Awkward History Lessons

Ron Paul, a Republican congressman running for president, indicts the Federal Reserve in today’s Wall Street Journal. Surely there’s no shortage of mistakes that can and should be leveled at the central bank. Institutions run by mere mortals are nobody’s idea of perfection. Yet there’s also some progress to report. In contrast to the early 1930s, the Fed’s response to the financial crisis was better this time. That’s a low standard, but at least we don’t have 25% unemployment. Better, but not good enough. But as Paul sees it, the true solution is removing the central bank from the system. All will be well, he suggests, once we let the market take over the delicate task of managing the nation’s money supply. The historical precedent for this idea, however, is thin, to say the least.


Paul’s advice, of course, is a cute way of favoring a gold standard, although he never mentions the metal in this article. It sounds like a reasonable idea on the surface perhaps, but there are some awkward questions that never seem to come up for the gold bugs. But inquiring minds want to know how the anti-Fed crowd would respond to a surge in money demand?
Imagine a scenario where an economy suffers a macro shock and the business cycle bites into growth. Imagine also that the public’s demand for money—for liquidity—rises sharply. Before we go on, hold that thought and reflect on the fact that dramatic swings in economic conditions, along with rising and falling demand for money, have a history in these United States–a history that predates the creation of the Federal Reserve in 1913. These pre-Fed fluctuations were neither trivial nor infrequent, according to NBER data.
Meanwhile, back to our theoretical scenario. Money demand surges, for whatever reason. What’s the effect? Assuming no change in money supply, a rise in savings implies deflation for goods and services and therefore the economy overall. The question is whether there’s an economic rationale for stabilizing a price decline driven by a surge in money demand that’s triggered by a macro shock? Is there a case for printing money that wouldn’t otherwise be available if left to “the market”? History has answered with a resounding “yes,” a preference that applies with or without central banks.
In the last major financial crisis in the U.S. before the creation of the Federal Reserve there was yet another surge in money demand. The year was 1907 and capitalism was relatively unconstrained by 21st century regulatory standards. This was also a time when a form of the gold standard reigned supreme. And yet the decision was made to intervene in the money market. There was no central bank at the time and so a defacto institution was carved together, led by banking magnate J.P. Morgan. For the details you can read The Panic of 1907: Lessons Learned from the Market’s Perfect Storm. The shorter version of this story is simply that someone or something was needed to restore order to stop the system from imploding. Was 1907 an anomaly? A rare event? Hardly. Booms and busts have been part of the economic fabric for centuries. The only thing that’s changed is how nations respond to these recurring crises.
The pre-Federal Reserve era is, of course, conveniently overlooked in some circles in a rush to restore something akin to a gold standard. If we could only return to those halcyon days before a central bank mucked up what was formerly a kinder, gentler business cycle. It’s a nice idea, but it’s a fantasy. Removing the Fed wouldn’t render the business cycle null and void, and it’s quite possible that such a change could exacerbate the ups and downs of the business cycle. Perhaps that’s a reasonable tradeoff, but history suggests there’s no free lunch here.
There’s a reason why central banks were invented. That’s no excuse to be uncritical of the Fed, or to assume that it can do no wrong. But embracing the opposite extreme is no less misguided. As usual, the solution, or what comes closest to a solution, lies in the middle.
Successful monetary policy, in short, is complicated for a rather simple reason: the business cycle endures. Why does it endure? If we knew the answer, we wouldn’t need a central bank (or a J.P. Morgan to act like one).

7 thoughts on “Awkward History Lessons

  1. Warren Gibson

    With no central bank, and private banks issuing notes redeemable in gold, but fractionally backed, an increase in the demand to hold money can easily be accommodated by an increase in note issue.

  2. Jason Soto

    I’ve actually read the Panic of 1907 and it creates a scathing rebuttal to all the anti-Fed rhetoric being spewed by the conservative/libertarian faction of the Republican Party.
    But then again, their argument is based on sound economic theory or mathematical modeling, it is based purely on moral judgment – practical application and reality be damned. What’s really distressing is that the business-centred portion of the Republican Party (I’m looking at you here Chamber of Commerce) hasn’t denounced this moral economic policy prescription more forcefully and publicly as outright dangerous lunacy.

  3. Fred Press

    An example of the DAMAGE THE FED IS CAUSING:
    A 60 yo woman has saved $1 million and she earns $85k per year. Her Federal tax on her income is about 25%, but she is also paying a confiscatory savings tax (with inflation at 3% and interest rates at zero, her savings are being taxed at 3% per year). This confiscation tax of 3% is applied to her $1 million in savings and comes to $30k per year. So her real federal tax for the year is 25% of $85k, plus $30k, which comes to $51k. This real federal tax she is paying comes to a 60% effective federal tax rate for the year. She must then consider her state, local, sales, and/or real estate taxes, which could take her up over the 80% mark!!!
    MESSAGE TO GREENSPAN’S MONSTER (BERNANKE)AND OBAMA – YOU ARE FAILING US!!!!!!

  4. Anonymous

    what we actually need is quite simple – we need real bills redeemable in gold coin back into circulation, so that commercial banks facilitate real bills circulation with banknotes of large denomination. Banknotes of small denomination should be forbidden. Central bank if still exist, should hold real bills and gold coins against its liabilities. Government bills and bonds should be forbidden asset for central bank, in order to prohibit monetization of government debt. All debts (and govt bonds as well) should be redeemable in gold coin. Bank loans for capital goods should be 100% funded by saving accounts. Banks should become objects for provisions of contract law like any other business. No TBTF whatsoever.

  5. mikeh

    I think Ron Paul’s point is that a higher demand for money wouldn’t be a huge shock without fractional reserve banking, which he views (correctly) as incompatable with the gold standard.
    Mike H

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