The Fed is as the Fed Does
A review of A History of the Federal Reserve. Volume 1: 1913–1951 by Allan H. Meltzer, foreword by Alan Greenspan (University of Chicago Press, 799 pages).
Thomas Jefferson, an opponent of our first national bank, is reputed to have said that a national bank is a greater threat to liberty than a standing army.
Here, in this interesting book about the history of the first few generations of the Fed, is a work with countless illustrations of that Jeffersonian fear of political banks underwritten by governments. To read this book is like reading a kind of Pentagon Papers of American monetary history: It is a litany of failed policies and mistaken notions along with frequent calls for the Fed to obtain greater and greater powers despite its poor record.
Most economists agree that Fed policies in the wake of the crash were incredibly wrong policies that led to a banking crisis in 1930 and 1931.
Nevertheless, the book has one glaring weakness: It lacks an Austrian perspective on central banks. One senses that the relentless criticisms of the Fed in this book are designed to reform the Fed; that Meltzer is preparing a case for, as Milton Friedman has elsewhere, an automatic pilot that would restrain the ability of the Fed to carry out monetary mischief.
Many episodes of the latter are well documented in this work. The Meltzer/Friedman critique of the Fed is a kind of monetary glasnost. It criticizes the Fed in the interest of preserving the Fed. The Austrian view of the Fed is one that holds the Fed can't reform itself; that central banking is a system that is inherently corrupt. Liberty, as well as the health of our economy, is in danger as long as we have a central bank.
Possibly the biggest chapter in the Fed's sad record is the one on the Fed's wrongheaded policies leading up to and after the Great Crash of 1929. And here is where Allan Meltzer's book goes off the tracks.
Meltzer writes that the Fed consistently misread the signals just before the crash. It then contracted the money supply after the crash. This turned what might have been a short recession into the greatest depression in the nation's history. The first part of that analysis is right, but the second part is wrong.
"If the governors of the Federal Reserve had used the stock of money instead of interest rates as an indicator of monetary policy, they would not have concluded that monetary policy was easy," he writes of the Fed a few months after the crash. "Additional open market purchases at this time would have contributed to the expansion. Instead, the further contraction of money contributed to the decline in output and to the bank failures that came with increased frequency after this meeting" (page 298).
Here's where Meltzer runs straight into the Austrian view, a view that holds that central banks distort the production structure and create business cycles. When their policies fail, central bankers blame markets, speculators and any convenient target for the problems. They also, tacitly or overtly, inject bigger and bigger doses of inflation into the economy, even though this is what caused the problems in the first place.
Why did the Fed's policies of the 1920s and 1930s fail? Was it because the Fed contracted the money supply or was it, in fact, because the Fed, along with flawed fiscal policies pursued by the Hoover administration, was creating too much money and running huge deficits—the same policies now advocated by the Bush administration—thereby preventing the purging of malinvestments? The purging process had cured previous depressions, but this time the Fed and the administration were not going to let it happen.
At the time of the Great Crash and its immediate aftermath, the money supply seemed to be contracting, according to Meltzer. Actually, the Fed was furiously trying to expand the money supply. The money supply did decline in the first years of the depression, but this was not because of the Fed's actions but rather in spite of them. Banks were failing because people lost confidence and wanted their money. Foreigners lost confidence in the dollar and wanted gold. Hundreds of millions of dollars in the gold stock were lost in the early 1930s.
Also, Hoover was running huge deficits, trying to use the same Keynesian policies to rescue the economy, even though Keynes's famous book was still to be written. He wanted no part of the traditional purging of malinvestments. He wasn't going to let it happen. But market forces overwhelmed his policies. Hoover was enraged with those who wanted their deposits and wanted gold. He railed against "traitorous hoarding," writes Murray Rothbard in A History of Money and Banking in the United States: The Colonial Era to World War II. Indeed, Hoover even set up a task force, Rothbard writes, to fight those who would not play along with the inflation. "The battle front today is against the hoarding of currency," Hoover noted in 1932 as the depression droned on.
The Fed was doing its best to expand monetary supply—like today's Fed furiously cutting interest rates and getting nowhere—but it didn't work then just as it isn't working today. Nevertheless, Hoover and his supporters at the Fed blamed "hoarders" and others who could see the con games that were going on. This is no different than another generation that blamed "speculators" in the 1970s who bought hard assets and jettisoned dollars. They did so because they were smart enough to see the counterfeiting games of another Fed and a venal president, Nixon, who were happy to distort monetary policy for their own purposes.
In fact, the Fed's big open market purchases in the 1930–32 period "retarded the process of liquidation and reduction of costs." And that accentuated the depression, according to Professor Seymour E. Harris, who was cited in Rothbard's America's Great Depression. The Fed's pumping up process—seemingly so successful in the 1920s—no longer worked—just as it seemed to work in the 1990s and no longer works today.
Rothbard, in his monetary history, wrote that in a typical year in the 1920s, some 700 banks failed with deposits totaling $170 million. After the crash, the number was 17,000 banks a year, totaling some $1.08 billion in deposits.
The Fed's failure in the Great Crash and after—and remember the Fed came into existence in 1913 with the promise of avoiding just such economic peaks and valleys—is indisputable. This record started to attract the attention of many critics on both the right and the left over succeeding generations.
Even though Meltzer never calls for the abolition of the Fed, as many Austrian economists have, his book flies in the face of the mythology of a Fed that would end the business cycle. The Fed skeptics, in the 1920s, 1990s, and today, have been vindicated by history. Indeed, even Alan Greenspan, in a foreword to this book, restates the skeptical view of the Fed's Great Depression policies: "In Meltzer's view, the System's adherence to the real bills doctrine, combined with a belief that the purging of speculative excess was necessary to set the stage for price stability, led to the failure of monetary policy to lessen the decline."
The silence after this passage is deafening. Greenspan never challenges that view. One must conclude that the venerable chairman is in agreement that his predecessors botched things.
But then again this skepticism about central banks is as old as our republic. It is a frequent current of American history and could be a subtheme of this book, which was written by a former member of the President's Council of Economic Advisers.
Meltzer details countless mistakes made by our central bankers, some of them so ridiculous that one wonders why any economically literate person still has any trust in the Federal Reserve Board. So Meltzer's book could be cited by Austrian scholars who believe that central banks are inherently flawed and inflationary; that their record is one of disastrous inflations.
In my youth, I also lived through many of the mistakes of this seemingly unchallengeable government institution, which along with so many other flawed government institutions—Social Security, Amtrak and monopoly mail—are proving that giving government exclusive control over almost anything is a guarantee of failure.
The Fed's great failure in my youth was the perverting of monetary policy in the early 1970s. This rigging of money creation policy was designed to reelect Richard Nixon, which it accomplished (By the way, Nixon pressured his Fed chairman because he believed that the distortion of monetary policy had denied him the White House on his first try for the brass ring in 1960).
The mistakes of the Fed didn't end with the Great Crash. They continued with the flooding of the markets with currency to help Richard Nixon's reelection in 1972 and with the recent inflation of the 1990s; the latter two capers are beyond this first volume. I am eager to see how Meltzer deals with these notorious chapters in the succeeding volume of this work. However, the first years of the Fed were as fascinating and gruesome as exploring the origins of a train wreck.
The Fed's governors, says Meltzer, often erred because they failed to understand a basic principle of economics. Therefore, their money creation policies were—time and again—flawed. Fed governors, the author concludes in a devastating critique, "failed to distinguish between nominal and real rates of interest" (page 411).
From the above statement, based on Meltzer's years of research, I ask this: So how could the Fed ever get it right? Answer: The Fed couldn't.
The same mistakes are made today because we have the same system: A central bank that can create and distort business cycles through politically motivated monetary policies. I say the disastrous Fed policies of the 1920s and 1930s were possibly its biggest mistake because their errors in the great inflation of the 1970s were also egregious. Remember stagflation and the damage it did to almost everyone? And, of course, the so-called recession we're living through bears several similarities to a crash.
Will the latter turn out to be worse than the Great Depression of the 1930s or the great inflation of the 1970s? I think it's too soon to say yes or no. President Bush seems to be proceeding much the same way as Richard Nixon did: Distorting monetary and fiscal policies for political ends. The election of 2004 could bear many similarities to the reelection of Richard Nixon in 1972.
Here's how the scenario goes. Dump more inflation into the economy and create another Potemkin Village economy just in time for re-election. Then have our nation pay the price once the president and his party are safely back in power. (Our economy looked great in 1972. One year later it was a disaster).
Still, it's not too soon to say that this economy has been another huge train wreck. The blame must go to the central bankers and most Americans. Many of us are the enablers. Many of us, who in the 1990s practically worshiped Alan Greenspan and his cohorts, seemed to be believe these monetary magicians could do no wrong and would provide endless prosperity. Three years later, with a staggering economy and stock market in front of us, it's tough for even the true believers to keep the faith.
Jefferson and others in American history sought to warn us of the dangers to liberty of state banks. Yet their warnings and the arguments of others for free banking, which call for poorly run banks to fail, have been largely ignored in the last century as America joined the central bank religion.
I don't think the purpose of Meltzer is to encourage Americans to consider the unthinkable: the Fed is dangerous to our economic and political health; that it should go. But maybe, just maybe, this flawed book may reignite a debate that goes back to Jacksonian America. If a central bank is, in fact, a favored political instrument that puts almost all of us at risk, then maybe it should be disbanded along with the huge military establishments that Jeffersonians believed were inimical to the liberties of a free people.
Gregory Bresiger, a business writer living in Kew Gardens, New York, holds a graduate degree in history from New York University. firstname.lastname@example.org. See his archive. For an alternative history, see Murray Rothbard's A History of Money and Banking in the United States and The Case Against the Fed.