March 22, 2011
End The Fed? And Replace It With... ???
The celebrated investor Jim Rogers thinks we should abolish the Federal Reserve. Asked in an interview yesterday what he'd do as Fed chairman, he replied: "I'd shut it down."
Rogers is a long-time critic of the central bank, and so his view is old news. He also has lots of company. Perhaps the most prominent and powerful critic is Rep. Ron Paul, head of the House subcommittee that oversees the Fed and author of End the Fed.
Attacking the Fed is an old sport, dating to the bank's founding in 1913. Inspiring the legion of critics over the years is the simple fact that the central bank is far from perfect. As an institution run by humans, policy errors are inevitable. But closing the Fed, for all its populist appeal these days, wouldn't solve much, if anything because something would need to take its place. Wouldn't a successor institution suffer from all the problems that bedevil the Fed? What's that? You have a solution to insure the delivery of superior monetary policy decisions? Really? Why don't we apply those cures to the Fed?
The hard reality is that a modern economy needs a central bank. Some institution has to oversee monetary policy, unless we're going to go back to bartering. Letting Congress assume these duties is asking for trouble. The Fed is far from immune from political influence, but imagine how monetary policy would be run via debates on the floor of the House of Representatives.
Some Fed critics like to argue for a return to the U.S. to a gold standard. That's unlikely for a number of reasons. But let's say the impossible happens. Even on a gold standard, a central bank is necessary to supervise the details and insure that the rules of the game are satisfied. Of course, one could argue that the country could return to the pre-Fed-era banking chaos of the late-19th century, but that's the monetary equivalent of advocating the use of horses as a solution to the traffic problems created by cars.
The irony in all the recent calls to end the Fed is that inflation is quite low by historical standards. Paul and others worry that the Fed's quantitative easing policy will soon unleash higher inflation. That's always a concern, and the solution is, as always, enlightened decisions on monetary policy. Unwinding QE2 doesn't have to bring higher inflation. It might, of course, but that's hardly a reason to shut down the Fed. By that standard, we should close the Pentagon because it might make a mistake in the next war.
Meantime, some Fed critics point to rising commodity prices as a harbinger of things to come. Rising oil prices in particular raise fears of future inflation in the hearts and minds of many Fed bashers. Maybe, although as Bloomberg's Caroline Baum points out, higher prices and inflation aren't always one and the same:
For folks who use the term “inflation” interchangeably with higher prices -- as in wage inflation or commodity inflation --they are not the same thing. A higher price for oil and/or other commodities is a higher relative price until ratified by the central bank.
What does the central bank have to do with it?
Inflation is a monetary phenomenon: too much money chasing too few goods and services…
Higher oil prices don’t cause inflation. They aren’t synonymous with inflation. Higher oil prices represent a relative price increase until proven differently.
None of this is an argument for giving the Fed a free hand. Debates about how the central bank—any central bank—conducts monetary policy are always fair game. There's certainly room for improvement; the past decade has revealed quite a few lessons about how to run monetary policy. But that's quite a different animal from calling for the institution's demise.
It's easy to say the Fed's makes mistakes and therefore it should be closed. But what's the follow-up plan? Will you create a new institution to run monetary policy? Are you willing to give Congress that power? The critics don't usually have good answers to such questions. No wonder that it's hard to take the kill-the-Federal Reserve-system crowd seriously.
Posted by jp at March 22, 2011 6:26 AM
Dear John Not Frank,
It's one thing to cite applications of Free Banking in the past, and quite another to make a persuasive case that it would work in the 21st century for the largest economy on the planet. I doubt it. But this is economics and so you can't prove it. For me, it's an intriguing idea to kick around over drinks, but I can't imagine recommending it as a real world policy. But, hey, that's just me.
The gold standard was and theoretically remains an option, perhaps a viable one of sorts. But as you say, it's sub-optimal. Big time, I think. Fiat currencies are no silver bullet, either. Lots of subjectivity in terms of whose running it. Worst path for monetary policy there is, except when compared to everything else.
Ultimately, there were reasons for abandoning the gold standard and, IMHO, they weren't trivial. Some of this comes down to the old saw that you can control prices or supply, but not both. Choices and compromises have to be made.
Let's not forget that the creation of the Fed in 1913 didn't come out of the blue. The country needed a central bank, or at least an official one to replace the private central banker role that was played by JP Morgan. Morgan was forced to intervene in response to the semi-regular financial crises in the late-19th and early 20th centuries. Central banking, in some form, is a necessary evil. For what it's worth, I think reforming what we've got is superior to trying to reinvent the system from scratch. Been there, done that.
Posted by: JP at March 24, 2011 6:28 AM
John, not Frank. Oh well.
Your criticism of free banking (vis a vis excessive note issuance) is akin to the Soviet commissar visiting Britain and asking how is in charge of making sure London gets fed. You could look to past examples of free banking (Scotland, Canada, etc) and see if this was a problem. I don’t think it was since banks have an incentive to keep currency trading at par wherever other banks will accept it. If they can’t get other banks to accept their currency on a secondary market, then it may not be profitable to issue currency. Regardless, it would be possible to use free-banking with the underlying money being current U.S. dollars, so long as the stock of money was fixed before starting the free-banking system. Due to network effects, banks have an incentive to keep the underlying asset for the money (gold, silver, weighted basket, U.S. dollars) the same so that it is easier for consumers and businesses to use it.
Regarding the GLD criticism, I think some who support the gold standard tend toward conspiracies, but most of us don’t. I think so long as GLD tracks gold prices well enough, I don’t really care. If the world really melts down, it isn’t like I’ll be able to ring ‘em up anyway and get my gold from their vaults. Anyway, in a free-banking world, what matters is how the notes trade on the secondary market. Most of the traders in this market will be from other large banks. These people will largely trust audits or ratings from independent examiners. Don’t forget also that the banks will be fractional reserve banks and not just a warehouse in a free-banking world. If you’re worried about runs on the banks, Larry White has written about the option-clause in Scotland that helped prevent runs. Also, eliminating bailouts and government subsidized deposit insurance would reduce moral hazard and force the banks to be more conservative.
I don’t care about your credentials or the credentials of those you cite if the arguments are mistaken. For instance, point 4 that I assume you conceded is frequently made by those in favor of the Fed when it is completely wrong. Also, people argue that since the Fed everything has been more stable, when there is research from Christine Romer (discussed in a recent Larry White/George Selgin paper) that says that isn’t true.
On point 2, I prefer to leave money to the market. The institutions in a free-banking world would be the various banks offering currency.
Regarding the inter-war standard, I think you’re wrong. I think getting the monetary system correct is one of the most important things a country can do. There’s no doubt that I would prefer the status quo to a poorly conceived system like the inter-war standard. I agree with Eichengreen and all those other guys that the inter-war standard contributed to the Great Depression and that devaluing their currencies allowed countries to escape it before others that didn’t. I don’t think that’s a particularly controversial issue. It is wrong, however, to say the inter-war standard was unstable and hence the classical standard was as well. I think there are sufficient differences (and I’m fairly sure Eichengreen would agree with me).
You make a good argument about communism. While I’m not out to defend the gold standard, I’m not sure anyone is saying the gold standard hasn’t been tried (the way that one would say that real communism hasn’t). Nevertheless, I think you could say there are sufficient differences between the inter-war standard and the classical gold standard and a history of the relative performance. Further, with communism I could point to theoretical difficulties such that a complex society transitioning to “real communism” would cause a whole heck of a lot of problems and hence would likely be abandoned quickly. By comparison, the theoretical problems with the gold standard do not preclude its existence (I just believe they make it sub-optimal). It has existed in the past and has a track record.
Posted by: John Hall at March 23, 2011 11:59 AM
On the argument that the U.S. should return to the era of Free Banking that prevailed in the 19th century, I respectfully submit that it’s not practical on countless levels. Yes, it worked in its day, but imagine 500 banks scattered throughout the U.S. issuing their own currencies. Even if they were all backed by gold, the logistical challenges associated with a Byzantine monetary system would be a nightmare. That starts with considering legitimacy. Yes, in theory notes backed by gold are widely accepted. But there would be no end to charges that this or that bank was cooking the books. Look at all the criticism of the gold-backed ETFs these days. Despite audits and other supporting evidence, there’s no shortage of claims that the ETFs really don’t hold as much, if any, of the gold them claim to own. In fact, similar charges are directed at the Fed/Treasury, which own some 8,000 tons of gold. Nonetheless, there’s a number of conspiracy theorists who say it ain’t so. Now multiply that by 500 or 1,000 banks and you can start to get an idea of the chaos that would result in a 21st century revival of Free Banking. Figuring out when, or if, to accept a given bank’s payments would be massively counterproductive.
Meanwhile, Frank says that few of my arguments are valid and that I lack the background to comment on such issues. Perhaps, but then Frank goes on to support my points, albeit indirectly and by criticizing that I don’t provide enough footnotes. As to my background, would it make a difference if I cited in great detail 10 economists with impeccable credentials who basically make the same arguments? That wouldn't be hard, but it probably would satisfy critics, at least for die-hard gold bugs, who recognize no authority other than the metal.
In any case, a few responses to Frank’s points:
1. “Before the Fed existed, did we only resort to direct exchange? No? Then you’re wrong.” That’s hardly a persuasive argument that we can go back to the Free Banking era. Equating what went on pre-1913 with the complexities of global trade in the 21st century is overlooking the elephant in the room. Again, the idea of having hundreds or thousands of banks issuing their own currencies is highly impractical. Even a dozen or so currencies in Europe became problematic, thus the move to the euro.
2. “Most Fed critics think we need less government interference in monetary policy, not more.” Exactly. You’re making my point. Some institution has to oversee monetary policy. Surely that isn’t Congress. So, that means an independent institution has to be created. Turns out we already have one. It’s far from perfect, but here’s an idea: Let’s reform it rather than kill it. Or should we try to recreate the wheel from scratch? Regardless, we need the wheel. But let's not make this harder than it needs to be.
3. On the point about Eichengreen’s research, it’s true that I don’t provide much detail in this post. But life is short and this isn't an academic publication. Meantime, I’ve written about his analysis before, such as this: http://bit.ly/drqoZL
On the point that the interwar gold standard really wasn’t a gold standard, well, that’s the ultimate straw man. It’s sort of like the argument that Russia and China’s communism wasn’t real communism, ergo, communism hasn’t really been discredited. You can make that argument, of course, but it’s not very compelling. Practical reality always falls short of ideals. We have to evaluate history as it unfolded, and the gold standard, in all its various forms, looks pretty bruised. Sorry, I don’t have time or space here to go into great detail, but history speaks loud and clear. A small sample of the many, many books with supporting evidence include Friedman’s “Monetary History, Liaquat Ahamed’s “Lords of Finance,” and, as Frank notes, Eichengreen’s “Golden Fetters.” You could also read some of Eichengreen’s papers, such as: http://bit.ly/dTQdgU or Romer’s overview: http://bit.ly/bBj9Iy There's also economist Scott Sumner's detailed analysis of went wrong in the early 1930s, which he's written about in great detail on his blog: http://www.themoneyillusion.com/
This only scratches the surface of the damning evidence against a gold standard. For now, however, we'll leave it there. Life is short and there are more productive battles to fight.
Posted by: JP at March 23, 2011 8:54 AM
YOU HAVE TO BE KIDDING!!!! we DID not have a FED before 1913....and the world still survived!!!!
Posted by: frank at March 23, 2011 5:19 AM
The Fed would be replaced by Free Banking. The US and many other countries operated without a central bank in the 1800's. A private bank would simply accept something of value (e.g., 1 oz of silver) on deposit and issue a paper receipt promising to return 1 oz., or something of equal value, upon notice from the depositor. The paper receipts (dollars) circulated as money.
Starting about 1861, the government restricted the ability of private banks to issue paper dollars, keeping that privilege for itself. Private banks are still allowed to issue checking account dollars and credit card dollars.
I suppose that if the government had restricted private issue of checking account dollars and credit card dollars, there would be people who could not imagine how those kinds of money could possibly be issued by private banks.
Posted by: Mike Sproul at March 22, 2011 12:56 PM
I don’t support the gold standard, but very few of your arguments are actually valid. I’ll focus on the ones that are just plain wrong. No offense, but you lack the background to comment on these issues.
1) “The hard reality is that a modern economy needs a central bank. Some institution has to oversee monetary policy, unless we're going to go back to bartering.” – You really don’t provide a justification of the statement that a modern economy needs a central bank. I think it’s definitely a debateable point and there are good points you could have made. However, your argument is a complete non sequiter. Monetary policy is not the same thing as money. If you eliminated the Fed, you would still have money. Before the Fed existed, did we only resort to direct exchange? No? Then you’re wrong.
2) “Letting Congress assume these duties is asking for trouble “ & “The Fed is far from immune from political influence, but imagine how monetary policy would be run via debates on the floor of the House of Representatives.” – This is a complete straw man of what any critic of the Fed believes. Most Fed critics think we need less government interference in monetary policy, not more.
3) “Even on a gold standard, a central bank is necessary to supervise the details and insure that the rules of the game are satisfied.” – This is a reference to Eichengreen’s Golden Fetters, but you don’t actually explain the argument that Eichengreen makes. Eichengreen is referring to the inter-war gold exchange standard, which is not what proponents of the gold standard actually support. Everyone agrees there are problems with that.
4) “Of course, one could argue that the country could return to the pre-Fed-era banking chaos of the late-19th century” – Well there was also banking chaos in the early 19th century, but there are plenty of reasons for that. I can think of three off the top of my head. A) banks had to basically hold state bonds that turned out to be junk, B) the states limited entry, ensuring little competition between banks, C) there were restrictions on branch banking (that don’t exist today) that prevented bank diversification that in other countries prevented the crises from happening that happened here.
5) “The irony in all the recent calls to end the Fed is that inflation is quite low by historical standards.” – Even ignoring the Fed’s history and assuming inflation AND unemployment were at appropriate levels, a critic of the Fed would still argue that there are theoretical problems with central banking. Further, the goal of an effective monetary policy is not to ensure low inflation. The goal is to stabilize the expected growth of nominal income. Inflation may be low, but the massive recession we just had happened on the Fed’s watch. The Fed has a dual-mandate (largely consistent with the goal above). Inflation may be low, but unemployment is 8.9%. They obviously failed at something.
6) “It's easy to say the Fed's makes mistakes and therefore it should be closed. But what's the follow-up plan? Will you create a new institution to run monetary policy? Are you willing to give Congress that power?” – The problem is that Paul has said exactly what he would do. In his book and in other places. Others who are criticize the Fed have done so as well. You make it seem like no one has proposed their alternative when there are alternatives all over the place (pre-war gold standard, free banking, targeting nominal GDP futures).
Posted by: John Hall at March 22, 2011 10:35 AM