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The Fallible Fed

Mises Daily: Monday, July 09, 2001 by

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Austrian economists, I believe, understand the Federal Reserve System like no other people because they despise it so much.  In fact, Austrians condemn central banking in general because they recognize that these institutions are set up primarily to fund profligate spending by politicians and to rescue banks from their own bankruptcy.

Outside the Austrian School, however, central banks often seem to wear a halo.  Historians praise them, most mainstream economists support them, and politicians quickly discover that they cannot exist without them.  This does not mean that these folks actually understand central banking.  In fact, most economists, having been schooled in either Keynesianism or monetarism or both, have a general idea of what the Fed does, but they are so woefully ignorant in financial matters that their "knowledge" proves to be less than worthless.

People trained in finance, unfortunately, are generally agnostic when it comes to knowing much about economics per se.  Thus, the modern world of economics and finance gives us the worst possible combination: economists who don’t understand financial instruments and financial "experts" who don’t comprehend economics.  Out of this witch’s brew come modern fiscal and monetary policies that emanate from Washington and nearly every other capital of the world.

Martin Mayer, who has distinguished himself in earlier works—and who was one of the few financial journalists who actually understood the roots of the 1975 New York City financial crisis—has attempted to shed some light on the Fed—and generally succeeds—in The Fed: The Inside Story of How the World's Most Powerful Financial Institution Drives the Markets (The Free Press, 2001).

I agree with Gene Epstein of Barron’s, who believes that a reader will learn more from Murray Rothbard’s The Mystery of Banking.  Rothbard was well-known for his everlasting hatred of the Fed (which, I may add, was well-deserved).  Mayer, on the other hand, while not worshipful of our august central bank, cannot quite bring himself to condemn this monstrosity, either.  

Unlike so many others, who have written about the Fed in hushed, reverent tones, Mayer does admit that, for all of the hype that politicians and the press give the Federal Reserve System, "a lot of them don’t know what they’re doing."  If he were absolutely honest, he could include Alan Greenspan himself in that group of the blind who are leading the blind.

For someone not trained in finance (like me), The Fed is quite helpful if one wishes to understand just what is going on in the markets and in banking today.  For all of the mysteries and complicated formulas surrounding modern finance, it is really quite simple: Securities must be "backed" by assets.  Once upon a time, the bedrock asset in the financial system was gold.  Today, it is debt, and, most ominously, it is government debt.  As I explained twenty years ago to an incredulous group of middle-school students who still believed that we were on a gold standard, the "backing" of money in this country is based upon the "ability" of the government to go into hock.

Furthermore, the Fed was created to back up the system of fractional reserve banking, which Rothbard and other Austrians have correctly defined as being legal fraud.  State authorities prosecute and punish polygamy, but they tremble before the "majesty" of the bank, which simply commits a form of polygamy with the money of its depositors.

If one is a Fed-watcher (which I admit to be from what I wish were a safe distance), then The Fed is important reading.  Mayer seems to mostly understand modern money and banking—even though his analysis is hardly Austrian.  He also allows the reader to see just how the Fed, like an octopus, has been able to slowly but surely extend its arms over the entire financial system, much of the permission to expand given it by Congress in the aftermath of crises generally spawned by the Fed itself.  In addition to Mayer’s explanation of the Fed and its actions, his chapter on central banks is important reading for those who don’t understand why governments more than three centuries ago began to originate them.

When the Fed was formed in 1914 (after being created by Congress the year before), its primary purpose was to serve as a "banker’s bank," an institution that would provide "liquidity" to banks in order to ward off periodic runs that would generally plunge the economy into recession.  The push to create the Fed, while strong since the end of the Civil War, became even stronger after the panic of 1907, which occurred after the Knickerbocker Trust Company in New York failed in the wake of a stock-market bubble that burst.

From its humble beginnings as primarily a decentralized backup system encompassing twelve districts across the United States (which are still in place today), the Fed quickly gained importance during World War I as a huge holder of short-term government debt.  Its place secured by its WWI performance, the Fed went on to quickly inflate the currency, leading to the short but drastic recession of 1920 and 1921.  Led by Benjamin Strong, the head of the New York Federal Reserve Bank, the Fed really turned on the crank during the 1920s in order to prop up the British pound, which had been unwisely set at its pre-WWI exchange rate.

The Austrians, especially Rothbard, have documented all of this, of course  (e.g., see Rothbard's article "The Origins of the Federal Reserve"). However, it is nice to read an outsider who gives us an account that differs from the disinformation which comes from Milton Friedman and the monetarists, that the decade of the 1920s was a "golden age" of the Fed and that, had Benjamin Strong not died of tuberculosis in 1928, the Fed would have simply provided "much-needed" liquidity into the system after "Black Thursday" on Wall Street in October 1929.

Furthermore, Mayer helps puncture the contention by Friedmanites that aggressive purchase of government bonds would have ameliorated the crisis of the early 1930s by noting that the problem was not necessarily a lack of liquidity or bank reserves, but rather that the whole system was falling apart and a few loans by already bankrupt banks would not have fixed things.  

Mayer, unfortunately, does not tell us that Herbert Hoover’s own "fiscal" policies—including the encouragement of wage and price rigidities; the disastrous Smoot-Hawley Tariff, a "gift" from Congress in 1930; and the unwise doubling of the tax burden in 1932—played a major role in pulling healthy firms into the abyss of the Great Depression.

The author goes on to describe the different Fed chairmen, from Mariner Eccles, Franklin Roosevelt’s appointee, to the latest monetary dictator, Alan Greenspan.  As one might expect from a book that attempts to give a detailed history of the Fed, there is much more information than I can ever lay out in a brief review such as this.  While Mayer might be supportive in general of the Federal Reserve System, he certainly does not regard the players in the system as demigods, and he still knows at least some fraud when he see it.

In describing the antics of Jimmy Carter’s administration, as well as the Ronald Reagan follies, Mayer gives us a mixed picture.  He correctly criticizes Friedman’s view, that somehow the Fed can coordinate monetary policy that money can grow at a planned maximum of 3 percent a year.  Then, however, he goes on to tell the reader that inflation is not a monetary phenomenon.  More specifically, he says Friedman claims that inflation is a monetary phenomenon, and then he leaves it at that, implying that such a belief is stupid and naïve.

If inflation is not tied to money, then what else is there?  Furthermore, Mayer claims that Friedman and his followers had a naïve view of Say’s Law, which he wrongly says is the belief that whatever is produced is automatically sold, end of story.  He goes on to say that those who believe in Say’s Law hold that free markets automatically and immediately correct themselves, as though Carl Menger, Ludwig von Mises, Rothbard, and other Austrians never existed.  

As others and I have written on Say’s Law, it is an acknowledgement that one can only consume what one can produce, which is the bane of any kind of government policy to "increase aggregate demand" by increasing the supply of money.  Friedman’s scheme to replace the Federal Reserve with a computer has nothing to do with Say’s Law, and someone as adept at understanding finance as Mayer should have instinctively understood that.

Mayer also allows his animosity toward gold to show, which I believe further discredits some of his analysis.  He describes Greenspan’s 1966 article on gold in Ayn Rand’s The Objectivist as "a truly nutty screed," in which Greenspan correctly identifies the source of the state’s antagonism toward gold—that gold prevents the willy-nilly funding of the confiscatory welfare state.

Mayer’s hatred of gold also has him taking shots at U.S. Representative Ron Paul, of all people, calling Paul "a medical doctor infected with the gold bug."  Since Paul is one member of Congress—and maybe the only one—who shows that rare trait of integrity, it is sad to see Mayer treating him so shabbily.

The author demonstrates monetary ignorance elsewhere.  On page 221, he writes:

There remains a mystery to haunt the dreams of central bankers, because nobody knows why monetary stimulus becomes consumer price inflation in one country and asset inflation in another.  For the followers of Milton Friedman, the strikingly successful result of monetary policy in the United States in the early 1990s has a bittersweet taste, for the Master had always insisted that monetary stimulus inevitably showed up (perhaps after a lag) as an increase in consumer prices.  And inflation in America remained dormant.

Such a statement is beyond mere ignorance, since Austrians have been answering that very issue for years.  Mises, Hayek, Rothbard, and modern Austrians including Joseph Salerno have clearly pointed out the answers that seem to have so eluded Mayer.  But, then, Austrians understand money, and Mayer does not.

I must admit that one thing I have taken from this book is that the financial system is much more fragile than even I had thought it to be.  Modern economists from Keynesians to monetarists believe that, as long as the Fed follows expansionary monetary policies in a downturn, depression is not possible.  

To be more specific, while Japan sits mired in recession despite interest rates of near zero, while the other Asian "tigers" are recovering from the banking and financial disasters of four years ago, and while the Euro slowly sinks despite efforts by European central bankers, Americans seem to be pretty smug in their belief that "it can’t happen here."  The dollar, after all, is the de facto world currency, and all we have to do in a crisis is to print more dollars.

Austrians are skeptical of this reasoning, and well they should be.  Only thirty years ago, and twenty-five years after the U.S. stood alone after World War II, the dollar was a joke; it received the same treatment at some overseas currency exchanges that North Korean money receives today.  It was not its natural destiny that the dollar recovered after the disastrous policies of the 1970s; rather, it was the cessation of inflation and the liberation of the U.S. economy during the 1980s from some of the worst Depression-era regulations that placed the dollar atop the heap.  

While Americans are loathe to admit it, loose money means loose lending policies, which mean the inevitable spate of bad loans.  Furthermore, loose money means inflation and destabilization, which means that a large number of those risky loans won’t be paid back in a timely manner—if at all.  Members of Congress, who are not the brightest apples in the bunch anyway, find their eyes glazing over when faced with the complication of financial schemes.  Thus, the Fed, bankers, and others who are game for what in reality is something akin to financial fraud go on their merry way, unencumbered by Congress, the law, or anything else that would serve as a brake for their foolishness—or so they believe.

However, free markets still have the final word.  One can concoct whatever financial scheme one may choose, but in the end it still comes down to assets and liabilities.  Unsound policies soon create conditions where liabilities outnumber the assets, and someone must pay the piper.

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William Anderson, adjunct scholar of the Mises Institute, teaches economics at Frostburg State University. anderwl@prodigy.net. See Anderson's outstanding Daily Article Archive. Buy the book