A Quick Case Against the Fed

I recently participated in another ZeroHedge debate, this time against my opponent David Beckworth on whether Americans should support the abolition of the Federal Reserve. Because our initial opening statements were tight on time, I’ll spell out a case against the Fed in this blog post—but I’ll still make it quick.

My strategy here is to hit three main categorgies of critique: First, the Fed’s founding itself was based on deception, as everybody (even the Fed itself) admits. Second, even on its own metrics, the Fed in practice has delivered worse performance than the pre-Fed era. And third, the Fed represents a dangerous hybrid of a quasi-private institution, which benefits from government privileges but lacks the transparency and accountability of typical government agencies.

The Fed’s Dubious Founding

The following excerpt comes from an essay that the Federal Reserve itself posted on an affiliated website, in celebration of its centennial:

In November 1910, six men—Nelson Aldrich, A. Piatt Andrew, Henry Davison, Arthur Shelton, Frank Vanderlip and Paul Warburg—met at the Jekyll Island Club, off the coast of Georgia, to write a plan to reform the nation’s banking system. The meeting and its purpose were closely guarded secrets, and participants did not admit that the meeting occurred until the 1930s. But the plan written on Jekyll Island laid a foundation for what would eventually be the Federal Reserve System.

…

By the fall of 1910, Aldrich was persuaded of the necessity of a central bank for the United States. With Congress ready to begin meeting in just a few weeks, Aldrich—most likely at Davison's suggestion—decided to convene a small group to help him synthesize all he had learned and write down a proposal to establish a central bank.

…

A member of the exclusive Jekyll Island Club, most likely J.P. Morgan, arranged for the group to use the club’s facilities…Munsey's Magazine described it in 1904 as “the richest, the most exclusive, the most inaccessible” club in the world.

Aldrich and Davison chose the attendees for their expertise, but Aldrich knew their ties to Wall Street could arouse suspicion about their motives and threaten the bill’s political passage. So he went to great lengths to keep the meeting secret, adopting the ruse of a duck hunting trip and instructing the men to come one at a time to a train terminal in New Jersey, where they could board his private train car. Once aboard, the men used only first names—Nelson, Harry, Frank, Paul, Piatt, and Arthur—to prevent the staff from learning their identities. For decades after, the group referred to themselves as the “First Name Club.” [“The Meeting at Jekyll Island,” Gary Richardson and Jessie Romero, bold added.]

As the above history illustrates, the main crafting of what would become the Federal Reserve Act was hammered out in a secret meeting that the organizers knew would arouse public suspicion and threaten passage of the legislation. 

If the founding of the Fed was dubious, let’s now turn to objective measures of its performance.

The Fed’s Abysmal Track Record 

To assess the Fed’s track record, we can consult a 2012 paper by Selgin, Lastrapes, and White. I want to emphasize that the Selgin et al. paper was not an ideological hit piece; it was published in the peer-reviewed Journal of Macroeconomics. Furthermore, the underlying data sets they relied upon were quite standard in the literature, and even the “revisionist” figures on historical GNP—which argued business fluctuations weren’t as severe in the late 1800s as economic historians had previously believed—come from the work of Christina Romer, who was the head of Obama’s Council of Economic Advisers and is hardly a laissez-faire apostle.

On the criterion of price stability, it’s not even close. As Selgin et al. report:

[F]ar from achieving long-run price stability, it has allowed the purchasing power of the US dollar, which was hardly different on the eve of the Fed’s creation from what it had been at the time of the dollar’s establishment as the official US monetary unit, to fall dramatically. A consumer basket selling for $100 in 1790 cost only slightly more, at $108, than its (admittedly very rough) equivalent in 1913. But thereafter the price soared, reaching $2422 in 2008… 

Now it’s true, as Selgin et al. concede, that (at least in some studies) the predictability of the annual rate of price inflation was better after the creation of the Fed than before. However, the authors go on to point out that the price level itself was still far more predictable before the Fed was founded, than after. What’s happening is this: Before the Fed, the US was still on a gold (and for some of the period, silver) standard. So even if there were periods of high consumer price inflation (such as during the Civil War, when the authorities suspended the dollar’s tie to gold), they would eventually be followed by periods of price deflation, in order to restore dollar:gold parity.

In contrast, after the founding of the Fed—and especially when Richard Nixon severed the last link between the USD and gold in 1971—if there were a few years of rampant price inflation, there was no in-built mechanism to ensure subsequent years of deflation.

So to summarize, in the pre-Fed era, even though the year-to-year consumer price inflation rate was more volatile, the long-run purchasing power of the dollar was much more predictable. And that’s what the average business person or investor needs to know, for confidence in making long-term investment plans. If someone is going to lend $1,000 for ten years, he doesn’t care so much about (say) the rate of inflation in Year 8. Rather, he wants to know the cumulativeamount of inflation during the decade, to gauge how much weaker those Year 10 dollars may be upon repayment, when deciding on how much interest to charge (or whether to make the loan at all).

Finally, when giving a score for the Fed, we can consider the metric of macroeconomic stability. Here again, it’s not even close. Consider the following table from Selgin et al.: 

The first five columns in the table above report output volatility (measured as percentage standard deviation from trend growth, using the Hodrick-Prescott filter familiar to macroeconomists) for different time periods. Column (1) is taken as the proxy for the pre-Fed era, because it covers the period 1869-1914. (The Federal Reserve Act was signed into law in late 1913, and the Fed got up and running in 1914.)

Because of the data availability for Selgin et al.’s paper, the full post-Fed era is column (2), covering the period 1915-2009. Another column of interest is (4), covering the post-World War II Fed regime of 1947-2009.

The final four columns in the table show various ratios, which let us compare output volatility in the various eras. I’ve highlighted (2)/(1), which is the best measure of Fed versus pre-Fed. Any value above 1.000 means the Fed performed worse, because output volatility was higher in 1915-2009 than in 1869-1914. As the table indicates, whether we use the standard historical estimates of GNP, Romer’s revised estimates (which show the late 1800s were not as volatile, due to her more nuanced handling of price deflators), or whether we use Balke-Gordon’s data, the full Fed period was definitely worse.

This is not surprising. The most volatile economic episode in US history was the Great Depression of the 1930s, which began a full 15 years after the Fed was formed. And the second most volatile is arguably the Great Recession which began in late 2007—again, clearly on the Fed’s watch.

As one final comment, note that even if we throw out WW2 as a Mulligan, and only assess the Fed’s performance from 1947-2009, if we use Romer’s estimates then the post-WW2 Fed era is still 0.959 as volatile as the pre-Fed era. In other words, even if we put aside the Great Depression and chalk that up to the Fed’s learning curve, according to Romer’s data set, economic output under the Fed is a mere 4% less volatile than the pre-Fed era.

Secrecy and Corruption

As one last category of critique, in the ZeroHedge debate I emphasized the lack of transparency of the US central bank. In contrast to other regulatory agencies like the FDA, the Federal Reserve is not an official department of the US executive branch. Indeed, the Fed is a quasi-private organization that is literally owned by its member banks—they own actual shares of stock in the Fed and receive dividends. Even though many Americans believe that there is far too cozy of a relationship between “Big Pharma” and the FDA, it’s not as if pharmaceutical companies literally own the agency that regulates them.

In the debate I mentioned this amazing episode, highlighting the lack of transparency at the Fed: In December 2008, a few months after the onset of the global financial crisis, chair Ben Bernanke was testifying before Congress on the emergency liquidity programs that the Fed had established. After explaining that the Fed had advanced many billions of dollars in short-term financing to various institutions, someone asked Bernanke if he could disclose the recipients of these funds.

Bernanke responded by saying that if the public learned which banks had used the new Fed facilities, then the public would be alarmed that these banks were sitting on “toxic assets” and would try to withdraw their money. This would cause runs on the troubled banks and thus defeat the entire purpose of the program, which was to restore stability and confidence in the banking system. And so, Bernanke concluded, he would not even tell members of Congress which banks had been borrowing billions of dollars from the Fed—some of which, we later learned, turned out to be foreignbanks.

Conclusion 

I am a proponent of voluntary, market-based transactions. Just as I would oppose a Ministry of Oil setting crude prices, so too do I oppose a central bank setting interest rates. In practice, the Fed has destroyed the value of the dollar, and promoted greater instability in the macroeconomy. Finally, the Fed gives us the worst of both worlds when it comes to government agencies—Congress grants the Fed special privileges denied to other banks, yet also shields the Fed from public scrutiny. I wouldn’t want the Fed’s powers to be in the hands of Treasury officials, but at least if they were, the public would know who to vote out in the next election. The citizens have no such recourse with the “independent” central bank.

Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together Whole Life insurance policies and digital blockchain-based issuance.

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