In Part 1, we discussed how the Fed’s ability to manipulate interest rates gives it an unmatched power to simultaneously influence all sectors of the economy in all regions of the country. In this post, I’m going to show how the Fed came to wield this vast power, what the consequences have been, and how this has contributed to many of the challenges we face today.
The Punchbowl (1800-1970s)
Before the Fed
Prior to the 1800s, Europe experienced recurring cycles of: war-driven deficits, which led to excessive money printing by central banks, which meant lenders were repaid with devalued currency. Over time, this raised interest costs and/or restricted access to borrowed funds. Recognizing these problems, Great Britain established the classical gold standard in the early 1800s to help rectify these problems.
The U.S. operated under the gold standard and without a central bank throughout the 1800s and into the early 1900s. While there were some meaningful fluctuations along the way, the gold standard served its purpose of reigning in the ever-present tendency towards inflationary finance. Overall, we experienced virtually no inflation for over a century. In addition, the Federal government was deeply committed to balanced peacetime budgets and minimal borrowing.
Real peacetime GDP grew at about 4% per year from 1800 to the early 1900s. This unmatched rate of sustained expansion enabled us to grow from about 5 million people in 1800 to almost 100 million in 1913, and to create vastly improved living standards for working class people even as we welcomed over 30 million immigrants from dysfunctional systems around the world.
The Fed’s Initial Mandate
The Federal Reserve was created in 1913 to supply currency to the banking system in times of emergency; specifically its job was to provide the funds needed to keep isolated bank failures from turning into full-blown panics. We now know that the Fed’s failure to fulfill its mission in the early 1930s was the primary domestic cause of the Great Depression; indeed, FDR created deposit insurance in 1933 to do the job the Fed had failed to do.
The Punchbowl
In the 1950s, still operating under the false assumption that the Depression was caused by private market failure, the Fed ironically shifted it’s mission from what it had failed to do (prevent bank panics) to protecting against what it was about to do (over-inflate the economy). The Chairman at the time famously redefined the Fed’s mission as acting like “the chaperone who has ordered the punch bowl removed just when the party was really warming up.”
The light-hearted nature of this memorable quip belies the enormity of its implications. The Fed had been created to keep what at the time were mostly local banking failures from turning into runs by depositors (i.e. panics) that caused the good banks in a given area from going down with the bad. It had failed miserably in this very limited mission. Now, the Fed was arrogating to itself the new and vastly expanded responsibility of a) recognizing when the economy as a whole was growing too fast (whatever that means) and b) implementing restrictive monetary policy to steer a better outcome.
Keep in mind: the Fed wasn’t assuming these responsibilities because it had succeeded in its original mission; just the opposite had happened. Nor had it demonstrated any unique ability to foresee the economic future; indeed, its forecasts have proven no better than anyone else’s, and no one is very good at predicating meaningful turning points. Further, nothing had happened in the economy that demonstrated the need for it to play this role. Rather, the Fed was merely claiming additional authority because it had the power to implement it and, apparently, no one thought to stand in its way.
Remarkably, it would not be long before the Fed would be caught spiking the very punchbowl it had just put itself in charge of removing.
Spiking the Punchbowl
When spending on the Viet Nam War and LBJ’s Great Society programs helped push the federal budget out of balance, the Fed did what central banks have always done, it printed money to help finance the deficits. The result was Stagflation, a dreaded combination of high unemployment and high inflation that ravaged the 1970s.
Still failing to recognize the enormity of the institutions failures, Congress passed the Federal Reserve Reform Act of 1977, which again expanded the Fed’s mission, this time to make it responsible for ensuring both stable prices and maximum employment. In effect, a small number of central planners at the Fed were now officially charged with steering the entire American economy by either spiking or removing the punchbowl at their discretion.
In light of its recent record, this was like putting a heavy drinker in charge of the whole economic party!
Adding Bailouts to the Punchbowl (1980s-2000s)
In the early 1980s, Ronald Reagan gave Fed Chair Paul Volcker the political backing needed to finally reign in the runaway inflation of the previous decade. When Volcker stepped down in 1987, Reagan appointed Alan Greenspan as his replacement. Shortly thereafter, on what became known as Black Monday, the stock market plunged by over 20% in a single day.
Greenspan responded by lowering the Fed Funds rate from 7.5% to 7.0% and affirming the Fed’s readiness to supply liquidity to the system. As it turned out, there were no underlying structural problems in the economy. Except for a brief, six-month downturn roughly four years later, the economy would go on to grow robustly for over a decade. Greenspan would later be dubbed “The Maestro” for his apparently masterful orchestration of such moments, but there was a darker side to all of this: the Fed’s mission had been expanded once again, this time to include the pre-emptive use of monetary policy to circumvent almost any and all potential economic disruptions.
So began the bailout era.
The dot.com bubble
In the 1990s, the collapse of the Soviet Union and the passage of the North American Free Trade Agreement (NAFTA) caused a flood of capital to rush into and overwhelm a number of smaller countries. This led to the Mexican Peso Crisis of 1994, the Asian Financial Crisis of ‘97 and the Russian debt crisis in ‘98. As each of these crises developed, what Time Magazine dubbed as “The Committee to Save the World” (Greenspan at the Fed, and Robert Rubin and Larry Summers from the Treasury) stepped in with a series of pre-emptive bailout packages and interest rate cuts.
The Russian debt crisis led to the collapse of Long Term Capital Management (LTCM), a massive and heavily leveraged hedge fund managed by Nobel Prize winning economists and Wall Street luminaries. After orchestrating a stealth bailout of LTCM funded by Wall Street’s largest banks, the Fed then implemented a series of three interest rate cuts as a reward for the banks that had done it’s bidding. As Roger Lowenstein wrote in When Genius Failed, “On October 15, the Fed chief cut rates a second time – a signal he would keep cutting until liquidity to the system was restored.”
In the 18 months prior to the bailout of LTCM, the tech heavy NASDAQ index increased by a little over 15%.
From just before these rate cuts until March of 2000, the index increased by over 230%!
The “Maestro” and the Fed had blown one of the most costly stock market bubbles in history. From peak to trough, the collapse represented a drop of over $5 trillion in value; innocent and unsuspecting investors lured in near the peak and then scared out as the bubble collapsed lost enormous sums of money.
Once again, the Fed failed to acknowledge, accept responsibility for, or learn from its failure. In fact, a bit like a liar trapped in an ever-widening web of deceit, it was about to up the ante on its growing addiction to easy money.
The Housing Bubble
The dot.com bubble collapsed in early 2000. To mitigate the impact on the economy, Greenspan responded with cuts that took short-term rates down to historic lows. As I show in 2008: What Really Happened, these rate cuts drove the Acceleration Phase of the housing bubble. The Fed failed to understand that driving short-term interest rates below already elevated levels of housing appreciation was a bit like spiking an already dangerous punchbowl with a double-dose of moonshine.
When the Fed finally tried to normalize interest rates in 2006, the pace of housing appreciation first decelerated and then collapsed. Nearly 4 million homes were foreclosed on, millions of Americans working in housing, construction and finance lost their jobs, and many of our largest financial institutions were wiped out, resulting in shareholder losses that ran into the hundreds of billions of dollars.
To its credit, the Fed had at least learned from its failure in the 1930s. When the collapse of the housing bubble pushed the system into a modern day equivalent of the bank panics the Fed was originally created to forestall, it did take measures to provide liquidity that helped keep the panic from becoming even worse. But, given the Fed’s role in causing the housing bubble in the first place, this is a bit like thanking an arson for helping to put out his fire.
Adding Long-Term Bonds to the Punchbowl (2010s - 2025)
In Free to Choose (1979), Milton and Rose Friedman noted, “In one respect the (Federal Reserve) System has remained completely consistent throughout. It blames all problems on external influences beyond its control and takes credit for any and all favorable occurrences. It thereby continues to promote the myth that the private economy is unstable, while its behavior continues to document the reality that government today is the major cause of economic instability.”
After the Financial Crisis, the Fed’s mandate was expanded to include greater regulatory oversight of the very financial system it had helped push to the brink of disaster. In addition, the Fed found yet another bottle of stimulus to add to it’s ever expanding punchbowl. Remember, historically the Fed’s preferred tool of monetary manipulation was short-term rates. But after the crisis it started buying bonds to manipulate long-term interest rates as well.
Addicted to Easy Money
Like an alcoholic who can’t give up the bottle, the Fed returned to the easy money policies that had previously ended with the collapse of the dot.com and housing bubbles. To get a rough sense of a relatively “normal” federal funds rate, we can look at the 1960s and the 1990s. This omits the high rates in the ‘70s and ‘80s needed to tame the runaway inflation of that era, and also omits the low rates in the 2000s that accelerated the housing bubble.
The average federal funds rate was a little over 4.0% in the 1960s and a bit above 5.0% in the ‘90s.
As an indicator of how far the Fed went in doubling down on the use of short term rates to try and juice the economy after the Financial Crisis, the average federal funds rate from 2009 to 2016 was less than 0.2%.
A logical question is: if it held rates so low for so long, why didn’t consumer price inflation take off? There are three reasons: First, the off shoring of jobs to low wage labor markets like China helped hold inflation in check. Second, rapid technological advances led to increased efficiency. And third, unemployment remained stubbornly high after the Great Recession.
As we’ll see in a moment, inflation did occur, but it happened in stocks, bonds, and housing prices, instead of consumer prices.
Lending long and borrowing short …at the worst possible time
As noted above, the Fed also started buying bonds to manipulate long-term rates during this period.
In 2007, the Fed owned around $740 billion of securities.
By 2024, this portfolio had ballooned to about $6,500 billion.
Adding insult to future injury, the Fed accumulated much of its bond portfolio when interest rates were at historic lows. As a result, the average yield today is barely over 2%.
In addition to accumulating a large portfolio of bonds at, from an investor’s perspective, the worst possible time, the Fed has also made the classic mistake of funding much of its long-term assets with short-term liabilities. When budget deficits shot up in response to Covid and then failed to come back down when the economy recovered, the Fed once again monetized the deficits, leading to another breakout of inflation reminiscent of the 1970s.
This burst of inflation forced the Fed to begin raising interest rates, which pushed the cost of its short-term liabilities above the yield on its long-term assets. This has led to operating losses of just under $200 billion in the last two years alone.
Additionally, at the end of 2024, the market value of the Fed’s portfolio was over a trillion dollars under water!
If taxpayers had the chance to address the Fed as a steward of their hard earned dollars, they’d be tempted to quote a former reality TV star who was famously known to say, “You’re fired!”
Summary
So, to summarize, since it’s creation in 1913, the Fed has played a primary role in causing the worst financial crises of the past century, including:
The Great Depression of the 1930s
The Stagflation of the 1970s
The dot.com bubble of the 1990s
The Great Financial Crisis of the 2000s
Even as it has caused one major problem after another, its power and influence over the economy have continued to expand. By doubling down on its failed policies over the past decade, the Fed has once again inflated asset prices to historically high levels, leaving us with:
An affordability crisis in housing
Inflated bond prices that rob savers of income and have already led to notable bank failures
Inflated stock prices that make the market more vulnerable to shocks and create the likelihood that future returns will be below historical norms
A bloated portfolio of low yielding, under water, bonds on the Fed’s books
Removing the Punch Bowl, once and for all
As I mentioned in my last post, President Trump was correct that the Fed’s track record has been abysmal and the institution is in severe need of reform. But as this history shows, the real solution to this problem is to finally remove the economic punch bowl, once and for all, from the Fed’s disastrous purview.
- Todd, April 27, 2025
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Happy to now be a Subscriber. Was great hearing you on WAAM YAH (1-2, or were you on the 2-3 hour?) yesterday - lots of great discussion/information.