and quality of coin and currency.
That leads to the last and probably best-known function of the Fed, monetary policy. The supply of money and credit affects economic activity and prices. The Fed is charged by Congress with conducting monetary policy in such a way as to achieve maximum employment and price stability, but doing this job in practice can be difficult, as history shows.
Knowing the basic functions the Fed plays in the economy is a starting point to thinking about how it should evolve in the future.
Just because these roles are filled by the Fed doesn’t mean they have to be, or even that any institution needs to fill them. Asking why they are important and who should be responsible for them is the next step in thinking about this year’s essay contest topic.
Take the lender-of-last-resort function, for example. The United States had no central bank for almost 80 year prior to the Fed’s creation, and this role was served privately—one bank would lend to another in distress. Sometimes distressed banks failed, and depositors lost their money. Students should evaluate how well this system worked and why the Fed was eventually created if they want to pursue this angle.
Likewise, the Fed doesn’t have to serve a regulatory role. In some other countries, regulation is handled by other authorities and the central bank carries out the monetary policy, payments and other functions. Students may wish to compare arrangements in other countries to evaluate what the Fed should do going forward.
Technology is radically changing how money and banking work. People can now use mobile phones to make payments or manage their bank accounts, and there’s no telling what other new tools may come in the next century. How should the Fed’s role in the payments system change, if at all? The evolving nature of money also changes the picture of monetary policy—managing the supply of money is no easy task when the very definition of money is constantly changing.
No matter what you wish to argue about the Fed’s changing role, you need to look closely at history and the future through an economic lens if you want to write a winning essay. You will also need to look carefully at the alternatives.
It’s tempting to be critical of the Fed. How well has it done, for example, at keeping inflation and unemployment low over its lifetime? Criticism is easy, but offering a better alternative is a challenge. This challenge offers opportunities to write an essay that stands out.
Perhaps you want to argue that the Fed’s money management is flawed. You’ll need to use economics to argue for a better alternative. What about a gold standard? Perhaps a system of competing privately issued monies? Look at the costs and benefits of the alternatives and make a case for why yours is superior. History is filled with examples. Perhaps you can suggest an alternative that hasn’t been tried yet.
Or consider the Fed’s regulation and emergency lending functions. There are many alternatives—letting banks fail and depositors lose their money, or fundamentally rethinking how banking is organized so that runs and panics don’t happen. Maybe you will argue that new technology makes banking obsolete. But whatever you choose, be prepared to research and think through the economics of the argument.
There are many other angles your essay could take, but one consideration deserves special mention: Students may be worried that if their essay is too critical they won’t have a chance. This is a contest run by the Fed, after all! But rest assured that we will be objective in judging the entries (many of the judges aren’t even Fed employees). We will select the essays that show the hardest work, most persuasive writing and most creative thought as the winners, irrespective of the position taken. But keep in mind what this primer advises: Criticism isn’t enough; the winners will make a good argument for a superior alternative.
If you have any questions, contact Joe Mahon at Joseph.Mahon@mpls.frb.org or call 612-204-5254.