The 23 years prior to the September 2008 financial crisis were widely considered a new golden age for the U.S. economy. Fluctuations in employment and output decreased, and all was quiet on the inflationary front. What was the source of this novel stability in prosperity? Then-Fed-governor Ben Bernanke argued in a 2004 speech that credit was due to improved monetary policy, and he had plenty of company. Robert Lucas asserted that “[macroeconomics’] central problem of depression-prevention has been solved,” and the New Monetary Consensus reassured policymakers, politicians, and the broader public that, so long as the Fed stuck to its Taylor rule, all would be well with the macroeconomy.
The farcicality of these pronouncements became clear as the cluster of malinvestments that constituted so much new US housing stock eroded in value, forcing borrowers to whom credit had been extended too easily to become delinquent on their mortgages, which in turn destroyed bank balance sheets as the asset-backed securities they had been encouraged to hold lost their value. This process involved many private-sector institutions, but at its root was the Fed. Whether one ascribes the 2008 crash to the Fed’s failure to stabilize NGDP, as Scott Sumner and the market monetarists have, or to the Fed’s having kept interest rates too low for too long after the 2001 recession, as John B. Taylor and others do, the primary enablers remain the Governors of the Federal Reserve.
In order to figure out whether or not it’s appropriate to eliminate the Fed, however, we must first establish what it is and does. This is similarly crucial for demonstrating the viability of potential alternatives.
Given the centrality of its role in explanations of US economic maladies, it might surprise us that the Fed is poorly defined as an organization, to the extent that it is a product of definition, and therefore design, in the first place! The Fed, after all, does more than merely print dollars: it chooses how many dollars to print, it chooses when it will print them, and it chooses where they will go. Coordinating these actions in the money market would present enormous challenges to any single entity in the first place, but the Fed’s job doesn’t stop there. It is also charged with intervening in the market for U.S. Treasury debt, revealing the farcical nature of its “independence” from the federal government. Through the discount window and, more recently, the special liquidity programs through which it responded to the financial crisis, it intervenes in the market for private sector debt. Thanks to its Humphrey-Hawkins tripartite mandate, which features both inflation and unemployment targets, it must intervene, if indirectly, in nonfinancial product and labor markets, too. Finally, emboldened by the Dodd-Frank Act, the Fed may now take over at its discretion any of its member banks, who together comprise all the major financial institutions of the United States.
This, if anything, is the epitome of mission creep. William McChesney Martin, Fed chairman during the mid-20th century, famously compared the Fed’s mission to removing the punchbowl from a party as it became raucous. With this analogy, he implicitly expected of the bureaucracy he ran purity of motive, perfect foresight, and an unshakable will. These are difficult standards to be sure, ones which any organization would have difficulty fulfilling, but he was right in his implicit assumption that for the Fed to fulfill its stated goals (“to furnish an elastic currency...[and] to establish a more effective supervision of banking in the United States” per the Federal Reserve Act), it would need all of these attributes and more.
Unfortunately, and problematically for its defenders, the Fed has historically exhibited none of these laudable traits. For example, Burton Abrams has painstakingly documented the effect of Richard Nixon’s goading on Arthur Burns’s early-‘70s monetary policy. Nixon was well-aware of the lag between increases in the money supply and their manifestation as inflation: in fact, he blamed former Fed chairman Martin for what he perceived as unduly tight monetary policy at the end of the Eisenhower presidency, contributing to his own electoral defeat in November 1960. With this in mind, and the assistance of Burns’s partisan affiliation, Nixon convinced him to ease and fairly successfully timed the resultant illusory increase in prosperity to coincide with his re-election. It took a decade and a serious commitment of political capital by Ronald Reagan and Paul Volcker to re-establish the Fed’s credibility with respect to controlling inflation. Political backbone that comes once a decade is insufficient for the purposes of Martin’s monetary übermensch.
The Fed’s inherent susceptibility to the wills of the legislative and executive branches of government was evident even before this, however. In fact, prior to its 1951 accord with the Treasury, the Fed was explicitly Uncle Sam’s lapdog: for a time, one of directives was to help finance the Second World War, and it continued to suppress interest rates afterwards. Regardless of one’s views with respect to the War and economic output, it is reasonable to ask whether an institution that spent a significant part of its early history testing the limits of government revenue from seignorage can be expected to stand strong against the whims of the political class today.
We need not, however, assume that every unfortunate macroeconomic outcome is due to political pressure on the Fed; other errors can be traced to its unadulterated ineptitude. Milton Friedman and Anna Schwartz documented the Great Contraction of the money supply during the years 1929-33; the Depression that followed testifies that any competent central bank would have acted differently. Other economists, for example Robert Murphy, point to what they see as inappropriately low interest rates during the ‘20s culminating in a Hayekian boom-bust. In both scenarios, the Fed is central to the plot and responsible for the hardships that ensue.
Regardless of one’s political views, the status quo seems indefensible. The Fed is overextended and hubristic, and we expect too much from it. Clearly, an alternative is in order. The Fed, however, does a lot: it is regulator, guarantor, banker, and payment processor, in charge of trillions of dollars and the welfare of hundreds of millions of human beings. Central planning has a history of failure for entire countries; this is a bad omen for its viability in a monetary context. The same quandaries that impede the Fed’s performance in theory will complicate plans for a replacement in practice.
There is another way, however. If the task of economics really is, per Hayek, to “demonstrate to men how little they really know about what they imagine they can design,” attempts to specify the ideal monetary system will prove fruitless. Economists of an Austrian persuasion, in heeding this, prefer market outcomes because macroeconomic phenomena reflect the choices of the individual actors comprising an economy acting in concordance with their own individual ends. The germane question for classical liberals is not, then, “what should replace the Fed?” but “what would replace the Fed?” What might our money look like now had Aldrich and his cohort not reached Jekyll Island then?
While counterfactual histories must confront the same epistemological boundaries that central planning does and thus ultimately fail, we can examine pre-Fed monetary systems for their stability. Under the assumption that sustainable patterns of economic activity continue in the absence of government intervention, we might reasonably conclude that the most successful of said systems would persist today.
Here advocates of the current Federal Reserve System eagerly turn to their charts of output fluctuations pre- and post-Fed, claiming that there are fewer in the latter than the former and that ipso facto the Fed is necessary and beneficial. George Selgin, William Lastrapes, and Larry White argue, however, using work by Christina Romer among others, that this inference depends more on spurious historical econometric data than macroeconomic reality. Despite this, the pre-Fed period is frequently used by Fed proponents as a benchmark for the performance of “free banking”. This completely ignores the numerous restrictions banks encountered then, including requirements to hold state government debt and restrictions on branching. Such a regime can hardly be called laissez-faire, and central banking apologists would be wise to note that institutions that perform poorly under unreasonable artificial constraints need not also screw up when given the freedom to maximize their profits.
Furthermore, and fortuitously for advocates of free banking, we do have uncontroversial examples of historical periods in which banks were largely allowed to compete as note issuers, lenders, and borrowers. As Ignacio Briones and Hugh Rockoff detail, Sweden, Scotland, and Canada each had periods in which banks were fairly unencumbered. Canada in particular had a much stabler banking system than its southern neighbor from the mid-1830s until after World War II. Selgin and White point out that banks in Canada could diversify through branching, preventing agricultural and other regional phenomena from affecting their national balance sheets and, therefore, the Canadian economy as a whole. In part due to this, Canada experienced no bank failures during the Great Depression. The contrast with the US experience is stark; in fact, the Bank of Canada emerged not as a way to stabilize money or financial institutions but instead to generate inflation in the hopes of alleviating the depression, as Michael Bordo and Angela Redish note.
From this it is clear that a system of banks can operate stably in a laissez-faire regime. Bank runs are preventable through contractual features on notes and accounts, as White has detailed with respect to options clauses in Scotland. It is also evident that banks can process payments through acquiring claims on the other and agreeing to exchange the difference, either through a private central clearinghouse or directly between institutions. Even better testimony than the theoretical possibility of such institutions, however, comes from the fact that they did emerge and survive in a competitive context. Given that economists see these phenomena in other sectors with light regulation and few state guarantees, it shouldn’t shock them that they would emerge in the context of a financial system with those same preconditions as well.
James Grant revived the figure of Thomson Hankey in a September 2008 New York Sun op-ed dissecting Walter Bagehot and the central bankers who claim inspiration from him. Grant, presaging the automotive industry bailouts that would start later that year, revisits Hankey’s point that banks aren’t the only firms that can affect macroeconomic stability. In fact, if stability is a policy goal, why shouldn’t sundry nonfinancial firms receive bailouts? Should every multinational corporation be too big to fail?
Hankey may have lost out in the 1800s, and his thinking might be unfashionable today, but there is no reason we can’t heed his wisdom tomorrow. It’s true that banks are unique. In a monetary economy, money comprises one half of every exchange: it serves as the catalyst for catallaxy. Anything that central and vital must be the outcome of a competitive market process, not the product of a state’s fiat. And, while banks are special, they must not be so completely divorced in nature from other economic entities that they violate without consequence the rules of profit and loss. If a better monetary system will lead to better macroeconomic outcomes, and the evidence suggests it would, our imperative is clear: end the Fed and, rather than allowing our banks to commandeer public funds, let them serve us, their customers, as every other business does in a free market.