The FED's Unsound Theories

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There are many slips betwixt cup and lip, and thus this introduction before getting to the FED’s unsound theories.

Neither the federal government nor its Constitution have a moral or rightful foundation over any person residing in America who does not consent to them, for civil and political rights include the right of association. If men and women cannot associate with those whom they will in governing themselves, then they have no liberty. They are governed by others against their will. They are slaves. The existing Union is a product of force, including the American Civil War (1861—65), also known as the War Between the States and the War for Southern Independence, and including laws we are made to obey today that lack our consent. Force is not a moral or rightful foundation for government.

But even if the federal government and Constitution had moral authority, the Constitution provides that government with no legal authority and power over any of us. Lysander Spooner has argued this case persuasively and at length in No Treason. For one thing, none of us has signed the document or made a contract with the federal government. Spooner’s many arguments have never been refuted, although some, like Colin Williams, have tried and failed. Even the manner of its passage makes the Constitution lack authority. See Hologram of Liberty by Kenneth W. Royce. The present-day states of the union have little or no viable legal or moral authority either, dating, as they do, from nothing more than monarchical and territorial claims of old. But, if the states did have such rights, the Constitution, as it has been interpreted by the Supreme Court (a body within the federal government that judges the power of the federal government), would still lack authority in nearly all of its actions. A good many state legislators understand this and wish for their states to maintain these rights, as in this resolution introduced into the New Hampshire legislature.

But even if the Constitution did have legal authority, the Federal Reserve (FED) is unconstitutional. Article 1, Section 1 says "All legislative powers herein granted" vest in Congress. The powers are granted in the document. The Constitution enumerates or lists the powers of Congress and confers no others except those necessary and proper to their execution. It is not within the enumerated powers of the Constitution to establish a central bank with the FED’s powers, nor is the FED necessary and proper to achieve any of its listed powers. Indeed, the FED contradicts the articles that mention money. Section 8 gives Congress power "To coin money, regulate the value thereof,…" This does not preclude the right of any person to issue money, so that legal tender laws for private transactions are unconstitutional. And it does not allow government to do anything other than coin money, which the FED does not do. Congress may regulate the value of these coins by stating the gold or other metal content, which is why the article goes on to say "fix the standard of weights and measures."

In sum, the FED lacks any moral and legal authority.

But even if the FED were constitutional, its actions are pragmatically unsound. And because they are unsound, they damage the interests of many Americans. The rest of this article focuses on the practical failings of the FED.

It is really not up to me to prove that what the FED does is unsound in practice or that the theories that found its maneuvers are unsound and lead to damaging consequences. It is up to the FED and the FED’s supporters to prove that the FED’s theories and practices are sound. I am aware of no such proof or evidence that the FED does any good, either in achieving aims that one might attribute to it or in achieving its own aims. If someone will point me to this proof, I shall happily consider and evaluate it.

The closest thing to a defense of the central bank is that it can supply credits when the banking system needs them either seasonally or due to some crisis. Banks would, however, operate more soundly without having this backstop. They would be forced to. They’d also find ways to backstop each other. They were doing this before the FED was instituted. The supposedly limited and restrained backstop initial capabilities of the FED (to provide an elastic currency on short-term collateral) at decentralized reserve banks have long since wilted in favor of legal amendments to the 1913 act creating the FED that have given the FED almost unlimited (and centralized) power to discount almost any collateral and issue credit against it. This is a development that parallels the constitutional relaxations of the Supreme Court. In addition, it did not take the FED long to discover the power of open-market operations that it had. The foot in the door has become a ferocious tiger in the room.

I have looked at the FED’s web site for proof that it does good. At the very top of the page, the FED characterizes itself as follows: "The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible, and stable monetary and financial system." The states met, in one way or another, and united to create a federal government governed by a Constitution. It is not clear whether the FED thinks of itself as the central bank of these 50 states (the United States) or as the central bank of that federal government (also called the United States). In either event, as noted above, the Constitution does not provide the Congress with the power to create a central bank. It does not even charge the Congress with the duty of creating a monetary and financial system, other than to coin money. And if Congress did coin money and regulate its content properly within the Constitution, the nation would be able to create a monetary and financial system that is sound, safe, flexible, and stable. And because Congress is enjoined in the Constitution from destroying contracts, the federal government could not arbitrarily alter the metal content of coins or seize the metal that goes into those coins, as the federal government did in 1933.

So, does the FED provide the nation with a monetary and financial system? If that is the FED’s claim, that claim is false. The FED provides nothing of the sort. The FED began in 1913. The nation developed its monetary and financial system long before the FED existed and has continued to develop it after the FED came into being. The evolving institutions of banking, clearing houses, correspondent banks, credit, money markets, stock markets, bond markets, foreign exchange markets, forward markets, commodity markets, futures markets, and derivatives markets pre-date and post-date the FED. The FED is one institutional development within much broader arrangements of many kinds that constitute money, credit, and capital markets. The FED is a central bank with particular powers, but it by no means provides the nation with a monetary and financial system. It has the power to alter, transform, regulate, and interfere with that system, and it has done so; but the basic system is not of its making. If there were no FED, the nation would still have a monetary and financial system.

If the FED’s claim, contrary to its expansive language, is that it makes the system safe, flexible, and stable, that claim too is false. It is up to the FED to prove that what it says is true, but it has never done so. If it has and I have missed it, which is surely possible, I will happily consider its claim. We know for a fact that the value of the paper dollar, which is the FED’s direct liability and note of issue, has experienced a long-term deterioration and that the nation has had to deal with and suffered from long-term inflation. There is hardly stability in this. We know that within that long-term downtrend, the dollar has fluctuated violently in value at times, both up and down. We know that these fluctuations have caused and/or contributed to violent fluctuations in employment, prices, and the production of goods and services. Where is the claimed stability for our economy? At times, the nation has endured severe depression under the FED, as in the 1930s, and that lengthy episode was preceded by the FED’s mismanagement of the dollar during the 1920s. The same thing is happening at present, again preceded by the FED’s inflation of bank reserves; and it is likely to occur again. Where is the safety in the FED’s monetary management? We know that inflation raged during the 1970s as a consequence of the FED’s loose monetary policies, and that the result was a series of severe recessions.

The FED makes no attempt to prove its claims, and it cannot prove them for they are false. The FED claims to be doing good for the nation. The Congress acts as if the FED is doing good for the nation. The system continues on its way with the powers-that-be acting as if the FED does good for the nation. Congress even wants the FED to have more powers. But there is no evidence that the FED has done good for the people at large who constitute the nation. The evidence, past and present, suggests the opposite.

The reason why this institution persists, which is to the detriment of many Americans, is that it benefits certain interests within the State and the banking industry, as well as certain Americans at large. Central banks benefit the States that create them. Historian Edwin J. Perkins writes of the Bank of England: "During the eighteenth century the British national debt had risen steadily in order to finance a series of overseas military campaigns, and the Bank of England had regularly accommodated the Exchequer [the Treasury] in financing budget deficits through the direct purchase of numerous fresh issues of government bonds running into the millions of pounds. Indeed, the Bank of England had been created in the seventeenth century for the explicit purpose of assisting Parliament in floating new debt issues." (From Perkins on U.S. Financial History and Related Topics.)

One may argue that the British military ventures that created the Empire benefitted the nation. One may similarly argue that the American military ventures, which could not have occurred in their frequency and size without the FED, also have benefitted the nation. This, however, is a thesis that is extraordinarily difficult to maintain. Great numbers of persons in the nation came to understand that the Vietnam War was wrong and that the Iraq War is wrong. As time passes, greater numbers may come to understand that these wars are not exceptions but the general rule, and that other American wars have equally borne bitter fruit in the making, the executing, and the aftermath.

Ben Bernanke knows that the FED mismanaged money in the past. For example, in a 1995 article he writes: "First, exhaustive analysis of the operation of the interwar gold standard has shown that much of the worldwide monetary contraction of the early 1930s was not a passive response to declining output, but instead the largely unintended result of an interaction of poorly designed institutions, shortsighted policy-making, and unfavorable political and economic preconditions."

In referring to "poorly designed institutions," Bernanke refers to various problems of the gold exchange standard and how central banks operated in the 1920s. For example, he writes "…for a majority of the important continental European central banks, open market operations were not permitted or were severely restricted." But in the current situation, central banks have had no such restrictions. They have been merrily inflating for a very long time. Why then has the world suddenly been plunged into depression? Why have commodity and asset prices fallen so sharply? This cannot be blamed again on a lack of power of central banks to inflate.

Will the next generation of central bankers and economists like Bernanke continue to ignore the connections between prior major inflations and subsequent depressions? Will they come up with yet another set of particular circumstances and blame the depression on them? There is never any shortage of such factors. In this case, there are hedge funds, derivatives, leverage, ratings errors, low loan standards, and securitization to name a few.

"Shortsighted policy making" refers to the errors of the FED and other central banks. Bernanke proposes to do better, but will he and can he? His own research only tentatively endorses two of the three main policies that he is now using, which are a huge expansion in the FED’s balance sheet, and the large-scale open market purchases of specific securities such as mortgage-backed bonds. In 2004, he wrote:

"Despite finding evidence that alternative policy measures may prove effective, we remain cautious about relying on such approaches. We believe that our findings go some way toward refuting the strong hypothesis that nonstandard policy actions, including quantitative easing and targeted asset purchases, cannot be successful in a modern industrial economy. However, the effects of such policies remain quantitatively quite uncertain."

Is it right that he and the FED have the power to experiment with these untried solutions on a massive scale? Should we be made to bear the risks of this enormous gamble? How can this gamble possibly be reconciled with the notion that the FED is bringing us a safe and sound monetary policy? That policy is certainly flexible, but is that good? Not if it is an ongoing and untried work-in-progress whose results may prove disastrous. If the FED still exists in a few years, another chairman will probably look back and cite the poor institutions and shortsighted policy making of the current FED and its officials. We can do that now merely by applying sound economic analysis to those policies.

Bernanke has a peculiar blindness to causation that is difficult to understand. His thinking about the Great Depression starts in the 1930s. He does not seek its roots in the FED’s actions in the 1920s and in the boom that the FED promoted that eventually came to grief. Similarly, in 2008, Bernanke has not gotten to the roots of the current depression. He acts as if depressions suddenly spring full-blown upon us and we need only deal with them at that point or before — with more inflation.

Bernanke’s answer to depression prevention and control is incredibly simple and nave: "Thus we believe that policymakers should continue to maintain an inflation buffer and to act preemptively against emerging deflationary risks."

The simple fact is that policymakers maintained inflation at high rates for decades on end. There has been a very large inflation buffer! They have acted preemptively against deflation for decades! Bernanke has to be wrong, because after all of that, the deflation in prices has occurred anyway. The inevitable depression has arrived.

Bernanke’s erroneous ideas would be a matter of indifference to me if Bernanke had no power. I would ignore his flawed ideas; and if I did stumble across them, I would dismiss them. Unfortunately for us, we have elevated him (and others) to power whose ignorance and bias can and will harm us greatly. We need to learn that we should never allow people to have such unchecked power, no matter how capable or learned we think they are.

In his 1995 article on the macroeconomics of the Great Depression, Bernanke argues that deflation (he means price deflation) propagated the depression and that inflation (here he means monetary inflation) alleviated it. His solution to a depression is therefore the inflation of money, and this is what he is now fostering to the best of his ability. Bernanke is not interested in basic causation. He thinks that the results of basic causes can be circumvented or thwarted by subsequent actions. He thinks that deflation (in prices) is the proximate cause of depression. Even in that regard, his thinking is wrong. Deflation in prices is a phenomenon during a depression that is correcting a variety of prior imbalances that have been built up. It is a liquidation that needs to occur in order to establish a firm basis for economic growth. That basis has to be rooted in prices. Businesses cannot begin to operate again and hire people unless they have some reasonably stable expectations about future prices and demands.

Deflation in prices is not a never-ending or self-propagating mechanism as some believe. Falling prices do not cause more falling prices. This is no more true than the opposite view that rising prices cause more rising prices. Some believe that everyone who observes falling prices will expect them to fall even more and hoard money as a result rather than spend it or invest it. This cannot happen on a broad scale by itself any more than prices can rise on a broad scale by themselves because they have already risen. If prices kept on falling, someone with a given amount of money would eventually be able to buy Rembrandts for small amounts or be able to buy factories and hire labor at small amounts. And he’d be able to sell the products to other people who had also hoarded their money. In other words, for a given stock of money, there would be immense profit opportunities to use capital assets to produce products in demand if prices kept falling. The existence of that stock of money prevents prices from falling indefinitely. Furthermore, given the monetary freedom and opportunity and not restricted by federal law, people will create their own money and scrip. They will see the profit opportunities presented by unemployed labor and unemployed capital goods, and they will create their own credit and payments mechanisms in order to bring them back into employment.

Bernanke emphasizes that bank runs cause a collapse in bank reserves and the money supply, and that withdrawal of money from foreign banks with questionable currencies does the same. He mentions the failure of Austria’s largest bank, Kreditanstalt, as a trigger in May of 1931. There is no doubt that a run on American gold began after Austria failed and after England unnecessarily went off gold. That action brought all currencies into question. Confidence in paper currencies plummeted.

But Bernanke does not raise the central questions. Why were these currencies questionable? How is it that banks with questionable practices could thrive and prosper, before they collapsed? Why have central banks in the first place? What might a stable monetary system look like? How is a depression related to and caused by monetary causes that occur in the boom? Bernanke is very concerned about the monetary cause of deflation in the 1930s but relatively unconcerned with the monetary and other causes that preceded the 1930s. He has very much ignored those, having made up his mind that both central banks and inflation are good things to have around.

Price deflation and depression in the 1930s, Bernanke fails to acknowledge, are the consequences of a severe prior central bank inflation that took place on three separate occasions when the FED, during the 1920s, stimulated the economy with the means of excessive credit. These were in 1922, 1924—25, and 1927. The third of these stimulated the stock market to an excessive degree, whereupon the FED reversed policy during 1928 and raised the rediscount rate in 3 steps from 3.5 to 5 percent. The boom went on for another 14 months. The FED could not have continued its inflation indefinitely without creating a severe inflation that would have disrupted the economy and sent stock prices lower in real (and perhaps nominal) terms. Contraction becomes a necessity at some point, the only alternative being an even worse contraction later. The 1920s money-induced boom would have come to an end anyway as it was associated with imbalances, unrealistic and uncoordinated prices, excessive leverage, attenuated balance sheets, and mal-investments. But these are common features of credit-induced booms. They were recognizable in the last 10 years, had Bernanke only looked, rather than turned a blind eye.

Bernanke has not yet addressed what it is about today’s central banking and the monetary system, with all of its powers, that has contributed to the current depression. He ignores the biggest question: why, despite the fact that central banks are not using the gold standard, has the world again been plunged into a depression? If, as he has written, it was the adherence of central banks to the gold standard that brought about the worst of the Great Depression, why is another depression in progress when central banks no longer adhere to a gold standard?

Bernanke criticizes the FED’s contractionary policy in 1928, but he is blind to his own contractionary policy. For the two years after he succeeded Greenspan, he kept the monetary base to a 1 percent growth rate. For most of that period he held the Fed Funds rate at 4.5 to 5.25 percent. This policy became something of a necessity in view of the mounting imbalances in the American economy, which included a stock price bubble and a housing and real estate bubble, both identifiable by using traditional value criteria. The imbalances included a massive credit expansion, extensive leveraging, loss of the country’s manufacturing base, a huge trade deficit and massive government debts. The FED’s easy money policy had gone on unabated, not just in 3 episodes as in the 1920s, but for decades. The monetary base increased from 70 billions to 800 billions between 1972 and 2006, when Bernanke took over. This was at a rate of over 7 percent a year, which is far in excess of what might reasonably be needed in an economy growing at 3 percent a year. The FED could not continue to pump out money without destroying the dollar or otherwise disrupting some part of the fragile system that its own actions had created. The illusion of a safe, flexible, and stable monetary system had eventually to give way to the reality that is now upon us. Eventually the imbalances had to be corrected.

Bernanke has now reinstated the FED’s inflation with a vengeance.

The FED’s policies are unsound in numerous ways, some of which I will mention.

The FED operates on the unsound theory that the economy is demand-driven. A sound economy is supply-driven, that is, production driven. Every person who produces goods and services has thereby produced the means to purchase (demand) goods from others who have also produced goods and services. Demands (wants) are always infinite. They can only be satisfied (and price-rationed) when there is supply (production.)

The FED operates on the unsound theory that it can affect demand in a sound and stable manner by influencing credit and by influencing the prices of certain assets. Typically the FED stimulates by buying short-term Treasury bills and raising their prices.

The reality is that there are no stable and sound connections between the FED’s influences and the economy at large. The FED hits buttons but the economy, not being a machine, does not respond immediately or in stable ways over time. The markets in an economy are very diverse and very complex in their interconnections, and all that happens in them arises from human actions, valuations, and expectations that cannot be contained in Bernanke’s favorite vector autoregression models. Anyone who looks at the data will find that many inexplicable things happen in the inter-market relations among wages, rents, consumer good prices, wholesale and commodity prices, exchange rates, interest rates, and the prices of capital assets. On a disaggregated basis, even more inexplicable changes occur. There are numerous frictions, costs of adjustment, shifts in demand, and lagged effects that are always occurring and shifting. There are industries that are dying and industries being born. There are industries going overseas, and there are overseas industries coming ashore. There are constant regulatory and tax and policy changes. There are wars.

The FED thinks that it can create stability by using its influence on short-term interest rates. This is a pipe dream. This is not to say that the FED’s actions will have no effects. They will. But they are unlikely to be what the FED expects and they are likely to cause more harm than good.

The FED can drive down short-term interest rates. If people expect this to continue, one effect is that the economy will shift to the cheaper short-term financing. This will move many people and businesses away from sound financing by long-term means.

Alternatively, long-term rates will come down, and this will distort the allocation of capital. There will be investment in uneconomic projects that would be rejected if the interest rates reflected real saving.

When the FED inflates, it creates uncertainty over future prices and interest rates. The FED is able to alter inflation expectations as well as the uncertainty of those expectations. It creates the instability that it claims to avoid. The FED is a large and powerful player. Its every statement causes assets to change price. Its every move can change the value of the currency we use. There is nothing more basic than the standard of value. If this is altering at the FED’s whim, where is the stability?

When the FED inflates, money is not neutral. It affects certain prices and not others in ways that lack a basis in the realities of demand and supply. This disrupts the economy by altering price relations and disturbing the coordinating effects of prices. Business firms alter their production as these effects ripple through the economy. When the inflation ceases, they find that their plans cannot be fulfilled.

The FED’s actions cause a lack of coordination with foreign economies, which have their own central banks and go their way with their own policies.

But, to a great extent, many foreign central banks are on a dollar standard. They use dollar assets as reserves. They amount to branches of the FED that create derivative currencies off of the dollar assets. The problem then becomes that the FED induces worldwide instability, worldwide bubbles, worldwide imbalances, and worldwide mal-investments.

The FED’s actions usually prevent prices from falling due to productivity increases. The benefits of production then do not feed through to the pocketbooks of those who produce and consume.

The FED’s current zero-interest rate policy will probably cause speculators to issue credit in dollars at vanishing cost by selling federal securities short or by borrowing at low bank rates. Having received dollars, they can buy other assets with them and create bubbles. This is exactly what the FED wants to happen. It will be the yen carry trade revisited. It will be a dollar carry trade. It is highly likely that the yen carry trade (having arisen from a zero-interest policy in Japan) that has gone on for years now, has contributed to the current financial market crashes and depression by having supported worldwide financial bubbles. Hedge funds, investment bankers, and many other investors and speculators have ended up buying overpriced assets using cheap borrowed funds. And they did this in part in an effort to obtain yields that could no longer be found in ordinary markets that had become overpriced. The FED is now encouraging a repeat performance.

The FED’s focus on the quantity of credit ignores the quality of credit. We have seen that a vast increase in the quantity leads to a lowering of credit standards. With credit widely available and a boom expected to continue, the quality of credit declines. We then observe the system accumulating loans that fail when the boom slows down or reverses. Again, the FED promotes instability.

Economics students are routinely taught that central banks are a good thing or that they are the highest stage to which banking has now evolved. This is a presumption offered without proof. There is no proof that I know of that central banks are a good thing. The FED offers none. This article presents a few of my reasons why the FED is a bad thing.

It may be thought that I am indirectly arguing here for 100% reserve banking. Those who do not know my position may think that is the only alternative to the FED. It is not. The alternative that I favor is known as free banking. I favor monetary freedom, and that may include fractional reserve banking without a central bank. The works of Larry Sechrest, George A. Selgin, and Kevin Dowd will provide a good idea of what free banking is about. One might start with Free Banking by Larry Sechrest.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.

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