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).