Can central banks protect us from depressions?

Without a central bank, there would be no way to control the dangerous excesses of the banking system and otherwise keep the economy on a steady course

The US Panic of 1907 provided some of the impetus for the Federal Reserve Act of 1913. Although the 1907 panic was unusually severe, it was only the latest in a long series of such episodes. As the Washington Post pointed out in an editorial:

“The world’s . . . history . . . [has been] a succession of panics, slumps, and crashes in which markets were working, all right—but working as they sometimes do, perversely and blindly.”

The Washington Post¹⁵⁷

The creators of the Federal Reserve hoped that it would prevent both bank excesses and bank runs, and by doing so help stabilize the economy. Despite uncertainties about how loose or tight monetary policy should be, the Fed has been a signal success. Economic writer Jeff Madrick states that “By 1913 the US federal government created a stable financial system with the creation of the Federal Reserve.”¹⁵⁸

• Jeff MadrickThe creation of the Federal Reserve gave the country a stable financial system. No qualification.
• Geoffrey MooreArchitect of the index of leading economic indicators, and more careful: in general the Fed has had a stabilizing effect, especially since World War Two.¹⁵⁹
• George MooreWho built Citibank: at the very least you have to put a floor under the economy by expanding the money supply whenever deflation threatens.¹⁶⁰
• Robert SolowOn Alan Greenspan’s eighteen years as chairman: massive respect, even awe.¹⁶¹

Read the qualifications rather than the praise. Geoffrey Moore says especially since World War Two, which quietly concedes the Great Depression. George Moore says at the very least, which is a floor and not a steering wheel. This is the strongest case for yes and it is more modest than its reputation.

Alan Greenspan’s long eighteen-year tenure as Federal Reserve Chairman at the end of the twentieth century and the start of the twenty-first was at the time particularly singled out for praise. Employment during that period remained high, inflation averaged less than 3% a year, and the chairman earned, in economist Robert Solow’s words, “Massive respect, even awe. . . .”¹⁶¹

The record of the US Federal Reserve has been poor. The country did better before its founding

From the end of the US Civil War to the founding of the Federal Reserve almost a half century later, consumer prices fell more years than they rose, but ended up about where they started. This was a time of excellent economic and employment growth and also included some of the best stock market returns. At least one study of stock returns from 1872 showed that periods of mild deflation have produced the best stock market returns of all, even better than periods of mild inflation.¹⁶²

Shortly after the founding of the Fed, inflation surged. Prices declined gently during the 1920s, fell dramatically during the Great Depression, rose during World War Two despite price controls, continued to rise after the war, and then surged again in the 1960s and 1970s. At the very end of the 1970s, the Fed under chairman Paul Volcker seemed to declare war on inflation, and double digit inflation rates fell dramatically. But in the quarter century following, consumer prices doubled again.

$1.00What a dollar bought in 1913, the year the Federal Reserve Act passed.At the start

2¢What the same dollar bought a century later.After one hundred years

The dollar lost ninety-eight per cent of its purchasing power during the first century of the institution created partly to look after it. Federal legislation requires the Fed to control inflation, and there is no doubt it could: all it would have to do is print less new money.

Yet by the early twenty-first century, the board was pursuing an unacknowledged and then acknowledged two percent inflation target. Since the price of manufactured goods was generally falling, an overall rise in prices could only be engineered by subsidizing the relative lack of productivity and oversize price increases in services such as healthcare, housing, and education. In 1985, Thibaut de Saint Phalle wrote that “It is puzzling that no one in Congress ever points out that it is the Fed itself that creates inflation. . . . The Fed, by financing the federal deficit year after year, makes it possible for Congress to continue to spend far more than it collects in tax revenues.”¹⁶³

Economist Murray Rothbard thought that there was no mystery about the Fed at all: “If the chronic inflation undergone by Americans . . . is caused by the continuing creation of new money, and if in each country its governmental ‘central bank’ . . . is the sole monopoly source and creator of all money, who then is responsible for the blight of inflation? . . . In short . . . the Fed and the banks are not part of the solution to inflation. . . . In fact, they are the problem.”¹⁶⁴

By the 1990s, even the widely respected Paul Volcker, deemed one of the most successful of Fed chairmen, concluded that “By and large, if the overriding objective is price stability, we did a better job with the nineteenth century gold standard and passive central banks, with currency boards or even ‘free banking’.”¹⁶⁵

Economist Gottfried Haberler observed that “During the second half of the nineteenth century there was a marked tendency for [economic] disturbances to become milder. . . . Before [the First World War], it was the general belief of economists that dramatic breakdowns and panics . . . belonged definitely to the past.”¹⁶⁶ Milton Friedman was even more critical: “The severity of each of the major contractions—1920–21, 1929–33, and 1937–38—is directly attributable to acts of commission and omission by the Reserve authorities and would not have occurred under earlier monetary and banking arrangements.”¹⁶⁷ Free-market economists do not all agree about how past contractions occurred, but all would agree with Friedman that “The stock of money, prices and output was decidedly more unstable after the establishment of the Reserve System than before.”¹⁶⁸

Price-fixing is especially toxic for an economy, and central banks are basically price-fixers

Interest rates represent the price of money, or technically the price of credit. The price of credit in turn is really the price paid for time, for deferring consumption from the present into the future. If I lend you money, I am putting off my own immediate consumption. Since money and time are involved in virtually every transaction in the economy, there is no more crucial price than the price of credit. Nineteenth-century economist Jean-Baptiste Say was right to say that “[The] rate of interest ought no more to be restricted, or determined by law, than . . . the price of wine, linen, or any other commodity.”¹⁶⁹

Economic writer Gene Epstein has correctly stated that “[The chairman of the Federal Reserve] is the head price fixer of a price-fixing agency.”¹⁷⁰ The agency not only fixes the short-term cost of credit, which in turn influences other interest rates. In addition, it heavily influences what is perhaps the second most important economic price, that of the US dollar in world markets.

A price is set below where it would have landed

BreadShelves empty within days. Everybody can see the queue, and everybody knows what caused it.

CreditInterest is paid over time, so the effects arrive years later, attached to something that looks like a separate event.

Gene Callahan’s point: because of that time lag, it is harder to trace the later problems to the earlier intervention.¹⁷¹ This is what makes the argument on this side so hard to settle either way, and both sides should admit it.

Central banks are national economic planners, and national economic planning does not work

Adam Smith wrote at the end of the eighteenth century that the statesman who should attempt to direct private people in what manner they ought to employ their capitals “would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.”¹⁷²

For a considerable time, Smith’s view prevailed, only to be superseded by Keynes’s ideas and by what Barbara Wootton called in 1935 “The Necessity of Planning”: “There should be some body of nation-wide authority charged with the duty of constructing [an] . . . economic . . . plan for the whole country.”¹⁷³

By the time the Berlin Wall fell in 1989, the pendulum appeared to swing again. Economist Robert Heilbroner, a prominent friend of national economic planning, wrote in that same year: “The contest between capitalism and socialism is over: capitalism has won.”¹⁷⁴ The Economist agreed in 1997 that “Almost any discussion of public policy nowadays seems to begin and end with the same idea: the state is in retreat.”¹⁷⁵ And David Landes added that all sides blithely assume that free markets are in the saddle and riding the world.¹⁷⁶

But was this assumption valid? Throughout the 1990s, central banks throughout the world were tightening their control of interest rates and currencies and taking on even more responsibility for guiding capital markets and economies. Economic writer James Grant observed that:

“Central planning may be discredited in the broader sense, but people still believe in central planning as it is practiced by . . . [The US Federal Reserve]. . . . To my mind the Fed is a cross between the late, unlamented Interstate Commerce Commission and the Wizard of Oz. It is a Progressive Era regulatory body that, uniquely among the institutions of that era, still stands with its aura and prestige intact.”

James Grant¹⁷⁷

Economist William Anderson agreed about the aura, but was even more sharply critical: “Central banking, for all its ‘aura,’ is no less socialistic than the Soviet Union’s Gosplan.”¹⁷⁸ Throughout the 1990s, the Fed published its own forecasts of economic growth, but these were rarely accurate. The Fed, like a majority of economists, has never correctly forecast a recession. Gene Callahan has compared the Fed to a hyperactive pediatrician determined to intervene to ensure that a child under his or her care is growing at the right rate.¹⁷⁹ In reality, no doctor, and no Fed chairman, can be sure what the right rate is.

The way that central banks operate, in particular the reliance on exceedingly flimsy tools and rules, is not reassuring

The most famous rule for guiding monetary policy was Milton Friedman’s: just pick a money supply growth rate and expand or contract the money supply to meet the target. This was an attempt to take discretionary decision-making away from unreliable central bankers, but proved impractical because the money supply could not be precisely defined, much less tracked, especially in a global economy. Another much cited rule developed by economist John Taylor of Stanford University also utilizes variables that are hard to define or observe, and thus subject to debate and disagreement.¹⁸⁰

These and many other formulas bring to mind a story told by social philosopher Irving Kristol about a friend’s mother. The friend used to bring college friends home for endless political debates. It was the 1930s, everyone was some stripe of Marxist, and the finer points of doctrine were argued into the night. The friend’s mother, a Jewish immigrant without much formal schooling, hovered wordlessly and provided tray after tray of food and drink. Then:

“Late one night, after they had all left, she turned to her son and said: Your friends—what brilliant young people! Smart! Smart!—and then, with a downward and dismissive sweep of her arm—Stupid.”

Irving Kristol¹⁸¹

How then do the monetary authorities get away with taking so much decision-making away from the market with so little intellectual basis to what they do? One explanation is that easy money policies generally suit whatever party is in power, and central bank chairmen want to be reappointed. Another, equally cynical, was offered by Milton Friedman: the System “blames all problems on external influences beyond its control and takes credit for any and all favorable occurrences. It thereby continues to promote the myth that the private economy is unstable, while its behavior continues to document the reality that government is today the major source of economic instability.”¹⁸²

Central banking represents a moral, not just a practical, problem

Economist John Maynard Keynes spent most of his lifetime mocking the values of ordinary, middle-class people. It is not surprising that his economic theories, the theories that underlie modern central banking, turn the old copybook maxims of morality on their head. In the Keynesian world, technical cleverness matters more than hard work, spending is a virtue, saving is almost an antisocial act.

What you were told

1. Work hard
2. Save what you can
3. Do not borrow what you cannot repay

What the policy implies

1. Technical cleverness matters more
2. Saving is almost an antisocial act
3. Spending, and borrowing in order to spend, is good for employment

This is the only claim on either door that is about right and wrong rather than about whether something works. Whether an economic policy can be judged this way at all is itself a fair question, and the greed lesson is where you were given the tools for it.

In the following passage, Keynes discussed how greedy and befuddled people are, but how they can be gulled through the device of a central bank: “Unemployment develops, that is to say, because people want the moon. . . . There is no remedy but to persuade the public that green cheese is practically the same thing [as money] and to have a green cheese factory (i.e., a central bank) under public control.”¹⁸³

Keynes has now passed from the scene, but his less nimble and witty heirs still run the central banks. People who criticize all this, who along with Paul Kasriel, chief economist for the Northern Trust Company, say that central banks are little more than “legal counterfeiters,”¹⁸⁴ that societies must save in order to become wealthy, that heavily indebted consumers are on a treadmill that will keep them poor forever, these people are just out-of-date.

Central banking serves the interests of politicians primarily, rich people secondarily, and the poor not at all

This debate can be traced to the beginning of the United States. The conventional wisdom records that Alexander Hamilton correctly perceived the need for a central bank, that Thomas Jefferson displayed an ignorant antipathy toward banks, and that after Andrew Jackson closed the second Bank of the United States in 1836 the economy drifted through unnecessary crises until 1913.

There are a number of flaws to this oft-told tale. First of all, Hamilton did want a central bank, but he specifically warned against governments or central banks printing paper money, as they do today:

“The emitting of paper money by the authority of Government is wisely prohibited. . . . [Paper emissions] are of a nature so liable to abuse—and it may even be affirmed, so certain of being abused—that the wisdom of the Government will be shown in never trusting itself with the use of so seducing and dangerous an expedient. . . . The stamping of paper is an operation so much easier than the laying of taxes, that a government, in the practice of paper emissions, would rarely fail . . . to indulge itself too far.”

Alexander Hamilton¹⁸⁵

Hamilton did not object to private banks issuing notes that were the equivalent of paper money. That was different, because it could be regulated by market forces. If a private bank overdid it: “It will return upon the bank.”¹⁸⁶

It is a complete mischaracterization of Jefferson and Jackson to say that they opposed banks, business, or modernity itself. What they especially feared, and with much justification, was that central banks would become the tools of politicians and their rich supporters. As Jackson said, “The mischief [in a central bank] springs from the power which the moneyed interest derives from a paper currency which they are able to control.”¹⁸⁷

When the Federal Reserve Act of 1913 came up for congressional consideration, Senator Elihu Root argued that Hamilton’s and Jackson’s words should be heeded. If a central bank were needed, it should at least be barred from issuing paper money. But most of Root’s colleagues thought this precaution needless, since under the original legislation any paper money would be backed by and exchangeable into gold. How surprised they would all be to see that paper money came to be backed by nothing at all.

Has it helped the poor? Alan Blinder, a former Fed vice chairman who has always focused on reducing income inequality, argues that even if an expanding money supply brings some inflation, “The harm [which] inflation inflicts on the economy is often exaggerated.”¹⁸⁸ But the poor are not generally able to borrow the new funds made available to banks. When they are able to borrow, they may lack the knowledge to do so wisely, as seen in the sub-prime mortgage debacle. It is businesses, rich people, people with assets and good credit records, Wall Street firms especially, who are best able to tap into these funds. Although the poor are generally unable to borrow, they do have to buy, and inflation relentlessly drives up the cost of everything they need.

1Wall Street, which generally gets it first

2Businesses and people with good credit

3Ordinary borrowers, later and on worse terms

4The poor, who mostly cannot borrow at all, and must buy

Domingo Cavallo, Finance Minister of Argentina in the 1990s, argued that the poor are the most punished by inflation, and Dollar and Kraay’s study of eighty countries found that reducing inflation was one of the most effective ways of helping them. This is the same study quoted on the other side of the inequality question, which is worth remembering.

Central banking can and should be replaced

Defenders of central banking allege that there are no real alternatives to the present system. This is false. Among the better alternatives are either gold or private (free) banking without a central bank. These alternatives made sense to Alexander Hamilton and other financial sages of an earlier age, and we could return to both. Private (free) banking could also be strengthened by tightening reserve requirements, perhaps even requiring 100% reserves against loans.

In the meantime, simply monetizing gold as an alternative currency and allowing gold-based checking accounts and interest-bearing deposits would represent a step in the right direction.