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.
Copyright Robert Schenk