Monday, December 23, 2013

The Federal Reserve at 100: How Fed Up Should We Be?

December 23, 1913, the date would change American currency and monetary policy. The nineteenth century brought about financial panics. However, the most severe financial panic to date was the Bankers' Panic of 1907. On Monday, October 21, the Knickerbocker Trust Company experience financial difficulties, and a "run" on the bank forced the bank to close the following day. The panic spread to other banks. Customers wanted to withdraw money, but the banks restricted these requests so they did not run out of money. Although the crisis was short-lived, it scared politicians enough to figure out how to solve the problem. As a result, the Federal Reserve Act was passed by Congress on December 23, 1913, which allowed for a central banking system to be created. The Federal Reserve Bank went through the transition from a true gold standard to a weakened, post-WWI gold standard to the Bretton Woods system to a fiat monetary system. For being around for a century, the Fed has seen its fair share of economic challenges. The question is whether we should view the Fed as a force of good monetary policy or one of good intentions with bad results.

One of the mandates of the Fed's dual mandate is price stability. I am more than skeptical about the Fed's ability to quash unemployment by printing more money and buying mortgage-backed securities and Treasury debts through quantitative easing. However, even I have to question the Federal Reserve's ability to deal with price stability. For quite a few years, the Federal Reserve has kept interest rates artificially low, something I would argue that helped lead up to the Great Recession. Even during the Great Recession, the Fed kept the interest rates low to incentivize consumer spending (a.k.a. increased aggregate demand) to boost the economy. Consumer spending has never been an issue in this country. More to the point, the Fed has disincentivized savings, which messes with retirement savings; the Fed has also severed the tie between interest rates and supply and demand (i.e., consumption vs. savings). The current interest rate does nothing to reflect the supply and demand for loans and credit.

Price stability was not an issue with the enactment of the Federal Reserve Act. Why? In spite of the short-run price volatility with the gold standard, there was that long-term price stability that evened prices out, i.e., long-term inflation was essentially non-existent. That would be why the Fed initially dealt with financial stability. Now we live in an era where inflation outpaces the money supply, which is why since 1971, 2 percent inflation has become the new norm. (This norm might be extolled by some, but in fact, is bad for society). As a result, the purchasing power of the dollar has decreased dramatically (see BLS Inflation Calculator; also see here), which given the monopoly status it has on the money supply, makes sense. The erosion of purchasing power is perturbing. Although the dollar can theoretically be in good shape as long as its value does not drop drastically relative to other major world currencies, the last thing we want is to print so much money that the paper it is printed on has more value than the dollar. There have been enough times where central banks have printed so much currency that it meant economic suicide. It would be nice to avoid that here in America.

Monetary policy in this country is discretionarily determined by political appointees who essentially have no guidelines. The Fed kvetches about NGDP targeting because "the economy is too complex to be summarized by a single rule." On the plus side, they're not completely discretionary; they try to follow the Taylor Rule. Aside from that, it's quite discretionary. Although the Fed says the quantitative easing would stop with unemployment less than 6.5 percent [or higher inflation], there is no foreseeable end date in sight. This is hardly surprising. The Federal Reserve does not possess clairvoyance. Their macroeconomic models have not been able to predict economic recessions. The Fed misallocates credit and keeps interest rates artificially low. The Fed has gone well beyond being the lender of last resort. It now has the expectation of fixing all economic woes. If the Fed is under the impression that it can keep prices stable while maintaining low unemployment, it has another thing coming. To summarize my blog entries on the Fed and monetary policy, in hindsight, creating the Fed was a mistake.

However, we don't have a time machine. We cannot change history. The question remains: where do we go from here? The Federal Reserve Bank, much like any other political institution, requires change if the situation is going to ameliorate. Do we reform the Fed or should we replace it with a different banking system?

My initial reaction is "liberalize the market." One possibility is through synthetic commodity money (Selgin, 2013). There is the possibility of private digital currencies, such as Bitcoin (Dwyer, 2013). We can even do something which I suggested a few days back, which is use a commodity standard which is reflective of a given country's wealth. Another option is to trade out the Federal Reserve Bank for a system of free banking, which entails replacing the central bank with competitive firms in free markets. This would be nice because it would be next to impossible for a private bank renege on its contractual obligation and get away with it. A free banking system might sound odd at first glance, but remember that a bank is like any other business in the sense that a bank's product is money. Free banking also has quite a few precedents, including Scotland (1716-1844), Canada (1817-1914), Switzerland (19 c.), and late 19th century Australia. Congress has tried with the Federal Reserve Board Abolition Act (H.R. 1094), but has not panned out.

Even if the liberalization of banking were deemed desirable, it would still have to be done in a more gradual manner. There are some reforms that can be carried out in the interim. The Fed has a major issue with opacity. If there is going to be massive expansions of balance sheets and this much discretion, there should be transparency, which is why the idea of the Federal Reserve Transparency Act to audit the fed was a good idea. Moving the Federal Reserve under the auspices of the Treasury Department would subject the Fed to Congressional oversight and the checks and balances system. There are the ideas of changing the dual mandate to a single mandate, adopting different macroeconomic targets (e.g., real GDP, balance of payments equilibrium, exchange rate), changing the fractional reserve rate, or we can create a fiat system subject to market forces by implementing NGDP futures contracts.

Regardless of what is done, one has to reduce the size of government and its insatiable appetite to fund its various, gargantuan projects. If the government does less, that would create a restraint on money creation. If there is to be any scaling back of the Federal Reserve, the levels of government spending have to be addressed first. Only then can there be true monetary policy reform.

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