From Chapter 19: Can Central Banks Protect Us from Depressions and Lead the Economy?—Yes
Although governments are in charge of a nation’s money, they usually delegate day-to-day control to a central bank. The central bank will then decide whether there is too much or too little money in circulation, whether money market (short-term) interest rates are at an appropriate level, whether the banking system is operating safely and smoothly, and so on. In most cases, the central bank will also directly supervise and regulate private banks.
As a general rule, political progressives are supporters of central banks, because they favor more government leadership of the economy, assume that economic conditions will lapse into chaos without such leadership, and think that central bankers are more qualified to carry out this critical task than politicians. Laissez-faire advocates, by contrast, take a dim view of this, since they think that the government should not try to lead the economy. Nor are they convinced that central bankers will be that much wiser or successful than politicians.
Argument 1: 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.159
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 US “Fed,” as it is commonly called, 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.”160
Given the convulsions of the Great Depression, economist Geoffrey Moore, architect of the government’s index of leading economic indicators, offers a sensible qualification: “I think in general the Federal Reserve has had a stabilizing effect on the economy, especially since World War II.”161
George Moore, who built the banking colossus Citibank, agreed and added that “The Federal Reserve has learned that at the very least you have to put a floor under the economy [by expanding the money supply whenever deflation threatens].”162
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. . . .”163
Some observers did express concern about the growing US trade and current account deficits of the Greenspan era. Because the US was buying far more from foreigners than it was selling, it was borrowing more and more to pay for the purchases. In many cases, the same foreigners who sold the goods provided the financing.
Worry about mounting US international debts was natural, but it was wrong. Trade and current account deficits do not really matter; it is probably a waste of effort even to measure them. The US ran in the red in both accounts for its first century. By the 1890s, foreigners owned sizeable minority and even majority stakes in the largest American companies, especially the railroads.164 What harm did this do? Only thirty years later, circumstances had reversed and Europeans were borrowing from America. We should not pay much attention to global financial flows and who owns what at any given moment.
It is also important to emphasize that the US, as a global currency reserve country, is able to borrow in its own currency, in dollars. This is unusual—most countries have to borrow money denominated in a foreign currency. Then, if the value of their own money falls in relation to the foreign currency, the amount of money owed can explode. By contrast, the US need not worry, since it can repay its debt in dollars, can even print new dollars for this purpose. If foreigners who have lent money to the US lose confidence in the dollar, the international value of the dollar will fall. But that hurts the foreign lenders, not the American borrowers. All the US has to do is to ignore financial writer James K. Glassman’s odd advice to borrow in yen, since the US cannot print its own yen, and all should be well.165
US economist Merton Miller has explained the situation clearly:
We’ve actually been playing a cruel trick on the Japanese [and Chinese]. We’ve persuaded them to send us expensive [goods]—and in exchange we give them pictures of George Washington. . . . [If] they want . . . their money . . . , “Okay,” we say, . . . “[but if you try to sell the US currency that we give you on world markets, you may only get] 20 cents on the dollar.” They’re the losers at this game.166
Economist Paul McCulley agreed:
To those with Calvinistic tendencies, always looking for what can go wrong, . . . the notion of . . . [the United States financing its consumption by borrowing from China] just doesn’t seem right . . . But . . . [at least for the moment] it is good, very good.167
From Chapter 20: Can Central Banks Protect Us from Depressions and Lead the Economy?—No
Argument 2: The record of the US Federal Reserve has been poor. The country did much better before its founding.
From the end of the US Civil War to the founding of the Federal Reserve almost a half century later in 1913–14, 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, such as we had in the latter half of the nineteenth century, have produced the best stock market returns of all, even better than periods of mild inflation.168
Shortly after the founding of the Fed, inflation surged. This was generally explained by the need to finance World War One. After that war ended, prices fell again, although not to pre-war levels. They declined gently during the 1920s, fell dramatically during the Great Depression (but again not to pre–World War One levels), 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. All in all, during the first ninety years of the Fed, the US dollar lost 95% of its purchasing power.
Federal legislation requires the Fed to control inflation. Successive chairmen and board members have repeatedly affirmed this objective, and there is no doubt that the Fed could stop inflation if it wished to. All it would have to do is print less new money. As production grew without new money being created, the ratio of goods to money would increase which would mean more goods for less money or, in other words, lower prices.
Yet by the early twenty-first century, the board was pursuing an unacknowledged two percent inflation target similar to the European Central Bank’s acknowledged 2% 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, author of The Federal Reserve: An Intentional Mystery, wrote that
It is puzzling that no one in Congress ever points out that it is the Fed itself that creates inflation and, more recently, permits Congress to ignore the growing budget deficits. 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. If it were not for Fed action, Congress would have to curb its spending habits dramatically.169
Economist Murray Rothbard thought that there was no mystery about the Fed at all:
If the chronic inflation undergone by Americans, and in almost every other country, is caused by the continuing creation of new money, and if in each country its governmental “central bank” (in the United States, the Federal Reserve) is the sole monopoly source and creator of all money, who then is responsible for the blight of inflation? Who except the very institution that is solely empowered to create money, that is, the Fed (and the Bank of England, and the Bank of Italy, and other central banks)? . . . In short . . . the Fed and the banks are not part of the solution to inflation. . . . In fact, they are the problem.170
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.’”171
As some economists see it, the economy not only had more stable prices before the creation of the Fed; it was more stable, period. Economist Gottfried Haberler observed that
During the second half of the nineteenth century there was a marked tendency for [economic] disturbances to become milder. Especially those conspicuous events, breakdowns, bankruptcies, and panics became less numerous, and there were even business cycles from which they were entirely absent. Before [WWI], it was the general belief of economists that . . . dramatic breakdowns and panics . . . belonged definitely to the past.172
Milton Friedman has been 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.173
Free-market economists do not all agree about how past economic contractions occurred. But all would agree with Friedman’s assertion that “The stock of money, prices and output was decidedly more unstable after the establishment of the Reserve System than before.”174
Argument 3: Price-fixing is especially toxic for an economy, and central banks are basically price-fixers.
As we have previously noted, 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. That is, if I lend you money, I am putting off my own immediate consumption. Once you pay me back, I can spend my money, but not for the time period covered by the loan. Since money and time are involved in virtually every transaction in the economy, there is no more crucial price than the price for 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.”175
But it is important to emphasize that restricting this particular price is especially dangerous, because (as noted in Part Four), the economy depends on free prices for information, and on this price more than any other.
Economic writer Gene Epstein has correctly stated that “[The chairman of the Federal Reserve] is the head price fixer of a price-fixing agency.”176
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.
Moreover, this is a form of price-fixing whose deleterious effects are notoriously difficult to detect. As economic writer Gene Callahan explains:
Because [interest rates are paid over] . . . time, the negative effects of the artificial [credit] price take time to appear. . . . And because of that time lag, it is harder to trace the later problems to the earlier intervention.177
Argument 4: Central banks are national economic planners, and national economic planning does not work.
Like the debate about price controls, there is an ebb and flow to the perennial debate about economic planning. 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.178
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, or at least with the duty of reviewing all our partial plans—plans for housing, plans for the relief of distressed areas, agricultural marketing plans, and so on—so as to make sure that they fit together.179
By the time the Berlin Wall fell in 1989 and Communism collapsed in the Soviet Union and elsewhere, 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. [We now have] . . . the clearest possible proof that capitalism organizes the material affairs of humankind more satisfactorily than socialism.180
Some years later in 1997, The Economist agreed that “Almost any discussion of public policy nowadays seems to begin and end with the same idea: the state is in retreat.”181 And economic historian David Landes added that “[All] sides blithely assume that free markets are in the saddle and riding the world.”182
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. As economic writer James Grant observed,
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.183
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 [the Soviet agency charged with creating Communist Russia’s economic plan].184
The growing power and prestige of central banking was surprising in other ways as well. Throughout the 1990s, the Fed published its own forecasts of economic growth, usually expressed as a rather broad range. But a study of sixty quarters through year-end 2004 revealed that actual growth had fallen within the range only a quarter of the time.185 The Fed, like a majority of economists, has never correctly forecast a recession.186
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.”187 In reality, no doctor, and no Fed chairman, can be sure what the “right” rate is, and interventions are little better than stabs in the dark.
Argument 5: 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 (e.g., potential output, inflation rate) that are hard to define or observe, and thus subject to endless debate and disagreement.188
These and many other formulas used by Fed and other monetary economists bring to mind a story told by social philosopher Irving Kristol about a friend’s mother. The friend, who eventually became a leading novelist, used to bring college friends home to his family’s New York City apartment for endless political debates. It was the 1930s, everyone was some stripe of Marxist, and the finer points of Marxist 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.189
The thought that the world’s monetary policy is worked out through discussions and equations vaguely reminiscent of what went on in that 1930s living room is not reassuring. How then do the monetary authorities get away with it, 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, whether ostensibly of the left or the right, and central bank chairmen want to be reappointed.
Another, equally cynical, explanation has been offered by Milton Friedman:
[The Federal Reserve] 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.190