Mises Daily Articles
Life with the Fed: Sunshine and Lollipops?
We have heard the objection a thousand times: Why, before we had a Federal Reserve System the American economy endured a regular series of financial panics. Abolishing the Fed is an unthinkable, absurd suggestion, for without the wise custodianship of our central bankers we would be thrown back into a horrific financial maelstrom, deliverance from which should have made us grateful, not uppity.
The argument is superficially plausible, to be sure, but it is wrong in every particular. We heard it quite a bit in the financial press several months ago when it was learned that Congressman Ron Paul, a well-known opponent of the Fed, would chair the House Financial Services Subcommittee on Domestic Monetary Policy. Fed apologists were beside themselves — a man who rejects the cartoon version of the history of the Fed will hold such an influential position? He must be made into an object of derision and ridicule.
My favorite example comes from columnist Joseph N. DiStefano, whose article on the subject is so defiantly at odds with the historical record, so ludicrously at variance with easily verified facts, that I thought for pedagogical purposes we ought to make an example of him.
DiStefano spends most of his article on the current crisis, but, having written quite a bit about that already, I prefer to spend most of mine on the cartoonish version of American monetary and banking history that seems to inform every outraged pro-Fed reply to Fed critics, this one being no exception. They read like fourth-grade book reports. Except DiStefano didn't even read the book.
The premise is familiar enough: Why, without a central bank or its lesser cousin, a national bank, we had nothing but boom, bust, and sorrow — but since the creation of the Federal Reserve System, it's been nothing but sunshine and lollipops. It really is that simple. People who believe in a free market in banking, as opposed to these cartel arrangements, are evidently so uninformed or so blinded by ideology that they have never heard or internalized this one-sentence encapsulation of 19th- and 20th-century monetary history.
The 19th-century boom-bust cycles DiStefano mentions in drive-by fashion are consistently attributable to artificial credit expansion, a practice government either connived at or actually participated in, through the various privileges it granted to the banking industry.
First, let's consider DiStefano's 19th century. We are to believe that national banks were indispensable sources of stability, while their absence yielded terrible business cycles. How does DiStefano account for the Panic of 1819, which contemporaries attributed to the inflationary and then rapidly contractionary policies of the Second Bank of the United States, the great stabilizer? That's easy — he leaves it out. (He likewise leaves out the Great Depression from his discussion of the 20th century, an episode one might think would count against the Fed, and which was likewise set in motion by central-bank inflation; Benjamin Strong, who headed the New York Fed, told other central bankers in 1927 that he planned to "give a coup de whiskey to the stock market.") The standard account is Murray Rothbard's The Panic of 1819: Reactions and Policies (Columbia University Press, 1962).
DiStefano does mention the Panic of 1837, and for that episode we are urged to blame President Andrew Jackson for having dissolved the Second Bank of the United States. DiStefano does not deign to reveal what the causal mechanism might have been. The strong implication, based on the rest of his article, is that we need institutions with monopoly privileges to oversee our money, and if they should ever be forced to close because the stupid rubes don't understand how indispensable they are, the economy will crash. That's not much of an explanation, but it's all DiStefano chooses to share with us.
Funny, the economy hadn't crashed when the First Bank of the United States was shut down more than two decades earlier. When the charter of the original Bank of the United States expired in 1811, and the institution set about calling in its loans and closing its doors, the DiStefanos of the world made wild predictions of bankruptcy and economic collapse. Nothing of the sort occurred. A contemporary noted in 1816,
Many persons viewed a dissolution of the late Bank of the United States as a national calamity; it was asserted that a general bankruptcy must follow that event. The fact was otherwise: every branch of industry continued uninterrupted — no failures in the mercantile community were attributable to that occurrence.
DiStefano fails to mention any causal link between the closing of the Second Bank and the Panic of 1837, so I'll provide him with one. The most common argument is this: without a national bank to discipline the state banks, the state banks that received the federal deposits after the closure of the Second Bank went on an inflationary binge that culminated in the Panic of 1837 and another downturn in 1839. This standard diagnosis is partly Austrian, surprisingly, in that it blames artificial credit expansion for giving rise to unsustainable booms that end in busts. But the alleged solution to this problem, according to modern commentators, is a robust central bank with implicit regulatory powers over smaller institutions.
Senator William Wells, a hard-money Federalist from Delaware, had been unconvinced from the start that the best way to encourage sound practices among smaller unsound banks was to establish a giant unsound bank. "This bill," he said in 1816,
came out of the hands of the administration ostensibly for the purpose of curtailing the over-issue of Bank paper: and yet it came prepared to inflict on us the same evil, being itself nothing more than a simple paper making machine; and constituting, in this respect, a scheme of policy about as wise, in point of precaution, as the contrivance of one of Rabelais's heroes, who hid himself in the water for fear of the rain. The disease, it is said, is the Banking fever of the States; and this is to be cured by giving them the Banking fever of the United States.
Another hard-money US senator, New York's Samuel Tilden, likewise wondered,
How could a large bank, constituted on essentially the same principles, be expected to regulate beneficially the lesser banks? Has enlarged power been found to be less liable to abuse than limited power? Has concentrated power been found less liable to abuse than distributed power?
A much better solution recommended by hard-money advocates at the time is what became known as the "Independent Treasury," in which the federal deposits, instead of being distributed to privileged state banks and used as the basis for additional rounds of credit creation there, were retained by the Treasury and kept out of the banking system entirely. Hard-money supporters believed that the federal government was propping up (and lending artificial legitimacy to) an unsound system of fractional-reserve state banks by (1) distributing the federal deposits to them, (2) accepting their paper money in payment of taxes and (3) paying it back out again. As William Gouge put it,
If the operations of Government could be completely separated from those of the Banks, the system would be shorn of half its evils. If Government would neither deposit the public funds in the Banks, nor borrow money from the Banks; and if it would in no case either receive Bank notes or pay away Bank notes, the Banks would become mere commercial institutions, and their credit and their power be brought nearer to a level with those of private merchants.
DiStefano is convinced that the movement against the Bank was led by antimarket, antiproperty populists. "Last time we had a central bank," he writes, "its advocates were conservative, hard-money businessmen, and its opponents were subprime borrowers and lenders who convinced President Jackson the bank was holding back the nation." That is as wrong as wrong can be, as we'll see in a moment. DiStefano proceeds from this error to the false conclusion that supporters of the market economy then as now should be supporters of the central bank.
To be sure, opponents of the Second Bank of the United States were no monolith, and even today the central bank is criticized both by those who condemn its money creation as well as by those who criticize its alleged stinginess. On balance, though, the fight against the Second Bank was a free-market, hard-money campaign against a government-privileged paper-money producer. "The attack on the Bank," concluded Professor Jeff Hummel in his review of the literature, "was a fully rational and highly enlightened step toward the achievement of a laissez-faire metallic monetary system."
We have already cited hard-money senators against the Bank. But for DiStefano to claim that the movement against the Second Bank was a movement of propertyless boobs who didn't understand banking, he would also have to be unaware of the most important monetary theorist of the entire period, William Gouge (mentioned above). Gouge was a champion of hard money who opposed the Bank; he considered these two positions logically coordinate, indeed inseparable.
"Why should ingenuity exert itself in devising new modifications of paper Banking?" he asked. "The economy which prefers fictitious money to real, is, at best, like that which prefers a leaky ship to a sound one." He assured Americans that "the sun would shine, the streams would flow, and the earth would yield her increase, if the Bank of the United States was not in existence." The conservative Bankers' Magazine, upon Gouge's death, said that his hard-money book A Short History of Paper Money and Banking was "a very able and clear exposition of the principles of banking and of the mistakes made by our American banking institutions."
DiStefano might also look into the work of William Leggett, the influential Jacksonian editorial writer in New York who memorably called for "separation of bank and state." Economist Larry White, who compiled many of Leggett's most important writings, calls him "the intellectual leader of the laissez-faire wing of Jacksonian democracy." He denounced the Bank for its repeated expansions and contractions, and for the economic turmoil that such manipulation left in its wake.
The Panic of 1819 was likewise due to such behavior on the part of the Bank, said Leggett, with a repeat performance in the mid-1820s. "For the two or three years preceding the extensive and heavy calamities of 1819, the United States Bank, instead of regulating the currency, poured out its issues at such a lavish rate that trade and speculation were excited in a preternatural manner." Leggett continues,
But not to dwell upon events the recollection of which time may have begun to efface from many minds, let us but cast a glance at the manner in which the United States Bank regulated the currency in 1830, when, in the short period of a twelve-month it extended its accommodations from forty to seventy millions of dollars. This enormous expansion, entirely uncalled for by any peculiar circumstance in the business condition of the country, was followed by the invariable consequences of an inflation of the currency. Goods and stocks rose, speculation was excited, a great number of extensive enterprises were undertaken, canals were laid out, rail-roads projected, and the whole business of the country was stimulated into unnatural and unsalutary activity.
But maybe the 19th century shows we need an institution capable of monetary "stimulus" to restore the economy to health following a crash. If so, the evidence isn't obvious. President James Buchanan engaged in no vain effort to reflate the economy in the wake of the stock-market crisis and bank run that constituted the relatively mild, six-month Panic of 1857 — which DiStefano, who is in a bit over his head when it comes to 19th-century economic history, calls a "howling depression." (That relatively mild downturn, incidentally, is attributable to the system of inflationary paper money, not the "gold standard"; as Buchanan said in his first annual message, "It is apparent that our existing misfortunes have proceeded solely from our extravagant and vicious system of paper currency and bank credits.")
Fashionable modern advice did not exist in Buchanan's day, and it showed. The economy recovered within six months, even though the money supply fell, interest rates rose, government spending was not increased, and businesses and banks were not bailed out. But Buchanan cautioned Americans that "the periodical revulsions which have existed in our past history must continue to return at intervals so long as our present unbounded system of bank credits shall prevail."
Buchanan envisioned a federal bankruptcy law for banks that, instead of giving legal sanction to their suspension of specie payments (that is, their failure to honor their depositors' demands for withdrawal), would in fact shut them down if they failed to make good on their promises. "The instinct of self-preservation might produce a wholesome restraint upon their banking business if they knew in advance that a suspension of specie payments would inevitably produce their civil death."
DiStefano makes specific mention of the 1870s, which once again reveals the superficiality of his knowledge. Unknown to DiStefano, the modern consensus holds that there was no "Long Depression" of the 1870s after all. Even the New York Times, which admits nothing, admits this:
Recent detailed reconstructions of nineteenth-century data by economic historians show that there was no 1870s depression: aside from a short recession in 1873, in fact, the decade saw possibly the fastest sustained growth in American history. Employment grew strongly, faster than the rate of immigration; consumption of food and other goods rose across the board. On a per capita basis, almost all output measures were up spectacularly. By the end of the decade, people were better housed, better clothed and lived on bigger farms. Department stores were popping up even in medium-sized cities. America was transforming into the world's first mass consumer society.
Perhaps DiStefano may concede in a candid moment that he unthinkingly accepted a caricature of the 19th century, but he'll still have his strong feeling that at least the Fed did away with financial panics. Not quite. Andrew Jalil of the University of California, Berkeley, concluded in a 2009 study that "contrary to the conventional wisdom, there is no evidence of a decline in the frequency of panics during the first fifteen years of the existence of the Federal Reserve." Elmus Wicker, in Banking Panics of the Gilded Age (2000), observes that
there were no more than three major banking panics between 1873 and 1907 [inclusive], and two incipient banking panics in 1884 and 1890. Twelve years elapsed between the panic of 1861 and the panic of 1873, twenty years between the panics of 1873 and 1893, and fourteen years between 1893 and 1907: three banking panics in half a century! And in only one of the three, 1893, did the number of bank suspensions match those of the Great Depression.
By contrast, there were five separate bank panics in the first three years of the Great Depression alone. (For these sources, see Selgin, Lastrapes, and White, "Has the Fed Been a Failure?")
Even during the pre-Fed panics, from the Civil War to 1907, the bank failure rate was small, as were the losses depositors suffered. Depositor losses amounted to only 0.1 percent of GDP during the Panic of 1893, which was the worst of them all with respect to bank failures and depositor losses. By contrast, in just the past 30 years of the central-bank era, the world has seen 20 banking crises that led to depositor losses in excess of 10 percent of GDP. Half of those saw losses in excess of 20 percent of GDP.
Moreover, the post–Civil War panics in the United States were due in large part to the unit-banking regulations in many states that forbade branch banking of any sort. Confined to a single office, each bank was necessarily fragile and undiversified. Canada experienced none of these panics even though it did not establish a central bank, DiStefano's trusted panacea, until 1934.
With regard to fluctuations both past and present, DiStefano implicitly gives us the classic pro-Fed position: business cycles occur spontaneously, and the Fed fixes them. We might call this the Fed as Innocent Bystander/Good Samaritan (IB/GS). DiStefano does not consider — not even to refute it, like an honest opponent — the Austrian argument that the Fed's manipulation of money and interest rates is what gives rise to the cycle in the first place. The Fed's palliative measures, in turn, amount to more of what caused the original problem. This was one of the points of my book Meltdown, the New York Times best seller that the New York Times pretended did not exist, which gave a free-market overview of the economic crisis as a counter to widespread DiStefanism.
(My reply is already longer than I'd prefer, so for the Austrian theory of the business cycle I refer readers to my Austrian resource page, and for the "TARP was a great idea" argument to economist Robert P. Murphy [PhD, New York University] and David Stockman.)
What would we do in such situations without the Fed? Under a more sound monetary system we would have far less violent fluctuations in the first place. And unsound firms would go bankrupt, as a former CEO of AIG later admitted would have been the best course of action after all. The world would not come to an end. If the market is freely allowed to reprice assets, which was the phenomenon we were terrified into not wanting to occur, that doesn't change the amount of physical stuff in existence. The assets themselves may be redistributed to new owners in bankruptcy proceedings, but the world has just as much stuff as it did before. Ownership titles are transferred, and a leaner outfit with more competent leadership moves the economy forward. An important lesson is learned for the future. Or we could be satisfied with DiStefano's solution, which is to keep Wall Street just as it is, without this salutary purge of leadership and capital, and without the corresponding change in entrepreneurial character that might yield a less debt-based and more equity-based business model and hence more stability in the future.
But the key problem with the DiStefano analysis is that it is no analysis at all. It takes the crisis as an irreducible given, and then launches into the IB/GS routine. The Austrian School argues that manipulation of interest rates causes discoordination across the structure of production, that this disfigured structure is unsustainable, and that the inevitable result is the bust. DiStefano gives us no reason to believe otherwise, or even to have confidence that he understands or even knows about the argument, an argument that won F.A. Hayek the Nobel Prize in 1974.
All these issues are covered in greater detail in the Fed chapter of my new book Rollback, which confronts the standard claims not just for the Fed but also for all the major areas of life we are told could not be managed without institutionalized coercion.
As with the Fed, so with these other things: critics of the status quo are reflexively condemned as cranks, and alternatives to the status quo are dismissed as unthinkable. But they are only unthinkable because we have allowed fashionable opinion to keep us from thinking them. We have been forced into a box that confines our choices to various forms of statism. The movement to end the Fed is an astonishing and most welcome first step toward clawing our way out.
Charles Calomiris, "Banking Crises and the Rules of the Game."
H.A. Scott Trask, "The Independent Treasury: Origins, Rationale, and Record, 1846–1861."
H.A. Scott Trask, "The Panic of 1837 and the Contraction of 1839–43: A Reassessment of Its Causes from an Austrian Perspective and a Critique of the Free Banking Interpretation."
George A. Selgin, William D. Lastrapes and Lawrence H. White, "Has the Fed Been a Failure?"
Thomas E. Woods, Jr., Rollback.