The Fed at One Hundred

From the early 1980s until 2007, the Federal Reserve System came to be regarded as a hallowed institution whose doings were, if not always above reproach, seen as beyond the reach of partisan politics and the petty concerns of government bureaus. The two Fed chairmen whose terms defined this period, Paul Volcker (1979–1987) and Alan Greenspan (1987–2006) were widely revered by the financial markets, media commentators, most monetary economists, many politicians, and even the public at large. They were portrayed by fawning media as larger than life characters, a “Financial Legend” and a “Maestro,” whose slightest word or vocal inflection could move markets. Their every pronouncement and deed were assiduously documented and studied. Whereas probably not one in a thousand Americans could identify William McChesney Martin in the 1960s or even Arthur Burns in the 1970s, the names of Volcker and especially Greenspan during their tenures were probably more recognizable to Americans than the name of the sitting Vice President of the U.S.

While economists have generally quite favorable views of market-oriented solutions to the provisions of goods and services, there is one common exception: money (Rothbard 1991: 2; Huerta de Soto 2012: xxx). This seeming paradox brings with it three unfortunate results. First, since the supply of money is assumed to be produced optimally by a central bank, monetary economics commonly treats it as an exogenous variable. Second, and as a consequence of this point, is that any change to central bank controlled monetary policy is seen as a panacea for economic disequilibria. Finally, since the central bank is in control of the panacea it is raised to the lofty position of “doctor” of the economy, a highly respected and necessary role to correct for imbalances caused by entrepreneurs and investors.

We have heard the objection a thousand times: why, before we had a Federal Reserve System the American economy endured a regular series of financial panics. Abolishing the Fed is an unthinkable, absurd suggestion, for without the wise custodianship of our central bankers we would be thrown back into a horrific financial maelstrom, deliverance from which should have made us grateful, not uppity.

Many economists have argued that Franklin Roosevelt’s famous New Deal exacerbated and prolonged the Great Depression that he had inherited from Herbert Hoover, making their case for the layperson (e.g. Murphy 2009) or professional economists (e.g. Cole and Ohanian 2004). Yet beyond the shortcomings in any specific New Deal program, FDR’s legacy includes a fundamental transformation—for better or worse—of the way Americans view the proper role of the federal government in economic affairs. In the terminology of Higgs (2006), the Great Depression was yet another example of the “ratchet effect” of growth in the Leviathan State, where the government expands to ostensibly deal with an emergency, but never returns to its pre-crisis size. Nowadays most Americans take it for granted that the federal government has an important role to play in combating economic downturns, regulating the financial sector, and providing for retirement income, yet these attitudes are themselves a result of the New Deal and its surrounding mythology.

Following the analysis of Milton Friedman, the conventional view of the monetary policy errors of the Great Depression is that the Fed’s policy was contractionary during the two periods of sharp downturns from 1930–1933 and 1937–1938. Had monetary policy not been contractionary in those years, the downturns could have been avoided or at least mitigated. Proper Fed policy would have been to continue the monetary inflation of 1924–1929, which had brought stable prices, and to continue the monetary inflation of 1932–1936, which had re-inflated asset prices. This conventional view overturned earlier analyses which concluded that the monetary inflation and credit expansion of the second half of the 1920s and mid-1930s resulted in asset price inflation and subsequent mal-investments throughout the capital structure. By interfering with the process of correcting the mal-investments, the Hoover and Roosevelt administrations deepened and lengthened the downturn. Recent scholarship is re-affirming the older analyses. Friedman’s view, therefore, may prove to be an unfortunate interlude between more sound understandings of the Great Depression.

Robert Higgs (1987) has made of brilliant career of showing how the state makes good use of crises both real and perceived by centralizing and accumulating power to itself. The advent of the Federal Reserve is quintessential example of this phenomenon of political economy. The Panic of 1907 opened the door for the creation of a central bank, as various bankers, intellectuals, and politicians cited the Panic to make a case for the benefits of central banking. Beginning with the now modest claim that a central bank would make financial panics obsolete by ensuring an elastic currency, over the past 100 years, Fed rhetoric has escalated so that the masses are now assured that our central bank is absolutely indispensable for the smooth functioning of the entire social economy. In light of the history of Federal Reserve activity and its consequences, Fed rhetoric was wrong at every point. Rather than promoting stability, Federal Reserve monetary policy has resulted in economic destruction: massive price inflation, the consequential withering away of the dollar’s purchasing power, and the worst financial panics and depressions in the history of the United States.

The idea that the Fed is, and ought to be, independent of politics is part of the ideological legacy of the “Progressive Era” of the early twentieth century. In order to combat the age-old skepticism about government intervention that emanated from the Jeffersonian tradition in American politics (i.e. “that government is best which governs least”), the Progressives used their positions in academe, journalism, and government to wage a crusade against the “spoils system” whereby the managers of government enterprises were typically political patronage appointees (Rothbard 1995). In its place, they argued, should be an army of professionally trained (by Progressive intellectuals) bureaucrats who would in theory serve only “the public interest,” especially if civil service regulations could protect them from political pressures and firings, granting them effective lifetime tenure in their jobs. No longer would the management of government enterprises change hands with every election cycle. That would supposedly assure that government employees would serve the “public interest” and not private political interest.

Every period of economic crisis or turmoil in the U.S. since 1971 has invariably elicited an outbreak of nostalgia for the “gold standard” among assorted financial journalists, investment gurus, policy wonks, politicians, and even a few economists. Generally the proposals that these reformers present take the form of a greatly watered-down version of the genuine, classical gold standard. For example, the monetary disorder attending the Great Inflation of the 1970s brought forth a public clamor for a return to gold that rose to a crescendo by 1980. Congress enacted a law in October of that year establishing what came to be called the Gold Commission to study the role that gold should play in the U.S. and international monetary systems. In June 1981, President Ronald Reagan appointed 17 members of the commission, which submitted its report to Congress in March 1982.

In the present paper we deal with the impact of monetary policy on incomes and wealth. We shall start off discussing a few basic theoretical issues and then provide some statistical illustrations for the case of US.

For the past several years, economists concerned with monetary policy have been establishing that an independent monetary policy maker provides superior price stability than a monetary policy maker that is more connected with politics (Alesina and Summers 1993). In short, introducing an independent monetary policy maker can lower average inflation without disrupting the economy. Americans, then, should rejoice that the Federal Reserve is considered to be one of the more independent central banks (Mishkin 2010). However, evidence suggests that the Federal Reserve is less independent than it first appears, and a more radical separation may be called for.

Monetary theory and policy are fundamental issues in economics and there are huge literatures on the theory and practice of central banking. While sometimes criticizing particular Fed policies or Fed behavior during certain episodes, the academic literature is generally laudatory (Friedman and Schwartz 1963; Blinder 1998, 2013; Meltzer 2003, 2010), and occasionally hagiographical (Bernanke 2013a, b). A few writers point to more serious problems, not only with the Fed’s overall track record, but with the very institution of central banking (Rothbard 1994, 1999; Garrison 1996; Selgin et al. 2012).

The essays contained in this volume have portrayed the Federal Reserve in a less than favorable light. In particular, they have pointed to both deficiencies in the theory guiding the Fed’s operations and the venerated institution’s historical record.