The Fed doing its job way it was meant to be

September 4, 2011

COLUMNS

Hgh treason? Them’s fighting words! I must come to the defense of the Fed.

The Federal Reserve was created in 1913 in response to the booms and busts in our economy. Booms were great, but the busts were causing too much pain. We were looking for a way to smooth out our business cycle, and this was the mechanism employed.

Long ago and far away, we used commodity money. Commodity money has value in and of itself; think salt and gold. This became cumbersome, though. Hauling around all that gold in your pocket could weigh you down. And a hole in your pocket could leave a trail of valuable salt a mile long.

So we switched to fiat money. Fiat money has no value itself. Its value comes from the strength of the entity backing up this currency. Confederate dollar bills are now only souvenirs, while U.S. dollars can be used to purchase goods far and wide.

For many years, we backed up all that fiat money with gold, hence the gold standard. Currencies around the globe were pegged to gold at a fixed price. Countries maintained gold reserves and could exchange fiat currency for this commodity money. In fact, silver was also used as commodity money for a time. In 1900 the Gold Standard Act made gold the commodity of choice.

For a period, the Federal Reserve System and the Gold Standard functioned at the same time. There are pluses and minuses to each approach. First, under the Gold Standard, inflation will always be low. Pegging paper dollars to a valuable substance ensures price stability. That’s a good thing. But depending only on the Gold Standard means we are subjected to booms and busts. There is no mechanism for dealing with a recession, no way to address high unemployment, so you get low inflation but a lot of pain.

The Federal Reserve can address recessions and periods of high unemployment by tinkering with the money supply. This tinkering often leads to higher inflation, since they are introducing more dollars into the marketplace in an attempt to encourage economic activity.

Could we go back to gold? Probably not. There’s not enough gold in the world to back all the currency that’s out there. The Federal Reserve still keeps large stocks of gold at its New York bank, but it’s not enough to handle the size of global economies today. It’s just not practical.

Should we go back to gold? Probably not. Most of us value growing economies and low unemployment over price stability, which brings me back to that treason thing. The Federal Reserve is an independent body and strives to encourage economic activity while keeping inflation low. The only case for treason would occur if they have the tools to help the economy and do nothing.

Nancy Lottridge Anderson, Ph.D., CFA, is president of New Perspectives Inc. in Ridgeland — (601) 991-3158. She is also an assistant professor of finance at Mississippi College. Her e-mail address is nanderson@newper.com, and her website is www.newper.com.

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