The Federal Reserve and Its Discontents
As we approach the centennial of the Federal Reserve Act of 1913 in December, it is at least a symbolic opportunity to look back from the perspective of a hundred years and argue (in a rhetorical sense) that (i) the law accomplished what its framers hoped and (ii) the country has benefitted from having a Fed regardless of the framer’s intent.
One place to start would be to observe that, in the century since the Fed took over the chore of maintaining stable prices, prices have increased by 2,241% – far more than the inflation in the hundred years preceding the Fed’s guardianship. Price inflation is due largely to the depreciation of the dollar, whose value the Fed is also supposed to protect. The Fed’s record isn’t too good in doing that either; the dollar is now worth 3.8 cents. Dollars deflate in value because too many are printed for the available goods and services – a quantification unknowable even to omniscient beings like Alan Greenspan and Ben Bernanke.
Of course, they and their Fed forebears would argue that the Fed doesn’t print money. True, but money is soooo yesterday. The Fed accomplishes the same effect by creating out of thin air a credit to a reserve account (i.e. an accounting transaction that increases the cash balance) on the Treasury Department’s ledger in return for an interest-bearing Treasury note (an IOU) which the Treasury Department created out of thin air … and printed … along with the dollars represented by the Fed’s reserve credit. A lot of these dollars are turned over to the Fed’s best customer – the US Government – to pay for its profligate spending (and its borrowings.) And some of the dollars turn up in private commercial banks as the other half of a loan transaction. The private banks lend it to the private economy to earn interest – their stock in trade.
When the real economy – the one that sells goods and services for a profit (hopefully) – realizes that their cash profits don’t buy as much as they once did, because of the Fed invariably misreads how much money needs to be chasing the available supply of goods and services, they raise prices. ‘Course other merchants in the real economy are doing the same thing for the same reason. Consumers don’t escape this cycle either. They realize that their wages aren’t adequate to maintain their standard of living, so in time wages go up. One day Jack comments to Jill that he can remember when he bought the family car for $10,000 that now costs $30,000. He fails to recall that his wages have also gone up by about the same amount … more dollars but about the same purchasing power. It’s like a 1980s newspaper ad I recall: “1970 … 'If I only earned $60,000, I’d be on Easy Street.’ 1980 and $60,000 later … ‘They moved the street.’”
“They” is the Fed.
Like the wheels on the bus that go “round and round” in the children’s ditty, the unvirtuous cycle of printing money, deflating the currency, and inflating prices goes round and round. It’s a bit more complicated than I’ve explained – but not much. The scary thing is this: there’s no natural limit on the Fed and Treasury in doing this trick.
The economic cycles we call booms and busts (recessions and depressions) occur, for the most part, when production and consumption get out of whack. Other circumstances can contribute – natural disasters and war, for example – but the origin of economic cycles is man-made. American society has suffered 18 recessions since the Fed was created to assure recessions didn’t happen. And with each recession, folks have to get out of the workforce so that production – which was overstimulated by Fed policy – gets back in line with consumption.
Unfortunately, like Mickey Mouse in Fantasia’s “Sorcerer’s Apprentice,” the Fed realizes too late that there are too many brooms carrying water. And like Mickey the Apprentice, the Fed jumps in to correct what it caused only to make it worse.
Why do you suppose that happens? Because Fed hubris tries to anticipate and manage human behavior through its policy – a fool’s errand. A big fool’s errand. In Milton Friedman’s magnum opus, Monetary History of the United States, which he wrote with Anna Schwartz, he argues that the Fed created the Great Depression and kept it going for years with its monetary policy mismanagement.
In a speech about ten years ago to celebrate Milton Friedman’s 90th birthday, Fed Chairman Ben Bernanke agreed that Friedman and Schwartz had gotten it right about Fed policy:
Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.
In the end, it would be World War II, not Fed monetary policy, which pulled the country out of the economic hell of the Great Depression.
Bernanke’s promise to Friedman and Schwarz notwithstanding, there is more than ample evidence the Fed policy was the culprit in the tech bubble of the 1990s and the housing crisis of the late 2000s. While markets are willing to play along with the Fed during the money-making stage of a boom-bust, it is the private sector that sees the folly before the Fed, and when the private sector pulls out of the game the boom turns to a bust.
The Federal Reserve System has been a target of criticism from both sides of the political aisle since its inception. Its 1913 creation was the third attempt to fashion a central banking system in this country. In the first attempt, Alexander Hamilton bargained for southern support for the First US Bank by trading New York City for Washington as the US Capitol site. Thomas Jefferson, among other Founders, hated the idea of a central bank, calling it an instrument for speculation. Two years after he left the presidency the bank’s charter expired and Congress refused to renew it.
The second attempt occurred in the administration of James Madison, the fourth president, who signed the charter for the Second US Bank. But the seventh president, Andrew Jackson, hated debt of any kind and believed its creation was the business of banks. Jackson grew up poor; as a child and an adult he saw what debt did to a society dependent on it. He pulled all US funds out of Madison’s bank and paid off the national debt (the only President to achieve that distinction) and when Second Bank’s charter expired, Congress once again failed to renew it.
The country was without a central bank for the next 75 years which included the Civil War period. There were recessions, depressions, and “panics” – bank runs – because there are greedy people in society. The bank run that got everyone’s attention was the Panic of 1907. An economic meltdown was averted only by the intervention of J.P. Morgan who called a meeting of the leading bankers in his home and locked them in his library until each signed up for a share of the money needed to pump liquidity into the economy. Morgan’s private banking syndicate became the prototype for the future Federal Reserve.
Given their experience in the 1907 Panic bankers concluded that the banking system was too decentralized to prevent another future panic and pushed Congress for consolidation. But the public thought the banking system was too centralized and that credit shortages were the fault of Wall Street bankers. The public wanted the big banks broken up. Forced to do something, Congress navigated for a solution between the Scylla of the banks and the Charybdis of the public.
Their task was made easier by the election of 1912 in which the Democrats won control of the Congress and White House. This allowed them to enact their liberal agenda the following year which included establishment of the income tax (16th Amendment) in February, the direct election of Senators (17th Amendment) in May, and the creation of the Federal Reserve System in December.
President Wilson’s demands for banking reform were met with the Wall Street bankers’ demand for a strong privately-controlled central bank. William Jennings Bryan, Wilson’s populist Secretary of State, led the charge to make banks accountable to public supervision aka government management. Farm belt interests whose livelihoods depended on credit, wanted no part in making banks more powerful than they were. Each special interest group had its stake in the ground. Unfortunately, J.P. Morgan’s leadership in crafting a solution was sorely absent. He had died in March while abroad. No one in the country understood banking better than Morgan and he would have likely had a dominant and quite probably a positive impact on the design of the final product.
The principal sponsor of the Federal Reserve Act was Representative Carter Glass (D-VA) – an inveterate defender of state’s rights. He saw the need for banking reform and proposed privately-owned regional banks that would be free of Wall Street banking influence. When Woodrow Wilson proposed governance of the regional banks by a presidentially-appointed Board, Glass and Wall Street pushed back. This looked and smelled like a central bank.
In the end a compromise was struck that (i) would provide “elastic currency” which meant the ability to expand and contract the money supply to control inflation, (ii) would create a market for commercial paper as a method for managing bank liquidity, and (iii) would supervise banking practices. Nothing was proposed that gave the Federal Reserve a role in regulating economic activity, which it wields today.
The framers of the Federal Reserve Act, however, left so many details out that it’s unclear they understood how the system would operate. After all, they were politicians not businessmen. Morgan, had he lived, would have forced out the details. But it’s unlikely that any of the politicians present at the creation believed the Federal Reserve Board would become so powerful or that a man like Greenspan or Bernanke would hold such sway in economic affairs – both in this country and abroad. Certainly none envisioned a system not backed by gold whose only method of making good its promises was to tax money out of its citizens.
What evolved in the century following the passage of the Federal Reserve Act has been a system accountable to no private, public, or elected agency. It has no budget. It is not subject to an outside audit. Its activities are secret except for recaps of meetings released six weeks after those meetings.
Two decades ago Henry Gonzalez (D-TX) mounted a serious effort to bring accountability to the Fed. He did not propose Congressional control of the Fed’s purse strings, but he did call for videotaping of their meetings, detailed minutes to be released within a week of policy meetings rather than bland summaries released six weeks after meetings. Gonzalez wanted independent audits of the Fed’s operations and he wanted the President, who appoints the Chairman and Board of Governors, to appoint the presidents of the regional banks instead of their current method of selection. These don’t sound like unreasonable requirements for a shadowy organization that has so much impact on the American economy, businesses, and society.
Chairman Alan Greenspan objected to the Gonzalez proposals:
The lure of short-term gains from gunning the economy can loom large in the context of an election cycle, but the process of reaching for such gains can have costly consequences for the nation’s economic performance and standards of living over the longer term. The temptation is to step on the monetary accelerator, or at least to avoid the monetary brake, until after the next election.
The reforms proposed by Gonzalez were shot down by the newbie Democrat President Bill Clinton because they ran the risk of undermining market confidence in the Fed. Huh? We’re not talking the Wizard of Oz here. Is the Fed so oracular in his judgments that making it more transparent undermines confidence in it?
Former Representative Ron Paul (R-TX), no fan of the Fed, introduced the Federal Reserve Transparency Act of 2011, which passed the House last summer and predictably died in the do-nothing Senate. As law it would have required an audit of the Federal Reserve Board and the twelve regional banks, with particular attention to the valuation of its securities. One has to wonder why the Democrat-controlled Senate would object to such benign transparency, particularly since audits are routinely required in business organization by lenders and stock exchanges.
Representative Kevin Brady (R-TX) is Chairman of the Joint Economic Committee. He believes the Fed centennial is an opportunity for a commission “to examine the United States monetary policy” and “evaluate alternative monetary regimes.” The commission has almost no chance of getting out of Brady’s Republican-majority committee let alone into law. It seems that Congress is content with the monster created by its legislative ancestors a century ago.
Whenever there has been an attempt by Congress to rein in the Fed, it has been met with a fusillade of defensive arguments that the independence of the Fed would be compromised if transparency was introduced. Allegedly the Fed would never be able to make the tough decisions in its never-ending battle against inflation – a battle which seems never to have victory or control of that evil enemy in sight – because the pursuer and the pursued are one and the same.