The Fed - Twentieth Century

The Federal Reserve System (or fed) was created in 1913, almost 100 years ago. It was created, along with dozens of other government regulatory agencies in a wave of populism spearheaded by President Woodrow Wilson. It was a time when the public was rebelling against wealthy "Captains Of Industry" for becoming too rich. It was a time when the policies of regulation and control were institutionalized to replace the functions of the free market. The fact that the free market had just produced an industrial revolution that led to the highest standard of living individuals and the world had ever known escaped the "wisdom" of the masses. To them the industrial revolution became unimportant compared to the more popular cries for "social justice". In the end they would receive neither.

The fed was created to protect individuals against the "discipline and harshness" of capitalism and the gold standard. It took the US off the gold standard which had lasted since America's inception. The industrial revolution was built upon the gold standard and the soundness and reliability of sound money. The fed could instead create paper money at will. The Constitution explicitly states that only specie, which means commodities like gold and silver and nickel and copper, can be money. The founding fathers knew that the biggest enemy of sound money was government. They knew that inflation was a tool of government to steal from the masses. The new populist government violated the constitution without even the pretense of a legal argument, and substituted their own wisdom over the Founding Fathers.

During the time of the gold standard consumer prices only varied up or down by about 2%. An ounce of gold bought about the same amount of goods and services year in and year out. That didn't mean that we didn't have panics or recessions -- we did. But, they were short lived and things returned to normal quickly. But, in 1909 the US experienced a rather severe banking crisis. Major banks went under and depositors lost their savings. In an attempt to "help", the populist movement, which was sweeping the country at that time, won the day and encouraged the government to create a central bank as a lender of last resort to back up banks that faced failure and closure. More importantly, it also gave the fed the authority to create and regulate paper money and credit and consequently to influence interest rates. 

No longer was the market to be trusted with money and credit creation -- the government was. Instead of the supply of money being limited to the production of metals, which was limited by nature, the government would simply print up paper dollars as needed. They could progressively increase the money supply in order to keep interest rates artificially low and foster what they thought could be permanent economic growth. They theorized that the only reason for recessions was the absence of money and credit as a stimulus. Tight money was the cause of recessions -- easy money the cause of prosperity, they reasoned. The result was the roaring 20's. All of a sudden America was on a binge they couldn't get off of.

By 1929 the binge turned into panic buying as the increased money found its way into the stock market. The worst thing a guy could be accused of was not owning stocks in the greatest stock market boom in American history. The fed fearing  the boom was artificial and getting way out of hand, panicked and slammed on the monetary brakes. They decreased the money supply by literally one third overnight. The result was the crash of '29 and the Great Depression of the thirties. No one had ever seen anything like it.  A massive deflation took hold causing a crisis that lasted for over a decade.

In 1933 President Roosevelt declared a bank holiday, confiscated the peoples' gold in an attempt to replenish the Treasuries' coffers and save the nations credit, then devalued the dollar which immediately increased the price of imported goods to an already impoverished population. Dollars were no longer convertible into gold even though the constitution declared that they must be. The revolution was complete. The US monetary system had been converted from a gold standard to a fiat standard where the quantity of money, and therefore the value of money, was determined not by the free market but by fiat i.e. government decree. Deflation had set in, the likes of which no one had ever seen before. Unemployment went to 34%. Homes were foreclosed on, credit vanished, and businesses went bankrupt. And this all in an attempt to "help". As stated previously, at the end of the day, government intervened into the economy in order to insure prosperity and promote social justice and ended up doing neither. They in fact did just the opposite.

During the thirties every trick in the book was tried in order to end the depression.  Grand public works programs were instituted. Social welfare programs were established. Taxes were raised on the rich to pay for these new schemes and "help" the poor. Redistribution was the battle cry of the day. Farmers were paid to burn their crops and paid not to plant new ones in a futile attempt to raise prices. Then came protectionism and the trade wars to "protect" our markets. It was an orgy of government gone wild.

By 1938, a decade after the stock market crash and the initiation of an array of new government rescue programs, employment and the economy were no better off than they were before the "help" from government began. Nothing worked to revive the economy. After every populist program imaginable, the country was still buried under the worst deflationary depression known to man in all of modern day history.

Meanwhile the fed was printing up fresh dollars in an inane attempt to eliminate deflation and create higher prices. Again nothing worked. It took World War II to pull the nation out of the depression -- every government economic program that was tried was worse than useless.

After the war ended the economy started a come back as soldiers trained in new skills returned home and began new productive careers. Once again the fed struggled to know what the right amount of money in circulation should be. In the late forties inflation, a term the American people were not familiar with, became a problem. The average guy on the street saw it as rising prices. But a handful of economists identified it for what it was, i.e. the fed's creation of too many dollars. Easy money was condemned this time by a vigorous handful of economists, writers, and commentators. The fed started pulling in the reins. They learned their lesson when it came to slamming on the brakes as they did in 1929, so they adopted a gradualist policy. Slowly inflation declined. The result was the "Nifty Fifties". Inflation returned to a low and stable rate due to a moderate monetary policy, and the government slowly began to step out of the economy and become small again. As government became smaller and less intrusive the economy became bigger and the economy and stocks went into a bull market that lasted nearly two decades.

But government could not leave well enough alone. In the mid 60's President Johnson launched his"Great Society" programs, designed to "help" Americans achieve a better and more secure life. This led to what these kind of government policies always lead to -- trouble. First, In 1968, when government found it needed more money to pay for their new welfare programs. So, they passed a law removing the silver from American coins. Silver dollars were outlawed and silver was extracted from other coins and replaced with tin and lead. After that bit of theft, they increased the supply of paper dollars to pay for their new social programs. By 1970 the fed started financing the Viet Nam war by once again increasing the money supply. By 1973 oil skyrocketed and the fed, in an attempt to prevent the economy from going into a recession ,"monetized" the oil rise. In other words, rather than allowing the price of oil to act as a tax which reduces consumption, it increased the money supply so everyone would have enough money to pay for higher gas prices. It was paper money on top of paper money on top of paper money. This simply led to higher and higher overall inflation.

One main reason that drove the fed to inflate during the 70's was the passage of the Humphrey-Hawkins Act by Congress. This legislation charged the fed with a new task: to encourage economic growth, fight high unemployment, and try to prevent possible recession, while at the same time fighting inflation. The legislation accomplished just the opposite. A new phenomenon developed called "stagflation".

As government grew bigger, instituting new programs to help the poor, tax the rich, and control and regulate business, the economy responded as it always had: unemployment skyrocketed to above 10%; an out of control monetary policy led to 12% inflation rates; we had 3 recessions in 10 years; and the dollar dropped like a rock, which took interest rates to 21%. Meanwhile gold, which was set free from its Roosevelt peg of 35 dollars an ounce in 1933, was made convertible for the first time in thirty years and soared to over 800 dollars, the equivalent of 2200 dollars in inflation adjusted terms, thereby exposing governments inflationary games over the previous 3 decades.

In 1980 Ronald Reagan was voted in as President and he together with the help of Paul Volker and later Alan Greenspan returned to sound money policies which returned the rate of monetary growth to the 2 to 3% level. The Reagan Administration reduced the size of government, reduced taxes, deregulated, and opened up international trade. The rest is history: To date, the result has been a period of 26 years of low inflation and unprecedented prosperity with only four negative quarters of growth in all those years.

The one thing that history teaches us is that the mandate of the fed to both fight inflation and economic recessions is impossible to achieve. The fed can not, and never could control the economy. Presidents Wilson and Roosevelt proved that, The Soviet Union and Communist China proved that, and Johnson, Nixon and Carter proved that. But the fed can control inflation. They can keep the money supply low and stable. They can approximate the Gold Standard where gold generally enters the economy at a 2 to 3% rate over long periods of time.

Greenspan used to explain to Congress every time he was challenged to "do something" to foster economic growth, that the best way the fed had of dealing with a slowing economy and a rising unemployment rate is to reduce inflation, and keep it low and under control. It is interesting that during Volker and Greenspan's tenure as Chairmen of the fed, the price of gold averaged about 500 dollars for about 20 years.  As soon as Ben Bernanke was named as the prospective new fed Chairman, gold began it's ascent and has not looked back since. Maybe gold was signaling us to beware, even back then, of a change in monetary policy. And, indeed, today, we have a fed that is erratic. The fed is once again struggling to determine the proper level of money supply and interest rates. 

The fed of the 21st century needs to change, but change for the better.  We know the lessons of the past. We know what has worked and what has not. We know that the fed can create deflation as they did in the 30's, and inflation as they did in the 70's. To avoid going through that unnecessary and very unpleasant experience again, the fed needs to do the following things.

The Fed Of The 21st Century

First, it should set the money supply to increase at a low and stable rate permanently.  The late Milton Friedman, the modern day father of monetarism, said that the Federal Reserve Board could be replaced by a computer. Some argue that the money supply is irrelevant in today's global economy. If that's true then there is no reasonnot to fix the increase of money. You don't need 12 men sitting around a table arguing about it. Just set it and leave it alone! A steady 2 to 3% increase in the monetary base would be just fine. This means that there will be a little inflation and a little deflation from time to time. They need to let both occur-- it's a natural result of sound money.

Next, don't set interest rates. Let the fed funds rate float just like any other interest rate. Why argue about what an interest rate should be when the market is telling you every minute of the day? And if they can't do that, peg it to the 3 month T-bill rate. That is a market oriented short term rate. At least the funds rate will be market oriented and not set by arbitrary decree.

This means ending the dual, and impossible, mandate of Humphrey -Hawkins. It means ending the feds attempt to target growth which they can not do, and control inflation something they can do. This requires that the fed allow the economy to go into recessions from time to time if rates rise. There is nothing wrong with a recession anymore than there is something wrong with winter. It just happens -- and there is nothing government can do about it anyway. Recessions are like the weather and the change of seasons. No act of Congress will change them or stop them from occurring. The same is true with panics and crises. They come with the territory and that territory is freedom. Freedom requires both the freedom to succeed and the freedom to fail. This is how we learn. The recent assumption that the government should do something to prevent the economy from going into recession presupposes that they can.Not the government nor the fed has the power to achieve that goal. They can only make things worse by trying.

Finally, a 21st Century fed in these times, and given a fiat standard, must be a banker of last resort. The concept of a bankers banker was invented as a man made device to shore up market failures and severe economic disruptions. I see nothing wrong with this Idea in general. The fed buying assets, or lending against assets, or guaranteeing assets at desperation prices, is fine as long as they do not create or prevent victims.

It is because no one else is willing to, or rich enough to touch these risky assets, that the fed finds itself in a unique position. They are able to acquire assets at bargain basement prices. In most transactions of this kind in the past the government has made money. Tax payers have in total, over many such rescues, not been affected. Today, if the government bought all of the bad mortgage paper outstanding at pennies on the dollar, then resold whatever paper was performing when markets were normal, the taxpayer would probably be the beneficiary. The fed should be a last resort buyer of assets only if and when necessary. If things become really dire, then the fed is there to buy when there are no other buyers. They are there to make a market, or clear a market, when markets can not do that for themselves.

The standard by which government decides to intervene must always be the same: to prevent structural damage to the monetary and/or economic system.The line drawn between government intervention, regulation, and the sanctity of free markets is that such intervention must be to prevent fraud through regulation, insure transparency, and/or facilitate markets that are unable to function. It needs to provide transparency on such things as leverage and risk so that the markets can provide individuals with the information to judge such risk and take actions to protect themselves.

The fed can assist in the orderly liquidation of large institutions in order to protect against economic contagion and structural damage. But this extraordinary intervention should always be a last resort.It should not be to prevent victims nor create or protect new victims. The question of moral hazard needs to be answered by example. Every central bank action to preserve the system must result in those responsible or involved in such action ending up where they would have been without fed intervention.

So, I'm not talking about a bail out. On the contrary. Companies, homeowners that can't make their mortgage payments, cities that have floated bad bonds, and financial institutions, creditors, and investors, all must be allowed to fail. The point is not to try and save a company or group of individuals. The point is to preserve the system and promote open and orderly markets. If successful the intervention of the central bank will have been neutral. There will be failures and victims specific to the institutions involved but without the spill over into the broad economy in general. This can prevent the onslaught of innocent victims who had nothing to do with the troubles of specific institutions. I see no sense in the fed ever taking action or not taking action to try and solve a problem that would ultimately hurt the economy at large.  Not when a surgical solution is possible.

But, intervention should only be an option and never a mandate. Intervention during financial panics and crises is not always necessary and rarely the same. For example, the government let thousands of savings and loan banks go under in the 80's without structural damage occurring. Hundreds more failed in the 90's. These were controlled liquidations. The government guaranteed the savers deposits, as promised.  But the bankers and the banks themselves were allowed to fail. Other examples are Long Term Capital which was one of the largest financial institutions around. Then fed Chairman Greenspan brought the interested creditors together and persuaded them to refinance the risky loans rather than "run" the bank. LTC was saved and not a penny of tax payer money was spent. More, the investors ended up making money rather than loosing it. And there was no financial melt down.

New York City was saved through government loans as was Chrysler Corp.  Both loans extended by the government were eventually paid back with interest. The government, therefore the American taxpayer, actually made money on the deal. Historically, the price of these kinds of extraordinary interventions have been in their entirety low to tax payers compared to the alternative, and helped the market "morf" into a new less regulated financial industry over the years. The role of a modern day central bank should amount to a stop-gap insurance program. Nothing more -- nothing less. All the rest, of it's functions, money creation and the setting of interest rates should be abandoned in favor of a market oriented and automatic process. This is the best a fiat standard can be.

But, if you are going to have a fiat standard, it's going to come with more regulation than desired. That's the trade off. A fiat standard requires more transparency, more monitoring, and more regulation and more tax payer dollars to run and support it than a gold standard. Fiat standards can work, but they are more costly and more intrusive than the automatic market process of the gold standard. The best a fiat standard can do is impersonate a gold standard. Such has been the case with having to regulate the money supply and interest rates rather than allowing the market to do it.

For my money and a host of other reasons, I'd prefer living under the gold standard any day. Perhaps we will some day, but until that day comes, the changes from the 20th century fed to the 21st century fed are needed and needed now. This will bring us closer to the gold standard, which is still today, an unknown ideal.

Much has been written and said of the fed lately. Most of it is not flattering and belies the fact that if the gold standard was flawed as its critics argue, certainly it can be argued that the present day fiat system has proven to be flawed as well. It is more closely watched than ever before. It is also more criticized today than in decades. And because of it we have the best chance of changing the nature of the fed today than at any time since the eighties. In doing so we can end up with a more reliable, less disruptive, and more market oriented monetary policy than at any time in the last hundred years. Such a change would be most welcomed.