The Perils of Central Banking

by Don Boudreaux on July 13, 2009

in Books, Financial Markets, Great Depression, History, Inflation, Monetary Policy

I just discovered this April 2008 essay by George Selgin.  It's filled with important facts that give us reasons to be skeptical of giving the Federal Reserve new powers — and facts that cast further doubt on the common understanding that the Great Depression was caused by unfettered capitalism.  Here are some key paragraphs:

How well did the Federal Reserve use its original powers? During
World War I it abandoned penalty rates for "easy" money, and then began
buying Liberty Bonds to support the government's war effort. Those
actions helped hoist the inflation rate from close to zero in 1915 to
almost 20 percent in 1920 — a level not seen since the Civil War. When
the war ended the Fed reversed course, triggering the severe (though
mercifully brief) plunge of 1920-1921.

Instead of learning a lesson, in the later 1920s the Fed turned to
easy money again. But bankers had learned a lesson, and so refused to
borrow from it even at low rates. Consequently the Fed, taking
advantage of some fine print in the Federal Reserve Act, started buying
large quantities of U.S. securities on the open market. The result was
an unprecedented stock bubble, which the Fed only managed to prick, in
late 1929, by choking-off normal business credit. During the ensuing
panic the Fed, pleading impotence, stood by while the U.S. money stock
lost a third of its pre-crash value. The "great contraction" — the
worst credit-crunch in U.S. history — culminated in the national bank
holiday of March 6th through March 12th, 1933, during which the
domestic gold standard, which the Fed was supposed to preserve, was
permanently disabled.

By the way, George's new, wonderful book, Good Money, is reviewed here by the noted economic historian Robert Whaples.

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vikingvista July 13, 2009 at 2:55 am

But the economy of the last 96 years would've been EVEN MORE unstable without the Fed.

Nice summary of Fed folly.

dg lesvic July 13, 2009 at 4:05 am

Prof Boudreaux,

If I understood you correctly, you spoke of the US money stock's losing a third of its pre-crash value as the "great contraction."

Was that just a different way of saying that the capital stock lost a third of its value, and that the money stock and capital stock were interchangeable terms?

dg lesvic July 13, 2009 at 4:17 am

I'm having a terrible time understanding "the value of the money stock." I can't figure out how you value it. I can understand how you value the capital stock. It's worth one third fewer dollars. But how do you value the money stock? It's worth one third less capital goods? But what are the capital goods worth?

K Ackermann July 13, 2009 at 4:32 am

dg lesvic, that's a good question; did it lose 1/3rd of its purchasing power? If so, for how long?

I don't remember reading about a money shock before the crash.

K Ackermann July 13, 2009 at 5:02 am

The Fed needs to be audited.

The thing that bothers me the most right now is how the Fed, and Treasury, have bent over backwards to prevent price discovery of bank's illiquid assets.

Even the ban on shorting back last fall was designed to prevent price discovery.

Now, with the change in accounting, the banks are carrying severely impaired balance sheets like nothing is amiss.

In fact, they are doing so well, and are so flush with money, that they can return the TARP funds. After all, the plan is for you and I to purchase this theoretically valuable paper.

Why should the banks have to borrow taxpayer money, when they can sell us valuable assets instead?

Merill got 22 cents for their paper. That's where I'd be willing to step in.

I bet the PPIP is not going to go forward until the next crisis of confidence in the banks. or in about 4 months – October.

The Fed absolutely needs this paper to be worth something. It's what is backing our currency now. It what the Fed is going to have to use to mop up reserves someday.

The Fed and the Treasury have made a mockery of the free market. The stimulus at least goes through the motions of adhering to the free market – albiet, the demand is artificial, but monetary, bank, and accounting policy during this crisis has been horrible.

I literally cannot go near the market right now, because I don't have a clue what is truth, and what is fiction. All I know is, we are in for some real pain.

vidyohs July 13, 2009 at 6:18 am

Whatever happened to Pauline?

muirgeo July 13, 2009 at 8:56 am

The Fed itself needs to have more oversight on its actions. Sadly Ron Pauls push for oversight was denounced by the administration. Worse yet the Fed threatened us with economic ruin if we audit their books. I think their books may hide some major scandalous issues. Here's a issue we can agree upon.

Daniel Kuehn July 13, 2009 at 9:12 am

I personally think we should think of the Federal Reserve more like the Supreme Court, and perhaps even a Constitutional amendment may be in order to establish it in that sort of institutional setting.

I agree with Don that we shouldn't give the Fed additional regulatory powers, but probably for different reasons. The Fed's job is to ensure price stability and "full employment" (wow… it sounds really antiquated to say that!), not to police the banking system. I think this drive to "audit the Fed" is highly ironic – because it risks politicizing monetary policy – something I imagine the Paulites would want to AVOID (as I would).

If the Fed were given some sort of Constitutional and institutional independence, with a clear constitutional delineation of powers that couldn't be adjusted by legislation, and with a clear appointment and confirmation process (just like the Supreme Court), I think it would go a long way to guaranteeing the independence of monetary policymaking.

Daniel Kuehn July 13, 2009 at 9:46 am

vikingvista -
RE: "But the economy of the last 96 years would've been EVEN MORE unstable without the Fed."

Ummm… ya, pretty much. Aside from the GD – where I supose the Fed was still learning the ropes, and the subsequent inflation (which I think we can quite decisively blame on der Fuhrer), there's only been one major incident of instability (in the 70s – and even THAT episode was mild by historical standards – and now that episode is much better understood, thank to Friedman, Phelps, etc.).

Few have claimed that the Fed would work magic or that the Fed has worked magic in the past (I hope those Greenspan-worshippers got that out of their system at this point). But you hit the nail on the head – Don is right that there are "perils to central banking", but it has served it's purpose predictably and reasonably well. It's a human institution. I hope nobody was ever under the impression that it could work miracles.

Daniel Kuehn July 13, 2009 at 9:48 am

And I should add, with respect to the inflation of the 70s, doesn't it register at all to people that that's the only real incident you can point to in the last century? Doesn't that say something? Perhaps if someone were alive today that actually lived through the 19th century, that would actually register with people.

Foster July 13, 2009 at 9:52 am

Daniel,

I like the thinking outside the box on this one but I think we need to consider how explicitly political SCOTUS is these days (see current confirmation hearings!). Granting the Fed a constitutional mandate does not guarantee them political independence. In fact, it may make the situation worse – at least now not many people know/care what the Fed is!

Martin Brock July 13, 2009 at 9:57 am

I can understand how you value the capital stock. It's worth one third fewer dollars. But how do you value the money stock? It's worth one third less capital goods? But what are the capital goods worth?

You ask the right questions. A dollar is like a yardstick, measuring distances in inches. My penis is nine inches long (in my imagination), but how long is an inch? Well, it's an inch long, and that's as long as the bureau of standards says it is.

Money authorities may change the definition of "dollar" as a measure of the market value of things, to increase the value of their penises, and they routinely do.

Gil July 13, 2009 at 9:58 am

Why hasn't anyone chimed in with: "Abolish the Fed and go on to a proper Gold Standard"?

Martin Brock July 13, 2009 at 10:03 am

If we had free banking and private money, monetary authorities would still inflate prices in their money to expand their personal consumption. The question is: in which system will authorities abuse the authority least?

Martin Brock July 13, 2009 at 10:06 am

Why hasn't anyone chimed in with: "Abolish the Fed and go on to a proper Gold Standard"?

Define "proper".

Martin Brock July 13, 2009 at 10:21 am

The Fed's job is to ensure price stability and "full employment" (wow… it sounds really antiquated to say that!), not to police the banking system.

The Fed can't ensure price full employment or even price stability, so it can only police the banking system, and policing the extension of credit is the central bank's job.

The whole point of a central bank is to limit the authority of other banks to create money by requiring them to "borrow" the money they create from a lender of last resort and then to repay what they borrow.

You'll never understand what a central bank is supposed to do until you understand what money was before central banks, and if you believe that money was gold, you're on the wrong track. Money was never gold. Money was always credit, and creditors always created money, even under gold standards.

Without a central bank, other banks still create money to lend it, and the money simply disappears as borrowers repay it.

Under a central banking system, only the central bank may create money. The central bank creates money to lend to other banks, and this money disappears as the other banks repay the central bank. That's the idea anyway.

When we confuse money with gold or some other durable commodity, we believe that money, once created, persists forever, but this understanding of money is utterly mistaken. Money does not obey a conservation law. It is not an elemental substance like gold.

Bret July 13, 2009 at 10:26 am

I don't see why you don't think the system is essentially free banking. If you don't like $'s, use Euros. Don't like Euros? Use Renminbi. Don't like those? Use the upcoming international currency maintained by the IMF that China and Russia want.

With money, think of each country as a large banking corporation in competition with each other. It's more or less what you'd get if you had a bunch of enormous international banks doing free banking.

vidyohs July 13, 2009 at 10:39 am

Why not examine a couple of facts?

The Fed is not shackled or restrained in any way as it exists today. The article above makes it clear that the Fed does what it wants.

Under those circumstances wouldn't we recognize it as an independent institution?

Another fact, very few of the rules and principles enshrined in the Constitution has been left unviolated by past and present Congress(s).

It is a joke to speak of making a constitutional amendment to establish the Fed as independent, and then give it institutional powers that would be restrained.

The Fed is refusing an audit, "how much mo' independent do it gotta be"?

"1929, by choking-off normal business credit. During the ensuing panic the Fed, pleading impotence, stood by while the U.S. money stock lost a third of its pre-crash value."

Now a question. In that scenario was the value actually lost, or was it just transferred to other parties, while the holders of the money were left sucking hind tit? Was the inaction due to doubt and confusion, or just part of the plan?

Another question, could that transfer of wealth be the reason the Fed stood by and let it happen?

Anyone who can look at the entire history of the Fed, the secrecy and stealth of its formation, its actions, its operating procedures, its power, its control of our government through loans, and finally the sucking of interest payments from the taxpayers, and not know instinctively that something is not right is pretty close to brain dead IMHO.

Rational examination of the Fed has to lead one to the conclusion that it is not owned by the American government (meaning you and I) and it is dangerous to us.

K Ackermann July 13, 2009 at 10:45 am

Price stability, and full employment…

Those are words the JP Morgan liked better than Lender of Last Resort.

The central bank was created by bankers for banks.

E Pluribus Unum is actually a joke. It means you have no idea how overextended a bank really is, because they all look the same now.

Gil July 13, 2009 at 10:51 am

You trying to use the old line of "true U.S. Constitutional money are gold and silver coins" then vidyohs? Besides even if the Fed was a government entity and not some sort of quasi-private thingamajig would it make any difference? After all how would the U.S. people magically 'own' a fully federalised Fed if you believe voting is bunk?

vikingvista July 13, 2009 at 10:54 am

"I don't see why you don't think the system is essentially free banking. If you don't like $'s, use Euros."

Only Federal Reserve Notes are legal tender in this country, not Euros. By law, banks must accept dollars as repayment. But that is only part of why the US does not have a free banking system. The other parts have to do with both the regulations and protections placed by the Federal Reserve and Federal government upon US banks. The latter institute a huge amount of moral hazard into the system. All depository banks today are essentially government franchises.

If the country ever wises up and chooses to start a free banking system, it would probably have to start in parallel with the current government banking system. Or possibly begin with a decentralization of banking authority to the state level. Legislation would remove legal tender status from Federal Reserve Notes and open the country to competing currencies (likely electronic in this day and age).

It would have to be labelled such that people participating in the new system knew what they were getting into, since free banking and government banking are different animals. There would be no more federal guarantees, and depositers would need more due diligence and diversification. It would take a generation before people's understanding adjusted to it, although of course the marketplace would almost certainly cater to the older generation and create a facade of the old system for easier understanding (and to attract depositors).

Daniel Kuehn July 13, 2009 at 11:03 am

Martin Brock -
RE: "The Fed can't ensure price full employment or even price stability, so it can only police the banking system, and policing the extension of credit is the central bank's job."

Right. I'm not under the impression they'll necessarily always be successful. But the idea that there was some golden age (no pun intended) of market stability before the Fed seems silly to me. Price stability is a goal, not something that will necessarily always be achieved.

And to the extent that "policing banks" is the same as "policing the extension of credit" then I suppose I agree with that as well – and I should say I share your understanding of money.

I'm refering to new proposals we've been hearing about giving regulatory authority to the Fed – something akin to the FDIC or the SEC I guess. I'm not a regulatory expert, and perhaps there are select functions that are reasonable for the Fed to perform relating to it's credit expansion functions – but I'm concerned about making it the primary regulator of banks. It risks Congressional meddling and the politicization of monetary policy, which I hope is something that nobody wants.

Martin Brock July 13, 2009 at 11:41 am

I don't see why you don't think the system is essentially free banking.

It's not free banking, because a central bank and only the central bank may extend lawful credit (in legal tender) or authorize its extension. That's just the antithesis of "free banking" definitively.

I'm not sure that any law in the U.S. forbids extending credit in other than legal tender. I may write you a note promising a specified quantity of gold. This promissory note violates no law as far as I know.

As long as I redeem my notes in a timely manner, some people might accept them in trade. Here, "timely" refers to the market not to a stately court. I only mean that I redeem the notes promptly enough to satisfy the market, so that people continue accepting my notes in trade.

I may then write as many of these notes as the market will accept, and I may extend credit with them, credit secured by the value of any number of things, relative to the value of gold. If any law prevents this business, I'm not aware of it.

Liberty Dollar's problem was making false or misleading claims, like "works just like U.S. dollars". Liberty Dollars are not legal tender, so this statement is false. A note that is not legal tender cannot work "just like" a note that is.

vikingvista July 13, 2009 at 11:57 am

"Ummm… ya, pretty much. Aside from the GD – where I supose the Fed was still learning the ropes,"

Ummm…your chart shows a relative period of price stability during the 1836-1913 period between US central banks–with a sharp spike only during Lincoln's civil war economic controls. It also shows an unprecedented half century of continuous inflation to the present day. And I'm glad you correctly blame the GD on the Fed, even while discounting it.

But thanks for providing me with a chart that supports my point.

"and the subsequent inflation (which I think we can quite decisively blame on der Fuhrer),"

Uh-huh. And I suppose the Kaiser caused the big spike before that. You are partly right, though, if by "Der Fuhrer" you mean FDR.

"there's only been one major incident of instability (in the 70s – and even THAT episode was mild by historical standards – and now that episode is much better understood, thank to Friedman, Phelps, etc.)."

Those episodes are better understood by mainstream economists. The problem is that the Federal Reserve only uses that knowledge to continue the impossible goal of stabilizing the economy through centralized interventions. Hopefully after this current Federal Reserve disaster we can get mainstream economists to understand the catastrophic nationwide risks that are inseparable from a central banking authority.

Create a national centralized authority to regulate the supply of shoes and you will see the unprecidented spectacle of an entire nation periodically plagued by barefootedness.

dg lesvic July 13, 2009 at 11:58 am

Gil,

You wrote,

"Why hasn't anyone chimed in with: 'Abolish the Fed and go on to a proper Gold Standard'?"

Again, I agree with you.

This is getting scary.

By the way, I just had a debate over at ThinkMarkets with Profesors Mario Rizzo, Gerald P. O'Driscoll, Richard Ebeling, and our own Lee Kelly, on the subject of monetary policy. The question: should the money supply be increased to counteract a deflation, and what was Mises position on this? The whole matter was very confusing, and I may have gotten it wrong, but it appeared to me that they all believed that it would be good to increase the money supply to counteract deflation, and that that was consistent with Mises' thinking.

I disagreed on all points.

And Vike, you hit the nail on the head, about legal tender laws.

Another discussion just concluded, apparently, over at ThinkMarkets, was how a fiat money system came into being. Supposedly it was backed by the power to tax. I contended that it was backed by legal tender laws, and a monopoly for it.

vikingvista July 13, 2009 at 12:06 pm

"The question is: in which system will authorities abuse the authority least?"

The answer is: free banking, because of competition and absence of government protections.

Martin Brock July 13, 2009 at 12:11 pm

Another discussion just concluded, apparently, over at ThinkMarkets, was how a fiat money system came into being. Supposedly it was backed by the power to tax. I contended that it was backed by legal tender laws, and a monopoly for it.

I'd say you're both right. Why is the explanation one or the other?

Of course, a gold standard is all about legal tender. Gold is a legal tender under a gold standard. It was under the U.S. gold standards anyway.

That courts will force payment in gold under a gold standard is why the value of other things is measured relative to the value of gold. Why does anyone think that a gold standard is somehow "stateless"?

Martin Brock July 13, 2009 at 12:17 pm

The answer is: free banking, because of competition and absence of government protections.

Well, free banking is not free of government protections. It could be (and I'd say "should be") free of government bailouts like state deposit insurance, but free banking still requires property rights and the interpretation and enforcement of contracts, both of which states establish. Legal tender is just part of the interpretation and enforcement of contract.

I do understand your point, and I agree with it, but it's always a mistake to forget the role that statesmen play in any system, because they can and will and do stretch this role to the breaking point.

vikingvista July 13, 2009 at 12:40 pm

"Well, free banking is not free of government protections. It could be (and I'd say "should be") free of government bailouts like state deposit insurance, but free banking still requires property rights and the interpretation and enforcement of contracts, both of which states establish. Legal tender is just part of the interpretation and enforcement of contract."

If a government exists, then at minimum it must at least in law recognize people's right to personal life and property, which will often be determined by contract. This is not a banking protection but a human rights protection.

And if a government is going to be codifying such protections, of course corruption will creep in.

Legal tender has little more to do with contracts than do income taxes. It is not left up to the bank and depositor what to accept in payment of debt. The legal tender provision is forced upon those agreements.

vikingvista July 13, 2009 at 12:50 pm

"Why does anyone think that a gold standard is somehow "stateless"?"

It's one thing for courts to order restitution in the form of something of market-determined, and presumably biparty, value (currency, gold, or otherwise). It is another thing entirely to order it only in the form of government-determined value.

This distinction is made more tangible in places like Zimbabwe, or during the Weimar Republic, than it is with our own creeping inflation, but it is always and everywhere a risk of fiat currency.

S Andrews July 13, 2009 at 12:57 pm

"Why does anyone think that a gold standard is somehow "stateless"?"

Here is your answer – Zimbabwe – people rejecting the state's currency ( Zimbabwe $s )and embracing market's currency.
Zimbabwe: Bread for Gold

vikingvista July 13, 2009 at 1:09 pm

"it appeared to me that they all believed that it would be good to increase the money supply to counteract deflation,"

I think the general idea was that IF there is a central bank, THEN the least damaging course of action is for the central bank to mimic as closely as possible a free banking response. And they believe that under free banking, markets would temper deflation.

dg lesvic July 13, 2009 at 1:12 pm

Martin,

Free banking implies an overall free market, and that implies communities as businesses, competing like any others, and, public administration, business administration, the rules of the community the rules of the business, subject to the democracy of the market and "sovereignty" of the consumers, choosing one community over another as one product over another.

Rather than states, there would be the private Los Angeles, Burbank, and Van Nuys Land Holding Companies, or California and Nevada Land Holding Companies, or American and Mexican Land Holding Companies.

There would be no taxes, just rent, and nothing supporting any money system but the choices of the consumers, choosing to live or not live within the given communities, each with its own rules, enforced, no less than those of the state, at the point of a bayonet, but only upon those who have chosen to submit to them.

That would be the free market, and free banking, not without bayonets, but without the state, and not anarchic, but governed by the only true agency of government, the free market.

dg lesvic July 13, 2009 at 1:12 pm

The self-governing, self-regulating market.

vikingvista July 13, 2009 at 1:17 pm

dg lesvic–

I would only add that "anarchic" is not synonymous with "chaotic".

dg lesvic July 13, 2009 at 1:41 pm

Anarchy and the state are both chaotic, but I prefer anarchy to the state. For, while the self-governing free market can emerge from anarchy, it is curtailed by the state.

yet another Dave July 13, 2009 at 1:55 pm

@ Daniel Kuehn | Jul 13, 2009 9:12:12 AM

Absolutely hilarious!

Mr. Econotarian July 13, 2009 at 2:13 pm

""1929, by choking-off normal business credit. During the ensuing panic the Fed, pleading impotence, stood by while the U.S. money stock lost a third of its pre-crash value."

Now a question. In that scenario was the value actually lost, or was it just transferred to other parties, while the holders of the money were left sucking hind tit? Was the inaction due to doubt and confusion, or just part of the plan?"

The Fed made a precise calculation in the late 20's that the stock market bubble needed to be pricked (and various Fed staff said this in public). They held fast to the gold standard during a fairly horrific deflation until FDR pushed devaluation in 1933. This was four pretty damaging years.

Given the last 50 years' history, most debt contracts included a "gold convertibility clause", and Hoover said in speeches that he would not devalue because that would put so many debtors way underwater.

FDR (with his typical "new view" on the power of the Federal government) pushed through legislation to ban "gold clauses" in contracts, thus putting everyone on a fiat currency standard, and devalued the dollar.

I think FDR did the right thing to devalue, but then he took that enhanced Federal power and did all kinds of other things which were either useless or damaging to the economy.

Countries that went off the gold standard earlier did better during the Great Depression.

dg lesvic July 13, 2009 at 2:17 pm

Econocontrarian,

You raise a lot of good issues that are over my head. Hope we can get some help with this, and that you will go into a little more detail with a little more clarity. Anyways, thank you for a good start.

Lee Kelly July 13, 2009 at 3:00 pm

Martin,

There is a reoccurring discussion between you and other commentators regarding property rights; I think the seeming disagreement is actually a misunderstanding.

You claim that states establish property rights, while most commentators would claim that states merely enforce property rights–or, at least, should do.

For most contributors here, just because a state no longer enforces Mark's property rights, does not mean Mark no longer has a right to property, because what is identified as Mark's property is defined by a set of abstract rules. A statesman may decide to no longer enforce Mark's property rights, but he cannot change the abstract rules by which Mark's property is identified, because they are, by definition, what they are.

You seem to not recognise a right to property unless it can be enforced. While it is your prerogative to define a term however you wish, a great deal of confusion could be avoided if you were careful to recognise that others may interprete it to mean something else.

dg lesvic July 13, 2009 at 3:06 pm

Lee Kelly,

Bravo!

Crusader July 13, 2009 at 3:10 pm

You can't have $14 trillion economy based on gold. Gold isn't just finite for use a currency; it has industrial applications like in electronics. Let's save our gold for real industrial purposes and accept we live in a fiat currency world.

SaulOhio July 13, 2009 at 3:54 pm

Crusader: Would you use a rubber ruler to measure beams that will hold up your roof?

Kevin July 13, 2009 at 4:00 pm

Good luck with that Lee.

Crusader July 13, 2009 at 4:01 pm

Would you use a rubber ruler to measure beams that will hold up your roof?

===

You have no alternatives to fiat currency except your outdated gold standard.

dg lesvic July 13, 2009 at 4:18 pm

Saul,

Good analogy.

Crusader,

How about just letting the market decide?

dg lesvic July 13, 2009 at 4:24 pm

From the Austrian Economists:

Latest Daily Bell
Issue 346 • Monday, July 13, 2009

"If a man has the right to self-ownership, to the control of his life, then in the real world he must also have the right to sustain his life by grappling with and transforming resources; he must be able to own the ground and the resources on which he stands and which he must use. In short, to sustain his "human right"-or his property rights in his own person-he must also have the property right in the material world, in the objects which he produces."

- Murray N. Rothbard

Martin,

If you can argue with that, you can argue with anything, and I'm sure you can.

Sam Grove July 13, 2009 at 4:29 pm

I think this drive to "audit the Fed" is highly ironic – because it risks politicizing monetary policy – something I imagine the Paulites would want to AVOID (as I would).

Are you supposing that the FED is not already politicized?

SaulOhio July 13, 2009 at 5:28 pm

Crusader: Why is it outdated? Why is fiat money better?

And your assertion that it is outdated doesn't say anything about the analogy I made, that money is a standard of measurement of value. Fiat money can be inflated or deflated at will, which is like trying to build a house when your only measuring device is a ruler made of rubber, which someone keeps stretching and contracting at random.

vikingvista July 13, 2009 at 5:40 pm

"self-governing free market can emerge from anarchy"

Precisely. That is not chaos. Complex, yes, chaotic, no.

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