Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Saturday, December 4, 2010

George Selgin on Replacing the Fed

In reply to one of my recent posts defending the Fed's actions over the course of the recent financial crisis, a reader asked me to consider George Selgin's recent talk, A Century of Failure: Why it's Time to Consider Replacing the Fed. I'm a big fan of Selgin's work and this is definitely a video worth watching. The main purpose of this lecture is to encourage people to be less complacent in their views of the modern day institution of central banking. (A short and useful history of the 19th century debates on central banking can be found in Vera Smith's 1936 thesis: The Rationale of Central Banking.)

I have some sympathy for many of the points made by Selgin in his lecture. But as it's no fun agreeing with people, I want to offer some criticism.

I am trying to imagine myself as a layperson attending this lecture. What impression would I be left with? The main impression would be that the Fed has failed miserably in its "promise" to maintain full employment, maintain price stability, to stabilize the business cycle, and to prevent banking panics. Comparing pre and post Fed data shows this. The Fed is like the Wizard of Oz. It's time to replace the Fed (he does not have time to say with what).

My own view on this, George,  is that you are largely barking up the wrong the tree. Let me explain why.

First, people seem to have a view of the Fed as some mysterious organism with great powers and an ability to set its own agenda. It is important to remember that the Fed was created by an act of Congress in 1913. The Fed's powers and agenda are not set by the Fed; they are set by Congress. For example, the Fed's "promise" to help sustain "maximum employment" was not the Fed's idea; it was imposed upon the Fed by the Humphrey-Hawkins Full Employment Act in 1978. Many, if not most, central bankers are horrified by this legislated responsibility; and what is happening right now in the U.S. is a perfect example why.

And what are the Fed's great powers? The main power rests in the Fed's monopoly control over the supply of small denomination paper money (cash) and reserve balances (electronic version of cash). It is important to remember that this is not the only component of the U.S. money supply; most of the U.S. money supply is created by private agencies (largely in the form of electronic demand deposit liabilities that circulate from account to account in the payments system).

So, the Fed has the ability to create (and destroy) cash. But what does it do with the cash it creates? Can it simply inject it into the economy? No, not exactly. The Fed is largely restricted to using its newly printed cash to purchase government bonds. In emergency situations, it is permitted--indeed, it is expected, by the Federal Reserve Act passed by Congress--to make short-term cash loans in exchange for collateral; see my earlier post.

The Fed does not have the power to engage in helicopter drops of money.

Of course, this does not mean that Fed power cannot be abused. If the U.S. Treasury is having a hard time raising money through debt issue, it may pressure the Fed to purchase the debt with new money. Whether this is a good or bad thing obviously depends on the circumstances. But one can obviously see the incentive that politicians might have to use the Fed's monopoly to extract resources via an inflation tax. This is why the Fed tries to defend its "independence" from the Treasury to the best of its ability. At the end of the day, however, we have to recognize that Congress created the Fed -- and Congress can dismantle the Fed. This is the political reality under which the Fed must operate. Is this the Fed's fault?

Would this political reality be altered if the Fed was replaced by an act of Congress with another institution? If so, please explain.

To make the point that the Fed "failed in its promises" to deliver wonderful things, George looks at pre and post Fed economic data. The pre-Fed sample period is roughly 1870-1913. The post-Fed era is 1913-present. This is a rather convenient truncation and division of the data.

1870-1913 was a time of peace and extraordinary prosperity (punctuated by severe recessions). In contrast, the early part of the modern era featured the largest civil war  in  in the history of mankind (Europe and her current and former colonies). This was followed by the Korean war, the cold war, the Vietnam war, the war on poverty, followed by the lesser wars in Iraq wars and Afghanistan. Wars are periods of extreme fiscal strain; and it is not surprising that the inflation tax is invariably used to help finance a part of wartime expenditure. Would this have been less the case had the Fed not existed? To answer this question, let us go back further into American history, say, to 1861.

I want to label the diagram above "How to Generate Inflation without the Fed." Here is another diagram (source):

Yeah, yeah...I can see what happened in 1933. But what I want you to also look at is the run up in the price level from 1745 - 1820 (it increased almost four-fold). My general point here is that there is more to inflation than simply whether a central bank exists or not. Political factors are the deeper cause; and this is what I mean by barking up the wrong the tree.

What about the failure of the Fed to prevent the wave of bank panics during the Great Depression? George, you know better than me that there were severe regulations restricting banks from diversifying their assets across state lines. Canadian banks suffered from no such restrictions and, indeed, no Canadian bank failed during the Great Depression (though Canada, like many other countries experienced a large contraction in output). This is not to absolve the Fed from any mistakes it may have made, but there is a difference in critiquing a policy and a critiquing an institution.

What of the Fed's conduct over the recent crisis? Well, I've written about this in my earlier post. Many people do not know that the Fed was granted no supervisory role over the majority of the institutions adversely affected in the financial crisis; see my post here: Did the Fed Fail as a Financial Supervisor?

And yet, when the shit hit the fan, the Fed was expected to act immediately (and believe me, Congress was very glad to have this responsibility thrust upon the Fed at the time, and to save their Monday morning quarterbacking duties for, well, Monday morning). The Fed, in fact, essentially replicated the actions of what many of the private clearinghouses did in the past to ameliorate the adverse consequences of a financial panic.

Anyway, here you have my 2 cents worth on the matter.

Having said all this, you may find it surprising to learn that I agree with George: It is time to consider replacing the Fed. But then again, I always think it is time to consider reshaping or replacing the institutions we use to govern ourselves. Let the discussion begin!


  1. David,

    I appreciate your comments very much. My main concern with attacks on the Fed is that people think the Fed itself is the problem. The problem, really, is that there is a money monopoly. Any money monopoly can, and generally will, result in abuse of the currency. I think we saw this with the Bank of England, if I remember V. Smith's book correctly.

    I do think Prof. Selgin was quite careful to avoid looking at the 1913 - 1945 period. He mentioned that a few times, calling it the "learning period." He also was careful to say he didn't want to return to the pre-Fed period, which was also quite terrible. Also, the employment stuff I think was excused on the basis that the Fed really can't do anything about that; far too many factors are involved.

    What I learned from this is that banking in the U.S. has quite a very negative history that is characterized more by public choice effects than by profit-maximizing effects.

    By the way, I've been looking at inflation effects on stock prices using different measures of inflation. It's very interesting to note that the PPI and CPI used to track very very closely, but began decoupling around the time of that 1978 act. Now the PPI is generally lower but far more volatile. I must think more on this.

    Thank you for your thoughtful comments on this matter and in general. Wish I had taken some classes from you instead of just auditing here and there.

  2. You are at your best, sir, when presenting your views on the Fed.

    But as it's no fun agreeing with people, I want to offer some criticism.
    ...The Blogger's Motto....

    As for myself, I'd keep the Fed, and think about taking the power to make economic policy away from the amateurs in Congress.

  3. "But what I want you to also look at is the run up in the price level from 1745 - 1820 (it increased almost four-fold)."

    I read it differently. One spike at the war of independence around 1766, and another during the War of 1812. At these points the government no doubt used the printing press or debauched the coinage to pay for wars. Which leads me think that the most useful conceptual dichotomy is not the be between Fed/no Fed, but monopoly control of money vs no monopoly control. While in 1776 there was no Fed, the government surely exercised significant control over monetary matters.

    Do you swing to the free banking side, David?


  5. we need ron paul to be our prez!!!

    check this out about the relationship between the fed and the us treasury and why schools don't teach about money:

    for more, follow the blog and "like"!/pages/Joshua-Gamen/115571041833009

  6. David,

    yet again I'm in absolute agreement, it's a bit disconcerting frankly!

  7. Time to think about non-monopolistic way of adjusting the money supply that minimizes stealing and devaluation of saver's money indeed.

    Agreed with JP Koning.

    Both the government and the FED should be highly distrusted.

    Of course the FED has little power to steal money (or does it?), but in cooperation with the (corrupt) government, stealing is apparently easily accomplished.

    The more people understand this the sooner we will find a way to replace the FED.

  8. David,

    My first post got deleted, but I'll refrain from conspiracy theorizing. But anyway, here's a few rejoinders.

    1) I have read an NBER working paper recently (I'll try to find a link for you) that shows the primary method that the Fed influences the short-rate is through the announcement effect rather than actually injecting new reserves or draining reserves. Of course, this study examines the period prior to recent nuttiness.

    2) I think Prof. Selgin was quite careful to point out that he didn't think the Fed should be held responsible for employment since there's too many factors outside the Fed's control that affect employment. So I can see your point to saying central bankers were "horrified" by the 1978 legislation. Well they should be.

    3) Prof. Selgin also most excluded the 1913 - 1945 period from his analysis. He called the "learning" period. He may have had a 'tone' when he did this, but nevertheless it seemed somewhat balanced in favor of the Fed to do this. Eliminates the GD, after all.

    4) As others have mentioned, the real issue is money monopoly and political control over the supply and quality of money. I think this concern existed pre-Fed as well, so the Fed couldn't be expected to fix that problem if the monopoly continued.

    5) Point of interest: prior to the 1978 legislation, PPI and CPI were very closely linked. After 1978 they began to decouple, and by the late 1980s, PPI and CPI shared a mild trend, but PPI was pretty independent of CPI - way lower but also way more volatile. Working on the effects of this right now, but equally important is why that happened.


  9. David has kindly alerted me to his critique and invited me to reply. So here goes. (I have divided it in two to conform to space limits.)

    A 40-minute public lecture is, first of all, not the best means in which to cover all the issues related to such a sweeping proposition as one holding that we can do better than we have with the fed. In fact my lecture is just the barest-bone summary of a much more complete argument contained in my, Bill Lastrapes, and Larry White's working paper, "Has the Fed Been a Failure?<' which is available online through both Cato and SSRN links. I urge David and his readers to have a look at that paper which addresses several of the issues he takes up in his comments here.

    With particular respect to those comments, a few points. First, of course the Fed answers to Congress, and has its goals set by that body. But note: my paper isn't a critique of the goals themselves (though there are indeed cogent criticisms to be made of the dual mandate in particular). It merely asks whether the Fed has been successful in achieving these goals. I claim that it hasn't been.

    Regarding the Fed's powers, it is a very serious mistake to assume, as David seems to do, that these are properly gauged by noting that it supplies but a small component of the total money stock, most of which consists of various sorts of bank deposits. In fact, by controlling the monetary base (which consists not only of the stock of paper currency, as David indicates, but also of the stock of bank reserves in the form of credits with the various Federal Reserve banks), the Fed operates a lever by which is is capable of regulating the total stock of money and the total flow of credit. Think of a government monopoly of shoes for left feet and consider the degree to which that monopoly would influence the total availability of shoes and you will begin to get the right picture.


  10. Concerning the fact that the Fed adjusts the available stock of base money through open-market operations and discount window (or other kinds of) lending rather than by dropping stuff from helicopters, I'm sure I've never suggested otherwise and that none of my critical observations concerning the Fed's performance hinges on the helicopter-money assumption.

    David asks whether the "political reality," consisting of the abuse of the Fed as a tool of inflationary finance and such, could possibly be altered by replacing the Fed with another institutional arrangements. The answer is that is can, if the alternative is a decentralized one in which no very large degree of influence is concentrated in a body over which the executive or Congress exercise considerable influence. Of course, even such an arrangement can be abused, but only through its being altered again. Whether that happens depends to a considerable degree on the state of professional economic opinion. For any economist to apologize for the Fed on the grounds that Congress is bound to saddle us with something at least as bad is for that economist to forget, first, that is is economists' responsibility to plead for better institutions and not to spare politicians the necessity of having to explain why they aren't following the economists advice.

    David suggests that I have "truncated" the sample period used in comparing pre-Fed and Fed performance in a manner calculated to make the pre-Fed period look especially good, by leaving out the Civil War and earlier disturbances. But the sample periods I used were chosen not for such a strategic reason but (1) because the comparisons are meant to be between the Fed and the "National Currency" regime that preceded it, which was set up during the Civil War and (2) because consistent statistics for the comparisons I'm concerned with simply don't exit for earlier periods or even, in many cases, for the full National Currency period. Without such statistics comparisons become arbitrary. For the CPI, statistics David cites from before the 1780s are especially doubtful, though no-one denies that prices rose considerably during the revolutionary, 1812, and Civil Wars. That we can have inflation without the Fed is of course not a revelation. Nor does it contradict the claim that the inflation record, and the peacetime inflation record especially, has been worse under the Fed than under previous U.S. monetary regimes.

    Concerning Canada's experience during the Great Depression, readers will find a very different take on this in our paper. Briefly, David sees it as proof that bad regulations rather than the Fed were to blame for the banking crisis. We see it as proof that the Fed was a poor solution to the problem of crises, that is, that there was a better, deregulatory solution. These claims aren't exactly inconsistent. But to suggest that Canada's experience should be viewed as undermining the case against the Fed is a stretch.
    Cont'd from previous post)

    As for the Fed mimicking what private clearinghouses used to do: Wicker and Timberlake, the foremost authorities on that matter, both think the clearinghouse solution was better. This, too, is treated in the paper.

    Once again, I'm grateful to David for inviting me to reply to his criticisms.

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  14. "Nor does it contradict the claim that the inflation record, and the peacetime inflation record especially, has been worse under the Fed than under previous U.S. monetary regimes."

    Bingo. That's an important distinction. Say David's shadowstats chart is right (and given the incredible amount of different currencies and coin circulating in the US in the 1700s I can't see how they can conceivably build a credible inflation index), during peacetime prior to the Fed's debut, inflation was muted.

    Mind you, a lot of the peacetime inflation subsequent to the Fed's establishment has to do with the devaluation of the dollar versus gold in 1933 and the constant reduction of Fed gold-backing requirements (and allowance of US gov bonds as purchasable assets). The Fed didn't enact these changes in gold policy; it was Roosevelt and other politicians.

  15. The Arthurian: Are my non-Fed posts really that bad? lol. Thanks...

    JP Koning: Yes, I do swing to the free-banking side. In theory, I think its the only way to go. The political reality makes me think, however, that this theoretical ideal is impossible. When have we ever truly had "free" banking? Scotland 18th C maybe? I'm not even sure of that.

    Adam P: Our persistent agreement is nearly intolerable! :)

    Prof J: No conspiracy...just a bug, I think.