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Don't Blame the Federal Reserve

Mises Daily: Tuesday, December 15, 2009 by

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Greenspace and Bernanke

Long ago I quit criticizing the Federal Reserve chairman for failing to avert the latest systemic financial disaster, though I still pity him for enduring the endless Socratic essays, polemics, and indignant soliloquies of his detractors. Criticizing the Fed chairman for a lack of prescience is like criticizing a dog for an inability to recite the alphabet. When something is physiologically impossible, why bother?

But many people do bother, and they bother by retreading the same opposing laments: insufficient regulation or misguided regulation; too much liquidity or too little liquidity; too-low interest rates or too-high interest rates; excessively political or insufficiently political. No one can get Fed policy right, and no one does. Every five to seven years it's déjà vu, as an economic calamity erases vast swaths of financial wealth.

"Regulatory reform" is the first term to fire in the synapses of the nation's economists and op-ed scriveners whenever the Federal Reserve fails to fulfill its charter. The theme is the same and the writing is predictable — indignation draped in snarky prose importuning that regulation be reformed to the writer's specifications.

And yet with all this mental horsepower plowing the fecund fields of regulatory introspection, so little of it unearths the argument for eliminating financial regulation altogether.

Regulators — Federal Reserve or otherwise — are stasis-oriented, rear-view-mirror-focused bureaucrats charged with overseeing the forward-looking financial entrepreneurs. The entrepreneurs are smarter and nimbler. They easily capture the regulators and bend them to their will. This is a mismatch on a Washington Generals–Harlem Globetrotters scale.

Furthermore, government regulations dull the conscience. Regulation dictates that principles give way to rules: "Nothing in the regulations stated we shouldn't have written a hundred credit-default swaps on every triple-A-rated collateralized debt obligation, so we did nothing wrong."

But, the regulatory reformers say, the Federal Reserve is unique because money is unique. Money, unlike other goods and services, is a facilitator that requires oversight; therefore it must fall under the purview of a central bank. The argument is the culmination of 96 years of political inculcation. It has proven very persuasive, and very wrong.

In reality, money is as easily supplied by the free market as any other good. The bottom-up approach of private markets "regulating" goods and services is unquestionably superior to the top-down government approach, so why not apply the bottom-up approach to money?

"Money, in essence, is debt, with supply dictated by loan demand."

The monetarists argue that a top-down central bank guarantees monetary stability. Well, sure if your definition of stability is a grinding erosion of value through incessant inflation: today's dollar is worth $0.19 in 1971 dollars (the year the United States officially dropped any pretense of abiding by a gold standard) and worth only a nickel in 1913 dollars (the year the Federal Reserve was voted into existence).

If money and banking were removed from the purview of the Federal Reserve and placed under the purview of the free market, two key events would occur: First, we would see a return to commodity-based (most likely gold and silver) money, which would transform our butterfly-floating, unpredictable, though always depreciating, currency into a precise, stable measure of commodity weight. Second, money supply would no longer be a function of debt creation.

Banks operate under a fractional-reserve system that allows them to create liabilities and money virtually at will. This system expands money beyond what it would otherwise be and guarantees inflation by pushing the broad money supply far beyond the base money. Money, in essence, is debt, with supply dictated by loan demand.

A full-reserve scheme would prevent banks from lending phantom money. Banks' primary functions would be bifurcated into money warehousing and deposit lending. As warehouses, banks would collect fees for storing deposits, with the deposited funds always available to the depositor. As deposit lenders, banks would accept time deposits to lend. The depositor would earn interest for the use of his money, while the bank would earn the spread between the rate it paid to depositors and the rate it charged its borrowers.

Insufficient credit is the first and most voluble objection to a full-reserve banking system. This shortage may or may not occur. If it did, no problem — private finance companies would arise to fill the credit void. They wouldn't accept deposits, instead they would raise funds by issuing equity and debt. These companies would be free to specialize and lend to what their charters dictate.

"A full-reserve system would facilitate credit flows while separating money from credit creation."

A full-reserve system would facilitate credit flows while separating money from credit creation. Therefore it would inject safety and stability into the credit system. Banks would require less equity to cover the risks associated with matching assets and deposits. Depositors would no longer fear bank runs: banks would carry reserves to cover all demand withdrawals. Banking panics, banking crises, and taxpayer-funded banking bailouts would be relegated to historical footnotes. We would no longer need a lender of last resort.

What's more, a stable lending environment, a commodity-based money, and a full-reserve banking system would release a deluge of domestic capital and attract a flood of foreign capital. Creditors and equity investors would no longer need to game inflation's corrosiveness or predict where our butterfly-floating currency will land. Inflation premiums and currency risk would be stripped from the cost of capital.

Albert Einstein defined insanity as doing the same thing over and over again and expecting different results. It's at least a little insane to repeatedly expect the Federal Reserve to do what's impossible when the free market can do what's desired.