The Federal Reserve has been getting a lot of attention in the last few months. With the recent housing meltdown and market volatility, it’s hard to miss the articles in the financial press. Some have blamed the Fed for causing the housing bubble, and others have argued that the Fed should take action to provide some relief. Meanwhile, one of the 2008 presidential candidates, Dr. Ron Paul, has long argued for abolishing the Federal Reserve and returning to a gold standard of the kind used around the turn of the century (as opposed to the Bretton Woods system which was in place from 1946-1971). Would that really restore financial stability to the economy? Volumes have been written on this subject, but I will try to at least summarize my own views without reciting every monetary theory in existence.

The Liquidity Problem

A bank works by taking the deposits people make and loaning most of that out to other people, so that not all deposits are available for withdrawal. Managing a bank’s liquidity involves making sure the bank can meet its obligations without incurring unacceptable losses. If people panic and start withdrawing their money, the bank has to somehow make good on those withdrawals. This might involve selling investments, selling loans, calling in outstanding loans, or borrowing from other banks. When those measures are exhausted, the bank is insolvent.

During the late 19th and early 20th century, the United States experienced a series of financial panics that resulted in runs on banks. The Panic of 1907 was the fourth panic in 34 years, and it set the wheels in motion for the creation of a new central banking system (the 3rd attempt in US history). The entrepreneur F. Augustus Heinze and his Knickerbocker Trust are generally considered to be the main players in this panic. David Fettig writes:

At the turn of the century the banking industry felt threatened by the new trust companies (and their young, wealthy financiers) and decided to sway public and congressional opinion by making an example of a trust company with connections to Heinze, namely, Knickerbocker Trust. If Knickerbocker Trust would falter, then Congress and the public would lose faith in all trust companies and banks would stand to gain, the bankers reasoned.

“Silent runs” began on Heinze’s bank and Knickerbocker Trust, and Heinze made a questionable loan to his brothers, who were faltering as owners of a copper company. In October 1907, Heinze’s brothers made a failed attempt to corner the copper market on the stock exchange, which allowed a competitor to exploit the Heinze family’s financial problems. Heinze was then forced to resign as president of his bank, “scare headlines” appeared in newspapers, runs started on both Heinze’s bank and Knickerbocker Trust, and both institutions were initially denied financial aid to keep from failing’”each event purposely caused, according to [biographer Sarah McNelis].

“The panic had long since been decreed and prepared and was inevitably on its way … The Clearing House refused to help and [Knickerbocker Trust] had to close its doors. Charles Barney, its president, shot and killed himself that night and runs started on nearly every bank and trust company in New York,” wrote one of Heinze’s brothers.

Several of the bank’s oustanding depositors shot themselves in the following weeks as well. The Panic of 1907 ensued, and it contributed to an ongoing decline in the stock market. Thus, a purposeful financial attack by some banks against others for political gain resulted in a nationwide economic crisis. Banker J.P. Morgan managed to organize a team of bankers and trust executives who directed money between banks and secured additional credit, effectively ending the crisis within a few weeks.

The Liquidity Solution?

Congress created the National Monetary Commission the following year, largely as a result of the panic, though many scholars would point to additional political motives as well. It issued 30 reports that eventually became the basis for the Federal Reserve, which was created in 1913. Initially, the role of the Fed was mainly as a lender of last resort. If a bank could not achieve sufficient liquidity via other means, but was otherwise financially sound, it could borrow money from the Fed to meet its obligations. This would dampen the effects of any future panics. After World War I, the Fed was given the power to both create and destroy money.

Unfortunately, study of monetary policy was a very young discipline at the time. The Fed experimented with the money supply throughout the 1920s, creating a bubble. Then the stock market crashed in 1929 and the Great Depression began. At the time, economists found it hard to explain the causes, and the Great Depression was generally considered to be market failure. Decades later, Milton Friedman and Anna Schwartz would show that the Federal Reserve had actually caused the Great Depression through a dramatic shrinkage in the money supply.

Today it is well understood that when the economy shows signs of recession, the Fed greases the gears by increasing the money supply. When the stock market crashed in 1929, they did the exact opposite. The money supply contracted by 2.6% over the next year, sending the economy into a deep recession. When banks began failing, the Fed raised the discount rate, reducing bank liquidity. Since this made it harder for banks to borrow from the Fed, they started hoarding cash and calling in loans in order to meet liquidity requirements, forcing borrowers into bankruptcy. The Fed responded by making it even harder for banks to borrow. About 10,000 banks failed, the deposits evaporating and further reducing the money supply. Friedman and Schwartz wrote:

The central banking system, set up primarily to render impossible the restriction of payments by commercial banks, itself joined the commercial banks in a more widespread, complete and economically disturbing restriction of payments than had ever been experienced in the history of the country.

The Fed has also been blamed for the severe inflation of the 70s, the tech bubble, and the recent housing bubble, among other things. The current chairman of the Fed, Ben Bernanke, said in a 2002 speech:

I would like to say to Milton [Friedman] and Anna [J. Schwartz]: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

Central Banking vs Gold Standard

It’s nice that the Fed is admitting past mistakes, and maybe we do know enough now to avoid another Great Depression. But the Fed still seems to be creating bubbles which later burst and inflict economic hardship. The Fed also usually implements an inflationary monetary policy. Anyone who has done some retirement planning knows that one’s returns have to beat an assumed 3-4% inflation rate to actually make any money. This inflation treadmill is courtesy of our monetary policy. Is there a better way? In my view, there’s not a straightforward answer to this question.

I count myself as a libertarian and a student of Objectivism. Most of that group would argue to abolish the Fed and return to a gold standard, along the lines of Ron Paul’s argument here, or Alan Greenspan’s old argument here (the two no longer agree on this issue, as Greenspan has abandoned advocacy of the gold standard). I do find these arguments convincing on many levels. The Fed has caused plenty of harm, and there is clearly some political influence on the policies of the Fed. At any time the Fed can devalue the money I’ve worked hard to earn, quietly draining away my savings, and there’s nothing I can do about it.

However, not all of those who want to abolish the Fed want a return to the gold standard. Milton Friedman, for instance, said he would like to “abolish the Federal Reserve and replace it with a computer” which would keep the money supply increasing at a steady rate. Friedman is a famous Nobel-prize-winning economist, and I don’t have the economic education to evaluate his own arguments against those of the gold standard advocates.

In defense of the Fed, they haven’t done all that badly over the last couple of decades. Sure we’ve had some inflation and some bubbles, but it could be worse. Would a return to a gold standard restrict liquidity to such an extent that it would throw us into a new Depression? Even if we did return to a gold standard, how would we fix the earlier implementation to prevent runs on banks that result in banker and depositor suicides?

This uncertainty has kept me from taking a firm stance for or against the gold standard. I do think the Fed can be replaced with something better – something more immune to politics and less susceptible to the whims of politicians and Wall Street. But I’m not sure what form it should take.

In the meantime, as my friend Josh put it, “There are much bigger policy-induced inefficiencies in the market to worry about that are easier solved, barring the rent-seekers and other special interests that stand in the way.” The Fed just isn’t at the top of my list of political concerns right now. Ron Paul also wants to abolish the IRS. How about we start there?