More On: Economics
Why do the vast majority of economists believe the Fed should control the money supply from a central location?
Almost all of the mainstream monetary policy debate in the United States today, and for decades, has focused on the type of monetary policy the Federal Reserve should pursue. Is it appropriate for the Fed to target interest rates, and if so, how? Should it, for example, follow the Taylor Rule, named after John Taylor, a Stanford economist and Hoover senior fellow? Should the Fed set a target for nominal GDP, as Mercatus Center economist Scott Sumner suggests? Should the Fed abandon the fight against inflation in order to avoid a jump in unemployment? Should the Fed abandon its efforts to reduce unemployment and focus instead on ensuring that inflation remains low or, given today's report, falls to a low level?
All of these inquiries are worthwhile. However, keep in mind that these inquiries are about the Fed's central planning of the money supply. Few Americans, and even fewer economists, believe it is a good idea for the federal government to decide how many vehicles should be produced in the United States. Economists rarely advocate for the government to determine how much steel should be produced. Why, therefore, do the vast majority of economists believe the Fed should control the money supply from a central location? It has to be because monetary policy before to the establishment of the Federal Reserve produced far worse results than it did when the Fed began operations in 1914.
However, before to 1914, we had superior results on inflation and about comparable results on business cycles. Furthermore, previous to the Fed, our monetary institutions had major flaws as a result of harmful regulation. Prior to the Fed, monetary policy would have been much better if those regulations had not existed.
Long-run inflation was not a problem until the Federal Reserve was established. The rate of inflation, as measured by the price of a fairly equivalent basket of consumer items, was 8% between 1790 and 1913, the year before the Fed was established. That isn't an annual rate of 8%. Over 123 years, it has increased by 8%. Over that time period, the average yearly rate of inflation was 6 hundredths of a percent. To put it another way, there was almost no inflation.
However, the consumer price index has climbed by 2,737 percent from 1914, the first year of the Fed's operation, and 2022. That means that during those 108 years, the average yearly rate of inflation was 3.15 percent. That's 52 times the average inflation rate before the Federal Reserve was established. After President Nixon severed the last link between the dollar and gold in 1971, inflation began to rise. He "closed the gold window," which meant the US government would no longer accept other governments' US currency at a $35 per ounce gold exchange rate. The CPI increased by 3.89 percent per year between 1971 and 2022. Inflation was very high from 1971 and 1982, averaging 8.21 percent each year.
It's true that after 1982, things improved. Paul Volcker, the head of the Federal Reserve, reduced inflation to 3.32 percent on an annual basis from 1982 to 1987. Greenspan made considerable gains between 1987, when he became Fed chairman, and 2006, when he left office, bringing the average annual inflation rate down to 3.06 percent. Oh, how we long for those days' inflation rate.
The near complete lack of long-term corporate bonds is one evidence of the challenges caused by long-term inflation. In their article "Has the Fed Been a Failure?" published in the Journal of Macroeconomics in 2012, monetary economists George Selgin of the Cato Institute, William D. Lastrapes of the University of Georgia, and Lawrence H. White of George Mason University note that 100-year bonds were fairly common in the decades before the Fed. Since 1933, however, we have seen inflation in all but a few years. It's not surprising, then, that there haven't been many fresh 100-year bond issues. It takes a lot of confidence to lend money to a company for a century when you don't know if inflation will remain low.
But, wasn't the price level more volatile before the Fed than after, owing in part to fluctuations in gold output? Yes. For the Fed, it's a win.
In the long run, one thing the Fed achieved was almost completely eliminate deflation. Was this, however, a good thing? As if deflation is always a bad thing. Whether deflations are positive or detrimental, however, is determined on what creates them. Selgin et al. point out in the above-mentioned article that deflation is beneficial if it is caused by productivity growth: with higher output and no change in the amount of money, prices will fall. The authors point out that damaging deflations arise when demand for products and services diminishes. Prices and wages are falling, but not quickly enough for employers to justify keeping as many employees on the job. As a result, there is an increase in unemployment. Selgin et al. cite two other writers' conclusion, based on the experiences of seventeen countries during the twentieth century, that the only time deflation and depression were linked occurred during the Great Depression in the United States. Of course, this occurred while the Fed was in charge.
Cycles of Business
This leads to the topic of business cycles. One of the main reasons economists prefer the Federal Reserve controlling money supply is to avoid the recurring recessions and depressions that plagued the nineteenth century.
For the Fed, there is one big flaw in this argument. The period is known as the Great Depression. People wanted to convert their demand deposits into money, and 10,763 of the country's 24,970 commercial banks failed between 1929 and 1933. Each dollar of bank reserves backs many dollars in checking accounts in a fractional reserve banking system, which we had then and still have today. As a result, banks fail when enough customers panic and try to convert their checking accounts into money. Consider the scenario in the 1946 film It's a Beautiful Life, but without Donna Reed's wonderful character spending her and Jimmy Stewart's honeymoon monies to stop the outflow of funds from their prized building and loan. A smart Federal Reserve would have responded to the banking crisis by acting as lender of last resort, as many of the Fed's supporters had wished. Many depositors would not have attempted to withdraw money if they had been certain that the Fed would lend enough money to banks to ensure that the money would be available if they needed it. The Fed, on the other hand, did not act in this manner. Between 1929 and 1933, the Federal Reserve let the money supply decline by 30%, as University of Chicago economist Milton Friedman and his co-author Anna J. Schwartz of the National Bureau of Economic Research demonstrated in their seminal 1963 book, A Monetary History of the United States, 1867–1960. That is what exacerbated what began as a routine recession, giving rise to the "Great" in the Great Depression. The Fed is to blame for this.
Many individuals today believe that the Federal Reserve learned a valuable lesson during the Great Depression. Indeed, during a party to belatedly honor Milton Friedman's ninetieth birthday at the University of Chicago, Ben Bernanke, then a member of the Federal Reserve Board, 'fessed up. "Regarding the Great Depression," he explained. We did it, you're right. Please accept our sincere apologies. We won't do that again, due to you." But to claim it was a learning experience brings to mind a famous moment from the 1964 film Dr. Strangelove, in which President Muffley (Peter Sellers) realizes that one of his generals, Jack D. Ripper (Sterling Hayden), has moved on his own to provoke a nuclear war with the Soviet Union. "General Turgidson, when you introduced the human reliability testing, you promised me there was no possibility of such a thing ever occurring," Muffley says to General Turgidson (George C. Scott). "Well, I don't think it's exactly fair to condemn an entire program because of a single blunder, sir," Turgidson replied. The Great Depression was a huge blunder.
Even if we ignore the Great Depression and compare the pre-Fed era to the post-World War II age, the Fed does not appear to be in good shape. Economists used to believe that the Fed had led real output to be less volatile after WWII than it had been before 1914. That's what would have happened if the Fed had reduced the frequency, duration, and depth of recessions. However, groundbreaking research by Christina D. Romer, an economist at the University of California, Berkeley, who later became chair of President Obama's Council of Economic Advisers, cast doubt on that view. Before 1914, Romer pointed out, the data used to evaluate volatility was nearly completely for commodities, whose output is more erratic. However, she discovered that output was less variable between 1869 and 1914 than after World War II when she looked at other components of gross national product (the metric often used until GDP was established in the 1990s). That's the end of the Fed's argument.
Business cycles and volatility are inextricably linked. But what about the recessions and depressions described earlier? Economist Joseph H. Davis examined two eras in a 2004 study published in the Quarterly Journal of Economics: the National Banking era, which spanned the years between the establishment of nationally chartered banks in 1862 and the establishment of the Fed, and the post–World War II era. He discovered no difference in the frequency and average duration of recessions. "The devastating deflationary depressions that reportedly followed the banking panics in 1837 and 1873 were actually quite modest recessions when expressed in real output," Davis discovered.
None of this implies that the banking institutions that existed before to the Fed were perfect. Restriction on branch banking was one set of regulations that was particularly detrimental. When depositors came in to receive their money, the bank was unable to obtain currency from other branches since, prior to the Great Depression, practically all banks were unit banks with no other branches to call on. There would have been a better effective banking system and less pressure to establish the Federal Reserve if branch banking had been permitted in the nineteenth and early twentieth centuries.
Wouldn't it be great if economists stopped telling the Federal Reserve how to be a central planner and instead questioned the concept of central planning as a whole?
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