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!