How the Fed has come to influence the world economy

ACCORDING to some economic historians, the Fed was modelled on the English system. The Bank of England was founded in 1694 to deal with “currency, government finance, and banking for the leading financial undertakings of the country, including the other banks.” The Bank Charter Act of 1844 gave powers to the Bank of England to manage and control note issues. All new banks were forbidden to issue notes. This was a very important measure because its objective was to prevent an over-issue of currency.
Both maximum employment and stable prices were established by the Congress as the macroeconomic objectives of the Fed. Besides acting as the lender of last resort, the Fed influences the general level of prices, stimulates the economy or otherwise through the use of the official Bank Rate because the entire system of money costs moves in sympathy with the changes in the Bank Rate. In order to control the economic activities which are closely related to the level of employment, the Fed also uses another instrument; it expands or restricts the monetary and credit supplies through its open-market operations.
The rise of the Fed to play a decisive role in the world economy is basically due to three reasons. First is the size of the US economy.  With over $16 billion of GDP, it is by far the largest economy in the world. Second, after the end of the Second World War, the US dollar has become the principal reserve currency of the world. A small change in the benchmark Bank Rate in the US or in any of its other monetary policies has global implications like the recent movement of hot money from the US to other markets looking for higher returns. Third, a huge proportion of international trade is conducted in US dollars.
Having defined in broad terms the responsibilities of the Fed chairperson, let us see how some of the recent incumbents of this position have performed.
Among the recent incumbents of the Fed, Greenspan´s name stands out as being the most important of all not only because he served in this position for nearly twenty years (1987 to 2006) and under four presidents but also because he is considered by many economists as the person responsible for the recent global financial crisis that started in 2008 and is still continuing with disastrous effects on the lives of hundreds of millions of people across the world. As a follower of Ayn Rand's philosophy of objectivism (rational selfishness), he practiced a version of wild capitalism. He used to think that the financial world had the inherent mechanism to regulate itself. This proved to be a terrible mistake. His super-low interest rates and disdain for regulation were responsible for the sub-prime mortgage bubble, the housing bubble and eventually the financial crisis.
Then came Bernanke, who took charge of the Fed in February 2006. By that time, the damage was done and toxic assets in the form of Collateral Debt Obligations (CDO) issued by the US financial institutions had already contaminated the balance sheets of most European and Asian banks and the resulting losses cascaded through the entire financial system of the world. The sub-prime crisis exploded in 2007 and after the collapse of Lehman Brothers in 2008, came the crash.
Even though Bernanke belonged to Greenspan´s team, he did not foresee the catastrophic nature of the crisis and much less prepare any contingency plans. But once he realised the gravity of the situation, he swung into action with an aggressive policy of quantitative easing and forward guidance which have saved the US economy from total disaster. As the US economy started to grow, its effects were felt across the globe and especially in Europe. Most economists agree that Europe would have been in a much worse situation had Bernanke´s policies failed.
What does the world expect from Yellen? She has got a very complicated task ahead of her.  There is no doubt that she will continue with Bernanke's latest policy of withdrawing hundreds of billions' worth of monetary stimulus from the US economy. The question is: How fast or how slowly will she do it? For this, she will have to watch carefully not only the employment and inflation (or deflation) figures in the US but also the impact of this policy on the markets in Asia and Europe because a sharp downturn in these markets will not be in the long-term interest of the US. Further strengthening of the regulatory function of the Fed will also be required to avoid the creation of new bubbles and to correct past errors.

The writer is a columnist for The Daily Star and an Officer of the Royal Order of Isabel la Católica of Spain.