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The Role of the U.S. Government

The U.S. federal government not only regulates financial markets and intermediaries, it also is a major financial intermediary itself. Two agencies with important regulatory functions are the Securities Exchange Commission (SEC), the Federal Deposit Insurance Corporation (FDIC). The SEC regulates behavior in stock and bond markets, and also specifies which information a publicly-traded company must provide to shareholders. The FDIC insures deposits at commercial banks and, with the demise of the Federal Savings and Loan Insurance Corporation in the 1980s, also deposits at savings and loan associations.

The U.S. government makes extensive loans for agriculture and housing. Because the government can borrow at a lower interest rate than most private borrowers, and because it does not need to make a profit, it can lend at lower interest rates than private intermediaries can. The government also subsidizes borrowers by guaranteeing loans that private lenders make. However, the issues that these actions of the government raise are primarily microeconomic in nature.

From a macroeconomic perspective, by far the most U.S. important government institution involved in financial markets is the Federal Reserve System. The Federal Reserve System (often referred to as the "Fed" by economists and bankers) is the central bank of the United States. A central bank functions as a banker's bank. Just as individuals and businesses have deposits at a regular bank and can write checks on these deposits, banks have deposits at a central bank and can write checks on these deposits.

The Federal Reserve System is a rather strange "central" bank because it is composed of 12 separate banks. When you examine your paper currency, you will see the district number and letter of one of these 12 banks on the left side of the portrait. This strange structure exists because of the political realities that faced Congress when it established the system in 1913. In 1935 Congress reduced the independent authority of these 12 banks and centralized policy-making authority in a group called the Federal Open Market Committee (FOMC) that decides monetary policy. Although today the individual Reserve banks retain little independent power, the president of each can serve as a voting member of the FOMC.

Other countries have central banks that perform many of the same functions as the Federal Reserve performs in the U.S. Much of Europe has the European Central Bank, which controls the supply of euros. The United Kingdom has the Bank of England, one of the world's oldest central banks, and Japan has the Bank of Japan. If a country has its own currency, the chances are very good that it has a central bank.

The discussion of financial intermediaries noted the possibility of financial shocks arising from problems within these intermediaries. A solution to this problem is for some organization, most often a central bank, to serve as a lender of last resort. Indeed, it was the financial panic of 1907 that gave rise to the legislation that established the Federal Reserve System. In 1907 people lost confidence in some banks and rushed to withdraw their money. Those banks paid their depositors in part by drawing on their deposits with other banks, so the panic had the potential to spread. A private individual, J.P. Morgan, organized the healthy banks to stop the panic. Concern that one private individual had such great influence and the realization that the U.S. lacked an effective lender of last resort contributed to the founding of the Federal Reserve System.

An effective lender of last resort wants to protect the financial system but does not worry about the fate of the managers or shareholders of troubled banks or financial companies. In fact, any attempt to protect managers and shareholders creates a problem of moral hazard: if managers know that they will not suffer the full consequences of their bad decisions, they will be more likely to make bad decisions. Many economists who have studied the Great Depression argue that the Fed's failure to act as lender of last resort during periods of bank runs was a primary reason that the recession lasted until 1933. Recent examples of the Federal Reserve acting as lender of last resort, though perhaps not always as effectively as possible and sometimes indirectly, include the takeover of Continental Illinois in 1984, the rescue and subsequent liquidation of Long Term Capital Management in 1998, and the agreement to merge Bear Stearns with JP Morgan Chase in 2008.

We next look at what people buy and sell in financial markets, and at what prices.

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