What's the Federal Reserve good for?

For those of us interested in our economy and the vagaries of the Federal Reserve, there was a fascinating bit of history told by Art Cashin on the floor of the NYSE last week. (Video here.) The occasion was the 24th anniversary of the day after the "Black Monday" stock market crash of October 19, 1987.

After the hideous sell-off on that Monday, the traders fully expected a swift rally on Tuesday morning, which is exactly what they got until everything went horribly wrong.

One of the main functions of the Federal Reserve is to prevent or stem bank runs.  A bank runs happens when rumors spread about the insolvency of a bank, and depositors show up en masse to withdraw their deposits.  Then the bankers can go to the Fed discount window and exchange high quality paper assets for short term cash.  Because of the discount window and also the FDIC, bank customer panics such as these were rare in modern times (before the 2008 crisis), although they were much more common before and during the great depression.

The story of October 20, 1987 is interesting because it is an example of stock traders (bank customers) remaining calm in the face of chaos, but in a turnabout the bankers panicked.  The New York Federal Reserve Bank president was able to stop the panic partly by threatening the bankers (the Fed is a key bank regulator) but also by putting their money where their mouth was via access to the discount window.

My objective here is not to be a Federal Reserve cheerleader.  I think QE2 (quantitative easing round 2) and the recent Operation Twist are doing damage to the U.S. and global economies.  But it is important to recognize that even entirely free markets can and eventually will participate in herd mentality panics, and that some responsible governmental policies can be enormously beneficial.

For those of us interested in our economy and the vagaries of the Federal Reserve, there was a fascinating bit of history told by Art Cashin on the floor of the NYSE last week. (Video here.) The occasion was the 24th anniversary of the day after the "Black Monday" stock market crash of October 19, 1987.

After the hideous sell-off on that Monday, the traders fully expected a swift rally on Tuesday morning, which is exactly what they got until everything went horribly wrong.

One of the main functions of the Federal Reserve is to prevent or stem bank runs.  A bank runs happens when rumors spread about the insolvency of a bank, and depositors show up en masse to withdraw their deposits.  Then the bankers can go to the Fed discount window and exchange high quality paper assets for short term cash.  Because of the discount window and also the FDIC, bank customer panics such as these were rare in modern times (before the 2008 crisis), although they were much more common before and during the great depression.

The story of October 20, 1987 is interesting because it is an example of stock traders (bank customers) remaining calm in the face of chaos, but in a turnabout the bankers panicked.  The New York Federal Reserve Bank president was able to stop the panic partly by threatening the bankers (the Fed is a key bank regulator) but also by putting their money where their mouth was via access to the discount window.

My objective here is not to be a Federal Reserve cheerleader.  I think QE2 (quantitative easing round 2) and the recent Operation Twist are doing damage to the U.S. and global economies.  But it is important to recognize that even entirely free markets can and eventually will participate in herd mentality panics, and that some responsible governmental policies can be enormously beneficial.

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