Forum Post: The Federal Reserve Did not Cause The financial Crisis. Instead it was changes in the laws over a 30 year period.

The Monetary base which is largely controlled by the Federal Reserve adjusts with the changes in interest rates with the goal of effecting the Greater Money Supply(M3 series). In the previous decade the Federal Reserve started out by slashing interest rates to historical lows, but by 2003 it was clear that central banking policy was centered on raising the Fed’s fund rate. Thus by 2006 a series of interest rate hikes brought the Federal Funds rate to be around 5%. Therefore It should be assumed that the monetary base(M2 series) should have decreased in the middle of the Decade. After looking at various charts published both by Federal Reserve board of Governors and independent sources it is confirmed that this did indeed occur. Henceforth, shouldn’t it also be probable to conclude that if the monetary base decreases shouldn’t the greater money supply do the same as well? Under particular circumstances the answer may be a yes, but In more recent times the more correct answer would probably be a no. This is because as the Decade wore on both bank and non-bank entities became increasingly dependent on the Shadow Banking Industry. This industry is primarily composed of non-depository banks that grew rapidly after the year 2000. These non-banking institutions primarily consist of investment banks, and insurance companies, but can also be separate divisions in a company. For example J.P Morgan Chase not only engages in investment banking, but has also used Credit Default Swaps in conjunction with other companies as an insurance policy. Therefore the Shadow banking industry in the previous decade was not only compromised by major lending institutions not backed by the FDIC, but also institutions that operated as a lender of last resort. The most important observation to made here is that because the Shadow Banking Industry became the dominant lending institution it should be of no surprise that the greater money supply operated separately from changes in the monetary base. This is because the M3 money supply, which is separate from the monetary base, is M1+M2+ large time deposits, liquid assets, and money market funds, and all three of these things after M2 Increased after the mid 2000’s. Therefore large financial institutions began to increase their portfolio with riskier assets and acted as a lender of last resort while ignoring Federal Reserve Interest Rate policy. Although the gap between changes in interest rate policy, and the greater money supply are slightly more pronounced then some economists assume, it is still a generally observed principle that an increase in interest rates should inform firms and consumers to tighten up. For the most part this did occur and proof of this is derived from the fact that consumer spending and the velocity of money began to decrease in the middle of the decade. Thus Federal Reserve Policy may have indeed reigned in consumer spending, and tightened the chord around regular loans, but their policy had no effect on the Shadow Banking System. A system comprised of massive financial institutions like Bear Stearns, AIG, JP Morgan, and Goldman Sachs. All of these institutions operated as commercial banks, investment banks, and insurers. Therefore not only did these financial institutions operate as primary lenders that eclipsed the role of central bank policy, but most importantly they operated as lenders of last resort(insurers). Thus the Shadow banking system operated beyond monetary policy because of financial practices, and debt instruments that were constructed in a manner that could operate beyond central bank policy. Furthermore as these major loans begin to pick up, and thereby leading to increase in the Greater Money Supply it was done so without any risk protection. For example when JP Morgan operated as an insurer and bailed out Exxon it did so without being backed by the FDIC. Such Credit Default Swap loans were common place through out the decade, and by simply being an insurer to another company it is easy to see how monetary policy probably had a very small effect in changing the direction of the Greater Money supply.