Last week, I considered the possibility that Barack Obama would fail to reappoint Ben Bernanke as chairman of the Federal Reserve. Events last week, however, would seem to indicate that this would be a very surprising move. Despite various provocations Federal Reserve officials have given the White House and Congress, most notably their refusal to make public any information regarding the funds provided to them through the various bailout plans, the administration’s white paper actually proposes to expand the scope of the Federal Reserve’s legal authority.

In package of financial reforms announced on June 17, the Obama administration proposed a new role for the Federal Reserve described as the Systemic Risk Regulator. This would involve giving the private central bank responsibility to regulate large financial institutions that are not banks, which is ironic given the fact that it is the Federal Reserve, more than any other party, that creates systemic risk to the economy by its constant expansion of the money supply. This isn’t putting the proverbial fox in charge of the henhouse; it is more like taking a very fat fox with feathers in its mouth out of the henhouse and putting it in with the flightless birds at the zoo.

I already pointed out that the Federal Reserve has failed in its responsibility to maintain monetary stability, as the value of its dollar notes have declined to a nickel in the 96 years of its financial stewardship. What is less well-known, even by economists and financial experts, is its similar failure to stabilize the American banking system. The common misconception is that the huge reduction in the number bank failures that followed the 1933 banking reform that established the Federal Deposit Insurance Corporation had anything to do with the Federal Reserve. It is true that bank failures were dramatically reduced, but they were all happening on the Fed’s watch since the central bank had been established 20 years earlier, in 1913.

Still, there’s no way that the various banking reforms were accomplished without the Fed’s input, so it’s not unreasonable to give the bank’s governors at least partial credit for any benefits that have accrued to the American financial system from them. However, the conventional history is both incomplete and misleading. First, it is not true that 4,000 banks failed in 1933. As an old report on U.S. banking statistics from 1921 to 1941 stated: “The figures for 1933 comprise banks suspended before the banking holiday, licensed banks suspended or placed on a restricted basis following the banking holiday, unlicensed banks placed in liquidation or receivership, and all other unlicensed banks which were not granted licenses to reopen by June 30, 1933.”

This is a minor objection, since 1,350, 2,293 and 1,453 banks had failed in the three previous years. A more serious problem, however, is the fact that while the number of banks failing has been reduced significantly, the amount of deposits held by the failing banks has greatly increased over time. The total amount of deposits in the 9,096 banks that failed or were closed down by the federal government in the four years between 1930 and 1933 was $5.3 billion. Corrected for inflation, that amounts to $83.2 billion in 2009 dollars. Only 64 banks have failed in 2008 and 2009 so far, but those 64 banks held deposits of $261.2 billion between them. If the economic contraction continues and the present rate holds steady for the next 30 months, the total deposits held by failed banks will come to $696 billion, 8.4 times worse than before the problem was supposedly fixed. This would not even be the worst four-year period in U.S. banking history, as the chart below will show that the 1988-1991 savings and loan crisis, in which institutions with $479 billion in deposits failed, was even worse when corrected for inflation.

Failed bank deposits in 2009 dollars

Defenders of the Fed and the FDIC will of course point out that banking depositors lost surprisingly little from these massive banking failures, since the assets and deposits of the failed banks were transferred to surviving banks with losses of only 15 percent on average. This is true. But it also misses the point, because the problem is that the present system is actually increasing systemic risk over time through this growing centralization; the Fed is in effect doubling-down each time a bank fails. Whereas there were once 30,000 banks in the country, there are now only 7,037 commercial banks, plus an additional 1,209 savings institutions. This decline in the number of depository institutions combined with the increase in the amount of failed banking deposits during economic contractions indicates that neither the Federal Reserve nor the FDIC has been successful in removing risk from the banking system, they have merely been successful at creating an illusion of lowered risk while at the same time increasing the costs of catastrophic failure in the future.

Assigning systemic risk management to the Fed is about as wise as giving the weekly grocery money to an inveterate gambler and trusting him to go to the supermarket instead of the casino. It’s possible that he’ll return with the groceries and a new car, but it’s much more likely that you’ll find yourself broke and hungry.

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