Can society survive and flourish without the Federal Reserve?
I read and enjoyed your book ‘Healing Our World: The Other Piece of the Puzzle.’ However, I am confused about the Federal Reserve.
The United States had a banking system without a central bank from 1830, when President Jackson closed the Second Bank of the United States, to 1913 with the passage of the Federal Reserve Act. Money was based on gold and silver from 1830 to 1860 when the Civil War forced President Lincoln to create unbacked paper money. Money returned to a gold standard in the 1870′s. From 1830 to 1913 there were three depressions (1839, 1873, and 1893) and several recessions and panics. The last quarter of the nineteenth century was mark by deflation, caused by the failure of the increase in the supply of gold to keep pace with the increase in the size of the economy.
From 1913 to the present we have had one depression, the worst in our history and several recessions. The only deflation we experienced was during the beginning of the Great Depression. Most of the time we have experienced mild inflation except in the 1970s when we had significant inflation. Additionally, since 1980 the Federal Reserve has performed independently of the politicians and, with a problematic beginning, controlled the money supply and inflation.
Mild inflation helps borrowers in particular and the economy in general, while mild deflation is bad for both. Comparing the two periods gives the Fed, one versus three depressions and mild inflation over mild deflation. The Federal Reserve has clearly outperformed a free market banking system. And its performance has improved over the century.
You point out that Scotland used a free market banking system in the first half of the nineteen century, but at that time Scotland was a small agrarian society, not readily comparable to even the industrialized United States of the late nineteenth century.
Looking at banking from economic theory, basic banking leads lenders to over-increase the amount of money in a boom, and decrease the amount of money in a bust. During a boom, all loans look good and banks create too many loans, inflating the amount of money. During a bust, all loans look bad and banks stop making loans, shrinking the amount of money and worsening the recession. I don’t like big government, but I see no other way to control the amount of money than a central bank. Specifically, interest rates must be lowered and the money supply increased during a recession. But in a recession banks, fearing the higher risk of defaults on loans, raise rates and decrease lending, which worsens a recession.
Finally, the Federal Reserve is the only department of the government I know of that actually makes a significant profit.
Am I missing something?
Modern banking is extremely complicated.
First of all, the Federal Reserve is a private banking organization, which has been given a legal monopoly on our currency by the same government that promises to protect us from monopolies. When the Fed manipulates the currency supply badly, the whole country suffers, as it did in the Great Depression. During that time, Canadian citizens lost only 3% as much as those of the U.S. Canada had a free banking system similar to the Scottish one. From this history, we can conclude that free banking works just as well in industrialized nations as agrarian ones.
During the 1800s, the U.S. had a regulated banking system without a central bank, not a free one. Regulations varied by state, but most required banks to use government bonds as part of their reserve. Before maturity, these bonds were often liquidated at a loss. Thus, the banks went under when faced with unusually high demands from depositors. Deflation caused by the resulting contraction in the money supply was rapid and destructive, just as deflation was during the Great Depression.
Some deflation, however, occurs when the production of goods and services becomes so efficient that prices drop, much as the price of computing power drops rapidly today. This type of deflation, like cheaper computing power, is obviously a boost to the economy, not a detriment. Much deflation of the late 1800s was due to this beneficial increase in efficiency.
When deflation is caused by the failure of the increase in the supply of gold to keep pace with in the increase in the size of the economy, gold becomes relatively more valuable, creating incentive to produce more. Mining generally continues until the balance between prices (including mining costs) and gold supply is restored.
Today’s inflation is caused by the central bank placing new money in the hands of the bankers and politicians faster than the economy creates wealth. These groups essentially pass GO; on the MONOPOLY game of life before the rest of us. Most consumers get the higher prices before they get the trickle-down; benefits of the new money. That’s why inflation is sometimes referred to as an invisible tax on consumers. Every decade, we lose approximately half the purchasing power that we would have otherwise had. Can you imagine what your life style would be if this buying power had not been taken from you?
Incidentally, Federal Reserve Chairperson Alan Greenspan, who is largely responsible for the mild inflation; that you applaud, advocated returning to the gold standard to avoid inflation altogether in the 1970s. To the best of my knowledge, he still holds that view.